Interest vs Inflation: The Bank of England’s plan to tackle post-Covid inflation

October 25, 2021

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3 min read

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What's going on here?

The Bank of England is speculated to raise the base interest rate to halt rising inflation in the economy.

What does this mean?

Inflation refers to the rate at which the general price of goods increases and the value of currency declines. At a basic level, this occurs when the total amount of demand in an economy exceeds its capacity to supply, resulting in a rise in the cost of living for the public and a loss of purchasing power.

To meet demand, businesses employ unused labour and resources within the economy to increase capacity. A steady rate of inflation, thereby, is necessary to maintain economic growth. Excessive inflation, on the other hand, is damaging to the economy. It occurs when demand rises faster than production can increase and puts a heavy strain on businesses.

The Bank of England (BoE) has set the target rate of inflation at 2%. Last August, the Office of National Statistics (ONS) reported that the rate had jumped to 3.2%, a figure the BoE’s Monetary Policy Committee (MPC) expects to peak at 4% before the end of the year.

Post-Covid inflation is said to have been caused by the global economic rebound, and has forced many domestic companies to go bust. This comes as no surprise given that the UK currently has little unused labour and resources for businesses to make use of. Largely due to Brexit, the global labour shortage has hit the UK hard, and a combination of soaring energy prices, increasing commodity prices and supply-chain bottlenecks have pushed the cost of production to record-breaking heights

To combat excessive inflation, central banks can increase the base interest rate. A higher interest rate reduces demand by decreasing disposable income, reducing borrowing due to the higher cost of interest, and encouraging people to save by earning interest on their bank accounts. When consumers have less money to spend, total demand in the economy goes down.

What's the big picture effect?

Governor of the BoE, Andrew Bailey, has signaled that the MPC will raise the base interest rate sometime within the coming few months – the first time they will have done so in over three years. Markets predict that the MPC will raise the base rate to 0.25% in November, but both its magnitude and timing will depend upon incoming evidence of the effects of ending the furlough scheme, and the degree to which businesses pass production costs onto consumers. The BoE will employ the fiscal tool to prevent a wage-price spiral, and begin a two-year plan to return inflation to a sustainable 2%, should they decide to increase it. 

Speculation surrounding the increase has put the BoE’s credibility in the spotlight. In a speech last September, Bailey made clear that a rise in interest rates would be very unlikely. He claimed that high inflation was temporary and caused by supply-side factors that monetary policy could hardly tackle. He seems to have done a u-turn since then, signaling in his comments to the G30, an international group of academics and financiers, that the BoE will be forced to act, likely by raising interest rates. The confusion caused has resulted in criticism that the Governor does not seem capable of “managing communications effectively”.  

Should the BoE act accordingly, mortgage holders will experience an immediate rise in costs as providers match prices to suit new interest rates. The cheapest mortgage deals have already been pulled out of banks following Bailey’s comments. This increase in housing prices will further burden consumers already squeezed by soaring household energy bills and the costs of essentials for their day-to-day living

Whether the BoE’s actions this Christmas fall in line with Bailey’s signals or not, financial markets have predicted the interest rate to rise and expect it to increase more in the next 10 months than it has in the last 10 years.

Report written by Johan Faisal

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