The Bank of England's Monetary Policy Committee voted to increase interest rates by 0.5 percentage points to 5 per cent on Thursday. But why does the cost of borrowing have to go up for inflation to come down?
The Bank of England is responsible for keeping inflation low and stable and the government has set a target of 2 per cent. Inflation is currently 8.7 per cent in the UK.
Why do higher interest rates lower inflation?
By raising interest rates, the Bank of England is aiming to reduce demand in the economy. It's forcing consumers to tighten their belts.
As the Bank of England increases its rates, so do the high street banks and other lenders. This means as people have to spend more money on their mortgage and loan payments, they have less to spend elsewhere, for example on holidays. Less money in the economy means that price rises will decrease.
The problem the Bank of England currently has is that not only is headline inflation not coming down (it was 8.7 per cent in both April and May, despite 12 rises in interest rates), but core inflation, which strips out food and fuel costs, is actually increasing.
Could the Bank of England’s rate hikes tip the economy into recession?
Absolutely. Interest rates are often described as a crude way of defeating inflation – a sledgehammer to crack a nut. The economy is basically driven by spending.
So, if too many people are paying a lot more on their mortgages and spending less in the economy, demand falls too much and the economy begins to shrink or fall into recession. It's at that point that deflation rears its head, which is falling prices.
If prices are falling, people often put off making purchases in the belief that goods and services will be cheaper in the near future. Also, there comes a point when higher interest rates weigh so much on consumer spending that companies are forced to drop their prices to unprofitable levels. The stage after that is the closure of the company and layoffs.
The Bank of England has put interest rates up 13 times – why is inflation not falling?
The effect of a rise in interest rate is delayed. It can take two years for a single rise in interest rates to feed through to the broader economy.
Also, in the UK, many people have been on fixed-rate mortgages for the past 2-5 years. This means that regardless of what the Bank of England does with interest rates, they have been paying the same monthly amount on their mortgages and, as such, have the same amount of disposable income to chase prices higher.
“We know that there are people who previously fixed at an abnormally low mortgage rate on a 2-year deal, many of which who’ll be shortly nearing the end of that period,” said Kate Anderson, mortgage expert at Finder.com.
“Those in this situation are going to face devastating increases to their monthly mortgage payments, and this could have serious negative implications for households across the UK.”
Many economists have argued that the Bank of England was 'behind the curve' and late in starting the current rate-raising cycle. As such, even after 13 rises in interest rates in 18 months, inflation remains stubbornly high.
Could the government take demand out of the economy in another way – a rise in VAT for example?
Increasing VAT would not be such a great idea, according to Stuart Cole, chief macroeconomist at Equiti Capital, but other fiscal measures could be considered.
“Raising VAT may not be the best way of doing this, as that would raise the price of goods and services and boost inflation,” he told The National.
“But the government could, for example, hike inheritance tax or cut tax thresholds etc, which basically leaves people with less money to spend.”
The trouble is, of course, no government wants to go into an election year having raised taxes.
The government can never admit it, but if the UK was to tip into a mild recession, would that be such a bad thing?
Speaking to Sky News on Thursday, Foreign Secretary James Cleverly denied any suggestion that the UK should intentionally aim to enter a recession to dampen persistently high inflation.
“What we need to do is we need to grow the economy,” he said.
“High interest rates don't help with that. This idea that we should consciously be going into recession I don't think is one that anyone in government would be comfortable subscribing to at all.”
For Stuart Cole, the idea of actively or passively allowing a recession to happen depends very much on an individual's standpoint.
“Higher rates of inflation are corrosive and damaging to an economy, so in that respect, a mild recession may be a price worth paying,” he told The National.
“But a mild recession means people losing their jobs, companies going out of business and so on. If you are somebody directly affected by that, you probably would not be so willing to accept a mild recession.
“And remember also, that growth that is lost has gone forever. You can grow your economy back to where you were, but you will never get back what you actually lost.”
The markets are already pricing in interest rates to be at 6 per cent by the end of the year.
“The likelihood of a recession in the UK at that rate level is high,” said Janet Mui, head of market analysis at wealth manager RBC Brewin Dolphin.
“But without the pain of a recession, the inflation beast is difficult to kill.”
