The Daily Telegraph
Truss hits the ground running with transformational move for prices
Inflation forecasts will be substantially lower as a result of moves to freeze energy costs for consumers
‘However high the ultimate cost, it will look cheap set against that of doing nothing’
Every time you look, someone has seemingly come up with an even more alarming forecast for peak inflation. The worst I’ve seen so far is from Goldman Sachs, which modelled CPI inflation at 22.4pc if gas prices remained where they were at the time the forecast was made.
They’ve come off a tad since then, but without the sort of intervention that the new Prime Minister is expected to announce later this week, inflation might well have been of that order of magnitude.
Such an outcome would have devastating consequences, both for the public finances and the wider economy; which is why no government, whatever its colour or ideology, could have allowed it to happen.
What Truss proposes therefore makes perfect sense, even if it is a policy that is essentially stolen from Labour and the Lib Dems. The costs look eye watering – anything up to £170bn to keep bills where they are until the next election in two years’ time, depending on what happens to energy prices in the meantime.
But however high the ultimate cost, it will look cheap set against that of doing nothing, with aggregate demand poleaxed by rocketing energy bills, surging unemployment, bankruptcy for tens of thousands of struggling small and medium-sized enterprises, a deep recession, and servicing costs on mountainous public debt through the roof. All these negatives follow inevitably from today’s supercharged inflation rate.
Whatever else it does, the Government’s first-order priority must therefore be to get the inflation rate down to more manageable levels. The subsidy plan goes a long way towards delivering that goal. Capital Economics says that freezing bills at current levels will reduce peak inflation from 14.5pc to 11pc. The inflation rate would then fall rapidly next year, and although there might still be a mild recession, it ought to be much shallower than otherwise.
Samuel Tombs, of Pantheon Macroeconomics, goes further still. The inflation rate could be back to 2pc as early as the second quarter of next year if energy prices are frozen at current levels, he believes.
Such forecasts naturally pose the question of just how high interest rates will have to rise to restore price stability. There have been some pretty fruity suggestions on that front too of late. Willem Buiter, a former member of the Bank of England’s Monetary Policy Committee, has suggested as high as 6pc.
Market expectations of Bank Rate have also risen dramatically in recent months, from as little as 2pc last May to 4.25pc today.
This is much higher than any commercial bank thought remotely possible when Putin first invaded Ukraine, and would, if it came to pass, require extensive debt forbearance by mainstream banks to avoid a frenzy of corporate and household bankruptcies.
In itself, this raises an interesting question. Just how much scope do central banks really have for putting up interest rates given the massive expansion in debt their own money printing has given rise to over the last 14 years?
The sheer quantity of the stuff creates its own form of financial repression, making it hard for the central bank to raise rates without destroying the economy.
In any case, is it really necessary to raise rates to 5pc or more to get on top of inflation? Even Tim Congdon, who almost alone among economists correctly predicted today’s spike in inflation, thinks that with the extreme money growth of the last two years now returned to more normal levels, such harsh medicine may no longer be needed.
Capital Economics has modelled the effect on mortgage repayments of a 5pc bank rate, and the results do not look pretty. If Bank Rate rose to 5pc, the economics consultancy estimates, then it would add around £18bn to household interest rate payments between the first quarter of 2022 and the last one of 2024. This is not nearly as big as the damage done by the energy crisis, but none the less would be another whopping great blow to demand.
It surely makes little sense to be paying out tens of billions of pounds of taxpayers’ money to protect disposable incomes from the ravages of surging energy bills, only for the Bank of England to undo much of the gain by whacking up mortgage costs.
As it is, the energy price mitigation package will take much of the heat out of the outlook for inflation, and therefore transforms the likely trajectory of interest rate rises.
The caveat here is sterling, which has come under sustained attack in currency markets, adding to inflation and therefore the upward pressure on interest rates.
As if the new Government doesn’t already have enough in its in tray, bolstering confidence in the currency must therefore also be a priority. It won’t be easy. Currency markets have a real downer on Brexit, which rightly or wrongly they think has significantly damaged Britain’s economic potential. They also worry about fiscal sustainability and, in particular, Liz Truss’s promise of unfunded tax cuts. Many economists believe that these cuts will in themselves be inflationary, and therefore cause the Bank of England to raise interest rates higher than otherwise. There is plainly an element of truth in this contention.
If Rishi Sunak’s planned fiscal squeeze is reversed, it creates a slightly looser economic environment, which the Bank of England may think it needs to counter with tighter money.
Yet there is also some reason for believing the effects would be marginal. As Gerard Lyons, expected to be named shortly as part of the new Government’s planned “council of economic advisers” (after the American model), points out, elevated inflation is usually the result of excessive domestic demand. Yet today’s inflation is largely the result of an imported supply side shock; we consequently have a quite unusual combination of high inflation and weak demand. In such circumstances, to slightly add to demand with tax cuts may be relatively harmless. Furthermore, the “tax cuts” as so far outlined – actually in the case of corporation tax simply a foregone planned tax rise – are deliberately aimed at the supply side of the economy, or in other words at boosting investment. We therefore don’t have to worry too much about their inflationary consequences.
All the same, you don’t want to be rocking the boat unduly given the fragility of market sentiment.
The desire to do radical things is understandable, but if the Government kicks too strongly against economic orthodoxy, it will find itself with a fully blown currency crisis on its hands alongside everything else. This is not, for instance, the moment to be fiddling around with the Bank of England’s mandate and other such free thinking nonsense.
Get inflation down, stop interest rates rising too far. For now, this has to be the Government’s focus.