The current economic situation is eerily reminiscent of some of the worst economic crises of the last 50 years. We have surging inflation and squeezed living standards, accompanied by strikes and widespread disruption. It sometimes feels that all we are missing is a plague of frogs.
Yet some key crisis elements are notably lacking. The typical economic crisis of yore might involve widespread job losses, weakening house prices, surging bond yields and sharp drops in the stock market – sometimes all at once. In contrast, the unemployment rate is currently running at only 3.8pc and shows no imminent signs of increasing. Meanwhile, until very recently house prices have been rising strongly and the market is currently steady, despite looking decidedly over-valued.
After a rocky start in the early months of the year, the UK stock market has recently been holding up remarkably well. Similarly, government bonds (gilts). Here we are with a large debt burden and inflation surging into double figures. Yet the yield on 10 year bonds is only 2.4pc. In other words, the real yield on gilts, which is a key determinant of other asset values in the system, including equities and commercial property, is heavily negative.
Does this mark out this crisis as being of a very different type, or are the missing elements yet to come?
The main explanation for the differences from crises past lies with interest rates. After recent economic news, the Bank of England may well increase rates by 0.5pc at its meeting in September.
This is supposedly going to cause shock and awe. But this increase would take rates to the less than earth shattering level of 2.25pc, compared with inflation that is already running above 10pc and which the Bank forecasts will peak at 13pc. The Bank has been increasing rates by much less than the inflation rate has been rising. The result has been that real interest rates have been becoming even more heavily negative.
This is bizarre. In the past, when the monetary authorities wanted to get on top of inflation they have increased real interest rates, sometimes to painful levels. During the 1970s, although nominal interest rates were high, because inflation surged above 20pc, real rates were heavily negative and inflation remained untamed. By contrast, over the 1980s, as the Conservative government got serious about reducing inflation, real interest rates averaged 5.2pc. And they averaged 4.5pc during the 1990s. Real rates stayed positive until 2008, when the onset of the Global Financial Crisis (GFC) saw nominal rates cut to 0.5pc, even though inflation was much higher. This began the long period of negative real rates that we are still in.
I doubt that interest rates, either nominal or real, will need to get to the level of the 1980s and 1990s this time round, not least because of the high level of personal debt and the fragility of key parts of the economic system. Nevertheless, the scale of the present interest rate danger is still not fully appreciated.
Admittedly, the inflation rate may fall back rapidly next year. But it is most unlikely to fall back readily to the 2pc target without further tough action. I could easily see inflation getting stuck in the 3-6pc range. To achieve real rates of 2pc, which would not be high by past standards, nominal rates would then need to reach 5-8pc. This would have dramatic consequences for mortgage rates and the housing market, as well as for the wider economy and the financial markets. Unemployment would surely rise.
It is sometimes suggested that by imposing higher interest rates on the economy, the Bank is increasing inequality as this hits already hard-pressed households with higher mortgage payments.
But this doesn’t really hold water. For millions of people at the bottom of the income scale will tend not to have mortgages at all. Indeed, it is striking that people who have held substantial amounts of their net wealth in housing and equities have not yet suffered an appreciable hit to their asset position.
Meanwhile, people who have their savings in bank deposits or National Savings have experienced very large drops in their real value, without this being offset by appreciable receipts of interest income. These people are to be found disproportionately in the lower income groups.
But for the personal sector as a whole, housing is the most important asset market. Past experience gives a clear warning of what may be about to happen. Real house prices fell sharply in the economic crisis of the mid-1970s, mainly through surging inflation rather than falls in nominal house prices.
Real house prices fell again at the beginning of the 1980s as the economy moved into recession and unemployment soared.
They again fell sharply at the beginning of the 1990s as the economy languished in recession during its membership of the ERM and they continued falling afterwards, even as the economy recovered. They again fell in the GFC of 2007-9 and didn’t start rising again until 2014.
Even though average house prices are still creeping up a bit, and the annual rate of increase is above the annual inflation rate, the monthly rate of increase has slowed markedly and is well below the monthly rise in the CPI. But this is just the beginning. I reckon that even though nominal house prices may only fall by about 5pc, in real terms they will fall by much more – perhaps by as much as 20pc, which would be in the same ballpark as the corrections in real house prices that occurred in 1979-82 and 2007-13.
You might well think that there is enough pain in the economy already without much higher interest rates. Yet, because of absurdly low rates, there is no real sign of pain in many of the traditional markers of economic crisis. Unfortunately, I suspect that if the Bank is really going to get on top of inflation then there will have to be.
Roger Bootle is chairman of Capital Economics
This is not a full-blown economic crisis (not yet anyway)
If the Bank is really going to get on top of inflation then there will have to be real economic pain