The Illusion of Inflation: A Critical Look at Economic Policy

In the UK, everyone prays at the “temple of inflation,” but few truly understand what inflation actually is. The number that people often associate with the ‘rate of inflation’, typically the Consumer Price Index (CPI) or CPIH, derives not from something intrinsic to the economy but is, in fact, a flawed fabricated metric. To create it, the Office for National Statistics (ONS) selects numerous items to place in an imaginary basket of goods, then tracks how their prices change over a year. These changes are then weighted according to how much people typically spend on each item, feeding into a final number we know as inflation. At first glance, this might seem logical, but it’s fundamentally flawed. While the metric itself isn’t insidious, what is truly concerning is how the Bank of England uses this flawed measurement to conduct inflation targeting.

The 2% Target: A Misguided Goal?

Central banks worldwide strive to maintain inflation at 2% to stave off deflation, which is seen as a haunting prospect that could lower consumer spending. The idea goes something like this: Deflation is falling prices of goods and services, meaning that the price of something this year would be lower next year. Therefore, deflation could discourage spending because people would save more and spend less, largely because their money will be worth more in the future than now.

This theory, however, is fundamentally flawed. It’s absurd to think that people would avoid buying a TV or cooker this year because next year it could be £8 cheaper. Yet, this is the rationale behind central banks’ policies. They aim to ensure that money continually loses its purchasing power by maintaining a 2% inflation rate, which means that the basket of goods in the CPI increases in cost by 2% each year. The 2% rate is chosen as a buffer to prevent deflation and encourage spending rather than saving.

The Bank of England’s Struggle: 2009-2021

In the period from 2009 to 2021, the Bank of England struggled to hit their 2% inflation target. Consequently, they held interest rates at record lows. The idea was that lower interest rates would raise inflation by encouraging more people to take out loans, thereby creating more money. It’s crucial to understand that every time a loan is issued, money is essentially created out of thin air. If more money is created, there’s more in circulation. Theoretically, you then need more money to purchase the same quantity of goods, thus inflation occurs.

However, during that period, money creation, when coupled with Quantitative Easing (QE), primarily inflated the prices of high-value assets, including housing, cars, and luxury goods. Meanwhile, the prices of everyday items like TVs, bread, milk, and washing machines remained relatively stable. In fact, we’ve seen a decline in the relative costs of numerous items. For instance, new computers, once priced at £1000 during my childhood, are now available for just a few hundred pounds. I recall buying a 14-inch TV for £75 from Argos when I was about 9 or 10 years old. Now, one can purchase significantly better TVs for less than £100.

The Role of Technological Advancements

Such price reductions can be attributed to advancements in various fields. Semiconductors, logistics, improved modelling software, and more reliable manufacturing processes have all contributed to decreasing production costs. The efficiencies gained in appliances, such as refrigerators, have also lowered consumers’ costs by reducing the operational expenses of shops. Even factors such as the use of larger, more efficient tractors have come into play, allowing a single farmer to accomplish more work in less time, consequently reducing labour costs on farms.

Interestingly, when inflation did occur in the 2009 to 2021 period, it was often due to government intervention rather than market factors. For instance, while gas prices remained stable, energy costs increased due to poorly planned green policies that inadvertently drove up the price of energy.

The Fundamental Flaw in Inflation Targeting

Consequently, the economy was in a prolonged period of natural deflation when the Bank of England was trying to stimulate inflation, but they only really succeeded in inflating the cost of assets. The measure of inflation they were trying to push up through inflation targeting, therefore, has a fundamental flaw. It does not account for technological advancements that lead to efficiency and cost savings, which should result in lower production costs for almost everything and therefore lower costs to the consumer and result in deflation. They created an asset bubble because inflation targeting is like using an asteroid to hammer in a nail – the wrong tool for the wrong job.

The Post-2021 Inflation Surge

After 2021, following the Bank of England’s inflation of asset prices, we experienced the Covid-19 pandemic. Demand for everything dropped, factories shut down, and stock in warehouses depleted. When the pandemic restrictions eased and people returned to work and resumed buying things, there was a high demand for goods and services. The demand was there, but the supply wasn’t, which nudged inflation up as people were willing to pay more for the goods they wanted.

Then, when the Ukraine conflict occurred, the country was primed for a significant leap in inflation. This wasn’t due to anything inherent in the economy, but rather because the cost of gas and fuel skyrocketed. The prices of goods and services surged because gas and fuel costs influence everything in the economy.

The Ripple Effect of Energy Prices

Increases in gas and fuel prices affect all sectors, not just home energy costs. Here’s how:

1. Agriculture: Fertiliser for farmers is produced through the Haber process, which requires natural gas and substantial amounts of energy. Farmers drive tractors that use diesel, the price of which has surged.

2. Transportation: Lorries, which also use diesel, have experienced a rise in costs to move goods from warehouses to shops. The cost of commuting to work, which requires diesel or petrol, has jumped.

3. Construction: The industry, which now cannot use duty-free red diesel, has seen costs increase.

4. Retail: Every retail shop in the UK uses electricity. A manager at Mountain Warehouse informed me that their company-wide energy costs increased by £6 million due to a leap in gas prices. This occurred before the real shock of price increases.

5. Service Industry: Restaurants, fish and chip shops, and swimming pools are all affected by increased energy costs.

Consequently, every product you buy in a store has its price indirectly influenced by the price of gas. This is where we encounter the problem with raising interest rates today.

CPI inflation is still high because it measures prices over a year, and the market hasn’t adjusted to the lower energy costs. This is problematic as the UK price cap (which relates to average energy costs for an average household) was around £2000 until October last year. It then jumped to £2500 when the Government’s price guarantee kicked in. So, we are still seeing the effect of this increase in the CPI figure even though the cost of energy has fallen and will drop further on July 1st.

The Bank of England is now setting the base rate, and therefore mortgage rates, on a figure of inflation which has not taken into account the decrease in wholesale prices of gas and energy. This is a deflationary pressure that will occur in just a few days.

Signs of Deflation on the Horizon

We can already see food costs dropping in supermarkets, but costs will fall across all sectors over the next few months. Expenses for heating, restaurants, swimming pools, fertiliser, and electricity for every business across the country will decrease, and therefore inflation will fall, potentially leading to deflation.

The Bank of England will likely argue that falling inflation is due to the raising of interest rates and that they did a ‘good job’, but this isn’t the case. It is entirely due to the fall in gas prices, which is a consequence of European storage being full and therefore Europe demanding less gas, with supply increasing from other parts of the world to replace Russia’s supply. Ironically, the Bank of England raising interest rates will increase inflation because it elevates the cost of housing in the CPIH measurement.

The Potential for Deflation and the Bank’s Response

In theory, we should see a period of deflation following the energy cost falls, but the Bank of England will do everything in its power to stop that. Just as it dropped the ball with its butter fingers on inflation, it will likely mishandle deflation as well. It will probably rapidly drop interest rates and carry out more QE to stabilise the economy. But this could be a disaster, like the train-wreck they are currently ploughing through the country.

The Theory Behind Interest Rate Hikes

The theory behind raising interest rates to reduce inflation is primarily based on limiting money creation via loans. People take out fewer loans, so less money is created, and more is destroyed. This, in theory, reduces the money in circulation, and if there is less money to go around, the cost of goods falls because its relative value goes up.

However, this simplistic view fails to account for the complexities of modern economies. It doesn’t consider factors such as technological advancements, global supply chains, or the varying impacts of interest rates on different sectors of the economy. Moreover, it assumes a direct and predictable relationship between interest rates and spending behavior, which isn’t always the case.

Conclusion: The Need for a New Approach

The current approach to inflation targeting and monetary policy is deeply flawed. It relies on imperfect measurements, oversimplified models, and outdated assumptions about economic behavior. As we’ve seen, the Bank of England’s attempts to control inflation have often led to unintended consequences, such as asset bubbles and increased inequality.

What’s needed is a more nuanced and flexible approach to economic management. This could involve:

1. Developing more accurate and comprehensive measures of economic health that go beyond simple inflation targets.
2. Recognizing the role of technological advancement and productivity gains in naturally reducing prices.
3. Implementing more targeted policies that address specific economic issues rather than relying on blunt instruments like interest rates.
4. Considering the long-term impacts of monetary policy decisions, not just short-term inflation targets.

Only by adopting a more sophisticated and holistic view of the economy can policymakers hope to navigate the complex challenges of the 21st-century economic landscape. The current system of inflation targeting and interest rate manipulation is, as this analysis has shown, little more than smoke and mirrors – a relic of an outdated economic paradigm that is increasingly ill-suited to our modern, technology-driven world.