The Bank of England has once again raised the interest rate, initially from 0.1% to 0.25% in December, and now from 0.25% to 0.5%, in an attempt to slow down the rapid inflation that has been taking place in the UK throughout 2021 to the present day. This rapid inflation is a result of a stage of high economic growth that the UK is going through. Production is not meeting the demand for goods and services in the UK economy, resulting in prices rising in order to maintain the profits of firms and thus creating inflationary pressures in the economy.
A minority of the Monetary Policy Committee (MPC) wished for an even larger increase of the interest rate to 0.75% to better tackle the surging inflation, but the majority of the MPC agreed on 0.5%. After this change in interest rate, markets are now speculating that the BoE will lift interest rates to 1% by May, and 1.5 per cent by November. These speculations will likely encourage firms to borrow and invest since the cost of borrowing is lower, however will make borrowing more expensive in the future, potentially hitting firms and households harder.
The UK’s inflation rate is currently sitting at 5.4% and is predicted to peak in April at 7.25%, whilst maintaining an average rate of 6% throughout 2022, as measured by the Consumer Price Index (CPI). The current inflation rate is well above the Bank's 2% target rate, and will most likely not be seen again at least until 2024, predicts the MPC, with the inflation rate being forecasted at 5% at the end of the year.
With inflation rising, Uk households have had a dramatic reduction in spending power, due to prices rising faster than wage rates, meaning that even if the labour force sees increases in their wage rates, their real wages, which account for inflation will in fact likely be decreasing. With this in mind, disposable incomes of UK households are being reduced, and to add to this, the higher energy and fuel bills are also contributing to the reduction in disposable incomes, which overall is creating a great increase in the cost of living.
In addition to the increase in the interest rate, the MPC voted to not redistribute any of the £875 billion of government bonds it has bought under quantitative easing programmes. The BoE is undergoing a passive quantitative easing contractionary programme, wherein essence they are decreasing the liquidity of the banking sector, encouraging banks to lend to people less, decreasing their ability to consume, slowing down the growth of aggregate demand and thus decreasing the pressure on inflation.
Following the rise in the interest rate, the pound sterling has seen appreciation by 0.2% against the dollar. With the rise of the exchange rate, this means that imports are relatively cheaper for the UK, meaning that the UK can import more for the same price, and therefore can increase its aggregate supply to try and meet a new equilibrium with the excess demand.
The appreciation of the exchange rate, although small now, will attract inflows of hot money in the future. Hot money refers to investors who transfer capital, into the UK in this case, in order to maximise their capital gain when there are higher interest rates.
Written by Matteo Malefora
Researched by Ibrahim Ahmed