Last week we received the highest quality and quantity of reader mail I have ever seen. You flooded the Fortune & Freedom inbox in response to my recent question about the inflationary nature of interest rate increases…

To all the entrepreneurs, business managers and small company investors in the UK, I need your help with an important question. Have higher interest rates had an impact on how much work gets done around the UK?

I mean, are companies producing more, and are new companies being founded to produce something, now that it costs more to borrow money?

Or have higher interest rates impeded production, caused companies to go bust, halted expansion plans and cut investments in new production?

Let me know what your experience has been, with your permission to republish comments anonymously: [email protected].

You see, I suspect that central bankers have made a high school-level mistake in their understanding of economics. They’ve forgotten about half the equation which determines prices and thereby inflation.

So, let me ask the question in a way they might understand. What effect do higher interest rates have on the supply side of the economy?

The idea in the article was that tighter monetary policy contracts the supply side of the economy, which actually causes inflation instead of alleviating it.

That was my theory, and I asked you for evidence.

You can read the rest of the article, which goes on to explain the importance of the question, here.

I had thought my request was a bit vague and wonkish, as they say in the United States. But… well, “show, don’t tell” is one of the rules of writing well. So, over to you…

This reader explained the point I was making in the context of agriculture, with my emphasis added:

In a previous career I was an agriculturalist. As you will know, farming is business where producers are price takers, and the production cycle is a long one, so that the farmer has to commit capital to inputs long before he knows what his output will be (assuming that he does not hedge his output, which the vast majority don’t).  

With inputs there are usually pretty good correlations between the amount of input used and the yield (for crops). Take nitrogen fertilizer use on a field of wheat for example. The rational farmer will optimise fertilizer application/yield relationship. Nitrogen fertilizer prices have increased way above general inflation levels, because it is largely made from natural gas.  

The rational farmer will use less fertilizer and accept a lower yield, in this situation. And bear in mind that he does not know what price he will get for his wheat crop until 6 months or more after committing his fertilizer input. And that calculation will be made worse if he has to borrow to buy the fertilizer. 

If these micro-decisions are being made by farmers all over the world, it is not difficult to see that we could be heading for food shortages, and the inelastic nature of demand and supply for agricultural products would see big price increases for basic food products. (Ironically, that might be a good thing for farmers who would likely see incomes surge on lower output.)  

There is recent historical precedence for thinking this. I was a postgraduate student in 1975 and 76 when we had two summers of severe drought in UK. The price of food in the shops, especially fresh vegetables, skyrocketed. Many vegetable producers rely on irrigation and with dried up rivers there was none. Potato farmers that did have irrigation made a fortune. At the time that was considered by economists to be a significant factor in the near 20% inflation experienced at the time, as I recall.

I wish you and all at F&F a great 2023.  

I suppose central bankers are reducing financial market liquidity when they tighten monetary policy, so a drought is a good precedent.

Anyway, the point is that higher capital costs for farmers thanks to higher interest rates mean less investment and therefore less food. And that is inflationary. So higher rates caused an inflationary effect.

The same reader applied the thinking to the musical industry too:

My son is a musician and ran a band. Established in 2014 it had just about paid off its startup debts when Covid hit in 2020, and the business effectively shut down. He has been trying to get a new band established (the other band members have gone on to other things). But capital has effectively dried up! It is not just interest rates – loan capital is difficult to obtain at all, and if it is, the interest rate makes the business non-viable.  

Previously some of the band’s capital came from me. But I am retired, I could live on my pensions, and afford to invest something of my savings in his fledgeling business. But my pensions are only partially index linked, and I will be hit hard if inflation continues at 10% or gets worse as seems entirely possible. I have to think very carefully now, whether it is wise for me to invest again in his business.

This reader applied the idea of higher interest rates restricting supply to the obvious place: property supply. It doesn’t seem to me that higher interest rates will solve the problem of inflation when it comes to rents…

I am a fan of your emails as they seem to have got a grip on what’s going on.

I am a 70-year old living on state pension with, in theory, my income topped up by rent from properties. I have been a landlord for 30 years and lost half my properties to Mortgage Express in 2008-09. They now hold charging orders on my remaining properties (5) derived from shortfalls by selling my seized properties at 30p in the pound. Therefore I do not own any equity in the remaining properties, so there is no point in selling. Unless forced to do so by high interest rates!

I have been reluctant to write to you having read your remarks about zombie companies. Increasingly I have felt that must be me. When I took the mortgages on my properties out, they were stress tested at 5% yield (rent). I could see the flaw in that test when I bought a flat that also had £200 a month in service charges and ground rent. But now, even freehold properties with no such charges are costing me 2% over base rate, resulting in mortgage payments at 5.5% and rising. These properties now only just break even yet I still have the unrewarded time and costs of looking after them all. 

I have got to a point where I will have to borrow from my state pension or from credit cards to keep things paid and maintained. (I have had to pay for 2 new boilers in the last year, both on credit card). I have become a zombie landlord and my personal life has become restricted to a very basic level without any other income. The likely outcome unless interest rates reverse soon is that I will have to surrender my remaining properties, as they will cost more to keep than I can get in rent. 

My interest only mortgage payments have increased by 135% and more in the last year and the December increase will increase my payments again in February.  No tenant is going to accept a 30% increase in rent, so the 10 people living in my properties may become homeless. And that is what the central bank’s decisions have done to my world!

Landlords are fleeing the private rental sector, rents are shooting up, and homelessness is increasing…

Keep up the informed and detailed reporting.

If higher rates cut the supply of rentals as landlords sell or stop making new properties available, this is bad news for inflation…

If landlords increase rental prices to compensate for higher interest rates, that’s bad for inflation too.

It is much the same for newbuilds, as this reader pointed out:

I’ve run a small business for forty plus years – property industry, residential and commercial redevelopment. In both sectors this has meant dealing with properties which all needed attention, from listed period houses to a business park.

Across the board tinkering with interest rates had a direct effect on building supplies to me : on a relatively simple level increased rates increased prices and vice- versa, lower rates either stabilised or lowered prices.

Having said that many other factors were relevant, particularly as supply increasingly came from outside the UK. Timber was always a moving target and came under Chinese dominance – most of their prices have tripled for example :  whatever the main factors, the days of cheap raw materials have gone.

There is a massive global factor to it all which may be political rather than the result of seen and unforeseen consequences of the actions of various central banks.

There’s always too much going on at the same time to be sure about relationships in economics. We can’t do clean experiments. But it seems to me that central bankers outright ignore the theory or the possibility that they are harming supply and thereby raising prices when they tighten monetary policy.

Research and development is often one of the first places companies cut their budget, as they do when interest bills rise.

R&D is taking a hit; where a Proof of Concept would have been signed off prior, they are no longer even entertained. Equally, something as simple as hardware replacements are now being delayed or foregone altogether. Technology refresh cycles may now be every 4-5 years rather than every 2-3.

Whilst this will have a clear impact on the earnings of those involved in manufacturing, distributing and configuring the equipment, it also means that equipment often designed to last only 2 to 3 years is now being ‘sweated’ beyond its life expectancy, carrying a myriad of security, supportability and efficiency issues (try using a low end mobile phone from 2017 and you will know exactly what I mean). This is already the case across many government institutions and I expect it only to worsen.

This reader argues that higher rates aren’t a big factor… relative to the other ones playing out right now.

What we are finding the interest increases are not the problem.

Business Mortgages are short tend to be max 20 years and the interest rates about 5%.

That means you are repaying large amounts of capital every year, and the increase is not doubling or trebling like if you were on say 1%.

The main problem is Electricity Costs at moment, increase in labour costs and various commodities.

On another note, J. Hunt is saying he is going to reduce inflation to 5 %.  I don’t think he has much control on inflation. And if he does … were Conservatives responsible for its rise then?

I was a governor of a small school once. Teachers blamed students for poor results and congratulated themselves for good. I wasn’t popular when this was pointed out.

It seems to me, that central bankers are either stupid or insane.

The prime cause for our current inflation are the global price of gas and grain, caused by Putin, and our deciding, quite rightly in my opinion, to stop buying from Russia.

That is an exceptional set of circumstances.

Raising interest rates cannot possibly do anything to bring those global prices down, and hence cannot bring down the consequential higher prices of things that need energy or grain.

This has the effect of reducing people’s spending power.

Now, the new higher interest rates put up the cost of borrowing for everybody, which takes even more money out of people’s pockets, and gives it to the banks.

Both people and business.

So under these circumstances, raising interest rates is going to help push the economy into recession. It will do nothing to bring down inflation, but no doubt the Bank will take the credit for inflation coming down because the global gas price has fallen.

It’s not just about existing borrowers being squeezed though. This reader does a good job of explaining how higher interest rates impact a business’ expansion plans:

Thank you for your article on the bankers focusing on the wrong half of the equation. Of course you are spot on.

I remember as a business analyst having to calculate the Net Present Value of projects. In simplistic terms, that is how long will it take to recoup the investment of a project. We would calculate the annual savings and the project expenditure including the cost of borrowing the funds. With high [interest rates] the cost of borrowing would be higher and this would reduce the financial gain of the project meaning that the gain from the project would be pushed further out in time.

Projects which would not break even after a reasonably short time would probably be scrapped or put on the back burner. Boards were less likely to commit to projects involving financial outlay in times of uncertainty. Instead business would focus on savings that could be made.

One popular area to examine would be their own supply chain. This would lead to squeezing their own suppliers, reducing stock levels, cutting out low yielding products and products with slow turnover. During uncertain times, Boards would also be considering risk. So projects with potentially great returns could be axed based on the risk involved which is always higher during times of inflation.

That sounds to me as if higher interest rates cause a contraction in supply. Which means higher prices and more inflation, not less.

This reader made a related point, and one that I missed in the analysis:

Hi Nick,

I read your piece on people focussing on the wrong aspect of inflation and thought I’d add my tuppence worth. You’ll see when you read this that I’m certainly not an economist, but I’m trying to think in terms of basic logic.

I think that inflation in this country is driven by the fact that we import so much and are therefore sensitive to exchange rates. If we need foreign currency to buy our goods and services, then, so long as we operate under a trade deficit, our currency is going to depreciate continuously, and this will show up as inflation in the supermarkets etc.

Because our domestic economy is stagnant, the government taxation and interest rate policy is only stripping money that is windmilling around our stagnant economy, thereby reducing the domestic money supply and steadily increasing the poverty of the domestic population, whilst all the time, we are still buying in imported goods.

Structurally, we can tinker all we want with the domestic money supply, but that doesn’t affect its apparent worth in the eyes of a foreign business; if we spend more externally than we bring in, our currency becomes less appealing to them.

In order to combat this type of inflation, we need to focus on boosting exports, with the aim of bringing money into the country; this money then causes ‘good’ inflation by increasing wages, which then drives up purchasing costs throughout the wider economy.

However, no government to date has provided any meaningful information on which countries have money and are in need of something which we can sell; if they could manage to do that without taking the place of the entrepreneurial sector, that would be the most useful that any government has been to its people in several decades.

Specialisation and trade are important sources of wealth. But the exchange rate likely does explain some inflation. The thing is, the US dollar roared in 2022, but inflation still took off in the United States first…

A few readers argued that monetary policy is playing second fiddle to fiscal policy, or should do so.

Hi Nick

Your description of the twin concurrent problems of both inflation and shrinking GDP highlight the impossible situation that an ‘independent’ Central Bank finds itself in. Certainly the problem must involve both monetary and fiscal policy and there may be global headwinds greater than any nation can sail against in the short term.

Over 25 years of cost deflation in the supply chain have been achieved through: adoption of new technology; from ‘off-shoring’ manufacturing, largely to China; and of lower labour costs through immigration. In addition, following the Great Financial Crash of 2008 Central Banks collectively injected vast amounts of liquidity – so called era of cheap money – which scarcely seemed to appear in the real economy and instead drove up asset prices: property; shares; bonds; cigars; cars; and art.

Now, as two of the three historical deflationary trends in the supply chain are reversing, coupled with huge rise in the cost of money, the resultant steep increase in inflation is ending the benefits seen for over a generation.

Do you feel that moving to Modern Monetary Policy and printing more (as in Trussonomics) is the answer or would that simply kick the can further down the road?

Certainly my experience as CEO and Non-Executive Director in the SME sector was that cheap money following 2008 kept alive zombie companies that by rights should have been closed and the resources redeployed in new and more productive organisations. Easy to say but hard and cruel for those who would lose their livelihoods. And now, 15 years later, we are also faced with labour shortages leading to rising wages even though in a recession. The opposite of what traditional economics would expect.

How about this for a radical solution?

The government uses their fiscal policy to alter the tax system to ensure that companies have an unmissable incentive to make capital investments to improve efficiency. They dovetail this with the Bank of England’s monetary policy for something more nuanced and targeted to business investment to help lift our productivity through better capital deployment. This would also help offset the labour shortage which seems to be part of the inflationary/recessionary problem.

What do you think?

I think that the government would muck up such a policy, favour their mates over what makes sense, and there would be an impressive amount of corruption. In the end we’d be left with a long list of industries that are even less productive and rely on government tax incentives. It would be better to let the free market figure out where resources should be invested.

Other than that, I agree.

This kind reader is a little worried about my relentless realism… when it comes to analysis of central banks and governments.

Dear Nick,

I am an avid reader of your column, and viewer of your podcasts. I have to say that I very much agree with your contrarian opinions, and criticisms of government policies and central banks. I’ve enjoyed a lot of really keen insights from your articles.

I have noticed, however, that your musings are almost entirely negative, and I have struggled to determine the alternative courses of actions and solutions you would propose. Yes, you were flagging inflation before it took hold, and before the BoE took action, but what would you have done to stave it off?

Also, in the current situation you point out that inflation is being driven by increased global energy prices and supply shocks due to the pandemic and the Ukraine (not going to be solved by raising interest rates), and the legacy of prolific QE including the effects of Covid ‘free money’ (probably can be eased with increased interest rates).

Has the BoE therefore not actually got it about right? OK, they were slow to start raising interest rates, but then could they really have done that before it was clear that there was a risk of inflation being more than a one off shock?

Also I am sure that you have pointed out that 3% interest rates are insufficient to tackle 10% inflation, and are indeed pretty much normal levels, but now suggesting that those rates are crashing the economy?  Has recession not been inevitable in that face of years of unsustainable public and private debt, and the end of the road for QE and absurdly cheap money?

So I’m thinking that the BoE has actually got it about right with a cautious approach to raising interest rates, acknowledging that at least some of the inflation is transitory? The contraction we are seeing in the economy is at present looking pretty small, and as I suggest above perhaps inevitable regardless of the BoE’s actions?

I am keen to clearly understand what course of action you propose the BoE and the government should be taking.

The reader carefully read both sides of the arguments which I’ve been trying to untangle for the past two years. Are we dealing with real inflation of the monetary sort, or just inflation of the price shock sort?

This article sort of answers the question. Credit data suggests we really did have monetary inflation and the central bank really should’ve hiked rates sooner.

But I take the point that we were all dealing with uncertainty at the time. And so can we blame the Bank of England?

Well, if you take responsibility for handling inflation in the way the Bank does, then you are responsible for it. The correct thing to do, given that central banks cannot and do not control inflation, let alone understand it, is to shut the place down and let the free market determine the interest rate by balancing savings and loans, just as we do for other prices in the economy.

This reader has an additional point about that:

You appear to start with the assumption that central banks are trying to work for the good of the general populous.

I, as an economic luddite, could see that they took interest rates too low for too long. I’m also old enough to remember UK in the 70s. Inflation high causes strikes – which also mucks up productivity.

So if I can see they are getting it wrong they should [too]. Follow the logic and consider that they do have a good idea of what they are doing. Could it be Orwellian? Kill of the entrepreneurs and make everyone state dependant.

More and more that is my take.

I enjoy reading your work. Thank you.

I enjoyed reading your work too, readers. Thank you!

Nick Hubble
Editor, Fortune & Freedom