sSharply raising central bank interest rates would be disastrous, and not merely inappropriate, as a solution to the current inflationary environment. That was the underlying message in a speech by one of the Bank of England’s monetary policymakers, Silvana Tenero, last week. It’s hard to disagree. While inflation disproportionately hurts the poor because of their lower incomes, raising interest rates is a worse “cure” than the disease.
The Bank considers rising unemployment to be a necessary trade-off to prevent accelerating inflation. Its central projection of rising interest rates suggests that nearly 2.5 million people will be unemployed in 2025 – with the worst-case scenario seeing 3 million unemployed. This would lead to widespread misery. Nobody wants to be unemployed. Karl Marx’s reserve army of the unemployed is filled with conscripts, not volunteers. Many have already abandoned their positions, preferring to leave the workforce entirely rather than be unemployed.
Both high unemployment and high inflation reduce welfare. Economist David Blanchflower showed in 2014 that unemployment makes people more miserable than inflation. He suggested that every one percentage point increase in the unemployment rate reduces welfare by more than five times a one percentage point increase in the inflation rate. Recent work suggests that people suffer “between nine and 13 times more daily suffering from unemployment than they do from inflation.”
Given that the UK economy has just emerged from Covid, orchestrating a deep recession is scary. The bank operates under a faulty logic: the higher rates are, the higher the unemployment rate and the faster the inflation rate will fall. But this relationship between unemployment and inflation does not exist.
Remarkably, the current low unemployment rates are now considered “unsustainable” even though comparable unemployment rates were good before the pandemic. For a decade after the 2008 global financial crisis, inflation remained largely unresponsive to the drop from 9% to 4% in the UK unemployment rate. Real wages have stagnated. This decrease in the unemployment rate was supposed to lead to a rapid growth of wages. This did not happen because of what the economist Michał Kalecki called the “monopoly degree” of the economy. This allows firms to limit the ability of workers, consumers and regulators to influence selling prices over costs and to defend the share of wages in production. Since 2008 average profit margins in the UK have increased from 20% to 35%.
Professor Blanchflower correctly weather forecast That the rise in prices in the United States will begin to slow. The Federal Reserve was surprised by the lower-than-expected inflation readings last week. The economist believes that Britain will likely follow the same path. The biggest driver of UK inflation in October will be the energy price cap hike. But seeing inflation this month continue to rise at the same rate as September would require prices to jump nearly ten times their historical average. That seems unlikely. Deinflation is the most likely outcome.
After the initial explosion of high energy costs and the fading of the Covid disruptions, there are few ways for the inflationary shock to spread. One mechanism is for companies to allocate sustainable cost changes. With no intervention to fix prices or a competition watchdog, Britain is a treasure island for companies to turn a profit using higher prices. If that happens, higher bank interest rates threaten to tip the economy into recession and hurt millions of people – with little impact on the overall rate of inflation.