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3 November 2022

Why has the Bank of England raised interest rates when a recession is inevitable?

The Bank’s pursuit of lower inflation means a new economic headache: business closures and much higher unemployment.

By Will Dunn

The Bank of England has implemented the biggest rise in interest rates for more than 30 years, increasing the bank rate by 75 basis points to 3 per cent. The rise is designed to reduce inflation, which reached 10.1 per cent (as measured by the Office for National Statistics’s consumer price index) in September. The basic principle is that by making borrowing more expensive, higher interest rates dampen demand in the economy, and with lower demand comes lower prices.

However, it’s not as if the UK economy is in danger of overheating: household debt is more than 130 per cent of yearly earnings, and in September consumer confidence hit its lowest point on record. A recession is inevitable and has, in many sectors, already begun. So why make it worse? 

To a certain extent, the Bank has to choose between two highly noxious buckets of slurry: inflation, which is affecting people on lower incomes more and is moving much faster than wage growth; and recession, which could lead to business closures and much higher unemployment. The Bank has no choice but to inflict pain on the economy, in one way or the other.   

It’s also a choice that is partly made by other central banks. Yesterday (2 November), the US Federal Reserve revealed its fourth successive 75-point hike, to 3.75 per cent. Tighter monetary policy in the US and Europe puts pressure on the exchange value of the pound, and a weaker pound inflates the value of imports such as energy and food.

[See also: The Bank of England cannot control inflation]

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It’s also the case that the rate-setters of the Bank’s Monetary Policy Committee are “flying blind”, according the Bank’s governor Andrew Bailey, because this decision has been made in advance of the government’s Autumn Statement on 17 November. Clearly it makes sense for the new Rishi Sunak administration to have time to formulate its fiscal policy, but the problem for the Bank is that it has had to make the most important monetary policy decision for many years without knowing how much the government plans to borrow and spend, or what the Office for Budget Responsibility thinks will happen in the economy as a result. 

However, the grim economic prognosis is also something of a get-out clause for the Bank of England. Bailey will not have to follow in the footsteps of Paul Volcker, who became a figure of public anger in the 1980s when he drove interest rates up relentlessly as chair of the Federal Reserve. The Bank now expects that a global slump will sharply reduce inflation; demand for commodities will drop next year and unemployment in the UK will rise, so the kind of rate rises that were being spoken about in the wake of Kwasi Kwarteng’s disastrous mini-Budget – when interest rate expectations peaked at more than 6 per cent – will not be necessary. 

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That’s not to say that further rises won’t happen, however. Many economists now expect interest rates to reach 4.5-5 per cent next year, and this will have a profound effect on the economy. The two-year fixed-rate mortgages that were popular with first-time buyers in 2020 and 2021 will have to be refinanced over the next year at a much higher cost, as will a third of new cars.

The Bank of England has to walk the line between inflation and recession, and none of its policy tools are without side effects. The question now is whether the government will attempt to blame the Bank for what’s happening in the economy – as Liz Truss did – or work with it to ameliorate the fallout from tough decisions.

[See also: Higher interest rates mean the end of cheap mortgages]

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