Recent sharp interest rate hikes by the US Federal Reserve and the European Central Bank highlight central bankers’ concern that high inflation could take root and spiral even further out of their control. As many advanced economies face the specter of recession, monetary policymakers are faced with an unenviable choice: gradually raise rates, which will drive up the cost of credit more slowly for already overburdened households, or charge them upfront to anchor themselves in a price spike. The Bank of England will face that trade-off when it announces its next interest rate decision on Thursday.
Since the BoE began lifting its pandemic-era stimulus in December with an initial hike of 15 basis points, it has raised rates in slow, steady quarter-point increments. Most of the members of the Monetary Policy Committee felt that fragile economic activity, in the midst of a crisis in the cost of living, meant that a half-point increase – its largest since 1995 – could be too aggressive. Yet, with price pressures in the UK unlikely to ease significantly in the near term, the BoE will fall even further behind the inflation curve if it does not act more decisively.
Price pressures have intensified since the bank’s previous meeting, when it warned that it may need to act more “forcefully” if inflation looks more persistent. The annual consumer price index for June was 9.4%, a new high in 40 years. Food and gasoline prices continued to soar, and factory gate inflationary pressures also increased, with producer prices hitting a 45-year high. After the wholesale gas price jumped again, the energy price cap for households is expected to increase in October by 70% and remain high until 2024. This means that inflation could peak at more than 11%, plus the BoE. had already written in pencil.
At such highs, the threat of “second round” effects, where companies drive up prices and workers seek higher wages as household bills rise, becomes intense. Wages are not yet skyrocketing out of control. But at over 4%, annual growth in regular compensation is still above the roughly 3% seen as consistent with the bank’s 2% inflation target – and unusually high bonuses and one-off payments mean the total compensation is growing even faster. Labor shortages will support wage pressures, while surveys show business expectations for selling prices are still at elevated levels.
There is little the bank can do directly to stave off international pressures on fuel, food and supply chain costs. Yet, with corporate and household price expectations being crucial to integrating high price dynamics, the bank will face a credibility problem if it is not seen to be acting robustly. With interest rates a crude tool to stifle inflation, a more vigorous 50 basis point hike – which markets have widely expected and which BoE Governor Andrew Bailey has said is “ on the table” – would act as an important signal to ease inflation concerns.
Some may point to easing core inflation and surveys showing price expectations cooling as justification for less urgency, but upside risks to inflation remain. As other central banks look to bigger hikes, relatively lower interest rates in the UK could weaken the pound, which would increase imported inflation. The war in Ukraine means that food and energy prices will remain volatile. And both Conservative leadership candidates are touting tax cuts that would add fuel to the inflationary fire.
Waiting for even clearer evidence of persistent inflation would already be too late. The MPC must decide which is the greater risk: exerting downward pressure on economic activity now or allowing price momentum to spin out of control, leading to potentially more painful and damaging upsides later.