Metis AM
In recent months, the rate of inflation has spiked to a 30-year high as the price of many goods and services have risen sharply, from the cost of energy to the price of petrol. Due to this, many households are finding their finances are more and more tightly squeezed.
As the cost of living rises, there have been many calls for the government to do more to address this problem. Of course, while the chancellor could offer direct financial help, this solution would only be addressing the symptoms of the problem and not the cause.
With that in mind, read on to find out what’s causing prices to rise so sharply, and what the government can realistically do about it.
The rate of inflation stands at more than 3 times the Bank of England’s annual target
According to data from the Office for National Statistics (ONS), the Consumer Price Index (CPI) rose to 7% in the year to March 2022. This level of inflation has understandably alarmed many people, since it’s more than three times the Bank of England (BoE)’s annual target.
There are several factors that are contributing to this rise and one of the biggest is the coronavirus pandemic. While the worst effects of the outbreak may be behind us, we are still feeling the economic fallout.
Due to the national lockdowns across the globe, the production of many consumer goods fell in 2020 and 2021, which has led to a shortage of supply. Of course, with many households having to tighten their belts in this time, it wasn’t immediately noticed.
However, now that economies are starting to open up again as the virus recedes, there is a double whammy of not only a restricted supply but a much greater demand. This has caused the price of many goods to rise.
The war in Ukraine has also been a contributing factor, due to the disruption it has caused to global supply chains.
For a start, the fall in Ukrainian exports has caused the price of food to rise. According to the ONS, in 2021 the UK imported around £830 million worth of goods from the country, mostly in the form of agricultural products such as wheat and vegetable oils.
Furthermore, the sanctions imposed on Russian oil and gas have caused petrol prices and energy bills across Europe to rise. This has been one of the largest contributors to inflation since higher fuel (and thus transportation) costs typically pushes up the price of other goods.
Addressing the issue of inflation can be a difficult task and so requires careful consideration
While a small amount of inflation can be a good thing, as it keeps the wheels of the economy turning, having too much can quickly cause problems and become difficult to control. This is why the government has to think carefully about their response to this issue.
In his famous speech to the Mont Pelerin Society Conference in 1969, the economist Friedrich Hayek compared the act of controlling inflation to trying to grab a ferocious tiger by its tail. While letting it run amok would be devastating, trying to stop it could also have some nasty consequences.
Essentially, there are two ways the government can address this problem – by influencing the supply of money in the economy and by intervening directly to reduce the cost of goods.
However, there are issues to consider with both of these approaches. This is why the government is hesitant to act too rashly, as any action could have significant consequences down the line.
Raising interest rates could curb inflation, but would punish borrowers
Historically, the ability to manipulate interest rates has been the main tool that governments use to combat out-of-control inflation. However, while this may be effective, this can be a bit of a blunt instrument, so it isn’t always appropriate to use.
Essentially, when the BoE raises their base rate, it puts pressure on lenders to raise their interest rates. This makes it more expensive to borrow money, and encourages people to save more, rather than spend. This can take some heat out of the economy and can be a useful way to reduce inflation.
However, raising interest rates would penalise people who hold a significant amount of debt. For example, if a person held a £200,000 mortgage and interest rates rose from 4% to 5%, then they would have to pay an extra £2,000 each year merely to service the loan.
At a time when many households are struggling due to rising living costs, raising interest rates could make it even harder for people to pay their bills. Even if the move is only temporary, and successfully curbs inflation, it could still be painful for many Brits.
Alternatively, instead of changing their monetary policy, the government could alter their supply-side policies. This would involve measures to make the UK economy more competitive, as the increased efficiency would theoretically reduce long-term costs.
For example, lowering Income Tax or cutting red tape to give businesses more flexibility could reduce inflation over time. However, while these policies would help in the long term, they would do little to alleviate the problem now.
One policy that the government could consider, at least in the short term, is to put a cap on rents in the private sector, to limit rising housing costs. While this move would potentially be highly unpopular, it could go a long way to control the rate of inflation.
As you can see, there is no easy answer to the question of how to solve this problem, which is why the government may have to use a hybrid approach.
For example, they may put pressure on the BoE to raise interest rates slightly higher but not so much that the move would negatively affect homeowners.
At the same time, while Rishi Sunak has committed to cut the rate of Income Tax to 19% by 2024, as we discussed in our spring statement update, he may go further and promise a larger reduction.
If the government want to lower inflation before it gets out of control, they may need to act quickly. This is why the policies they make in the next few months could have far-reaching consequences.
Get in touch
If you’re concerned about rising inflation and want to know how you can protect your money from it, we can help. Please email enquiries@metiswealth.co.uk or call 0345 450 5670.
