At the latest meeting of the Monetary Policy Committee, the Bank of England left its policy interest rate unchanged – at 5.25% – the first time since November 2021 that the cost of borrowing wasn’t raised. The decision follows new data showing consumer price inflation for the year to August at 6.7%.
The rate of inflation in the UK fell from 6.8% for the year to July to 6.7% for the year to August. This positive news was followed by the Bank of England choosing not to hike interest rates for the first time since November 2021 – although the current policy rate remains at its highest level in 15 years. That decision, accompanied by the latest data on underlying inflation, raises the possibility that the current cycle of monetary tightening (interest rate rises) may have peaked.
As UK inflation remains well above the Bank of England’s 2% target, the central bank has signalled that interest rates could stay above 5%, and are unlikely to fall in the medium term – something that is reiterated in the minutes of the latest meeting of the Monetary Policy Committee (MPC).
Having higher rates for longer than needed is good news for savers (they benefit from higher returns on their savings), but it causes further pain to the stagnating wider economy. The decision risks aggravating the financial struggles that households and businesses are facing, leading to eye-wateringly high mortgage rates and dampened investment opportunities for businesses that want to borrow to invest but are unable to because of the high cost of borrowing.
Both the Bank’s forecast and the one produced by the National Institute of Economic and Social Research (NIESR) suggest that inflation will ease very slowly. The consumer price index (CPI) is set to remain above the 2% target beyond 2024, with interest rates also remaining elevated for an extended period.
What is the link between inflation and interest rates?
Inflation and interest rates usually have a contemporaneous relationship. This means that as inflation rises, so does the nominal interest rate. The idea is that lenders demand higher nominal interest rates to compensate them for higher expected inflation, ensuring that they receive a positive real interest rate on their lending. In other words, they want to get back more than they put in once price rises are taken into account.
Higher nominal interest rates will be associated with higher current inflation, to the extent that higher inflation today implies higher expected inflation. This relationship is illustrated in Figure 1, where periods of high inflation generally coincide with high interest rates and periods of low inflation with relatively low interest rates. This relationship is particularly apparent starting from the middle of the pandemic period (June 2021), when inflation began to rise to the present high rate and interest rates rose in a similar pattern.
Figure 1: UK inflation and interest rates (1989-2023)
Source: Bank of England, Office for National Statistics (ONS)
Where does monetary policy fit in?
When inflation rises too high (relative to the inflation target of 2% per annum), as is the case in the UK right now, central banks raise interest rates in an effort to bring it down. Higher interest rates make it more expensive for households to borrow money, decreasing spending (consumption) and encouraging them to save. The same is true for firms, which are likely to cut back on making investments. If households and firms overall spend less on goods and services, prices will tend to rise more slowly, slowing the rate of inflation in the economy.
The same principle holds in reverse: when inflation is too low or economic growth is stalled, lowering interest rates makes borrowing cheaper, and reduces the incentive to save. This encourages households and firms to spend, increasing the rate of inflation.
The other key instrument of monetary policy – which has been used by central banks since the global financial crisis of 2007-09 – is quantitative easing (QE). The central bank buys longer-term government bonds (known as gilts) in the open market to influence long-term rates and spur economic activity. This is particularly attractive when interest rates are near zero (and can’t be lowered any further) and economic growth is stalling. These purchases raise the market price of the bonds, causing a fall in corresponding longer-term interest rates.
On the flipside, quantitative tightening (QT) reverses (or ‘unwinds’) QE. This is done either by not reinvesting the proceeds of maturing bonds held or selling bonds directly. This policy was only started recently (last year). The idea is to contain inflation by reducing the amount of money in circulation and increasing longer-term interest rates.
The Bank of England commenced the process of QT in 2022 when inflation was significantly higher than its 2% target. This was done initially through not investing the proceeds of maturing bonds, followed by a programme of gilt sales.
What are the factors currently causing high inflation in the UK?
To understand what is driving inflation currently, it helps to break down the CPI into its different components. The latest data from the Office for National Statistics (ONS) show that the CPI rose by 6.7% in the 12 months to August 2023, down very marginally from 6.8% in July. Among all components, ‘Food and Non-alcoholic Beverages’ was the most significant contributor to the latest inflation figures (see Figure 2).
Similarly, as noted in NIESR’s recent Summer 2023 UK Economic Outlook, with the large energy price rises ‘falling out’ of the CPI basket from April 2023 onwards, the drivers of inflationary pressures have shifted towards rising prices for food, non-energy goods and services.
Figure 2: Contribution of different sectors to the UK’s annual CPI inflation rate since July 2021
Why does the UK seem to be having a more severe bout of inflation than some comparable countries? This is due to the compounded effect of a myriad of ‘shocks’: the Covid-19-induced supply shock, Russia’s invasion of Ukraine and associated energy price shocks, Brexit, and a tight labour market, which is driving higher wage growth, generating further inflationary persistence, particularly by keeping service price inflation elevated.
UK inflation has broadly followed the same pattern as in other G7 countries, suggesting that underlying factors are common across countries, but exaggerated risks particular to the UK have exacerbated inflation. The UK’s dependency on imported goods and commodities, an over-reliance on the service sector, and labour market constraints and trade barriers resulting from Brexit are all combining to deepen the crisis.
As the world’s third largest net importer of food and drinks (according to the Food and Agriculture Organisation of the United Nations) and a net importer of energy, the UK is particularly exposed to sudden changes in global commodities prices and gas prices.
When and how quickly can we expect inflation to fall?
This is not an easy and straightforward question. It is difficult to specify the precise timing of when inflation will fall, as its dynamics are influenced by several factors – global externalities and domestic demand. But the latest inflation figures from the ONS can help us to make an informed judgement about roughly how quickly inflation will fall.
Annual CPI was 6.7% in August compared to 6.8% in July. This marginal fall was driven mainly by a fall in inflation rates from restaurants and hotels, and food and non-alcoholic beverages categories, although these were partially offset by a large upward contribution in transport (higher oil prices).
Annual core inflation (CPI excluding energy, food, alcohol and tobacco) rose by 6.2% in August, from 6.9% in July. The key measure of domestic inflation (all-services index) also dropped significantly, from 7.4% in July to 6.8% in August. These measures may indicate that the past successive interest rate rises are starting to work their way through the economy.
As monthly inflation is volatile, the Bank of England will need to see sustained falls in both headline and core inflation to be confident that inflation will return to its target of 2% in due course. The Summer 2023 NIESR forecast is for CPI inflation to fall to 5.2% by the end of 2023 and be in the range of 2-4% by the first quarter of 2025 (see Figure 3).
Although the most likely outcome is an easing in inflation (shown as the black line in Figure 3), it remains the case that we have yet to see a significant turning point in underlying inflationary pressures in the economy. If risks to inflation escalate, inflation could remain higher than forecast (as illustrated by the red-shaded areas in Figure 3).
Figure 3: The UK’s medium-term inflation forecast
Source: NIESR (NiGEM database, NIESR forecast and NiGEM stochastic forecasts)
What have we learned about the UK inflation and interest rates – and what might be coming next?
Considering the aggressive and significant hikes of the Bank of England’s policy interest rate since the start of this current tightening cycle, today’s monetary policy stance is restrictive. As Huw Pill, the Bank’s chief economist, indicated in a recent speech at South Africa’s central bank, he would prefer to keep rates at the current level of 5.25% for a longer period than raising them further as it constricts the economy less and curtails risk to financial stability.
So, it is possible that we are close to the peak of the current period of continuous monetary tightening. But this is conditional on indications of the persistence of inflationary pressures and resilience in the economy as a whole, including labour market tightness, wage growth and service price inflation.
It is equally important to take into consideration the fact that monetary policy operates with a lag (of about 18 months) and is forward-looking. This means that we won’t start to see the effects of the most recent interest rate changes for quite some time.
The inflationary outlook for two years time is critical for monetary policy decision-making – more so than the latest inflation figures. That said, it is crucial for policy-makers to know how the country is doing right now to assess potential future steps.
Where can I find out more?
- NIESR UK Economic Outlook Summer 2023, available here.
- QE at the Bank of England: a perspective on its functioning and effectiveness.
- Quantitative tightening: the story so far.
Who are experts on this question?
- Jagjit Chadha, NIESR
- Richard Davies, Economics Observatory
- Huw Dixon, Cardiff University
- Stephen Millard, NIESR