Inflation means we’re in for a tough year ahead – how will increasing interest rates help?

Interest rates will remain very low by historical standards and they will stay far below inflation driven in part by soaring energy and food prices, writes Hamish McRae

There is a genuine debate as to whether the central banks have been wise to push interest rates so low for so long (Getty)

This week will see an increase in interest rates in the US and UK. Or at least that is the widespread expectation of the financial markets.

Their argument is that central banks have no option but to increase rates in the face of soaring inflation, and that economic growth is solid enough to support that.

In the case of the US, last week saw consumer inflation reach 7.9 per cent, the highest for 40 years. The Federal Reserve has paved the way for the first increase in interest rates since 2018, with its chair Jerome Powell telling Congress that he is in favour of a 0.25 per cent increase. The Fed meets this week to decide.

As for the UK, the Bank of England has already increased rates twice but is also expected to make another move. The only thing that might stop it would be a fear that the threat to economic growth from the war in Ukraine might make it better to pause until the situation is clearer. UK inflation, as measured by the consumer price index, is currently 5.5 per cent, while the retail price index, the traditional measure still used for many contracts, is 7.8 per cent.

So, interest rates will remain very low by historical standards and they will stay far below inflation – inflation driven in part by soaring energy and food prices. That leads to the tough question: what will a quarter-point on interest rates do to cut the price of oil and gas, given that the main driver of this has been war in Ukraine?

The answer is it will have zero impact, which in turn leads to another question: so why do it? The short answer comes in two parts. One is that this is not about inflation this year – it is about inflation next year and beyond. There is roughly an 18-month lag between a policy change and that change having a full impact on prices.

And the other is that it is also about asset inflation, including house prices. US house prices were up nearly 19 per cent last year, while the most recent figure for the UK from the home-lender Halifax is nearly 11 per cent.

There is a genuine debate as to whether the central banks have been wise to push interest rates so low for so long. I think that this policy will go into the economic history books as a classic failure. But there is not much debate as to what they have to do next. The danger of a 1970s inflation spiral is too great. The only issue is how swiftly they should move.

So what happens next? Five things. One, inflation in most of the developed world will peak at somewhere between 7 per cent and 10 per cent this summer. That is, both literally and figuratively, in the pipeline. In the UK the RPI may nudge into double digits.

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Two, this will lead to massive distress everywhere. The squeeze on living standards will be greatest for people on low incomes, both within developed countries and between the rich world and the emerging world. I am even more worried about food prices than about energy prices.

Last year Fitch, the rating agency and economic consultants, calculated that food accounted for 35 per cent of the average household budget in India. According to the UK government, it was just under 11 per cent for the average family in the UK in 2019-20, while for the poorest households it was 15 per cent. In the US the numbers were a little lower than the UK. The Department of Agriculture reported that spending on food was 8.6 per cent of average incomes in 2020.

Three, there will be a massive effort by governments everywhere to try to mitigate the impact of inflation, particularly on the most vulnerable. Rishi Sunak will announce more measures in the budget on 23 March. He has to. But neither he, nor anyone else, can do much about the things that are driving inflation, at least in the short term. And the mathematical rules of public spending still apply. Money spent now on supporting families is money that will have to be raised in taxation later, or borrowed from the markets, in which case borrowing costs will climb. (The cost of servicing index-linked debt has already shot up.)

Four, by the end of the year inflation will be starting to fall back. Energy prices may not come down much, but they won’t go on rising forever. What we cannot know is whether inflation will then settle to an acceptable 2-3 per cent, or whether it will stick closer to 5 per cent. Where it does settle will determine where interest rates will go next year and beyond.

Finally, this inflation shock will lead to huge changes in the world economy. There will be much more investment in renewable energy; greater efforts to become more self-reliant in food where possible; more conservation; changes in lifestyle; changes in the way we save money – and so on. Eventually, this surge in inflation will peter out. But it will be a tough year ahead.