By Ollie Lycett (Economics Editor)
Edited by Ben Evans (Economics Correspondent) and Ollie Lycett (Economics Editor)
On the 4th of August the Monetary Policy Committee (MPC) of the Bank of England raised interest rates by 0.5 percentage points from 1.25% to 1.75%, making it the largest single increase in 27 years.
The aim of this latest increase in the base rate is undoubtedly to curb inflation in an effort to return the Consumer Price Index (CPI) annual inflation rate to the target 2%. Whilst sceptics label such an effort as one that dooms the UK economy to an inevitable recession, it is most convincing to argue that actually, there is little other choice.
With inflation soaring to 13% – the highest it has been since 1980 – action is a necessity, as if it is left alone, inflation will likely continue to climb. To understand the intended effect of the rise in interest rates, we must first examine the causes of the current inflationary crisis. Firstly, there is a degree of post-COVID ‘demand-pull’ inflation, where, following the laxing of restrictions from 2020 and 2021, consumers are increasing expenditure after a long period of saving during the pandemic, thus increasing consumption and aggregate demand (AD) within the UK economy.
This is somewhat responsible for the level of inflation, however the effect of the Russia-Ukraine War and the consequential climb in oil and gas prices is arguably more of a driving factor. The war has dealt significant damage to pre-existing oil and gas agreements between Russia and Western Europe, as the latter have imposed sanctions on the former. Despite the UK not being particularly reliant on Russian energy, the war has forced Western European nations to import from other sources, leading to a global increase in prices. As oil prices somewhat underpin much of energy production and the wider economy, these dramatic increases have had an unprecedented impact in inciting ‘cost-push’ inflation. Fears are this combination of inflationary pressures may lead to ‘stagflation’, where prices rise but real output falls, which could lead to a recession.
So, it is evident that action is required from the Bank of England, and that there are indeed benefits to raising interest rates. Through increasing the bank rate, consumers are incentivised to save, as they will see a greater return on their savings, and so their Marginal Propensity to Consume (MPC) will fall – potentially leading to a reduction in AD and a reduction in inflation. A similar effect can be seen with firms, where they take out smaller loans (due to the higher repayment costs), which in turn reduces investment and eases inflation. Effectively, both firms and consumers would return to spending a lower proportion of their income/capital, reducing the overall demand in the economy.
However, these same benefits can also be limitations. Through disincentivising investment, ‘demand-pull’ inflation may be eased, but ‘cost-push’ inflation may be exacerbated. With higher borrowing costs, firms may not have the ability to make supply-sided improvements, and may be forced to limit their output, which, in the short term may incite a recession. Additionally, there could be longer term costs, as firms may struggle to fund innovation and developments, which could reduce the productive potential of the UK economy – Long Run Aggregate Supply (LRAS) or ‘trend rate’ of growth.
For consumers, a reduced level of expenditure may, in the short term, erode standards of living until inflation is eased sufficiently for their purchasing power to rebound, and; as firms scale down and slow investment, unemployment would be inevitable.
Therefore, it is clear that there are not only pros and cons to this act of contractionary monetary policy, but also a considerable level of uncertainty. From this, the question arises as to the feasibility of alternatives – well, are there any?
The answer is that no other option would be guaranteed to have a distinctly better effect than a rise in interest rates.
The Bank of England could potentially implement ‘reverse Quantitative Easing’ (reverse QE), which, in short, involves selling bonds back to banks to reverse previous Quantitative Easing, which is where the Bank of England increases the money supply. So, the overall effect would be taking money out of the circular flow, thus reducing inflation. Sounds easy enough, right? Also, it may not have the effect of inciting a recession, or some of the drawbacks of raising inflation rates. The issue is that it has never been done – QE has only been implemented post-2008, let alone reverse QE.
If the MPC decided to take no specific action at this time, what would be the effect? In theory, with ‘stagflation’ looming, a recession may still be likely without the rise in interest rates. In addition to this, the UK could experience ‘run away’ inflation, as the impact of rising wages in response to the ‘cost of living crisis’, fuels inflation potentially up to 20%+, which is known as a ‘wage-price spiral’.
Overall, these circumstances highlight once more the paradoxes and uncertainties of economic circumstances and policy. The increase to interest rates is the most tested approach, and would likely ease the current inflationary crisis. The fate of the UK economy is inherently linked to the fates of international economies, and until oil prices return to a pre-Russia-Ukraine war level, the price to be paid by those poorest remains high. Not only will the future of our economy depend on international events, but also on the fiscal policy implemented by the government in the coming months. If Sunak is to hold the keys to No 10, a pragmatic and perhaps higher tax ‘sound money’ approach aimed at easing the national debt, which is approximately £2.3 trillion (106% of real GDP), may prevail. His policies may succeed in easing inflation through disincentivising consumption, but whether or not they will lead to a recession is uncertain. If Truss is to become our next PM, a recession may be avoided, considering that her Thatcherite policies of cutting taxation may drive growth. However, the price may be even higher levels of inflation, as the ‘demand-pull’ effect may be worsened.
In conclusion, there are a multitude of complicating factors that may influence the fate of the UK economy, however, in theory, raising interest rates appears to be the only feasible action. It goes without saying that much of the theory outlined in this article, whilst valuable, remains just that - theory. In practise, it is often far less simple.
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