Inflation and interest rate increases

 The Bank of England is busy raising interest rates in order to tame inflation. Interest rates is pretty much the only lever they have but does it make sense to raise interest rates?  We are constantly being told we live in a global economy so therefore it’s pretty much impossible to control things at a small country level like the UK if we genuinely do live in a global economy. 

I have developed an opinion that the Bank of England (BoE) is run by idiots and that they are busy harming the UK population and the economy by rapidly increasing interest rates. At best we will have a recession as a result of their actions although it's increasingly looking like we will have a period of the much worse stagflation.  

The government kind of likes inflation.  Inflation silently steals wealth and makes their huge debts they have racked up disappear.  However it also means the costs of servicing the debt are increasing – they need more tax from the population just to stand still. Governments borrow money and UK government borrowing has exceed 100% of GDP for the first time since 1961. Unfortunately 25% of British public debt is inflation linked compared to most other countries where it is 10% of debt.  So bad news for the government too.  Either they borrow more money to pay the interest or hammer people with taxes. It seems modern governments are incapable of cutting spending.  The austerity period didnt really cut public spending - the headline is there were £500Bn in cuts.  This ignores the extremely generous public sector final salary pensions which is  £2.6 trillion  government liability (106% of GDP) this has ballooned since the start of the austerity period dwarfing the trivial £500Bn in austerity cuts.  Most of this liability is inflation linked.   In 2023 UK civil servant pensions rose by 10.1%.  This is not just increase for current pensioners but effectively an increase for all future pensioners.

Now 25% of the government debt, called gilts, is linked to the RPI inflation measure.  Each time the Bank of England  increases interest rates  it also has an increasing affect on RPI. So the cost of borrowing is rising.  Governments can decide to spend less, increase taxes to service this debt or print more money (inflationary).  Well it certainly looks like the government is doing very little to curtail spending - quite the opposite.  It would be politically unacceptable to print more money when it is promising to curb inflation so it looks like higher taxation is inevitable.    

As I studied engineering at university I tend to take a systems approach to understanding things.  The economy is clearly a big complex system. It must also be a closed loop system otherwise the crazy idiots at the BoE must be even more crazy than I already think they are by trying to “control” a system if it’s not closed loop. By the very nature of closed loop systems they are subject to control.  The evidence is that the economy is a closed loop system.  The thing they are trying to control is population behaviour.

Inflation is a symptom of the system which they are trying to control. So what is inflation?  Well that’s not straight forward.  Comparisons are often drawn with other countries “USA inflation has fallen to 4% in May 2023” for example. Well there is no standard for how inflation is calculated. How the US calculates inflation is different to how the UK calculates inflation.  In fact the UK has several different ways of calculating inflation CPI, RPI etc which all give different answers. 

To me it was quite clear that the inflation we are seeing is supply side inflation.  This is very different to other inflation I have seen during my life which is demand side inflation.  Supply side inflation is where raw materials eg energy and food are experiencing inflation.  Demand side inflation is where there is increased demand for things like cars and hence the price of cars rises.  Now the price of cars has increased.  That’s because of the cost of raw materials and energy to make cars has increased.  Shortages of electronics has also been a problem.  Also electric cars need roughly double the resources to make than combustion cars so they are more expensive so that has to be thrown into the mix.  However the prices of second hand cars has risen sharply – that suggests there is price sensitivity in the new car market. If they are too expensive then people look for alternatives.  Human behaviour is creating a control loop.

We do know the BoE is increasing interest rates (borrowing rates).  Borrowing rates affect businesses and home owners. By increasing borrowing rates,  money is taken out of the pockets of home owners so they have less cash and they therefore spend less. Now inflation has predominately been energy and food.  We all need this. Energy rates are generally falling whilst food inflation is stubbornly high.  We’ll come back to this later and stick with home owners now.

There are roughly 25 million homes in the UK.  Roughly 5 million homes are privately rented so owned by landlords.  There are 4.4 million social homes in England, 320k in Scotland, 240k in Wales and 57k in Northern Ireland so just over 5 million. So the rental sector is 10 million.  So there are 15 million owner occupied homes or roughly 60%.  28% of homes are mortgage free (4.2 Million).  Lets take social housing out of the mix as it’s not clear increasing interest rates affects the behaviour or councils and other social housing bodies so there are 20 million homes.  Of the 20 million 15.8 million have a mortgage.  74% (11.7 million) of these are on fixed rate mortgages so 4.1 million are  on variable rate.

In other words only 16% of homeowners are impacted by the BoE interest rate increases – this seems a pretty weak control to me.  It’s impacting a minority.

Now most mortgages are on 3 year terms.  Since 2019, 96% of new borrowers have chosen fixed rate terms.  Statistics vary but is suggests overall 75% of borrowers are on fixed rate mortgages. 

This means the majority of people are currently isolated from interest rate increases.  It means it could take several years for 75% of borrowers to change their behaviours. 

Now landlords with mortgages may elect to increase their rents in order to recover the increased borrowing costs.  This impacts the tenant (assuming they pay). Due to the crazy way the government and HMRC work, the landlord  is unlikely to make any gains  by increasing rent. Private landlords cannot offset borrowing costs against tax. That means if the mortgage goes up £100 per month and the landlord increases the rent by £100 per month then the tenant is worse off by £100, you give the bank £100 to cover the increased mortgage cost, the tax man will want and additional £28 in tax on the £100 revenue – you are are £28 worse off.  I suppose that is slightly better than being £100 worse off.

Rent and mortgage  are included in RPI inflation calculations but not CPI.  Expect RPI to continue to rise due to the BoE rate hikes as these are passed on in mortgages and rent increases.

It is worth mentioning that farming is a capital intensive business.  Its more like gambling than a business.  Over the last couple of years farmers have been hit with huge increases in the cost of fertiliser, energy etc.  Ignoring things like immigration etc its a tough time to be a farmer.  If someone came to me with a business plan saying I need £200k and I might make £30k profit in one year or lose £100k  of the £200k due to bad weather, I would tell them they were crazy yet this is reality for farmers.

 Farmers need to borrow money and hence interest rates impact them.  The reality is many farmers will scale back production when interest rates rise – not good news for the UK as that means we become more reliant on food imports. I’ve always thought that a country that cannot feed itself is very vulnerable.  Farmers may well exit the market. Interestingly 5% of UK farm purchases are from Chinese investors.  Maybe long term that food will go to China rather than domestic mouths...

Now back to core inflation – food and energy.  

The UK imports 46% of the total food it imports.  In other words if there is food inflation then 54% of that inflation originates from outside the UK. It is therefore far from clear how the BoE rate increases will reduce that inflation.  39% of that 46% (18% in total) originates from Netherlands, Germany, France and the Republic of Ireland. So lets looks at these countries.  Food inflation in France in April 2023 was 14%.  It has dropped significantly to 6% in May 2023 (not quite sure how they came up with that number given it's an annual measure but I will accept it ).  Germany however had food inflation of 14.5% in May 2023. Same story in the Netherlands – April food inflation was 13.2%.  

Why is food inflation happening everywhere?  Well Ukraine was one of the largest manufacturers of fertilisers in the world.  Fertiliser is created using the Haber chemical process. The process combines nitrogen from the air with hydrogen derived mainly from natural gas (methane) into ammonia and hence fertiliser.  Given it relies upon natural gas (from Russia) to make fertiliser then the price of fertiliser has sky rocketed.  That ripples through - either farmers dont use fertiliser so crop yields are lower (and hence more expensive for the same effort) or they use expensive fertiliser. 62% of crops output is  used to feed animals and 12% used in industry / biofuels, with only 23% feeding humans.  Hence if crop prices rise it impacts the price of meat and dairy.  The price of cheese has risen sharply - firstly it costs more to feed the cows and secondly cheese production uses quite a lot of electricity.

It’s clear that the UK is importing food inflation and it’s far from clear that raising UK interest rates will impact French & German food producers and encourage them to stop causing UK inflation….

Now with France experiencing a rapid drop in food inflation in May 2023, it is encouraging that food inflation may well be coming under control.  

Energy prices are falling in the UK however they are  slow to pass reductions on to consumers.  Wholesale energy and gas prices have significantly fallen but the regulators price cap formula means they arent really being passed on to consumers.  Prices are more than double what they were 1 year ago.  

Prices at the pump however have dramatically fallen. This means transport costs are falling whilst the utility companies seems to be profiteering.  

The energy regulator seems to be very weak.  Energy companies have been increasing standing charges way in excess of inflation whilst only slowly reducing the energy consumption unit price.  It seems that standing charges are exploitative and clearly inflationary.  If I modify my behaviour to reduce energy consumption by accepting that I should be colder then my bill should fall however this isn't happening – standing charges have increased – you have to pay them – they are a tax.  

The regulator price cap model inherently makes inflation stickier.  As they change infrequently it means prices stay higher longer. 

In the meantime the BoE is rapidly increasing interest rates whilst changes are slow to filter through.  Hopefully France and the rest of the countries that feed us should see falls in food inflation which will filter through into the UK.  I’m sure the BoE will claim this reduction in food inflation as a victory and that their controls and action made this happen.  

Do they think we are stupid?