Stewart Hotston

Hope, Anger and Writing



Interest Rates and Inflation (this is a long one)

Everything here is my own view and does not reflect upon any institutions I may work for or be involved with. That’s not to say what I’m going to write is controversial (it largely isn’t among experts) but, you know, this is me.

It may also be that you have a view on this already and on that basis nothing I’m going to say here is written with a view to changing your mind should your view be different to mine. I am going to be snarky and if you find your view ridiculed? Sorry, I think these issues are important enough that those whose approaches would leave us all worse off need, at the very least, to be made fun of.

A couple of housekeeping points. First – prediction is really hard, especially when it’s about the future. (thanks Niels Bohr). I’m not going to talk about the future in this post. I’m simply going to talk about what some things are and what we know about them thanks to past events. Second, I’m going to try to keep jargon (such as monetarist, neo-liberal, keynesian, chicago school, exogenous, M0, M1 supply etc) out of the text – not because I can’t swing my educated dick around with the best of them but because this isn’t a policy document.It’s something I wanted to write to explain some stuff about inflation, rates and the consequences for you and me.

Third and final point of housekeeping – economics is not a science no matter how much maths is used, no matter how many formula. It is much harder than most science. It is also, as a discipline, much more arrogant. Although I’m trying to explain something here, I’m also giving you a health warning that although looking back we can try to describe what happened and then venture explanations as to why – the truth is there are no ‘great men of history’ driving what happens.

Right. That out of the way, let’s take a look at what I’m interested in talking about today.

The BoE describes Inflation as the word we use for rising prices. Which is annodyne without being incorrect.

The rate of inflation is therefore the rate at which prices are rising. Again, accurate without being insightful.

What that doesn’t do is explain WHY prices might be rising, what impact that has nor the fact that the measurement itself is…a thing worthy of examining.

So, first, what creates inflation?

Some people blame capitalism and suggest we could have a zero growth kind of world. I wish them luck. Why the snark?

Because inflation is a measure of what it takes to maintain the standard of living we have now. Think about that for a moment. Inflation is a measure of the cost of something at a given moment in time against another moment in time. I always struggle to help people see how inflation is a measure of cost over time. It’s not a measure of something today.

Think about it like this: I have built a road. To pay for the materials, expertise and labour I have to have money (and investment in stable systems in place over time to create expertise, tools and those same materials). I may have this money through two routes. I can save up until I have the funds OR I can borrow the money. Borrowing is essentially bringing money I might have in the future into today.

So I build my road. The money is spent. The road lasts forever.

Wait. Something isn’t right with that statement.

Yep. The road doesn’t last forever. It degrades. It crumbles and gets potholes through use. It needs maintaining to keep it in good nick. You could think about inflation as the amount you spend through time to keep that road in good condition. It’s not a perfect analogy but hopefully you get the point – which is inflation is a record of the cost of having something over time.

I think it’s a better description than saying inflation of 10% means a shirt that cost £10 last year will now cost £11 because it gives you a sense of why that additional cost has materialised.

So far so vague.

let’s delve into the weeds a bit. To do that we’ll need to leave the rather hand wavey/philosophical description above and assume that inflation’s about people wanting things and what they’re prepared to pay for them that drives prices – it’s obviously way more complicated than that. We’ll also ignore why basic measures of inflation entirely ignore the indirect impact of how society is structured and the economic and social policies in place for that society (and those it interacts with). For now though let’s go back to school for a moment and assume that what high schoolers and undergraduates are taught about inflation is actually true (pfff).

There’s basically two types of inflation. The first is what we call demand led inflation. This really means that you want something and you’re prepared to pay for it. If there’s not a lot of something and you still want it you might actually be prepared to pay more for it and the people selling it will therefore choose to charge you more because you’ll still buy it when they charge more. That is demand led inflation because your demand led to prices increasing.

Side Bar: this is not really what demand led inflation is – because that entirely ignores unequal demand, inequality and the elasticity of demand. ie. you may want something badly but can’t afford it, so you don’t buy it. I can afford it but the seller knows I can afford it and that I’ll still choose to pay for it if it’s twice the price. So they raise the price twofold and hey presto we have inflation. Except that the costs haven’t changed and now the seller is richer and there are lots of people(think about this globally) who can’t afford this thing that’s desirable. That might sound reasonable until you think of it being clean water or access to medicine. Inflation is too often thought about in connection to luxuries and not often enough with basic human essentials in mind. It’s important because sometimes the demand that we all have access to something is reasonable, compassionate and humane. Other times it’s not but the two things can both be true. END of Side Bar

There can be many reasons for this kind of inflation. You may be wealthy. You may have a critical need. You may simply want something for no other reason than you want it.

The other side of this coin is supply led inflation. Basically when the person/people/companies selling something jack up the price compared to the last time you bought it. Think Martin Schkreli who tried this with medicines and was, in the end, convicted although the actual gouging he engaged in wasn’t the illegal part (thanks laissez faire economics!).

The reasons for why supply led inflation may rise are also many but are rarely the same as those on the demand led side. They could be that the prices of raw materials have increased or the cost to heat their factory or the wages they must pay or the im(ex)port taxes levied by international treaties. They may be required to adjust their methods or invest in new machinery. Sometimes just the cost of keeping things running can lead to them needing to put cost up.

Side Bar: you may have heard of shrinkflation – this is a recent word for something that’s as old as the hills. When a company needs to put prices up it may not be able to because demand for that product would collapse. So it might keep prices the same but reduce what you receive for that. It may be a smaller chocolate bar or a flight with no free meal or a train that has no tables…these are all examples of the same thing. END of Side Bar

The perils of high inflation are unique to the human condition. high inflation, regardless of the cause, a the fact that prices are rising fast. Now, high inflation sounds like its a thing that happens in a moment but it’s not and this is REALLY important to grasp. Rising prices rise over time. That means that what costs £10 today may cost £12 next week but then £15 the week after. If you’re earning only £10 then both of those rises are damaging to your ability to just STAND STILL and maintain the quality of life you had yesterday.

You could just give everyone more money so they can afford everything but that too is definitely inflationary as suddenly people will spend this will definitely lead to SELLERS raising prices because they can and that will bring us right back to where we started but WITHOUT solving the problem of everyone spending more just to stand still.

It’s really important to realise that most inflation is transitory. By which I mean that there is a period in which the prices rise and then they stop rising. Think of it like this – when you accelerate from 20mph to 30mph there’s a period when you’re accelerating but when you reach 30mph you stop increasing your speed. Inflation is the acceleration and, just like driving faster, it stops when you reach that new level/speed.

Most of the time at least.

Knowing this doesn’t help if your wages don’t match the increased costs. Now, not being able to have the same quality of life as you did yesterday sounds bad and it is. For many people they absorb these costs and carry on but for many others they find they can’t eat or pay for heating or afford new clothes. For the least well off they discover they can’t afford to live in a house with walls and a roof. Inflation is exceptionally damaging in many circumstances because it always hits the poorest hardest, earliest.

Now, you’ll often find a moral dimension in inflation arguments and it runs like this. Talking heads moan about workers wanting more money arguing that if they do get more money they’ll then by able to buy more and therefore drive prices further up. No one ever criticises bosses for taking huge payrises or suggests that billionaires are responsible for asset bubbles (news flash, they’re a symptom of the disease not the cause, but they’re a cancerous symptom, one that spreads and does damage similar to but not identical with the problem from which they burst like nasty buboes). This one sided offence and moral castigation tells you people i) don’t understand inflation and ii) think workers should know their place and that place is to do work and not really be humans who might live for other reasons than work.

However there is some truth in the argument if you carefully excise the moralistic puss. It is this: if costs remain stable then demand led inflation can lead to price rises that increase inequality and damage economic stability. I come back to the fact that the ultra wealthy do this simply by existing as nodes for wealth accretion but hey, that’s just me.

In these circumstances, and these circumstances alone – that is where it is the great mass of people driving prices up via demand for more – then raising interest rates can have some impact. Not a huge amount, certainly not directly on people since the majority of homes in the UK are owned without a residential mortgage attached (the ONS estimates that only 28% of homes have a mortgage attached)) and so rising rates will have no DIRECT impact on the majority of people. If you factor those in with fixed rate mortgages the proportion remaining unaffected rises even higher. (and let’s not talk about the US where standard fixed rates are between 10-30 YEARS, not 1-3). For these people rates could rise to 10000% and they’d still not be directly impacted.

For others who borrow, the rate at which they borrow may only reset once every few years. So raise it today and rising rates won’t impact them until a few years from now.

Yet in fiction and in many economics textbooks and certainly in most news media, this is the only kind of inflation anyone ever talks about (because it’s easy to be moralistic about individual choices and being judgy sells copy).

What we’ve experienced in the last twelve months certainly has some elements of this – there was a huge amount of pent-up demand post lock down. Yet inflation was exceptionally low during lockdown and so this, really, can be balanced out by its later contribution to our overall inflation numbers (the rate at which prices rose reflected, in some part, the sudden demand in the market after months of people being stuck at home. This isn’t correct across many sectors but it’s close enough to being right that we’ll let it pass unremarked).

What isn’t well understood outside of banks and hedge funds, insurers and other financial professionals is this: the inflation that kicked UK CPI to 11.1% for it’s October reading is largely led by supply led factors. That is, factors that I as a consumer have no influence over. None at all. My buying habits have largely been to stay where I was this time last year. What I’ve discovered is that to do so I have to spend 11.1% more (on average – for those with less the inflation rate could be as high as 20% because the items they want have seen more extreme localised inflation). This isn’t me wanting more, it’s me struggling to stay still. Again, when I ask for a pay rise it’s not to buy more but to buy the same as what I was buying last year! That is hardly demand led as traditionally defined.

Why is this? A bunch of complex reasons all coming together at the same time.

The first is the impact of lock downs on a global scale. Factories shut, ships didn’t sale, ports were closed, mines stopped mining and people stopped planning for normal levels of demand. This meant that when the world started to ignore covid and carry on as if it wasn’t there (thank goodness for vaccines) the demand for life to return to how it was in 2019 simply couldn’t be met.

There were no factories producing widgets, no ships to take them and no ports to receive them. These shortages resulted in companies struggling to fulfil demand and prices rising because just to ratchet up production and mend supply lines and get shit around the world demanded new, unforeseen investment. It turns out that if you turn big things off it’s not simple (or free) to switch them on again.

Then the fact that some places responded to proposed shortages by agreeing to pay more than others. This demand inflation wasn’t created by you but by companies who wanted to sell to you and knew they could make you pay more just to stand still. So shortages turned into prices rises.

No one was earning more at this stage, we were just paying more.

Then came the war in Ukraine which obliterated the world’s grain supply as well as making its energy supply something it hadn’t been for 30 years – a geopolitical existential crisis.

Again, the desire to be warm is not a demand led problem. it’s a supply led problem. We ‘demand’ being warm but it’s not us pushing prices up wanting to be WARMER. We want to be as warm as we ever were not baking like never before…The political risk involved in this market which is a fundamental for EVERYTHING else meant that as unit costs for generating energy increased everything else also became more expensive. That is a cascade which means disproportionate non-linear rises in manufactured goods downstream. That process still hasn’t finished playing through the global system and there’s nothing to say it won’t continue for at least another 18 months (sorry, just the messenger here).

Now, I hear lots of ill informed people saying we need to raise rates to suppress demand. The desire to be warm when it’s -4C outside isn’t going to be suppressed by having the price of energy go up. You will impoverish people or, worse still, kill them from lack of heating. But you won’t make their desire to be warm go away. Fundamentals like this are not luxuries and the callous and wilful ignorance that refuses to see the nuance here infuriates me. That’s not the worst of it.

In a supply led inflationary scenario raising rates doesn’t work to bring prices down. Prices stop rising by themselves. Now, for those at the back – something really fucking important. When inflation falls from 11.1% to, let’s say 5%, that doesn’t mean prices are falling. It means prices are STILL RISING but only at a slower rate. In our car example, it means it’s going to take me longer to reach 30mph but I’m still going to reach 30mph.

It also means that price rises will naturally slow because the shocks play through the system and are gone. i.e. rising rates have no impact on those price rises and certainly had no influence on them slowing down. Prices have risen, the change is done, inflation has fallen but that doesn’t mean prices have fallen, on that the pressures on the supply side have stopped pushing prices rises through the system. We’ve reached 30mph which is, it turns out, too fast for many people to keep up with.

That is not a comfort to someone who’s already been priced out of being warm because their wages haven’t kept pace with rising costs.

Secondly, sure, Mr Governor, raise rates in the UK to 10%. I’m sure Putin and Zelensky will take notice in Russia and Ukraine…or not. I’m sure energy generators selling to China or the US will take notice and reduce their prices…or not. I’m sure people shipping from India will reduce their prices…or not. I’m sure the fact the EU can afford to pay more than they did before for supplies which once came to us will mean our prices fall…or not.

Localised raising of interest rates CANNOT control for global events as they interact with a thoroughly interconnected economic system.

What raising rates WILL do is lead us into recession as companies and individual exposed to interest rates find they can no longer meet interest payments, find that their customers can’t afford even what they bought last year. As their revenues decline those same companies will close and put people out of work and so on. It is, as the chief economist of a certain bank I know well said, meaningless and an act of self harm to raise rates when the drivers of inflation are i) not impacted by those rates and ii) those who are impacted by those rates will only be further impoverished.

Why? Well on one side prices are rising and will continue to do so. On the other hand my ability to even pay what I paid last year is now diminished because I’m at risk of losing my job and because my interest payments have increased. This triple whammy of rising prices, falling incomes and increasing interest rates is an economic disaster and why we’re likely to see rates in the UK peak around 4.25% – which is still historically low.

Sure it will reduce demand but it won’t reduce prices because those prices were rising independently of consumers.

Smart move there Mr Armchair Economist/Political Hack/Moralistic Moron.

Do I have better answers? There are some REALLY smart thinkers out there who have suggested alternate approaches for this specific kind of economic challenge but that’s for another post, another time.

The coming crisis

This post contains my own personal opinion (I work in finance and this is neither official advice nor representative of what my employer thinks – caveats done with, let’s talk turkey). There’s been a lot of words spilled in the last few months over inflation and [interest] rates and energy prices.

I’ve become convinced that we’re about to see a change in the shape and nature of British society that we haven’t seen in 50 years. I won’t rehearse the arguments here about how much energy prices are going to rise or what inflation is doing to our paychecks.

I also don’t want to make this a doomsday post. What I want to do here is spell some things out clearly and then offer some help (mostly by signposting you to others who are much better at this than me). If you want to skip my longer discussion about what is going on, just go to the end where I’ll make some recommendations you might already know, but hopefully will provide some tools for managing budgets and thinking about insulating yourself against rising prices.

Inflation hasn’t hit us yet. Nor have rises in interest rates. We’re still only really just seeing the impact on housing of changes wrought first by Margaret Thatcher and then exacerbated by the Financial Crash of 2007-8 (It hit the US earlier than the UK).

Which is why I’m worried. An inflation shock like this – specifically because it’s driven by factors coming from outside the UK cannot be controlled – it can only be prepared for and survived.

There’s been lots of discussion over interest rate rises. So I’m going to do write a short 101 on why interest rates are rising (and will continue to rise, perhaps has high as 4%). Classical economics suggests that inflation is driven by people wanting to buy more things, by growth being such that the sellers can increase prices because people can pay more. In that scenario you raise interest rates to make people poorer. Simple as that. Poorer people buy less. If they buy less sellers can’t keep raising prices and hence inflation stops.

This is fine. It is also literally economics for toddlers.

Actual inflation comes in many varieties and the kind we have here isn’t the one I describe above. It’s what we call exogenous supply side inflation. Those fancy words mean the following: exogenous – coming from outside. Supply side – meaning that prices are rising not because people want to buy more stuff but because the goods themselves literally cost more to make and provide. So, if we put that together we see that this inflation shock is best seen as prices for the things themselves rising because of outside factors which are largely beyond our (and our government’s) control.

For instance, there has been a food crisis globally because of supply chains which, when Russia invaded Ukraine became a catastrophe. Food may be more expensive here but it can still be bought. In places like Egypt, there is literally no grain regardless of how much people are prepared to pay. This is a global problem and the food is being shipped to places who can pay more – like the UK. This means that prices go up because a shortage of supply means EVERYONE EVERYWHERE has to pay more just to get what they used to get. No one is trying to get more here, we’re all trying to get what we had before and discovering there isn’t enough to go around.

Into this scenario we have a central bank with a strange mandate and only one tool to achieve it. They have been mandated to keep inflation at 2% +/- 1%. Their only real tool is interest rates. This may sound ludicrous and it is. However, there are good [limited access link] reasons that this mandate and this tool sit with the (currently) independent Bank of England.

I’m not interested in rehearsing those arguments or those as to how we got here (hint: decades of exporting inflation). We are here, now. We discussed above why people often think raising interest rates cures inflation. As you’ve probably guessed, in this case it can’t work. Indeed, raising interest rates has literally no intersection with exogenous supply side inflation because no one who is involved in the rising prices is impacted by those rising interest rates. Even worse, if interest rates are rising where those goods are made/created then they are only going to make our inflation experience worse as those increased costs will be passed onto us.

Now, you could argue that this will necessarily make us poorer and so make us buy less.

Well. Yes. We’re being hit by rising inflation AND rising rates. So not only are goods becoming more expensive, but our own lives are becoming more expensive and hence we can buy less.


Except this doesn’t mean we buy less because for most people, in a normal environment, they aren’t running a profligate personal spending lifestyle. We buy what we need, we save and we plan for the future if we can/have the bandwidth.

The situation we’re in now means we find ourselves not able to even afford what we could buy yesterday. It’s not that we can’t afford these extras, it’s that we can’t afford to stand still. This is bad for us all – both individually and also as a society because this kind of stress has no real outlet or safety valve. Not least because the ‘help’ we’re getting from the system is to make our lives even harder.

As the pandemic showed – we’re prepared to put up with a lot as a society if we’re in it together and if we feel there are effective measure in place for us all to make it through. Raising interest rates at this point is literally the opposite of that.

So we’re falling backwards as a base case. Ordinary people hit on all sides.

And still interest rates are going to keep rising because when all you have is a hammer your problems tend to look a lot like nails. I have every confidence that the BoE understands everything I’ve written above. I also have every confidence that the current executive of the British government doesn’t.

This means that not raising interest rates is impossible for the establishment.

A couple of reasons why

  1. Politically, the reasoning is the simple (idiotic) version that we’ve just trashed. But the reasoning holds and so there is immense pressure to rein in inflation. Not least because people are (absolutely rightly) very frightened for societies where inflation runs out of control. There is a high tolerance towards suffering if it holds back the kind of political turmoil we saw in the 1930s.
  2. The bank wants to bring inflation down and believes that by making people poorer it can achieve this end.

Newflash – inflation will fall. Like the sun will come out after a storm. Neither the fall in inflation that will hit next year nor the reappearance of the sun after rain have anything to do with ANY actions taken by people. It may look like raising interest rates works when we look back, but let’s be clear – they will have had negligible impact. As an aside – in 2008 the BoE had a webpage where you could model the impact of changes to the base rate. Here’s a fun fact. It is generally assumed that a change to interest rates takes at least 18months to work its way through the system. Ie, if rates rise today it won’t be until 2024 that you see the real impact. It is the same with inflation The scary headline is today, but trust me, you won’t feel the worst of the impact for another 2 years. Yes. 2 years.

This is why I’m worried and why I’m writing this post now. The worst is very much still to come. It is unlikely that even a competent government who cares about the poor can do anything to help with this crisis. It can, however, make things much worse.

Opinions are divided on how to manage a high inflation environment that leads to recession because it’s been rare and so varied each time. Economists like to think they know the rarefied truth. They do not. (queue gnashing of teeth by amateur economists from across the spectrum with their own takes – they’re all still wrong)

However, one might think that investment in future industries like renewables would make sense. yes it would. But rising interest rates mean that the government can’t afford to be splashy with our cash even if they want to be because they too are paying more to borrow.

You could say that we hold off on raising rates. Except we can’t because central banks across the world are doing exactly the same as the BoE. There’s a complex relationship between exchange rates, currencies and what we call the risk free rates (basically the government cost of borrowing) of each of those currencies . If we leave our interest rate low while others raise theirs then guess what…yep, our currency depreciates relative to others and we get…inflation!!!

So we’re left with mitigation. Both at a societal level but also at a personal level.

So here’s my thoughts on that because this is the most important thing. None of the below is easy and none of it is necessarily going to fix anything but it may well help and I hope it doesn’t come to it but I know I’ve just refreshed by monthly budget and the changes in energy costs really frightened me.

  1. Create a monthly budget. Be really honest and look at what you’re spending your money on and figure out how much buffer you’ve got. This is just general good practice but right now it might be the difference between entering into debt and not. There are lots of good websites that offer FREE budgeting software if the idea of doing it yourself is too hard. Even the government has one.
  2. Where it’s a case of disposable income being mashed then look at turning down your boiler or radiators by a couple of degrees, about being fanatical about lights and turning off monitors and tvs and pcs at night.
  3. Where you can’t afford to live the lifestyle you have now (and I’m sorry if this is a euphemism for not being able to afford heating and lighting and food). Start talking to service suppliers, think about what can be binned (like TV subscriptions and gyms and, and, and.). Where that’s not enough start thinking more drastically about talking to landlords, electricity/gas suppliers about payment plans.
  4. Follow people like Martin Lewis and Jack Munroe on twitter and at their actual sites. Money Saving Expert was once a gimmick. Right now it’s essential reading.
  5. Think about how, for food and other items, you can club together with others to buy in bulk. For many people buying in bulk alone is out of the question, but we can do it as a team.
  6. Savings often go out of the window at times like this but please, save. Save to pay for bills, save for emergencies, because as sure as we don’t they’re going to come along and kick us up the arse anyway.

I am ALWAYS happy to help think through what you can do and I hope the above has been even a little useful. As a I started – there are many who are better at this than me – but right now I’m so nervous about what’s to come I wanted to say something no matter if it only helps one person.

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