The UK now has high inflation both by international and historical standards.  And it is causing a serious cost-of-living crisis which our government needs to address.

This article looks at why there is a serious risk of mis-handling inflation in the UK.

If you wanted to mishandle inflation, you would:

  1. Treat it as a single, simple issue;
  2. Mistake inflation for a measure of ability to buy;
  3. Assume that low inflation is a sign of a strong economy;
  4. Panic about it; and, most importantly,
  5. Use the wrong tools to contain it.

In the UK we are set to make all five of these mistakes.

Treat it as a Single, Simple Issue

We often talk about ‘Inflation’ as though it were a single, simple phenomenon. It is not.

The satirical book, 1066 and All That, exposed how simplistic and prejudiced was the teaching of history in schools –   it boasted of containing, “A memorable History of England, comprising all the parts you can remember, including 103 Good Things, five Bad Kings, and two Genuine Dates,” and neatly divided events into good things and bad things. The Roman invasion of Britain, for example, was a good thing because “the Britons were only natives at the time.”

Much of our discussion of inflation is at a similar level. We tend to ignore asset price inflation, as it is seen as good thing. (Which it is if you are a house-owner with no desire to buy a larger house, no younger relatives who might wish to get onto the housing ladder and no concern about bubbles and the stability of the financial system). Since 2009, the Bank of England has generated £895 billion of new money via Quantitative Easing (QE) and this has inflated asset prices. But it most obviously has not pushed up demand for goods and services, which has been depressed since the Global Financial Crisis. Those who predicted that QE would lead to inflation were half right: it led to asset price inflation, but it has nothing to do with the inflation we are worried about today.

We do not distinguish between the rate of inflation as it affects an ‘average’ consumer and the experience of the poor (or the very rich) both of whom have a different experience. Even different regions of the UK have different experiences.

Even more critically, we do not distinguish between inflation with different causes. Economists often say that inflation is what happens when too much money chases too few goods. This immediately suggests an important distinction between demand-driven inflation (when there is too much money floating around) and supply-driven inflation (when there has been a problem supplying goods). Another important distinction is between globally driven inflation and domestically driven inflation. Oil prices, for example, are set on world markets and UK demand has relatively little impact. So if oil prices rise sharply, that is almost certainly globally-driven.

The Governor of the Bank of England recently set out what he sees as the sources of our current inflation –  rising prices for energy and goods – and highlighted as root causes unexpected supply shocks such as Putin’s invasion of Ukraine and the impact of China’s zero-COVID policy. Others have pointed out the wider impact of COVID on global supply chains and, of course, Brexit, which former BoE policy maker Adam Posen claimed is responsible for 80% of the UK’s inflation.

All of these are supply problems; and several of them are not domestically driven. The problem in the UK, in other words, is not that UK consumers have too much money. (You may not be surprised to hear that).

We will come back to this important point in looking at the tools we should be using to manage inflation in the UK.

Mistake inflation for a measure of ability to buy

Until you think about it, it sounds reasonable to think that inflation determines whether we can afford to buy what we need – especially right now, when inflation really is limiting many people’s ability to buy even fundamental things like food.

But the real measure of ability to buy is real (inflation-adjusted) wages. I would rather have 5% inflation and a 7% wage rise, which means that I can afford to buy 2% more this year than last year, than 2% inflation and a pay freeze, which means I can afford to buy 2% less than last year.

During the Golden Age of Capitalism (1945-1980), every economic indicator apart from inflation was better than during the Age of Market Capitalism (1980-2015) – and the result was that the typical person saw a far greater increase in ability to buy. Look at the household income of the median family in the US, for example.

Since 2010, median real earnings in the UK have fallen – most people can buy less today than they could 12 years ago – but for most of that period inflation was low. That is a period of mass impoverishment we have not seen since the 1820s, and it has nothing to do with inflation.

Here are data for the UK from 1950-2016, from the Bank of England.

The periods when we had strong wage growth were by no means all low-inflation periods; the negative wage growth has all (until this latest bout of inflation, which we shall come to later) taken place in low-inflation periods.

We should be very concerned about ability to buy, but we should measure it by real wages, not by inflation.

Assume that Low Inflation is a Sign of a Strong Economy

We talk about inflation as though it were a bad thing without really examining the extent to which that is true. We have already seen that inflation does not measure ability to buy, so it does not tell us if a country’s economy is serving its citizens. But does low inflation perhaps have wider benefits to society? Does it, for example, lead to stronger economic growth?

There are reasons to believe that it may not. Not at all. First, let’s think about demand. If I have money whose value is declining, I will spend it quickly; if it holds its value well, especially if I have reasons to be cautious, I may not. Here from FRED (the Federal Reserve Bank of St Louis Economics Data) is the velocity of money in the US – that is the number of times a dollar gets spent in a year. You can think of it as measuring ‘how hard a dollar works to sustain the economy.’

At least in the US, it seems clear that higher inflation makes a dollar work harder for the economy.

Secondly, let us think about when a business will invest to grow. First, it will only do so if it needs to: if it has spare capacity, it will simply grow without investment until it has used up that spare capacity. Then it will consider whether it will get a decent return on an investment in growth, and to have a good chance of doing so it must be making a return (profit) above its cost of capital and expect to do so even after making its investment.

In other words, an economy with many businesses investing in growth is one in which many businesses are running at or near capacity and able to price their goods and services to make good profits as they do so. That sounds very like an inflationary environment.

Does the evidence back that up? We saw some crude evidence in the first chart: the Golden Age of Capitalism was a period in which the US and UK economies (and most others) performed better than before or since, but had higher inflation. And if we look in more detail at the experience of developed economies since the year 2000, we see further confirmation: there is a weak but positive correlation between real economic growth and inflation.

Based on the evidence, it seems more than plausible that a certain level of inflation may an important price signal that businesses need to tell them it is safe to invest. Of course, to be a good thing inflation only needs to be high enough to send that signal. A rate of inflation higher than businesses can sustainably expand capacity would produce no additional benefit. But that means that an ideal rate might be around 3%-4% (based on the demonstrated growth during the Golden Age), that is as much as double our current target rate.

Moderate inflation, quite a bit higher than our current 2% target, may be the optimal level.

Panic About It

Ah! But perhaps the problem is the word ‘moderate’ – perhaps inflation is like a genie: once you let it out of the bottle, it will naturally accelerate away until we get hyper-inflation. If that is the case, then we have no choice but to panic.

As the Governor of the Bank of England says (without explaining precisely why): “The most important thing we can do is to get inflation back to target and to get back to target without unnecessary disruption to the economy,” He implied the BoE would not shy away from generating a recession to do that if it was necessary. “We have to get [inflation] back to target. And that is clear.” He seems to have accepted the argument that we should panic, even if it means plunging the UK’s already very weak economy back into recession. This approach would, of course, make our problem of mass impoverishment even worse than it is today.

But let us think about the mathematics of accelerating inflation for a moment. The chart below shows three scenarios for inflation and prices.

In the first chart, we see a one-off price shock: an event happens which triggers price rises. The event causes a permanent rise, but is not also followed by a series of other events of similar magnitude. The war in Ukraine has triggered a price rise, but it is unlikely that each following year will see a further war triggering compounding price rises.

The second chart shows what happens with repeated price shocks. COVID has caused a rise in prices. But if every year a new pandemic emerged, on top of continuing COVID, that would cause compounding price rises.

The third chart shows the impact of a series of growing price shocks. It is difficult to think of a plausible sequence of supply-shocks which could cause such price rises; the only way it could plausibly happen is to combine one of the previous scenarios with uncontrolled money creation and spending – QE as we have seen it so far merely produced asset price inflation; to create accelerating inflation would require putting too much money into the hands of UK citizens. Not a problem we are close to at the moment.

Looking at the three charts, we see that neither of the two on the left produce accelerating inflation.

The left-hand chart is most likely to represent the situation we face: a serious set of supply issues, which may be sustained but are unlikely to be followed by compounding issues of similar magnitude every following year. This means that we are probably facing self-correcting inflation.

Even if they were followed by compounding issues of similar magnitude every following year – and that seems a rather far-fetched base-case – we should be facing high but steady inflation as in the middle chart.

Therefore, far from being the natural path of inflation, the right-hand chart is only possible if demand explodes. And this can only happen if pay rises start to exceed inflation very significantly (and given that they have not even kept pace for the last 12 years, that does not seem plausible  —  indeed the Office for Budget Responsibility and the  Bank of England both forecast that this year will see the sharpest fall in real wages since their records began) or if government spending shoots up (and we have a government keen on austerity). There is simply no evidence that we risk accelerating inflation.

We have a government and a Bank of England suffering from inflation hysteria. That is not a good basis for sound policy-making.

Use the Wrong Tools to Contain It

At the beginning of this article, we pointed out that there are different possible causes of inflation: the root cause could be on the supply side or on the demand side, and it could be primarily a domestic issue (in which case domestic policy may be able to fix it) or it could be globally-driven  (in which case domestic policy may well be powerless). In general, global issues will tend to dominate domestic issues. In combination, that gives us 16 possible inflationary scenarios, some of which have been grouped together in the diagram below.

The code in each box indicates the most likely cause of inflation – if it occurs – in each situation. For example, in the bottom right-hand cell, the situation is that both globally and domestically we have lower demand and lower supply. In this case it is clear that we cannot have demand-driven inflation of any kind and since global forces tend to outweigh domestic ones; if we have any form of inflation, it is most likely to be global supply-driven inflation.

The colour in each box indicates whether restricting the ability of domestic consumers to spend is likely to contain the type of inflation in that box: green means that the policy could well be effective; amber means that it could be effective; and blue means that the policy is not addressing the root causes and its effects will be negative.

The black dot shows the situation we currently face. As all commentators agree, we face global supply issues; and as almost all agree, these are compounded by serious domestic supply issues, most notably caused by Brexit and COVID. In this situation, seeking to reduce domestic demand is not going to solve the problem: it is simply going to damage the economy further and to cause enormous – pointless – hardship to UK citizens.

The Governor of the Bank of England seems to recognise this, at least in part:

“It’s a very, very difficult place to be. To forecast 10 per cent inflation and to say there isn’t a lot we can do about it is an extremely difficult place to be. …  This is a bad situation to be in.”

The Bank of England, however, is responsible for keeping inflation close to 2%. It feels it cannot simply do nothing in the face of 10% inflation. And it has just one tool in its toolkit: raising interest rates to slow demand.

Despite the fact that this will do immense damage to the UK, it seems quite possible that that will be our only policy response.


Policy-making on inflation is poor: we treat it as a single, simple issue; we mistake inflation for a measure of ability to buy; we assume that low inflation is a sign of a strong economy; we panic about it when we see it; and we use the wrong tools to contain it.

We should, of course, be doing the opposite. We should treat the different forms of inflation differently; focus on real wages as the true indication of ability to buy; consider whether having had such low inflation may itself be damaging the economy; think calmly about how to tackle it; and, most importantly, use tools appropriate to the situation we face.

Right now, that means that the Bank of England should be writing to the Chancellor and the Prime Minister explaining that this is not the kind of inflation the Bank can tackle with interest rate rises and suggesting government policies which could help. These would include:

  • Protecting the most vulnerable by imposing price caps on energy and windfall taxes on energy companies, by reforming the energy regulator Ofgem so that it properly protects consumers’ interests, and by temporarily reducing taxes on energy;
  • Progressive taxation to fund a rise in benefits without fuelling inflation – raising the rates of tax on dividends and capital gains so that unearned income is taxed at the same rate as earnings would be a start;
  • Investment in capacity building in green energy generation, energy storage and energy efficiency measures to help reduce the supply constraints. Although in the very short term, this could fuel inflation, in the long-run, building capacity is what prevents supply shocks and will prevent inflation taking hold. And, of course, we face a climate emergency, which makes these things even more urgent.

It is not that there is nothing constructive that we could be doing to ease the cost-of-living crisis; it is simply that our government is not planning to do it.

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