Easing the credit surplus and increasing interest rates could be a timely response - particularly as revenge spending rears its head.
The fundamental concept supporting a central bank flooding the economy with cash is that inflation will be the ultimate Credit Master. Uh - Credit Master? Well, when central banks flood the economy with money, particularly like the US stimulus cheques, they create credit. This rise in consumer credit is traditionally corrected by inflation. So, what’s all the fuss about?
Source: Adrian Raeside for the Times.
What is inflation?
Inflation is essentially the rising of prices for consumers. For example, the cost of a basket of goods in the supermarket today vs. last year. It is measured by the Consumer Price Index (not incl. mortgages) and Retail Price Index (incl. mortgages/housing costs). That's all folks.
So, what does that mean for the economy right now?
At the moment, consumers generally have more money supported by furlough in the UK and stimulus cheques in the US, and on top of this consumers are generally: not going out, not going on holiday, not buying lunch out, and have limited commute costs. This is why individual savings and house prices (more deposit money = more demand) have increased.
Let’s take a particularly close look at not going on holiday, which should impact GDP if holiday spending is domestic rather than foreign. It is logical that if increasing holiday spending is domestic, then domestic demand will increase, and the prices of local holiday destinations will increase. In other words, local holidays are experiencing inflation supported by a myriad of factors including government stimulus.
We should not be alarmed or confused that the price of a pint has increased, considering that bars and pubs have been closed for a year and we are all very thirsty. We also should not be surprised that importing and exporting of everyday goods has increased, considering – in the UK at least – that manufacturing (China) and cross-border shipping (Brexit) has been met with considerable barriers for almost two years. The only surprising part about inflation currently, in my opinion, is that we are surprised by it at all.
Let’s look at interest and inflation working together, considering that QE (in my opinion this includes CLBILS) and nil interest rates were a considerable part of Covid stimulus in the US and UK.
On that CLBILS point, direct and easily accessible business loans are probably better than QE. This is because CLBILS are directly targeted at businesses at least who demonstrate some need for the cash. Remember that with QE, the government can only really access higher grade companies and hope that the cash reaches the wider economy.
Nil interest rates
The key factor to understand about interest rates for consumers is that higher interest rates translate to larger borrowing costs for items purchased on credit. The lower the cost of financing (i.e. low interest rates), the more consumers can afford to borrow/invest/spend. When rates are ‘too’ low for ‘too’ long, this inevitably leads to inflation because the surplus of credit in the economy has to be corrected.
Stimulus – furlough, CLBILS (UK) and stimulus cheques, QE (US).
In Covid, we are entering a period of inflation caused by an excess of credit that has been caused by unprecedented central bank and government stimulus measures. Not all of the money that went into the economy (furlough, stimulus cheques) went to people who spent the entirety of that cheque on essentials such as rent or basic groceries. Many of those people invested in stocks and shares (retail boom), invested in home improvements, or increased basic expenditure at home (buying more expensive items from supermarkets). Not all of that QE money went to support businesses who were in dire straits. Some would have been taken up by businesses, who now are in a position where they have increased power to invest in the business.
All of these factors of surplus credit cause inflation. They mimic what an economy would look like if it were doing well – because although it is artificial, it appears as 'growth’ because many people and businesses saved their cash. The issue faced by governments now is not inflation, because inflation will appropriately correct surplus credit.
So how do interest rates and inflation interact, and what really is the problem here?
If credit and borrowing is more expensive, but so are household goods, then consumers with limited disposable income – who rely on credit – are placed in difficulty. Theoretically, what should be different in Covid is that consumers have had the opportunity to save on typical expenditure such as eating out, commuting to work, and travel in general. As such, it should be a logical progression that if there is surplus cash in the economy – which there should be in theory – then consumers should be able to afford to live through inflation.
Logically, the government’s response to Covid does not actually make sense – because there is a credit surplus bottle neck. This is because the government is incentivising spending with low interest rates and furlough/CLBILS, but there is not actually anywhere for consumers to spend this money. Actually, inflation is trying to correct this macroeconomic error. Prices cannot be stable while this credit surplus is bubbling under the surface.
Once the economy starts again, and people are able to spend money, it is likely that consumers will go a little ‘crazy’. In Covid, it is absolutely no surprise that we are seeing an influx of ‘revenge spending’ – consumers spending savings aggressively to make up for lost opportunities during Covid. To prevent negative future implications from blasting through savings, actually higher interest rates that incentivise saving would probably be sensible Central Bank policy. The Central Bank will not need to incentivise spending after Covid – it’s going to happen anyway. If interest rates are low AND there is revenge spending, then inflation truly will pick up at an unmanageable pace.
Ok, but what’s the answer?
The answer is stopping government surplus credit and moving the economy back to normal conditions where there is travel, working from the office, footfall and consumer expenditure. On top of this, the government ought to get ahead of revenge spending and allow interest to creep back up. This could at least give us a chance in controlling inflation.
The solution itself is not the issue here – the issue is whether consumers are actually willing to return to how things were before. Either way, some lower income demographics will suffer the outcome of Central Bank cash flooding – particularly if revenge spending brings inflation to an unmanageable level.
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