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4 August 2022

Can interest rate rises reduce the UK’s “astronomical” inflation?

The Bank of England announced a 0.5 percentage point rate hike, the biggest in more than a quarter of a century, raising UK interest rates to 1.75 per cent.

By Emma Haslett

It has been more than eight months since the Bank of England first began to raise interest rates in an effort to combat rising inflation, and today (4 August) it announced a 0.5 percentage point rate hike, the biggest in more than a quarter of a century, raising UK interest rates to 1.75 per cent.

The move came in the same week as the National Institute for Economic and Social Research (NIESR) released data showing that “astronomical inflation” could push the UK into a crippling recession that could leave 5.3 million households with no savings at all by 2024.

Nevertheless, economists assure us that interest rate rises are the best way of controlling inflation: increasing rates pushes up the cost of borrowing, thus reducing people‘s disposable income, which in turn drives down demand, slowing price rises. And yet, after six rate rises, inflation continues to rise: the latest data, released at the end of last month, shows that prices are currently 9.4 per cent higher than they were this time last year, and the Bank of England said today it expects that figure to rise as high as 13 per cent before the end of the year.

To complicate things further, the causes of these price rises are, for the most part, outside of the Bank of England’s control. Energy prices have been pushed up by the war in Ukraine and have exacerbated rises in the cost of production for food, electronics and just about any other industry which uses gas or electricity in its day-to-day functioning. So when exactly are interest rate rises going to start controlling inflation, as we’ve been promised? Or is this cycle of rate increases, as some suspect, really just theatre by the central bank – a well-meaning yet futile attempt to make us (and whoever moves into No 10 in September) feel more in control?

The simplest way to answer this question, says James Smith, a developed markets economist at the Dutch bank ING, is to break down the exact causes of inflation. “Currently, electricity and gas alone are contributing 2.5 percentage points, petrol is about another 1.5 points, food is about 1 point and used cars is about half a percentage point,” he says.

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It may get worse before it gets better, admits Smith: this week analysts at Cornwall Insight predicted Ofgem may be forced to raise the energy price cap to £3,359 and £3,616 respectively in October this year and January 2023, which will increase inflation further in those months. By October, “gas and electricity will be contributing over five percentage points alone [to the inflation figure]”, says Smith.

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What can the Bank of England do? Martin Weale is a professor of economics at King’s College Business School who used to sit on the Bank’s Monetary Policy Committee (MPC), which sets the interest rate. “There’s not an awful lot that interest rate policy can do about [energy prices],” he admits. “It can‘t create extra gas.”

But there is one option. Two factors are contributing to rising inflation: the first is that high energy prices are making people poorer, and the second is that unemployment is unusually low, meaning jobs are very hard to fill. That puts all the power in the hands of workers: if employers can’t fill jobs, they’ll increase wages, which will increase inflation. And that, says Weale, is something the Bank of England can control.

“What I think [the Bank] has in mind is trying to ensure that the labour market is sufficiently slack,” he says. Pushing up interest rates means employers have less spare cash to meet employees’ demands for pay rises. Workers having less disposable income brings down demand, which in turn helps to control inflation. But that “does mean more unemployment than there is at the moment”, says Weale.

[See also: Only radical solutions can tackle this cost of living emergency]

It isn’t a course the MPC will take lightly, he adds. “The sort of questions that the people on the Monetary Policy Committee will be asking themselves is, do we really need to do that? Because of course, with the country becoming quite a lot poorer, people’s spending power is being reduced anyway. There is a view that perhaps the increase in gas prices… takes the demand out of the economy and reduces the pressure for pay increases [anyway].” So it may be that inflation itself controls wage rises – but it looks probable that most of the MPC won’t agree and will continue to raise rates, for the next few months at least.

Even after today’s rate hike, inflation will continue to climb for some time because there is usually a “lag” between the rate hikes and inflation beginning to slow, says Yael Selfin, the chief economist at KPMG UK. “It generally takes about 18 months for interest rates to influence inflation.”

Selfin expects a few more interest rate rises before the end of this cycle. “Our expectations at the moment are for another rise in September, one in November and another one in February, and then potentially a pause, because by that stage we should hopefully see inflation starting to moderate quite significantly,” she says. Economists expect interest rates to peak between 2.5 per cent and 3 per cent early next year.

But it’s also worth remembering that a drop in the inflation figure doesn’t mean prices are falling – just that they have stopped increasing. Cornwall Insight has warned that energy bills could stay above £3,000 a year until at least 2024, which will keep up the pressure on people’s finances. “Inflation coming back to the [Bank of England’s] 2 per cent target isn’t going to make people feel better,” says Weale. “It will just stop them feeling they’re getting worse and worse off.”

This piece was first published in the Crash, the New Statesman’s regular update on the global economy and the challenges it now faces. Click here to sign up.

[See also: What the UK’s obsessions with washing-up bowls says about our economy]