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15 December 2022

Why is the Bank of England raising interest rates when inflation has peaked?

The Bank has to account for the long-term effects not only of its own decisions, but also of government policy.

By Will Dunn

The Bank of England has raised interest rates by 0.5 per cent today (15 December), bringing the current Bank rate to 3.5 per cent. The point of raising interest rates is to reduce inflation: if borrowing is more expensive, people spend less, and the reduced demand in the economy keeps prices from rising too quickly.

But the rate of inflation is already falling. Figures published by the ONS yesterday showed that consumer price inflation (CPI) had reduced from 11.1 per cent to 10.7 per cent last month. So why is the Bank still hiking rates?

One answer is that while monetary policy might look as if it’s reacting to what’s happening in the economy now, it’s a game of expectations. Decisions made by the Bank of England can take months or years to feed through into the real economy (depending on which part – house prices change more quickly than wages, for example). “Because of the lags in the economy, it’s always the case that you move gradually,” explains Tony Yates, the Bank’s former head of monetary policy strategy.

It’s also true that prices are still rising very quickly across the board. At 10.7 per cent, headline inflation is still five times the Bank’s target, explains Janet Mui, head of market analysis at Brewin Dolphin. “There’s little excuse that they can stop at this stage.” In fact, Mui says that markets expect that interest rates in the UK will not peak until August next year, when they will reach 4.5 per cent.

“The Bank is walking a very difficult path,” says Yates, between the “terrifying prospect of two really bad things happening. One is that people lose confidence that the Bank cares about inflation any more, and long-term expected inflation rises quite a bit above target, and then it becomes very costly to get actual inflation back to target. The other risk, of course, is that the Bank greatly aggravates a recession that’s already going to be painful for people.”

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Mui says it looks at the moment as if policy is having roughly the right effect. “Markets are predicting a mild recession, for now.”

[See also: Interest rates are fuelling a great banking rip-off]

There’s also an argument to be made that the Bank wouldn’t have had to hike interest rates to this extent had the government done more to manage demand in the economy, especially demand for the most volatile and expensive item in the inflation basket: energy.

As a universal benefit, the government’s energy price guarantee, which has limited bills, gives very large numbers of well-off people who can comfortably afford higher energy costs almost no incentive to put on a jumper. While other countries have asked their citizens to reduce energy use (with great success), the Truss government cancelled its own public information campaign on energy use, thought it was eventually approved by Rishi Sunak last month and will begin this weekend.

The effects of this policy are laid bare in a report released yesterday by the energy company Drax. Researchers from Imperial College London concluded that as the UK went into autumn without any public information campaign on curbing energy use, gas demand was 4 per cent higher than in previous years. “In contrast, German gas demand was 17-33 per cent lower, and there is a similar story across France, Italy and Spain: all the largest economies in Europe have reduced the amount of gas they consume much further than Britain,” the report observed.

Overall the demand for gas in the UK has reduced by just 0.3 per cent when weather conditions are accounted for. Dr Iain Staffell, lead author of the report, said it showed the UK up as “an outlier on the world stage, showing no signs of reducing its appetite for gas during a time of dramatically higher prices”.

Yates points out that if the failure to conserve energy use results in blackouts or rationing (especially if they are unplanned), “that could be really huge for the economy. The consequences for inflation will be masked, because of the price cap, but the underlying shortages, and therefore real economic prices, would rocket – and that would mean a lot of misery.”

Beyond the energy and food prices that have been behind the racing inflation of this year, “core” inflation remains high against a background of low real interest rates. Gerard Lyons, chief economic strategist at Netwealth, says that beyond the “cyclical” issues presently affecting inflation there is a wider “structural” issue. “We have had cheap money since 2008,” he says. “Cheap money has caused a fundamental problem in the economy. It’s contributed to many of our current difficulties: asset price inflation, markets not pricing for risk, inefficient allocation of capital, and a bedrock for inflation to take off when problems arise.”

The loose monetary policy of recent years has left the Bank with a “credibility gap”, Lyons argues. “They need to show that they’re tough,” he says, in an uncertain environment. But he, too, agrees that caution is needed: “The speed, the scale and the sequencing of monetary policy tightening needs to be very sensitive to the current performance of the economy, and also to the lagged effects of previous tightening that’s already in the pipeline.”

[See also: What if inflation falls in the wrong way?]

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