Raising interest rates is traditionally seen as a tool to control inflation, but that is based on an assumption that inflation is being caused by traditional drivers such as increased consumer demand. However, the current inflationary driver is Brexit and the resultant fall in the value of the pound, which is making imports more expensive.
Since the 2007 crash, wages have been depressed and demand has been driven by unsustainable levels of personal debt. As a result, raising the Bank of England (BoE) interest rate will now increase the mortgage payments of consumers who are already stretched and make those with high personal debts more likely to default (especially if raising interest rates becomes a trend).
Traditional economic thinking assumes that raising prices are driven by a rising economy but the UK economy is stalling. The economies of independent Northern European nations grew 3.31% in 2017 – whilst the UK’s only grew 1.8%.
There are only two ways to get the economy going again: firstly, for consumers to increase their spending. However with low wages, rising inflation and now increased interest rates making consumer debt-funded spending less attractive or even advisable, this is not going to happen.
The second way to boost the economy is to increase public spending but austerity is in full swing, even to the extent that some Councils in England are at risk of failing. The Conservative Party mantra of small Government and reducing Government spend has led to a flawed policy of austerity. According to the Westminster Government funded office of Budget Responsibility, tax hikes and public spending cuts of an extra £39 billion a decade will be needed for the next 50 years to get UK national debt levels under control – however, as austerity slows growth and Brexit adds massive market uncertainty and a weaker pound, inflation will rise again making it more likely that the BOE will gain have to raise interest rates.
Raising interest rates when the economy is stalling will put downward pressure on already low pay rates and stall investment, lowering productivity and creating a downward spiral of lower spending, lower standard of living, higher debt interest payments for consumers and thus weakening the economy again.
It is clear that the BoE, had it not raised interest rates, may have helped drive more unsustainable mortgage borrowing which is a significant danger to the economy as house prices across the UK are as much as 10% over priced and as much as 30% over priced in London and the South East. Indeed, the Bank of England has issued a warning that house prices could fall by a third and interest rates soar by 4% or more and the economy may enter a recession in the event of a no deal Brexit.
Ending austerity and increasing public sector investment in capital projects aimed at increasing productivity, and frankly ending Brexit, is the only way out of this mess and both of these options are being ruled out by the Westminster Conservative Government (and its Labour opposition) on dogmatic rather than sensible economic grounds.
The reason the UK Government is married to the failed policy of austerity is because they do not understand the difference between how a household budget and a national budget work. The argument that when income falls you need to spend less makes sense when you think of household budgets, but national economies don’t work that way because Government income is related to what you spend. When the government primes the economy, the money it invests generates more economic activity, lots people out of poverty and generates more tax revenue.
If you want to understand this better there is an easy visualisation exercise I wrote three years ago that can help people to easily understand why austerity is bad for the economy and why increases in Government investment will create growth, increase revenues and lower the national debt.
You can find it here – Why austerity is failing and how maximum devolution drives growth