Felsted Economics Blog - January 2022

by Francis Barrett- Head of Economics at Felsted School


A new year and one new year’s resolution has already been achieved. To start writing an economics blog to serve as an excellent source of information on many economic topics that pupils at Felsted School study as well as keeping everyone in the Felsted community informed on current economic events. The hope is that not just the Head of Economics will be the author of this blog but going forward teachers, pupils and parents and all those in the Felsted School community may also wish to contribute on areas of interest and indeed pose questions and or submit thoughts.

The first topic for discussion is the current hot topic of inflation. Inflation is a sustained increase in the general price level in an economy. When we have inflation this means there is an increase in the cost of living as the price of goods and services we buy become more expensive. This lowers the value of money as the increase in prices leads to a decline in the value of money because put simply, your money won’t buy as much today as it did yesterday because prices are rising. Inflation is very much in the news at the moment as it is rising in many countries across the world. Many people fear inflation because as goods become more expensive, this lowers their standard of living as they can purchase less.  

Economists keep a very close eye on inflation figures as it can be a sign of what is happening in the wider economy. Inflation is not necessarily bad, in fact, it can be a good sign that the economy is growing, which is good for businesses, workers and the economy in general. Central Banks around the world like to see inflation rising, but not too fast or too high. Annual inflation (rising prices) of 2% within the economy is deemed satisfactory. If, however, prices are rising too fast, it is seen as a sign that the economy is having problems, as demand may exceed supply. This is why, if inflation rises quickly, Central Banks, who answer to the Government, will tackle it by raising interest rates.

If interest rates rise, then the cost of borrowing money goes up resulting in less money being spent in the economy, which is bad for businesses. The global pandemic has caused big issues not just with our health and well-being, but also with inflation. Before the Covid-19 pandemic hit, inflation in the eurozone countries, America and the UK was around 2%.

However, during the pandemic, with people staying at home and having to isolate, demand fell for goods and services and so overall general prices fell. Last year, inflation in many countries was just above 0%, well below the 2% target. Low inflation indicates to economists that the economy is contracting as demand is low, which is not surprising when most of the population of the world was in lockdown.



The response to low inflation was for central banks around the world was to reduce interest rates, the cost of borrowing, to stimulate borrowing and increase demand. Interest rates were lowered to record levels. In the U.k., interest rates were as low as 0.1% and in the eurozone countries, its benchmark refinancing rate also hit a historic low of 0%. In the USA, the equivalent rate, known as the Fed Funds Rate, was reduced to 0.25%. These rates are extremely low when you consider that in the U.K. in 1979 the then Prime Minister, Margaret Thatcher, raised interest rates to 17% when rising wages and oil prices resulted in inflation also rising to 17%.

Those willing to admit they are old enough to remember the 1970s will be aware of the dangers posed by out-of-control inflation. Price rises reached their peak in 1975, hitting a rate of 22.6%, as the cost of oil tripled and sent petrol prices rocketing. However, this was a time when powerful trade unions demanded higher wages, to match those price increases, causing an inflationary spiral.

In June of this year, the inflation rate in the UK rose to 2.5% in just one month, the highest rate in almost three years, and well above the Bank of England’s (BofE) 2% annual target. A combination of supply shortages and rising demand prompted by the easing of lockdown restrictions led to higher prices. The sudden increase in demand is not surprising given how long people had been under restrictions and many referred to this increase in demand as “Pent up demand” and was therefore expected to ease off as consumers returned to what is considered more normal levels of consumption.

Many economists believe the supply issues are due to the pandemic and Brexit, as firms find it harder to source raw materials and finished goods from abroad. In the months leading up to Christmas, the rising prices did not ease, in fact, they got a lot worse putting central banks under increasing pressure to act. In August UK inflation hit 3.2%, Eurozone inflation 3.4% and in the USA inflation hit 5.4%, seriously eroding the value of citizens' money.

It didn’t stop there, by November the Bank of England Governor had to apologise announcing he was "very sorry" that UK inflation was so high. Why sorry? Because rising prices erode our standards of living. Torn between keeping interests low to support the economy as central banks prioritised economic growth and low unemployment over inflation. 

It wasn’t just U.K. consumers feeling the pinch. German inflation rose to 4.6 % in October — its highest level since shortly after the country’s reunification three decades ago. 5.2% in November, as soaring energy costs and supply chain bottlenecks weighed heavily on Europe's top economy. Spiraling prices are a sensitive subject in a country where people’s approach to money is still haunted by the hyperinflation of the 1920s and 1940s that wiped out most Germans’ savings.



The story of rising inflation was being replicated across the world as more and more people became vaccinated against Covid-19 and lockdowns were lifted, consumer and business activity rebounded and the supply of many items from semiconductors to natural gas struggled to keep up with demand, driving up prices and inflation. Prices are “skyrocketing, our purchasing power is melting away,” warned Bild, Germany’s top-selling tabloid newspaper. It suggested readers invest in property, shares or precious metals to protect their money from “Madame Inflation” — a reference to Christine Lagarde, president of the ECB.

Matters in the U.K. came to a head in December when the BofE could no longer justify low-interest rates when inflation hit 5.1%, the highest in a decade. The central bank, not wanting to be labeled scrooge just before Christmas, was forced to act and increased the cost of borrowing from 0.1% to 0.25% in a bid to curb inflation. Scrooge-like rate increases before Christmas are rare, with only one December rise since the mid-1970s.

But there is no guarantee this will solve the problem of rising inflation.

Many economists say they expect that the rate of inflation will fall again at the beginning of this year, as the current high energy prices and supply chain logistical issues are temporary. Others argue that increased interest rates do not solve the problem of supply chain logistics and higher interest rates don’t get you more semiconductors or indeed more gas and oil. In addition, increased interest rates will negatively impact 1/3 of UK adults who have a mortgage. The impact of this is relatively low in financial terms – perhaps £15 a month on the average mortgage, but it comes at a time when households are already being impacted by record high petrol costs, many households seeing their gas and electric prices soar as their suppliers go bust, and the recent end to the £20 uplift in benefits. £15 a month might not be much for many, but for others, it has a significant negative impact on their finances, particularly the poorest in society. Many are questioning if the government could and should be doing more to support those on low incomes.

This was very evident in recent data which has emerged from the USA highlighting how inflation affects lower-income groups disproportionately. Rising prices make it much harder for people who struggle to make ends meet. The perceived effect of recent price increases varies significantly by income group. While 70% of those living in households with an annual income of less than $40,000 experience some kind of financial hardship, just 28% of those earning $100,000 or more claim to do so.


Looking ahead to 2022 there are many questions. Will workers demand higher wages to cover their increased costs at home? However, increased wages would in turn increase costs for already struggling businesses who may then need to pass these costs on to consumers in the form of higher prices. Higher prices, higher inflation and inevitably higher interest rates with possibly lower borrowing and lower, much-needed, post-Brexit investment.

The Financial Times’s annual survey of almost 100 economists recently revealed that most expect inflation to outpace wages in 2022, while Covid-19 will continue to disrupt production and consumption. At the same time, high energy costs and the increase in National Insurance contributions will hit those on lower incomes hardest.

Will interest rates rise further? Although many countries are experiencing high inflation, because of supply-chain disruptions and labour shortages, Brexit could make these problems more severe in the UK, and many economists believe that this will prompt the BofE to raise interest rates more rapidly than other central banks. German inflation is projected to trend around 1.7% in 2022 and so low-interest rates look set to stay, which is frustrating German savers. However, in the USA, the latest figures out show that prices are rising at their fastest rate in almost 40 years, with inflation up 7% year-on-year in December and interest rates set to rise as a result.

Some economists do see grounds for optimism, noting that the pandemic sparked a new wave of investment in technology and digitalisation, a key supply-side policy that all Felsted School economics pupils know well! However, several economists out there believe that the benefits could flow into corporate profits rather than higher wages. In addition, Felsted pupils are also keen to point out that any supply-side gains from investment need to be accompanied by the policies necessary to boost productivity in the longer term, such as investment in skills, training and pro-investment regulation to reduce costs, increase profit, lead to higher wages and resulting higher standards of living.

For 2022, UK Economist Victoria Clarke believes the Omicron variant reminds us that Covid-19 is likely to be with us for a while longer, but UK activity should be impacted relatively less than some of its peers, amid the government’s ‘living with Covid-19’ strategy.

So let us look at the positives, which is difficult for economists given their cautious nature. Indeed, it is not all doom and gloom. If inflation does fall quickly as energy and supply-chain issues get resolved, and Omicron is a mild and swift route to higher levels of immunity, the economy could bounce back well with increased output, economic growth, and lower levels of inflation. This could, in turn, keep the interest rate from rising too high in 2022 and possibly remain below 1% leading to increased borrowing and that much-needed investment. 

Recoveries are driven by optimism about the future. That optimism drives investment and that investment will drive the economy forward. If there was ever a time for an economist to be optimistic, it is surely at the start of a new year.

Happy New Year! May your 2022 be peaceful, positive, prosperous, informative and fulfilling.