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3 August 2023

Is the Bank of England raising interest rates too far?

The base rate has risen to 5.25 per cent. Will it do more harm than good?

By Will Dunn

Jerry Seinfeld has a good line about pain medication: “Nobody wants anything less than Extra-Strength… it’s all Extra-Strength. Some people aren’t satisfied with Extra, they want Maximum… Give me the maximum allowable human dosage! Figure out what will kill me, and then back it off a little bit!”

The Bank of England’s Monetary Policy Committee followed a similar logic today (3 August) as it raised interest rates for the fourteenth time in a row, to 5.25 per cent. The Bank’s job is to keep administering the medicine of higher rates to reduce inflation, and it must do so until the patient starts to look really quite unwell – but it also has to know when to stop.

The point of interest rate rises is that by making debt more expensive they discourage consumers and businesses from borrowing, encourage saving, and therefore reduce demand and subdue rising prices. If the Bank doesn’t hike them enough, inflation will remain higher for longer; if it hikes them too far, it risks creating a deeper recession and the risk of long-term damage, or “scarring”, to the economy.

Tony Yates, the Bank’s former head of monetary policy strategy, says the MPC has to “operate in the dark”, in that it can take 18 months for all the effects of a rate rise to become clear in the real economy. Yates and others say that 50 to 60 per cent of the current cycle of rises “have yet to be felt in mortgages”, because most people’s mortgages are fixed for two or five years. This is one of the key points in the argument that the Bank should stop where it is, and Jagjit Chadha, director of the National Institute of Economic and Social Research, agrees. “It really does look like inflation has turned,” he explains, which implies that “there’s no sense in which you have to do any more at the moment”.

However, Yates says that while it may be true that half of mortgages are yet to be affected, “almost everyone knows exactly what’s coming”, and will already be taking action to reduce their spending – which could mean that much of the power of the rate hikes implemented so far has already been used, and without further action we risk yet more embedded inflation. “Inflation, although it’s turned, it’s not fallen that much – particularly with core inflation, or services inflation, or regular pay growth – all of those things are still pretty robust.”

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Chadha, however, thinks the more important risk is that of “promoting a much deeper contraction than might otherwise be the case” – that the Bank could, by further trimming the investments made by businesses and the spending of consumers, create an economic slump that is even more difficult to get out of than a period of inflation.

[See also: Is anybody running the Bank of England?]

Alfie Stirling, chief economist at the Joseph Rowntree Foundation, the anti-poverty charity, says that while there is rightly a great deal of concern for people struggling to pay their mortgages, the effects of interest rates can also be “extremely acute, and damaging”, to people on low incomes. Research by the foundation shows that 2.3 million families have taken on new unsecured credit to pay rent or energy bills.

Stirling says there’s a risk that people who have taken on new debt to cope with the cost-of-living crisis now face a “second wave” of cost increases as the price of servicing that debt rises still further. “There’s a big risk that the core cost-of-living crisis persists, because people are just swapping price rises on essentials with price rises on the cost of money.”

He believes the greater risk is of raising rates too high: “Economic scarring is very hard to reverse. If people become unattached to the labour market, it’s harder to get them back in. If companies don’t make investments, the opportunities can go by.”

Why would the Bank of England choose one sort of pain over the other? It has a mandate to fight inflation, but it also has to maintain “credibility”: a nebulous but poorly understood part of how central banks work is that they must convince the economies they serve, like a Victorian schoolmaster with a cane, that the pain they’re inflicting is really for their own good.  

Central banks establish credibility by giving people, businesses and financial markets a transparent impression of how their policy will work in the long term, but the Bank of England has struggled with this somewhat. Stirling says there’s now a risk that the Bank is treating being credible and being tough as the same thing. “The Bank is supposed to be credible in terms of having a stable inflation outcome, and that means not overshooting or undershooting. If you go really tough, you’re going to undershoot your inflation target in about 18 months’ time.”

There is one person who wouldn’t mind a bit of extra pressure. Rishi Sunak (whose predecessor, let’s not forget, spoke openly about returning the Bank to government control) has promised to halve inflation by the end of the year, and too-fast, too-tight monetary policy – whatever its implications for economy – might give an unpopular and embattled Prime Minister the headlines he wants going into the next election.

[See also: The algorithms quietly stoking inflation]

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