As expected, seven out of the nine members of the Monetary Policy Committee voted on 21 June 2023 to increase the Bank of England base interest rate by a half – percentage point (or 50 basis points) to 5 per cent-for the 13th consecutive time since December 2021, when it was a mere 0.1 per cent, ever since March 2020- to its highest level since April 2008, even though this risked setting off an already ticking mortgage time-bomb in the process. Apart from immediate increases in monthly repayments on standard variable rate or ‘discount’ mortgages and variable rate tracker mortgages, home owner-occupiers with soon-to-expire two-to-five year fixed-rate mortgage deals will also be hit with higher bills, amidst an unrelenting cost-of-living crisis.
The base interest rate is a central bank inflation-targeting monetary policy tool, aimed at keeping the annual rate of inflation at around 2 per cent. Rising prices imply a lower purchasing power of money, which is particularly painful when money is tight just as wages stagnate. The rate at which banks borrow from the Bank of England is used as a benchmark for pricing loans, savings, and bonds, thereby influencing borrowing, saving, spending, and investment decisions. It can at best be considered a blunt tool, designed to stifle demand for goods and services and thereby slowing down price rises, at the same time encouraging savings and investment in annuities. The price of money, and consequently the cost of borrowing, both by households (mortgages; credit card purchases; loans; overdrafts) and businesses (loans; bonds, or securitised loans), increase in an attempt to apply brakes on the economy, with the inevitable risk of recession- a cure that is likely to be more damaging than the illness it is designed to treat. It is indeed a matter of securing the right balance between inflation, growth, and employment- no mean achievement. Ideally, a soft landing should be hoped for, when the economy slows down without actually crashing and going into recession, just as inflation continues to fall at the desired rate and productive capacity goes into recovery mode. One of the perverse features of base interest rate rises is that high-street banks and building societies seem tardy to pass on the increases to savers, while not sparing borrowers.
Across the world, the recent fetish for ultra-low interest rates is coming to an end, as interest rates have recently risen in the US, EU, and elsewhere. Even in Turkiye, where Recep Tayyip Erdogan opted for low interest rates despite raging inflation, the interest rate has just been raised to 15 per cent in a dramatic reversal of economic policy.
Inflation in the UK, as measured in May 2023, was 8.7 per cent for headline, or consolidated, Consumer Price Index (CPI) inflation, 7.1 per cent for “core goods” price inflation, which excludes volatile food, energy, alcohol, and tobacco prices that do not reflect the strength of the economy, and 7.4 per cent for services CPI inflation. The underlying causes for this inflation include the legacy of the Covid supply shock, the ongoing conflict in Ukraine and its effect on energy supply and costs, and the emerging effects of Brexit. Other inflationary pressures arise from wage growth, tight labour markets, and services price inflation.
As with all economic policy decisions, there is no unanimity regarding the benefit of continued interest rates and on the precise elements of the economy that require resuscitation. Suggested treatments depend on economists’ diagnoses for their perceived causes of financial malaise. In the UK, it seems that the economy is suffering from a restricted supply of goods and services, and stifling demand by further hiking interest rates may well be counterproductive.
Some feel that the Bank of England has been slow to, as well as timid, in raising interest rates, while others feel that their choice of prescription is inappropriate. But the central bank has limited options, and the alternative of quantitative tightening, or restricting the supply of money, is also painful. Opponents of the present, as well as likely further, rise in interest rates caution delay as the effects of previous interest rates have yet to kick in. Inflation is indeed falling, albeit as not as fast as hoped for, and will continue to fall, but a policy to reduce demand in the economy by reducing the disposable incomes of households and further compromising standards of living in the pursuit of an arbitrary inflation target warrants closer scrutiny over the coming months.
Ashis Banerjee