The UK’s official measure of inflation, the Office for National Statistics’ Consumer Price Index (CPI) came in slightly lower than widely anticipated, falling from 3.0% in August to 2.9% in September. This is good news, not so much for the (slight to non-existent) impact it implies for most people’s living standards, but because it will help stay the hand of the Bank of England’s Monetary Policy Committee (MPC), otherwise poised to start cranking up interest rates for the first time since covid-19 struck.
Like Pavlov’s dogs, the tinkle of the inflation bell has set the hounds on the MPC slobbering over the prospect of rates rises, writing in its September report that “The MPC’s remit is clear that the inflation target applies at all times” and so “some modest tightening of monetary policy… was likely to be necessary.” Bank of England Governor Andrew Bailey has doubled down on the message since. This is despite Bailey also recognising that such rates rises would be useless, telling the financiers and academics of the Group of Thirty that “monetary policy cannot solve supply-side problems”. “Supply-side problems” describe precisely the kind of inflation we have right now: driven primarily not (as in the traditional models) by “excess” demand pulling up prices, but by severe supply-side constraints. In other words, covid and other shocks have made it harder and more expensive to use energy, transport goods, make things, and to ask people to perform some tasks (working in bars, for example). The result is that prices have risen.
It takes a small feat of cognitive dissonance to both recognise this supply-side reality, and then carry on acting as if we faced a demand-side problem. But interest rate rises would be worse than useless – and quite plausibly even worsen inflation, setting the setting the British economy up for the dreaded “stagflation” over the foreseeable future. We could expect overall growth to be squeezed by interest rates rises as a result of borrowing becoming more expensive. But because borrowing is more expensive, investment will be squeezed: yet the one thing that might, plausibly, begin to ease supply-side problems is investment. By investing in new equipment, new buildings, new technology and so on, investment by companies is one of the ways that the supply of goods and services can grow over time, and the price of those goods and services be brought down. So by making investment harder today, we are reducing the potential supply of goods and services in the future – but restrictions in supply are precisely what is causing inflation today.
Future instability
For now, a slight decline in the rate of inflation might stay this prospect. But there is a bigger issue. The MPC believes that “that current elevated global cost pressures will prove transitory.” In other words, that the current upsets and dislocations to the supply of goods and services will prove to be a temporary blip before the economy returns to its “trend” path of continual growth.
But we know covid will remain with us now, in some form, for the rest of our time on the planet – barring some fantastical new virus-zapping technology, the disease will circulate in endemic form alongside the other six coronaviruses we are known to contract. The path to something like peaceful coexistence – SARS-Cov-2 circulating in relatively benign form – is hardly likely to be smooth, however, as more infectious variants circulate, vaccine effectiveness wanes, and indeed vaccine distribution globally remains disastrously bad. The hard, global shocks of the 2020-21 lockdowns are not likely to return with the same severity, but clearly life will remain unsettled for some time.
And we also know – or at least can forecast with a high degree of certainty – that the environment is going to become more unstable. The number of environmental shocks now hitting global supplies is dramatic: drought in Taiwan and frost in Texas restricting semiconductor production; drought in Canada hitting wheat production; frost in Brazil hitting the production of corn, coffee and sugar, driving up global food prices. Bailey, noting the chaos, has joked that he was expecting a plague of locusts to appear – but of course they already have, swarming across the Middle East and East Africa last year, destroying crops and devastating farmers’ livelihoods on a scale not seen for 70 years. Climate change has been plausibly blamed, with cyclones in southern Arabia in 2018 providing the perfect damp conditions for a desert locust population explosion. These swarms then spread outwards over 2019 and into 2020; the cyclones, meanwhile, are linked to the Indian Ocean Dipole, describing the difference in sea surface temperatures between the Arabian Sea and the eastern Indian Ocean. Severe differences in these two temperatures, attributed to climate change, are thought to have driven both Arabian cyclones and bushfires in Australia.
None of this is “transitory”. These sorts of supply-side shocks are here to stay, and the environmental modelling we have says they will worsen with rising average global temperatures. Yet our conventional understanding of economics lags far behind the changed reality: the models economists use, including those in the Bank of England, predict a future in which whatever dislocations are happening right now, the economy returns smoothly to a stable, balanced growth path. It’s not just that the MPC are likely to be (sadly) wrong about the “transitional” nature of current supply shocks; it’s that economics in general has serious problem even conceptualising supply constraints as anything other than temporary and conditional. Economic modelling – the social science of economics as such – is built on the fundamental assumption of a benign global environment. What happens when that no longer applies?