The Bank of England has raised its policy interest rate for the fourth time in a row, yet still expects inflation to reach double digits before the year is out. Policy-makers must rise to the challenge of mitigating the cost of living crisis, while supporting the post-Covid-19 recovery.
Newsletter from 13 May 2022
Policy-makers around the world are scrambling to deal with the effects of inflation and the growing cost of living crisis. Last week, the Bank of England raised interest rates for the fourth time in a row and its counterpart central bank in the United States, the Federal Reserve, announced the biggest interest rate hike in over 20 years.
New data show that the UK economy contracted in March and growth looks set to be stifled for the rest of the year as inflation squeezes living standards across the country. How policy-makers navigate this threat of ‘stagflation’ depends partly on what is valued, how different goods and services are priced and what sacrifices are made.
High prices, low rates
With inflation at its highest level in three decades, and predicted to climb as high as 10% later this year, Huw Dixon (Cardiff Business School and a lead editor here at the Economics Observatory) this week laid out how inflation affects the economy when interest rates are near zero.
The Bank of England’s Monetary Policy Committee has set very low nominal interest rates since the global financial crisis of 2007-09, so the recent spike in inflation has just extended the longest period of sustained negative real interest rates in UK history (see Figure 1).
Figure 1: Nominal and real interest rates (2009-2022)
Source: Bank of England
Large-scale asset purchases or quantitative easing by the central bank have also helped to keep real interest rates low in a bid to stimulate the economy. But the most important effect of inflation, Huw argues, with these conventional and unconventional monetary policy measures in place, is the redistribution of wealth from savers to borrowers.
The most notable beneficiary of this transfer is the government. As the biggest borrower in the UK, (with debt equal to around 100% of GDP), inflation can be seen as a tax on government bond-holders. As a result, if inflation reaches 10%, the inflation tax will be equivalent to about 10% or more of GDP. Households bear the brunt of this, although Huw points out that those with mortgages also benefit from the real value of their debt being eroded.
The 1970s offer a lesson here: when inflation is prolonged, it becomes entrenched and difficult to reduce. In such circumstances, as now, UK central bankers face a difficult decision. Raising interest rates further will weaken government finances. It will also be unpopular with those who have benefited from high house and share prices, and could contribute to a recession.
On the other hand, not acting would erode confidence in the Bank of England’s ability to control inflation – something it has worked so hard to achieve in the quarter of a century since its independence (as reported in an Observatory piece last week by Jagjit Chadha of the National Institute of Economic and Social Research, NIESR, another of our lead editors).
When the Office for National Statistics (ONS) calculates the rate of inflation each month, it uses a ‘basket’ of 700 good and services and measures changes in their price. As pointed out by Diane Coyle (University of Cambridge and another of our lead editors) in a new piece this week, social media and internet search are examples of products that are not included in this basket. As free services that we don’t directly spend money on, they cannot be included in price data. Instead, we pay for them in terms of our time and our data.
In general, the rise of the internet has been a good news story for inflation, as many of the products that we used to pay for are now free. The price of telecoms – such as bundles of calls, texts and data services – have also fallen significantly, for example.
But zero prices for much-valued free digital apps do not tell the whole story. Advertising opportunities and data collection are needed to keep these services free. Universality and affordable access are also important challenges for policy-makers. For example, there is evidence that children in lower-income households in England had worse access to online lessons during school closures as a result of the pandemic – a problem anticipated by some of the early pieces on the Observatory in mid-2020.
The cost of lockdown
Lockdown learning is explored further by Per Engzell, Bastian Betthäuser and Anders Bach-Mortensen (University of Oxford) in their piece for the Observatory this week. Educational data are less widespread and timely than many other sectors of the economy. But the authors highlight an early and influential study from the Netherlands, which finds that students learned very little during the first eight weeks of home schooling. Students whose parents were less well educated also suffered the largest setbacks.
A systematic review of the current evidence also finds that students lost out on around 43% of a school year’s worth of learning, on average (Betthäuser et al, 2022). This study suggests that the worst learning deficit occurred early in the pandemic.
And yet, the research indicates that there are some reasons to be optimistic even after two years of interrupted schooling. In particular, the learning deficit can be undone and long-term consequences prevented, as long as decision-makers show enough resolve.
Just as with the challenge of the escalating cost of living crisis, making up for learning losses caused by Covid-19 remains paramount. Children and young people need to be equipped with the skills necessary to enter the ever-turbulent world of work. Policy-makers must continue to recognise and mitigate the hidden costs of Covid-19. Now as much as ever, knowing both the price and the value of everything is vital.
- ESCoE Conference on Economic Measurement (25-27 May), University of Strathclyde. On Thursday 26 May, the Economics Observatory will be running a two-hour workshop at the event to highlight the advantages and some caveats of using data visualisation as the main channel for communicating economic information to a wide and diverse audience. This workshop will include a 'code along' where participants can learn to create an interactive chart like those on our data hub. Registration for the conference at the University of Strathclyde is open here.
- ECO Collection: Scottish Independence. We recently launched our first printed collection Scottish Independence – Economic questions and research evidence. A digital version is available to read online.
- UCL Stone Centre. Our colleagues at University College London are running an event to celebrate the launch of the UCL Stone Centre (on Wealth Concentration, Inequality, and the Economy). This will be held at Church House, Westminster on 26 May 2022 at 5-7pm, followed by a reception. The event will feature a keynote lecture in-person by Nobel laureate James Heckman, on policies around social mobility and human flourishing. This will be followed by a panel discussion on inequality and firms chaired by another Nobel laureate Sir Angus Deaton (also in-person). The registration link is here for both in-person and online.