Can rate hikes reduce UK’s ‘astronomical’ inflation?

It has been more than eight months since the Bank of England first began raising interest rates to combat rising inflation, but yesterday (22nd quarter of next year.

The prediction came a week after the Office for National Statistics said the consumer price index had risen further to 10.1 percent – the first time it had been in double digits in 40 years. Earlier this month, the National Institute for Economic and Social Research (NIESR) released data showing that “astronomical inflation” could plunge the UK into a crippling recession that could result in 5.3 million households by 2024 at all have no more savings.

Still, economists assure us that raising interest rates is the best way to control inflation: Rising interest rates push up the cost of borrowing, reducing people’s disposable income, which in turn reduces demand and slows price increases. And yet, after six rate hikes, inflation continues to rise: even the Bank of England has admitted it expects a rise of up to 13 percent before the end of the year.

To complicate matters further, the causes of these price increases are largely beyond the Bank of England’s control. Energy prices have skyrocketed due to the war in Ukraine, compounding the rise in the cost of producing food, electronics, and pretty much any other industry that uses gas or electricity in its day-to-day operations. So when exactly? are Rate hikes starting to control inflation as we were promised? Or is this cycle of rate hikes, as some suspect, really just central bank drama – a well-intentioned but futile attempt to make us (and whoever moves into No. 10 in September) feel more in control?

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

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Things could get worse before they get better, Smith admits: This month analysts at Cornwall Insight predicted Ofgem could be forced to raise the energy price cap to £3,382 and £4,426 in October this year and January 2023 respectively, which will further increase inflation these months. By October, “gas and electricity alone will contribute over five percentage points [to the inflation figure]’ says Smith.

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What can the Bank of England do? Martin Weale is an economics professor at King’s College Business School who formerly sat on the bank’s Monetary Policy Committee (MPC), which sets interest rates. “Interest rate policy cannot do much there [energy prices],” he agrees. “It can’t generate additional gas.”

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

“What I think [the Bank] has in mind is trying to make sure the job market is sufficiently weak,” he says. Rising interest rates mean employers have less money left over to meet workers’ demands for pay increases. Workers with lower disposable income reduce demand, which in turn helps control inflation. But that “means more unemployment than there is now,” says Weale.

It’s not a course that the MPC will take lightly, he adds. “The kind of questions people are going to ask themselves on the monetary policy committee are: do we really have to do this? Because of course the purchasing power of the country is already reduced by the significant impoverishment of the country. There is a view that perhaps the rise in gas prices… takes demand out of the economy and eases the pressure for wage increases [anyway].” So it may be that inflation itself is driving wage increases – but it’s likely that most members of the MPC will disagree and will continue to hike rates for at least the next few months.

Even after rate hikes, inflation will continue to rise for some time because there is usually a “lag” between rate hikes and inflation starting, says Yael Selfin, chief economist at KPMG UK. “It generally takes about 18 months for interest rates to affect inflation.”

Selfin expects a few more rate hikes before the end of this cycle. “Right now we’re expecting another rise in September, one in November and another in February and then possibly a pause, because by then hopefully we should see inflation ease off quite significantly,” she says. Economists expect interest rates to peak between 2.5 and 3 percent early next year.

But it should also be remembered that a fall in inflation numbers does not mean that prices are falling – just that they have stopped rising. Cornwall Insight has warned energy bills could remain above £3,000 a year until at least 2024, which will keep pressure on people’s finances. “Inflation is coming back to the [Bank of England’s] The 2 percent target isn’t going to make people feel better about themselves,” Weale said. “It’ll just keep them from feeling like they’re getting worse and worse.”

This article was first published in The Crash, the New Statesman’s regular update on the world economy and the challenges it now faces. Click here to login.

[See also: The UK’s broken food system requires radical change]

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