The UK Chancellor Rishi Sunak is due to set out new contractionary fiscal rules in next month’s Autumn Budget. The review will outline how much money various government departments can expect to receive over the next three years. According to a report by the Financial Times, the Chancellor is under pressure to taper borrowing and spending due to rising inflation and the potential raising of interest rates by the Bank of England’s Monetary Policy Committee (MPC).
The announcement would see a return of the Conservative Party to its status as the small-state party of fiscal restraint.
If interest rates were to be raised, the costs of servicing government debt would rise as some Gilts are index-linked. In his March budget, Sunak reported that ‘’just a one percentage point increase in both inflation and interest rates would cost the government over £25 billion’’.
The primary objective of the Bank of England’s MPC is to ensure that the inflation rate remains low and stable, at the Government’s target of 2%. Rising inflation, currently at 3.2% (as measured by the CPI) up from 2.0% in July, has led to suggestions that demand-pull inflation needs to be constrained through contractionary monetary policy, with The Guardian reporting that four (of the nine) members of the MPC felt that the conditions had been met for interest-rate rises at the central bank’s meeting in August.
The central bank may choose to implement contractionary monetary policy due to fears that inflationary pressure may be more long-term than initially anticipated. This would involve raising the bank rate from its current level of 0.1%. In theory, this should reduce marginal propensity to consume, incentivising individuals to save, as the return on saving (interest) is higher. This should reduce demand-pull inflationary pressure as consumption is a component of aggregate demand, pushing inflation towards the bank’s mandate.
However, raising the bank rate would have little impact on cost-push inflation, which is currently thought to be the main cause of rising inflation. Supply bottlenecks including labour shortages, Brexit red tape and rising container costs have increased costs of production for firms and constrained supply, feeding through to higher prices in the economy. Hence, given that higher interest rates are unlikely to impact cost-push inflation, it is likely that, similarly to the Fed, the Bank’s Experts will consider other economic indicators including unemployment, growth rates, supply-side pressures and state finances, in conjunction with inflation when making such decisions.
The end of furlough, recent announcements about increased National Insurance, rising utility bills and the impending cut in universal credit will impact household finances and decisions about consumption so it is likely that the MPC will see how the economy fares in the coming months before making any announcements.
Written by Deandra Peiris