Inflation Blog Series (5/5) | Winter of Discontent

Posted: 21st December 2022 Key

This short blog will look at what has happened to the prospects for inflation since I last wrote about the subject in September.

Today, the nurses are on strike, as are the railwaymen and the postal workers. The strikers will be joined later in the month by bus and highway workers, baggage handlers, ambulance drivers, driving examiners and the Border Force. Inflation may have peaked around 10%, but that still means that if your pay hasn’t grown by 10% in the last year, then you are worse off than you were a year ago. No one in the UK public sector is in that fortunate position, which is the unifying factor in the strikes currently paralysing the UK.

Yesterday, the Bank of England raised its base lending rate by 0.5% to 3.5%. 3.5% isn’t a very high rate in the context of history, but it’s very shocking when you think that the base rate was just 0.1% a year ago. Yesterday’s rate rise adds another £50 a month to the average household mortgage, whose holders are already struggling with today’s multi-tentacled cost-of-living crisis, compounded by a cut in their spending power from below-inflation pay rises.

Why are central banks raising interest rates now? In classical economics you raise interest rates at the top of the economic cycle, to curb demand which has become excessive. Inflation happens when ‘too much money chases too few goods’. An interest rate rise sucks money out of the economy, leaving borrowers less to spend on other things. However, the inflation we’re seeing today is largely exogenous – a by-product of Russia’s invasion of Ukraine and the lingering impacts of the pandemic. Inflation in the cost of oil, gas and foodstuffs isn’t caused by excess demand in the UK economy, rather it is caused by supply shortages. Inflation acts as a tax on consumers, and higher borrowing costs act as a further tax. The country is already in a recession, when in classical economics interest rates should be cut to stimulate demand.

Raising rates now is like throwing open the doors of your house to cool it down when it’s already freezing. So, what’s going on? I can think of three possible reasons for interest rates to be raised in a recession.

One is the fear of a return to the wage-price spiral of the 1970’s. This is where inflation is 10% and workers ask for 20%, 10% to cope with the inflation that’s already happened, and another 10% in anticipation of the inflation that’s going to happen between now and the next pay-round. The 20% pay rise creates more demand which contributes to more inflation, making further big pay rises inevitable. There’s little sign of that spiral today. Public sector pay demands are mostly aimed at restoring what has been lost. Where demands are above inflation (as with the nurses) the extra can be explained by underpayment in previous years. Conditions today are unlike the 1970s in many ways, of which only one is that the power of unions across the country is far less now than it was then. Fear of the 70’s is a good enough reason to urge pay restraint, as it’s hard to disprove, but I can’t help wondering whether proponents of this argument really believe it themselves. I suspect the real reasons involve a degree of self-interest on the part of the Government and the Bank of England. The Government needs inflation to fall quickly so it can argue for lower pay settlements in the public sector. It seems likely now that inflation will fall rapidly from here. I believe this would have happened anyway and higher interest rates will only accelerate the process.

The second is a response to energy costs. The price of gas has risen astonishingly but is falling. The forward wholesale price of gas in pence per therm rose from 60p in January 2021 to £6.50 in August this year. However, is is now £3.00 – in other words, it has halved in the last four months. We haven’t seen this drop in our domestic gas bills yet (I suspect because the gas we’re buying today was bought forward by our suppliers at the top of the market), but based on recent movements in the wholesale market, it seems inevitable that the retail price of gas must come down. The world price of Brent Crude oil per barrel (a barrel holds 42 gallons) has touched $125 twice this year and is currently just below $80. The pass-through is more immediate in the oil market and we have already seen lower prices at the pumps, where petrol has dropped from £1.92 to £1.56 per litre. Energy is a crucial factor in determining the cost of producing food, so it’s likely that food costs have peaked, or will do so soon.

A third element is timing in that the current annual inflation figure is very high and demands action. According to a research group GfK, quoted in today’s Financial Times (December 16th), consumer confidence is now at its lowest level for fifty years. The FT article shows that at bleak times (1974, 1981, 1990, 2008, 2020) the index drops to almost minus 40. Today’s number is minus 50. When people are scared, they don’t spend money unless they really have to, and there’s nothing like a drop in demand for goods or services to bring their prices down.
However, inflation is always calculated over the previous twelve months, so each month, a new number comes into the headline figure and the earliest one drops out. In the first three months of this year, inflation* rose by 0.6%, 0.7% and 0.4%. Prices in the first three months of next year will have to rise by those amounts to prevent the headline figure from falling – and they won’t. It’s almost certain now that inflation by the end of March will be significantly below where it is today, and on a clear declining trend. This is certainly the position the Government is anticipating. I guess the plan is that if they can hold out till then, they can reject high public sector pay demands as excessive. This argument, were it to be made, would be specious – even if inflation were 0% by then, a lower pay settlement would not compensate for inflation that has already occurred.

For the Bank of England, an early return to its 2.0% inflation target is highly desirable, however that result is achieved. For years, the BoE was criticised for its inability to prevent inflation from undershooting the target by staying stubbornly close to zero. Then inflation soared dramatically to its current level, defying all the bank’s predictions, and stands today at roughly five times the target level. The BoE feels it must act. There are times when to do nothing is impossible, even though nothing would be the right thing to do. This is one such time. It’s clear that the Bank’s remit, to keep inflation as close as possible to 2.0%, is too narrow. It should also look at employment and the overall health of the economy. Yesterday’s rate rise looks certain to make the recession deeper than it would otherwise have been, causing further damage to the economy.

A shorter, deeper recession would suit the Government, too. It would be helpful for them if the economy were climbing out of recession before the next general election. Then the narrative would be ‘the government took the hard decisions in all our interests, we have all suffered the pain, and now we are all about to reap the rewards.’

The financial markets are in a mood of deep pessimism. 2022 has been disastrous for investors’ previous favourite assets – US big tech, private equity, government and company bonds and all the products based on these assets, commercial property and cryptocurrencies. The fog is starting to lift, and we’re getting brief glimpses of falling inflation. An end to interest rate rises is nearer than anyone thought possible. But to a pessimist, all news is bad. Will lower inflation be welcomed, or merely seen as further proof of the economic mire into which we’ve all sunk?
As a longer-term investor, I take comfort at the extremely low prices at which quality assets are being offered. If it can’t get much worse, then it can only get better.

*Inflation quoted here is the CPIH – the Consumer Price Index including housing costs.

Tony Yarrow, December 2022

Inflation (1/5): An Introduction

Inflation (2/5): Greed and the Four Horsemen

Inflation (3/5): The Death of Money

Inflation (4/5): Inflation Today & Tomorrow


Please note, these views represent the opinions of Tony Yarrow and do not constitute investment advice. This document is not intended as a recommendation to invest in any particular asset class, security or strategy. The information provided is for educational purposes only and should not be relied upon as a recommendation to buy or sell securities. Wise Investment is authorised and regulated by the Financial Conduct Authority, number 230553.


Tony Yarrow