Economics vs the laws of unintended consequences

It’s not just the chancellor who’s dishing out the economic bad medicine these days. Central bankers are behaving like specialist hospital consultants. These people aren’t just pill peddlers but they are actually the ones who have to perform the often painful and unpopular physical procedures such as raising interest rates. The medical profession are extremely candid these days, they tend to tell it as it is without any sugar-coating. A chancellor or a BOE Governor, on the other hand, has to be a whole lot more diplomatic. That’s because economic patients are incredibly prone to bouts of extreme neuroticism. One wrong word could easily induce panic and send the whole damn ward into a frenzy.

The good or the bad news?

So, picture this. We’re in the doctor’s consulting room. In comes the doctor and plunks your medical folder onto his desk. He pushes back his spectacles up beyond his temple, rubs his eyes and sighs. He looks at you with a wry smile and asks which would you prefer: the good news or the bad news?

Frankly, I think it’s best to start by looking at the better news first, it usually takes less time and might be a handy cushion. And, the good news is (at the time of writing) that the UK’s consumer price inflation rate has fallen from 10.1% to 9.9% in August. The drop was because of recent falls in petrol prices which are down by over 7% over the last month. In the US, who have been more proactive in the fight against inflation, the consumer price index fell to 8.3% last month which is down from a high of 9.1% in June. So, is it time to relax and consider inflation licked? Have price rises and long last been tamed? Well, not quite. Let’s not get too excited.

I do my level best not to be a gray old Welsh ‘glass-half-empty’ gloomster. But beyond the world of ONS headline figures, the price of lots of things continue to spike. For example, the cost of food and (non-alcoholic) drink in the UK is now growing at a staggering 13.1%. Dairy products and eggs are going up the most. These items are considered staples, so it’s particularly worrying because the consequences are likely to hit the poorest households first.

The current reduction in the price of crude oil (again at the time of writing) suggests the energy sector is dealing with diminished Russian supplies, caused by Western sanctions. But we’re only just entering the meteorological autumn. Colder weather could quickly push up oil prices once again.

Approaching peak inflation?

Let’s just say that we are hypothetically approaching peak inflation. Problem is, I’m hearing concerns that the headline figure will remain well above the central bank’s target of 2% for a lot longer than envisaged. While escalating costs may ease a little, people’s budgets will remain squeezed for some time to come.

Services inflation often remains hidden from headline news but wage/price spirals are the most feared consequences of inflation by central banks because such trends become self propagating scenarios that push up headline inflation figures from the eerie shadows.

I fear that inflation has not yet peaked despite some encouraging August figures. One swallow doth not maketh a summer(eth). Economists still believe that the headline inflation rate will rise to 11pc by year-end. The Bank of England will therefore continue to increase interest rates which is something that has a habit of spooking investors. Here we have the unintended consequences factor. Or if we stay with medical analogies, we can call them side-effects.

Investors are perpetually worried about something, predominantly losing their cash. So, when they hear talk of central banks pushing Western economies into recession in order to halt inflation, they will be getting pathologically nervous. Markets have already reacted with the three main US indices recently suffering their biggest drop since June 2020.

Between a rock and a hard place

Many in the markets have voiced concerns that the Federal Reserve may stick to a higher-for-longer strategy which will probably lead to recession. But Central banks find themselves between a rock and a hard place. Doing nothing guarantees rocketing price rises while massive rate hikes risk other shocks which brings us neatly back to doctors: What’s the most debilitating, the disease or the treatment?

Threadneedle Street finds itself in a much happier position than most. Liz Truss’ new Government strategy of capping domestic energy bills at £2,500 will undoubtedly take the top off the inflation figures but it isn’t a completely get out of jail free card as far as inflation is concerned. What is effectively being done once again is to increase the money supply (by up to £150bn). This will result in some families having more cash to spend on other things which will inevitably filter through to push up prices, especially in these days of increasing supply shortages.

The old adage that if Uncle Sam sneezes, we all get a nasty cold still holds true today. If the Federal Reserve takes the ‘go big or go home’ approach to interest rate hikes, it will only further boost the value of the dollar. This means that the Bank of England will be forced to follow in order to protect the value of the pound to help keep down the cost of imports, including oil.

Thing is, recessions can be just as painful as inflation because recessions mean unemployment which has a dire impact on people’s well-being. Some economists have deduced that in order to swiftly bring down inflation towards anything like Central bank targets would necessitate a deep recession with millions more people losing their livelihoods.

It’s been argued that central banks seem to be throwing too many things to the dogs in the name of taming inflation. Policymakers will surely realize from past mistakes that jumping up interest rates in order to calm inflation will inevitably halt economic growth. While it’s clearly very uncomfortable living with constant price rises, it has to be asked whether the rush to head off one major problem will just help stoke another equally big headache? It really does beg the inevitable question: which scenario is actually the worst?

But every storm eventually passes by. The biggest question is how much sweeping up will we end up having to do and how many casualties will there be?

Disclaimer:
The views expressed on this page are those of the author and not of The Portugal News.

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