Interest rates are going up again this week – this is why

This week interest rates go up again. They will go up here in the UK, in the US and in Europe, with the only issue being how much they go up by: 0.25 per cent, 0.5 per cent, or maybe 0.75 per cent. The stated aim of the central banks is to combat inflation.

Yet we all know that the two principal drivers of inflation this year have been the war in Ukraine and the sanctions that the West has imposed on Russia, and the wider supply-chain disruption that has resulted in the aftermath of the pandemic. Interest rates have nothing to do with either the war or the disruption. So where is the justification for increasing people’s mortgage rates at a time like this?

The central banks have been very bad at explaining what they are doing but their collective actions are putting a damper on the festive season. Add in the understandable labour unrest – understandable because if people face 10 per cent price increases they might reasonably try to get a decent pay rise – and it is all pretty glum.

And yet there is both a credible explanation and a chink of light. The explanation goes like this.

Quite aside from the war and the post-pandemic disruption, there was already a problem with inflation. There was a huge problem with asset inflation, the puffing-up of the price of everything from bitcoin to houses in just about every country in the developed world. And there was evidence of current inflation creeping up well before the invasion in February.

The need to increase interest rates was to cap the surge in asset prices and nip that upward creep of current prices before it got out of control. The central banks should have been increasing rates a year ago. They failed to do so and now have to overcompensate for their errors – though don’t expect central bankers to apologise, for that is not what they do.

So the double blow of the war and the post-pandemic disruption simply made a bad situation worse. Interest rates would have had to go up anyway. The question then is: have they gone up by enough?

Here, I think there is growing evidence that they have. You can see that in our own housing market in the UK, where prices are now falling. It makes no sense to have a housing crash because that would damage the entire economy. What we need is a period of stable prices, allowing rising wages to catch up and make homes affordable again. And there is the chink of light.

If interest rates have risen by enough to stop house prices from rising, maybe they have also gone up enough to contain inflation more generally. This time next year I could see both inflation and interest rates coming down quite sharply. Indeed, we may well be at the peak of inflation right now and if we are, then rates will come down too.

What about labour unrest? It is completely understandable. If your real pay has gone down by 10 per cent and you feel you are in a strong bargaining position, then the natural thing to do would be to try to use that position to claw back your loss. It isn’t helpful to try to make moral judgements as to whether strikes are justified or not but it would be silly not to acknowledge that anyone whose real pay is being cut has a right to feel upset. Inflation has a catastrophic impact on labour relations.

Now look ahead. Energy prices will come down. Already the oil price in dollar terms is cheaper than it was on the eve of the war in Ukraine, for on the Brent benchmark it is around $80 a barrel, whereas on 24 February it was $90 a barrel. True, the pound has fallen against the dollar since then, as indeed has the euro. But exchange rates are adjusting slowly and the pound and euro are climbing back. Cheaper oil has not yet fed through to the price of fuel at the pumps, or at least not fully, but it will eventually. It will take longer for the gas price to steady but eventually, that will too.

If this is right, then gradually both inflation and labour unrest will ease through 2023. The winter of our discontent will not be transformed into a glorious summer, as Shakespeare had Richard III proclaim. But inflation is the driver of labour unrest, and as it eases industrial relations will improve.

This will not happen suddenly and there are several difficult weeks ahead. But while it is always hard to spot turning points until well after the event, I am pretty sure we have passed the peak of inflation. If that is right, the peak of interest rates will come in the spring. This will not make this not-very-festive season feel any more festive, but it gives a glimpse of calmer times ahead.