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Kemar Whyte

May 16th, 2023

Will the Bank of England’s strategy pay off?

0 comments | 7 shares

Estimated reading time: 4 minutes

Kemar Whyte

May 16th, 2023

Will the Bank of England’s strategy pay off?

0 comments | 7 shares

Estimated reading time: 4 minutes

The decision to further raise interest rates came as a surprise to few. Kemar Whyte discusses whether, given the current state of the UK economy, this was the right call to make, and how the government should intervene to curb the most damaging effects on the population.

The Bank of England, at its meeting on 11 May 2023, increased the policy interest rate by a quarter of a percentage point, meaning UK Bank Rate now stands at 4.5 per cent, its highest since the global financial crisis. The rate hike will have come as little surprise to many as the Bank feels it must ensure that the supply shocks facing the UK do not lead to chronic inflationary pressure. Instead of inflation falling below its 2 per cent target within a year, the Bank now expects it will only hit that goal at the start of 2025.

Little room for manoeuvre

One could argue that the increase in interest rates is needed to ensure that, once the temporary inflation has abated, wage and price setters base their future decisions on inflation expectations consistent with price stability. This would help to ensure that aggregate demand is brought down in line with a lower level of capacity than was previously thought to be the case. But at the same time, the UK economy is currently stagnating, not overheating, so was another rate hike the right call? Raising rates to stymie consumer spending growth at a time when consumer spending is already being crushed by soaring inflation might seem ill-judged.

But how much of the current high rate of inflation in the UK economy is the Bank of England’s own doing? It is difficult to quantify that, but it is reasonable to argue that an earlier response by the Bank to building inflationary pressures in the economy might have meant a lower peak in headline CPI inflation. One could argue that if the Bank had adopted a more forceful approach any sooner it would have threatened rising unemployment and put the economy at risk of deflation. But the Bank ought to have recognised that the pent-up demand on the back of the pandemic meant they should have switched from monetary easing to normalisation and then gradually tightening earlier.

How much of the current high rate of inflation in the UK economy is the Bank of England’s own doing?

Nevertheless, we are where we are now. Double digit inflation is not the outcome anyone wanted, and it is imposing genuine hardship, especially on the most vulnerable UK households. In these circumstances, it can be argued that the government has a job to do here. To be clear, this job is not setting a target of halving inflation by year end, but instead to be offsetting the adverse distributional effects of high inflation by offering more targeted relief to households towards the bottom of the income distribution.

Delayed consequences

What’s more, it will take time for the full impact of the 12 consecutive increases in interest rates to be felt by consumers, given both the delays in the pass-through of changes to the policy rate into other interest rates (such as the deposit and lending rates of financial intermediaries) and the cumulative nature of the change in rates. Indeed, the Bank of England estimates that about two-thirds of the effects of the tightening are yet to come. There is also the risk that once previous monetary tightening takes full effect, inflation might be pushed down too far, necessitating a reversal of policy.

It is becoming difficult to ignore the suspicion that the Bank now risks overcompensating for earlier mistakes on inflation. The Bank has tightened enough (or maybe too much) already. There is a danger now that it will swing the other way and make similar mistakes, but from the opposite direction. Higher interest rates will worsen the cost-of-living crisis, and I struggle to see many benefits.

But sticky inflation raises the possibility that the UK Bank rate will go higher, particularly given the data-driven approach being used by the Bank. And, judging by the hawkish skew of last week’s announcement, the prospect of rate cuts could very well be delayed until we are some way into 2024.


All articles posted on this blog give the views of the author(s), and not the position of LSE British Politics and Policy, nor of the London School of Economics and Political Science.

Image credit: Photo from public domain pictures, via pixabay

About the author

KemarWhyte

Kemar Whyte

Dr Kemar Whyte is Principal Economist in the Macroeconomics Modelling and Forecasting Division at NIESR.

Posted In: Economy and Society | Fairness and Equality | Governance
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This work by British Politics and Policy at LSE is licensed under a Creative Commons Attribution-NonCommercial-NoDerivs 3.0 Unported.