By Paul Kelly
Due to the ongoing Russian invasion of Ukraine, food and energy prices have risen substantially. As a result, the inflation rate has reached a 40 year high of 9.4% in the UK and rates are similarly high in other Western economies. Given lower real incomes resulting from higher energy and food prices, central banks must therefore decide whether to increase interest rates to reduce inflation, but risk recession, or keep rates constant.
Since the recent bout of high inflation has been largely caused by an external reduction of supply in certain goods, there is a temptation to say that the inflation is transient. However, it is clear that a lack of Russian and Ukrainian supply in energy and food can only partially be mitigated by the increase in supply elsewhere and the conflict in Ukraine is unlikely to end in months at a minimum. Hence, inflation will likely remain persistently high unless central banks raise rates.
To this effect, the governor of the Bank of England Andrew Bailey said last week that whilst ‘time lags’ in policy need to be taken into consideration, the bank’s commitment is fundamentally to a 2% inflation target, with ‘no ifs or buts’. Therefore, it is widely assumed that the bank will raise rates in August, with the governor explicitly saying that a 50 basis point rise is on the table.
That inflation should stay within reasonable limits and can lead to harmful spirals when these limits are exceeded is generally accepted. However, there are potential concerns if any rate rise is too severe. Firstly, if any rise in rates is enough to cause a sharp downturn in spending or significant financial disturbance, it may cause a recession. Secondly, there could be problems if the bank’s policy diverges from government policy. In the recent Conservative Party leader election, for example, Liz Truss, one of two people who could potentially be installed as prime minister, favours reducing tax rates to stimulate economic growth. If she is elected as leader by the conservative members, she will have a strong incentive to show quick results with respect to economic expansion. Therefore, she may attempt to pressure the bank into compliance with government policy or cut tax deeply enough to offset any deflationary effect the bank may have. That tax reduction will increase inflation, however, is assuming that the decrease in government revenue will not be met in proportion to government expenditure.
Furthermore, it is important to consider the impact of high interest rate climate on government debt. Though most British bonds have a 10-year maturity, and therefore there is a significant time lag before interest rate hikes increase the government’s cost of servicing debt, the long-term cost of servicing the debt will likely increase beyond the low borrowing costs of the post-2008 era of low interest rates. Given an already high level of debt relative to GDP, this may cause significant pressure on government budgets that have already been in deficit for several years. Additionally, the mortgage payments of those with variable rate mortgages will increase with interest rates in the short term, whilst those with fixed rate mortgages will likely face increased payments in the medium term too. This may cause tension in a climate where household budgets are being squeezed by pay rises that are often below inflation, but the state pension has increased in line with inflation. For all of these reasons, it appears likely that the bank will opt for a moderate but not severe increase in interest rates.
References:
https://www.itv.com/news/2022-07-20/inflation-hits-new-40-year-high-at-94
https://www.bankofengland.co.uk/speech/2022/july/andrew-bailey-speech-at-mansion-house-financial-and-professional-services-dinner
https://www.ons.gov.uk/economy/governmentpublicsectorandtaxes/publicspending/bulletins/ukgovernmentdebtanddeficitforeurostatmaast/december2021
