"Tell ya what mate, that inflation fings gone nuts innit" said a good friend of mine in the pub this week, whilst we commented on the lack of gas in our Fosters. "Yep, double the government target now. One sure way to control that is by increasing the base rate. Pretty sure we'll see the base rate go up now my fine friend" i replied. "Tottenham looked good though didn't they..." i continued.
It was then that it dawned on me. I often write about how increasing the base rate will control inflation. I often tweet about how the rate of inflation is a key factor in The Bank of England's decisions on the base rate. But i never explain why. So, for the sake of Ben and many others that often hear these comments but never understand them, i am going to break it down a little bit for you.
Ben, this one is for you buddy.
The government set a target for what they feel inflation should be. This target is set at 2%. So what does 2% inflation mean? Well, in Ben's terms it means that pint of Fosters he is drinking for example would cost 2% more this January than it did last January. However inflation was announced at 4% for January. This is double the 2% target. So, Ben's Fosters in Jan 2010 would have cost him £2.80p. January 2011, it would have cost £2.91. And there we have it. Inflation, described with the use of a pint of Fosters, in very very simple terms. Its double what it should be, everything is too expensive, the government need to sort it.
So how does increasing the base rate do this? I hear you cry. Well lets go back to Ben. Look at him, standing there at the bar at 4.13pm on a Thursday (lets ignore the fact i am standing beside him please). The reason Ben is standing there is because i sorted him out with a nice lifetime tracker deal a few years back with Woolwich at...drum roll please...0.17% above base for the life of the loan. So while base rate has spent near on 2 years on 0.5% Ben has been paying 0.67% interest on his interest only mortgage! That is why he can afford to drink all afternoon, why he can afford the £170 jeans he wears, the flash watch and the BMW M3 Convertible he drives way too fast.
HOWEVER! If the base rate were to increase, what happens? Ben's mortgage gets more expensive, the finance on the car gets more expensive. Ben's disposable income goes down. The luxury items have to get sacrificed to compensate for the increase in the payments. Demand for items drop, demands for services lower (he stops dry-cleaning his Y-Fronts), shops can't sell, prices comes down...inflation CONTROLLED!
That is a very very basic understanding of how increasing the base rate can help reduce inflation. Think of it in the bigger picture however. With the base rate at 0.50% there is no encouragement to save. Stick that in the bank and your returns will be pitiful. So, no one is saving. They are spending while the cost of borrowing is so cheap. Companies will buy equipment, because they can afford to. People will spend more on luxuries, because they can afford to. They will spend more on services and no one will save. What people should be doing is clearing their debt, but that is another diary entry. The Bank of England Base rate does not just effect mortgages. It effects savers, pensioners, it effects business, services, retailers, it actually effects everyone in a lot more ways than people realise.
So Benny boy, inflation is here, its out of control, but like your drinking, it can be controlled by an increase in the base rate. So be warned...rates will soon be a rising but with your 0.17% over base...you'll be alright! No need to jump ship yet. You don't know how lucky you are my friend.
And so endith our basic economics class. I trust you enjoyed it.
Ben, mines a Becks Vier please mate, this Fosters is too flat. Oh, you've forgotten your wallet?! Why i oughta....
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