In the Bank of England’s recent Monetary Policy Committee meeting, the MPC voted to raise the base interest rate to 0.75% from 0.5% in an 8-1 vote to further taper inflation rates within the UK economy as the central bank continues with its Contractionary Monetary measures.
This rate rise is designed to help combat high inflation rates within the UK economy as price levels had already increased by 5.5% in the year to January, the fastest rate for 30 years and well above the Bank's 2% inflation target. As such, the decision to increase interest rates will increase the cost of borrowing and servicing debts, thus reducing the amount of disposable income economic agents have to spend on goods and services.
This reduction in real incomes is designed to yield a contraction in aggregate demand, which, will widen the UK’s output gap and will lessen demand-pull pressures on price levels, which, in theory, should yield a reduction in the rate of inflation, helping to achieve the Bank of England’s 2% CPI target. It is important for the Bank of England to try to steer the rate of inflation towards the target as current forecasts suggest that the UK rate of inflation will reach 8% by April, a pattern that will worsen inflationary pressures on UK households that are already facing higher gas prices and economic uncertainty with the recent Russian invasion of Ukraine.
In the most recent Bank of England report, this war was mentioned as one contributing factor towards a rate rise as increased economic uncertainty paired with supply chain disruptions via sanctions as well as Germany’s decision to freeze the construction of the Nord 2 gas pipeline will likely yield further reductions in aggregate supply, thus driving additional cost-push pressures.
However, this brings us to a problem with the Bank of England’s decision, that being that Contractionary Monetary Policy is only effective when combating demand-pull inflation as it is a demand-side policy. As such, with cost-push pressures such as rising gas and oil prices, as well as labour costs, being the driving factors of higher inflation rates, the decision to increase the base rate to 0.75% may be ineffective at reducing the rate of inflation within the UK economy.
This factor was reflected in the Bank of England’s voting as deputy Bank governor Jon Cunliffe was the only member to vote for keeping rates unchanged. He said this was because of the impact of rapid price rises on household incomes. The committee said that more interest rate rises "might be appropriate in coming months, but there were risks on both sides of that judgement depending on how medium-term prospects evolved." This is because these rate rises will further reduce the real incomes of consumers within the economy, which are already being stretched thin with rising price levels. Yet, this does not make the rate rise completely unjustifiable as strong employment within the UK attributed to a tight labour market signifies that incomes will begin to rise in the medium to long-term, hence, a rate rise in the present will help to ease potential demand-pull pressures in the future as the Bank of England fears that rising wages will yield a wage-price spiral that will lead to even higher rates of inflation.
As such, with three back-to-back rate rises occurring in the last Bank of England meetings, economic agents can continue to expect another rate rise in the coming months, which, will likely instil some levels of confidence in Financial institutions - another key focus of the Bank of England - as these organisations will be expecting a rate rise and won’t see one as a massive shock.
However, one economic agent that will see inevitable costs is the UK government, which, saw a national debt of £2.4 trillion during the COVID-19 pandemic as the government implemented Keynesian economics in the form of expansionary fiscal policy by raising government expenditure to pay for schemes such as the Furlough scheme that cost a total of £70 billion.
Although this decision helped to prevent a downward economic spiral by safeguarding employment within the UK economy, it did yield a large national debt of £2.4 trillion, which, must be repaid by the UK government as missing a debt-repayment will lead to a massive fall in the confidence of lenders and will negatively impact the UK government's credit score and capacity to borrow cheaply in future recessions.
Yet, the decision to raise the base interest rate to 0.75% by the Bank of England will further worsen the state of public finances as such a rate rise will lead to an interest in the cost of servicing debt for the UK government. We currently do not have official figures for what the debt repayment costs are, however, predictions state that the repayments will be approximately £64 billion. As such, it is undeniable that further rate rises that have been hinted at by the Bank of England will continue to increase this figure.
This will further worsen the opportunity cost of repaying the debt for the UK government and for current generations, as well as future ones, as austerity measures - higher taxes and lower government expenditure on public goods - will likely be introduced so that the UK government can reallocate more resources towards the repaying of the debt, which, is essential for balancing the budget deficit so that the UK can sustainably borrow in the face of other economic crises.
Written by Hubert Kucharski