The inflationary elephant in the room

House prices are supposedly due to fall by as much as 12 per cent in 2023. There is a cost-of-living crisis. Taxes are at record highs. Inflation at around 10 per cent is bringing Britain to a standstill thanks to a series of strikes over pay by everyone from nurses to border guards.

Much of this has been caused by the war in Ukraine and the resulting rise in energy prices.

But it is also due to the Government and the Bank of England’s reckless money-printing programme which dates back to 2008 when the capitalist system almost imploded.

Finally, in December 2021, the Bank of England woke up to the idea its 21-month-long 0.1 per cent base rate was childish and nonsensical and started, slowly and cautiously, raising interest rates to the present, still historically-low, 3.5 per cent.

Given the Bank’s one and only Government-imposed task, when it comes to interest rates, is to keep inflation at two per cent, it has failed abysmally and must share much of the blame for the economic crisis and our winter of discontent.

The question is why did the Bank get it so wrong? If we discount the war and the pandemic and even the credit crunch of 2008, when there is some justification for lowering interest rates to keep the economy alive, the Bank still failed to react fast enough to the threat of inflation.

And we have to recognise that inflation – for a time presumed to be dead but, in reality, merely waiting to pounce – is still and always the economy’s greatest enemy.

The answer is in the way inflation is calculated – the statisticians fail to take into account the single most obvious and pernicious inflationary stimulus of them all: house prices.

There are technical arguments about why house prices are excluded from the calculation, largely to do with the fact that a house is a capital good, not a direct influence on the day-to-day cost of living.

However, neglect of house price inflation is one of the prime causes of this bout of inflation. And analysis of previous economic cycles shows this neglect his stimulated inflation in the past and forced the Bank (and before that, politicians) into belated attempts to retrieve the situation.

The rate of house price inflation is a clear and obvious indicator that the official inflation rate is set to rise sharply and that the Bank base rate must be increased. Failure to take account of house prices in the official calculation of inflation means the Bank is condemned to reacting too late. By the time it puts up the cost of borrowing, the inflationary damage has already been done.

If we look at previous inflationary spikes, this becomes clear.

In 1972, house prices rose 26.7 per cent and another 39.8 per cent the following year. Official inflation was at 7.1 and 9.2 per cent; base rates at five per cent rising to 8.2 per cent. In 1974, they had to rise to 12.75 per cent as the Barber boom turned to bust.

The 1988 Lawson boom and bust had inflation at just 4.9 per cent, base rates at 8.3 and house prices running away at 10.3 rising to 32 the following year. Too late – again – interest rates rose to peak at 14.79 in 1990. High interest rates persisted through the 1990s – partly because of the Government’s ridiculous European exchange rate disaster – and house prices actually fell while inflation was tamed for the time being.

In the early 2000s, the official inflation rate was down around two per cent but house prices were once again soaring ahead – 25.8 per cent in 2003, 16.9 per cent the following year. Interest rates were around four per cent. But the failure to consider the housing market boom was the cause not of inflation, this time, but of something even worse – the financial crisis when it looked, for a moment, as if the entire capitalist system might come crumbling down.

If the Bank recognised the early warning presented by rising house prices, and if it had put up interest rates in response, would it have averted this disaster? Possibly, though of course we will never know.

The rock bottom interest rates we had for more than a decade after the 2008 crash have inevitably stimulated greater borrowing and soar-away house prices (exacerbated by the quantitative easing money-printing indulged in by the Government and the Bank to the tune of an incomprehensible £875 billion.

Between January 2009 and July 2022, the average house price rose 73 per cent, from £157,234 to £272,111. Had house prices risen with the official inflation rate, the average home would have cost £222,240 last July, a rise of 41 per cent.

Prices really took off after the pandemic but the Bank, slow to react, as usual, was still fiddling about with piffling rates of interest. It only started to take action when the official inflation rate began to rise, ignoring the early indicator of yet another over-heating housing market.

The failure to account for house price increases may be justified by economic purists but the evidence strongly suggests they feed into the economy as a whole and lead inexorably to rising prices.

This is inevitable, if only because home-owners see the value of their biggest asset rising and, as a result, their mortgage debt is, in effect, shrinking. They are encouraged to spend the extra wealth they do not actually possess, or they can cash in by increasing the amount of money they are borrowing. Either way, it leads to delusions of prosperity and results in too much money chasing too few goods.

By the time the Bank notices, in the official inflation figures, it is too late. The time has come to insert this massively significant aspect of the economy into the way inflation is calculated.

In the USA, house prices were included in the calculation of inflation from 1953 to 1983 despite the economists’ specious arguments. House prices were removed from America’s inflation calculations because their presence was increasing the rate of inflation and, therefore, increasing the cost of index-linked benefits and pensions.

But if appropriate and timely action were taken by the Bank of England, that should not become a danger. Indeed, it would save the State\ money by ensuring policies like the pension triple-lock do not become as expensive as an average terraced house in London.

In short, our cost-of-living crisis has been caused in great part by the refusal of economists to recognise the inflationary elephant in the room. As a result, house prices have once again trampled all over the economy and we are all now paying a heavy price.