As expected by current financial markets pricing, the Bank of England (BOE) raised interest rates to 5% in June, half a per cent up from the May level of 4.5%. The increase was not unanimous, just as the previous one was not, with two members voting to leave rates at 4.5%. Interestingly, the two members that voted to hold rates – and not to genderise this – were the women on the committee.
The debate about the rise is disappointing in its lack of depth and understanding of the nature of the supply side shock, which created most of the inflation we are seeing, and of the limits of interest rates as a tool to combat it.
If the BOE continues to follow financial markets, they may hike another two or three times, taking the Bank rate to about 6% by September. The Bank’s forecasts make clear that, despite the recent persistence of price inflation, all the forward indicators show that it will fall rapidly over the year ahead. Moreover, since only about 1/3 of the impact of the interest rate increases so far has been felt, sizable effects will come through over the months ahead. These will push inflation below target over the next two years.
Indeed, factoring in the current rate increase and the impact of higher market interest rates on the economy means the risk is that inflation significantly undershoots the 2% pa target over the two-year horizon.
Calculations by the Office for Budget Responsibility in March suggested that if interest rates go up to 5%, then the likelihood is that inflation will turn negative in 2025. Another possibility is that the UK economy could contract in Q3 and Q4 of this year and grow by just half a per cent in 2024. Households will have to pay more on their mortgages and interest payments, so they will have less to spend.
UK businesses will see lower profits and higher borrowing costs, so invest less. The consequences will be weaker economic growth accompanying a significant undershoot of the inflation target over the year ahead. It is hard to see that as a desirable policy outcome. But it is what we are likely to get.
The UK economy is suffering from a supply-side shock, and the demand-side policy instrument, that is, interest rates, cannot solve that problem but it can worsen it. Higher interest rates in a financialized economy will have a much more profound effect than in the past. Low unemployment is not a product of a fast-growing economy but the product of an ageing population and slow productivity growth. Wage inflation is below price inflation meaning negative growth in incomes. That is not inflationary.
Slow productivity growth and its twin, slow economic growth, will only put more pressure on an economy that is not generating tax revenues to meet the growth in demand for public services, infrastructure upgrading and the challenges of adapting to climate change.