Are We Nearing the End of Tight Monetary Policy?
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In recent times, the Bank of England has enforced a tightening of monetary policy through the means of interest rate hikes to combat staggering inflation which has currently reached 10.1%, an almost 40-year high. This has largely been due to sharp rises in the prices of food and wholesale gas, largely attributable to supply disruptions resulting from Russia’s invasion of Ukraine over a year ago. In response, the central bank has risen the base interest rate to 4.0% – the highest since the 2008 financial crisis. Recent indicators suggest that inflation has peaked and will continue to fall throughout the year, and a looming recession could act as a further incentive towards easing interest rates to stimulate consumption and investment, hence encouraging economic growth. However, there are concurrent challenges to decreasing – or even maintaining – the base rate, as shown particularly through the notably high growth in wages.
In light of these contending factors, the probability of a reversal in monetary policy can be considered within the context of disinflationary forecasts.
Since October, the inflation rate has fallen incrementally from its peak of 11.1%. This trend is likely to continue and accelerate as a result of two factors. Firstly, wholesale gas prices have fallen and are expected to keep falling, which is likely to place downward pressure on the inflation index. Secondly, it is worth noting that the implementation of monetary policy comes with a time lag of around 18 to 24 months between changes in the interest rate and any consequent effect on the economy. Considering that the first interest rate increase occurred as early as December 2021, with subsequent increments having followed soon after, the effects of this are only just now becoming apparent.
Variations do exist in inflation forecasts. While the Bank of England predicts that CPI inflation in the fourth quarter of 2023 will fall to 4%, analysts such as Citigroup believe it could even fall as low as 2.3% – in line with the central bank’s target. Indeed, the general expectations of inflation are becoming lower and lower by the day: economists polled by the Treasury this month predicted inflation to fall to 4.5% in the fourth quarter, down from a forecast of 5% last month. Only the test of time will be able to show which of these many forecasts foresaw the right magnitude of disinflation but considering that all opinions converge on inflation being on track to fall significantly, an argument may be made that increasing interest rates further is unnecessary. After all, the UK economy is in a very fragile position, having narrowly avoided a recession in 2022, when the third quarter saw negative growth of -0.2% and was followed by complete stagnation in the following one.
The Bank of England still expects the UK to plunge into a recession this year, though it will likely be shorter and less severe than previously anticipated. In this context, further incremental increases in the base rate could become problematic: depending on when the effects of such a change would become noticeable, another rise in interest could prolong the recession or inhibit much-needed economic recovery by deterring consumption and investment.
So far, the end of contractionary monetary policy appears imminent. In concluding on such a note, however, an important obstacle would have to be decisively neglected.
Though it may appear that maintaining or even decreasing the base rate is the best course of action, certain issues prevent the Bank of England from doing so without hesitation. Specifically, UK wages have seen surprising growth – in the final 3 months of 2022, the average regular pay growth rate rose to 6.7%, up from a revised 6.5% during the 3 months leading up to November last year. The Office for National Statistics even stated that, excluding the pandemic period, it was the strongest regular pay growth rate since records began. Although wages grew more quickly in the private sector than the public one, the two are likely to equilibrate as a result of the government’s £30 billion windfall in tax revenue, with the Prime Minister reportedly considering a 5% increase in public sector pay in hopes of ending a bitter period of strike action. However, whilst solving concerns over equity, such a decision may create greater issues. On one hand, increased government spending in the public sector stimulates aggregate demand and expands output, lending to higher inflation. Contractionary monetary policy would therefore still be needed to limit the marginal propensity to consume, so that the multiplier effect, thus inflation caused by the government spending, is minimized. The more optimistic and desirable disinflationary forecasts could be disproven without it.
Additionally threatening the disinflationary predictions, the increasing wages within the private sector could potentially fuel inflation further through a wage-price spiral. The idea follows that as long as positive inflation persists, workers demand higher wages so that their real incomes do not deteriorate comparatively, which increases the costs of firms and in turn prices, with the process repeating as a positive feedback loop. In such an adverse scenario, firms could decrease their costs yet maintain their workers’ wages by decreasing their workforce, though this seems unlikely in practice. Not only do job vacancies remain above the historical average, but a recent Reuters survey found that UK firms are experiencing growth and becoming more optimistic about their prospects. Therefore, the only way to avoid the dangers of a wage-price spiral would be the continued tightening of monetary policy.
Overall, whilst we are indeed nearing the end of tight monetary policy, we are not yet at the turning point. Considering that tight monetary policy is the most effective way to prevent inflationary pressures such as through a significant increase in aggregate demand or a wage-price spiral, a further increment in the base rate resulting from the Monetary Policy Committee’s next meeting seems inevitable. But with inflation beginning to decline and an imminent recession on the horizon, this interest rate hike will likely be smaller than before and potentially one of the last before the base rate is maintained and eventually brought down.