The Bank of England’s monetary policy committee has decided not to raise interest rates in a time of high inflation. Here’s a brief primer on why that’s interesting and what that might mean for financial independence planning.
Monetary policy, inflation, and interest rates
I’m assuming that you have a bit of knowledge of how £££ are added into the economy. If you’re feeling a bit rusty, check out my post on how money is made.
Monetary Policy Committee of the Bank of England
Let’s call these guys the MPC, to save my typing fingers from repetitive strain injury.
The MPC’s job is to try to – indirectly – steer inflation towards a target of 2% CPI. No more, no less. Obviously, it can’t hit a perfect 2%, so we’ll expect some wobbling above and below that.
The theory goes that 2% inflation of the money supply is the right compromise between making sure that there is enough liquidity in £ for everyone to get a slice as the population grows, and prices shooting up because there’s more £ available to buy stuff with. You would expect that sellers of goods and services will probably charge as much as they can get away with for their products. Therefore, if there is more ash to be spent, they can presumably get away with charging more.
The MPC only has a couple of levers it can pull:
- It can agree to buy more government bonds; and/or
- It can change the interest rates on borrowing from the central banks.
That’s pretty much it. The MPC meets up, looks at where the economy is going, and agrees on the combination of government debt it will buy and changes to the central bank interest rate that it charges to intermediary banks. An exact science, this is not.
Inflation
As you saw in last week’s post on the autumn 2021 budget, we’re expecting 3-5% inflation as a country for the next 1-2 years.
So, you know, double the target rate.
That’s a problem because cash is therefore devaluing pretty quickly. To give you an indication: if we assume a 4% inflation rate over 2 years, you’d expect £100 today to be worth £92.16 at the end of those two years. Unless some interest is earned, people are getting poorer by being priced out of goods and services.
The central bank rate isn’t your interest rate, but it influences the costs of banks and lender doing business. Thus, if rates don’t increase, cash savings won’t grow to soften the blow, although borrowing will be marginally cheaper.
Nothing says “responsible spending” like having cheap debt and being punished for saving! Oh, wait… never mind.
For the government, inflation is pretty great. It allows more cash to be made available and put into public spending. It also means that if this cash isn’t spent, they can pay back more of the government bonds and not have to create many more new ones.
However, the MPC isn’t an arm of government. It reports to government if it isn’t doing its job, and it can curtail reckless government spending, but it isn’t government. That’s something to be aware of.
Where interest sits in monetary policy
Higher interest rates tends to promote saving. Saving means taking money out of the economy. Cash isn’t a good measure of an economy; it’s just a measure of debt borrowed against a country’s capital.
Cash? Capital? Fiat cash? Eh?
This is quite a hard concept to get your head around. I’m not going to go into much detail on this, but the basics of a fiat cash system and the wealth of nations is that the capital is the product and the fiat cash issued by the government is kind of like a share of that capital.
Fiat cash (i.e. pretty much all cash used in the world today) is a token of your debt owed by the country. If all the capital value of a country could be piled up, your cash represents a share of that pile if it was split amongst all cash holders.
You can’t cut the same cake into 16 slices and expect to get the same size slices as if you’d cut it into 8 slices – there’s only the same amount of cake. Therefore, more cash with the same amount of capital means that cash represents a smaller slice.
Interest is meant to compensate you for the effects of inflation somewhat. Your cash may be worth less, but you have more of it thanks to earning interest. If you’re lucky, the interest rates mean that you’re in profit; if you’re unlucky, the interest rate just means you’re a bit less worse off.
When cash is saved, it isn’t available to buy stuff with. That should prevent sellers from raising their prices too much. The idea is that potential buyers won’t be interested in taking cash out of savings to buy stuff with.
It’s not a perfect system, but basically interest rates are there to prevent too much buying and encourage saving, minimising the inflation caused by new cash being added into the economy.
The MPC’s current policy
Last week, the MPC decided to retain low interest rates.
There is a nice headline from the BBC reporting this: Bank of England sorry for rising cost of living. I think my favourite quote from this article is from former MPC member Danny Blanchflower. See the quote given to the BBC below.
So, the central bank really hasn’t a lot of clue what is going on.
D. Blanchflower, 2021.
Wait… that doesn’t follow what you said at the start..?
No, it doesn’t.
From my reading of the MPC’s monetary policy announcement, Mr Blanchflower has a point. The MPC assesses that GDP growth will revert back to pre-COVID levels in Q1 2022 (i.e. by September 2022); however, inflation is expected to revert back to 2% CPI in the “medium term”.
If that sounds like a lot of mumbo-jumbo to you, that’s because it largely is. If the economy is looking to recover so quickly, it shouldn’t need more money added to incentivise spending and growth: it is already happening. Likewise, if this is happening, inflation is likely to keep rising.
Looking at the minutes of the meeting, two out of the nine members present agree with me.
Simply put, the interest rates ought to be rising, the MPC has decided that they won’t raise them and it is “sorry” about it.
What this means for your money
We can pretty much deduce three things:
- The MPC probably can’t be trusted to make sound monetary policy decisions.
- Cash savings are going to be terrible places to put your money for the next few years.
- Debt is probably going to be cheap for a while yet.
OK, I was being flippant about number 1. Still, I suspect that the MPC is more concerned with keeping the Chancellor happy than following its mandate to sensibly control monetary policy.
What I’m doing with this knowledge
I’ve mostly been doing these things already, but the latest announcement simply confirms that my approach should stay on track.
I’m keeping my emergency fund small, and I recently spoke about how I’m using a credit card to extend my modest emergency savings.
Doing this is allowing me to maximise money for investments. It’s quite clear that the only way to get my wealth to grow in the next few years is to put it into non-cash assets, like shares, real estate or crypto.
I will consider cheap debt as a potential leverage tool for buying new assets, but it’s not something I’m planning on in the next two years. I’m open to the idea of it, I just don’t have any short-term plans. If I did have such plans, now might be as good a time as any – debt isn’t going to get any cheaper.
