With the cost of living increasing and financial instability becoming the norm, understanding UK monetary policy and the causes of a potential UK recession is becoming more and more important
On the third of August, the Bank of England raised the base rate of interest to 5.25%, which is the 14th increase in a row since December 2021. This is the highest rate seen since the 2007 financial crisis, and to find an example of higher rates, one has to look back to the 1970s or 1980s. Interest rate decisions are made by a nine-member committee that votes to raise, hold or lower the Bank of England’s official bank rate. This time the vote was split 6 – 3.
The government’s attempts at slowing inflation
The logic of the interest rate rise is to purposefully increase borrowing costs, which, in theory, slows inflation. The current inflation rate in the UK has dropped to 7.9% – this is still uncomfortably high as the Bank of England is mandated to keep inflation around 2%.
The current inflation rate in the UK has dropped to 7.9%
Indeed, the Bank now predicts that this will not be achieved until mid-2025, largely due to persistence brought on by rising wage levels giving people increased spending power in the shops. This is partly borne out by food prices continuing to rise; however, households should be seeing reduced energy costs.
A second key issue is cost-push inflation, which is more so faced by firms rather than households; inflation for industrial goods currently stands at 5.83%. (Author’s calculations based upon ONS data).
Inflation: Driven by households, faced by firms
Here rests a key distinction, where inflation is driven by households (demand-pull inflation), the established practice of raising interest rates will likely be effective in slowing price increases. On the other side of the coin, if inflation is faced by firms (cost-push inflation) the idea of raising interest rates to correct it becomes a flawed idea.
Some economists will worry that pushing up interest rates to correct cost-push inflation will only increase the risk of suppressing economic growth, triggering a recession, and pushing up unemployment. This distinction between types of inflation seems to be rather vague in the latest summary of the interest rate decision (Bank Rate increased to 5.25% – August 2023 | Bank of England), which only notes a decline in external cost factors.
In reality, the link between interest rates and demand-driven inflation is determined by a variety of factors, so the effectiveness of the relationship is not always equal. A key determinant is the willingness of individuals to save money rather than spend it right away.
Marginal propensity to save
This is known to economists as the marginal propensity to save and is partly determined by interest rates available on savings. In a positive move, new directives from the Financial Conduct Authority are pushing for retail banks to pass on higher interest rates to those who deposit their savings (FCA sets out a 14-point action plan on cash savings | FCA).
This has a positive impact in driving up the sensitivity and effectiveness of monetary policy and may reduce the Bank’s reliance on increasing the dose in the longer term as this would attract the risk of steering the UK economy into recession.
A recession is not yet a certainty
Whilst growth is still positive at 0.2% and a recession is not yet a certainty, there are other morbid symptoms arising from the present high-interest rates, namely mortgage costs.
Repayment rates on variable-rate mortgages are directly linked to changes in the base rate. If the base rate goes up, the interest rate on a variable-rate mortgage increases too, causing a homeowner’s monthly mortgage repayment to rise.
This puts homeowners who are financially stretched at risk of losing their homes and is causing more and more people to struggle to buy a home. Recent reports indicate a rise in mortgages issued with repayment periods longer than 36 years (Taylor Wimpey signals tripling of buyers for mortgages longer than 36 years | Financial Times (ft.com)) in order to get on the property ladder.
However, some banks in recent weeks do appear to be lowering interest rates charged on mortgages in response to market pressures and expectations that inflation will begin to inch back toward 2% (Three large UK lenders cut mortgage rates as inflation outlook improves | Financial Times (ft.com)).
All in all, there can be differences of opinion on the best way to steer the economy back towards low inflation and stable growth. The targeting of inflation to 2% perhaps causes policymakers to focus upon one economic indicator rather than considering wider implications and social consequences.
This piece was written and provided by Dr Michael Harrison, Senior Lecturer in Economics & Finance, University of East London
