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The usual reason given for raising rates to control inflation is that it reduces consumer spending, increases borrowing costs and slows the economy.

However, in an environment where the inflation has largely been caused by external factors (Russian war, Covid, manufacturing bottlenecks)... What purpose does raising rates serve?

(I'm deliberately ignoring the need to keep the currency strong when other countries such as US raise rates)

Surely raising rates when the inflation has Not been caused by an overheating economy only makes the situation worse for the average citizen, driving up mortgage expense and the prices of essential goods etc

In fact, the higher rates effectively force people to demand higher wages, thereby baking in an inflation that might have been temporary.

The only way I can see higher rates helping, given the situation described, is by seriously damaging the economy to the extent that meaningful numbers of businesses fail and the unemployment rate is driven up.

Please don't just quote Basic Monetary Policy (rates Vs inflation) at me. I want to know whether the UK government is deliberately aiming to tank the economy, or are they mistakenly using the wrong tool for the job.

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  • $\begingroup$ Hi @Garbonzo. I think most people (including Mr Bailey) share similar concerns regarding the limitations of monetary policy given supply-generated inflation. Monetary policy is a demand side tool for managing inflation through unemployment/borrowing levels. So, I think even if Mr Bailey etc acknowledge that when inflation is caused by supply side pressures, that they only have a mechanical demand-side response available to them regarding their inflation mandate. $\endgroup$
    – EB3112
    Commented May 13, 2023 at 16:15
  • $\begingroup$ See economics.stackexchange.com/a/53365/37817 which is essentially the same question $\endgroup$
    – AKdemy
    Commented May 14, 2023 at 4:49
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    $\begingroup$ @EB3112 : "If the only tool you have is a hammer, it is tempting to treat everything as if it were a nail." (A. Maslow) I think a lack of vision by the UK govt left the CB with only the hammer. Apparently Germany has responded with tax free payments to the lower paid, thereby taking a concrete step towards heading off wage inflation. The UK govt in contrast seems to have just watched the inflation wave roll in. Maybe they gambled on blaming the lefties when the inevitable wage protests started. $\endgroup$
    – Garbonzo
    Commented May 24, 2023 at 13:10

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There is a mistake in your premise that this inflation is supply driven which is widely understood to be false by economists already for some time. Initially there was some controversy about this (e.g. the Krugman vs Summers debate), but you would be hard pressed to find any mainstream economist now calming that inflation is just supply driven.

Especially in UK current inflation is predominantly demand driven. According to OECD estimates more than half of current UK inflation is purely demand driven (almost 4.5%), whereas about 1% is ambiguous and only about 3% can be attributed to supply side factors.

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Moreover, there are other issues with your premises. You seem to claim that central bank cannot do absolutely anything about supply side inflation, but that is simply not true. Although central banks have much less control when it comes to supply side inflation because of course they cannot 'fix' supply shocks or somehow manage natural level output, they can still manage inflation expectations that determine inflation even in presence of supply shocks. For example if you take basic Philips curve given by;

$$\pi_t = \pi^* -\beta(u_t-u_n) + \epsilon_t$$

where, $\pi_t$ is current inflation, $\pi^*$ inflation expectation, $u_t$ current unemployment and $\epsilon$ vector of shocks, then even in presence of negative supply shocks that CB cannot do anything about inflation can be lowered by lowering inflation expectations $\pi^*$. Hence to an extent that people will expect lower inflation when central bank increases interest rate it could still help at least a bit even if it couldn't bring down inflation in line with CB's mandate.

So to sum up, BoE likely increased its interest rate because:

  • more than half of current inflation in UK is demand driven. In principle, sufficient interest rate hike could lower current >8% inflation by about 4.5%. Of course BoE might not want to go pedal to the metal on hiking the interest rates for other reasons, but in principle this is how much inflation could be for sure reduced by sufficiently aggressive policy.
  • While BoE cannot fix issues causing about 3% of current inflation they could still possibly bring inflation at least little bit further down by lowering inflation expectations.
  • 1% of inflation is ambiguous, in case this 1% in reality relies mostly on demand factors higher interest rate can bring inflation down even further.

Taking the three points above one could reasonably argue that BoE could in worst case scenario cut the current inflation in half and in best case scenario bring the inflation down to something around 2.5% which would be quite close to its target.

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  • $\begingroup$ Thanks for the reply. I find it partly convincing. I think the fact that Demand driven inflation suddenly spikes after the Russian invasion is probably explained by the fact that higher energy prices instantly flipped a Supply factor into higher local prices (ie Demand). "We can't blame all the house fire on the match, because look the curtains are now on fire". The Philips Curve equation works on the assumption that raising rates now, weakens the economy in the future - which was my original question : Is the Central Bank responding to a overseas war by weakening the UK economy? $\endgroup$
    – Garbonzo
    Commented May 24, 2023 at 12:57
  • $\begingroup$ @Garbonzo how are higher local prices demand? I am not sure if you understand the difference between demand and supply driven inflation. Supply driven inflation is inflation that is driven by higher cost of production (e.g. oil shock) demand driven inflation is inflation that is driven by increase in consumer spending. Supply driven inflation does not cause demand driven inflation. These can be more or less separated using econometric techniques which is what the researchers in my source did. You can debate accuracy of any statistical finding but those OECD guys are top class analysts $\endgroup$
    – 1muflon1
    Commented May 24, 2023 at 16:42
  • $\begingroup$ rather what happened is that that escalation of the war in UA that lead to higher oil prices happened to occur almost exactly at the same time covid restrictions were lifted. During covid BoE and gov created unprecedented stimulus (and stimulating economy can lead to demand driven inflation) but inflation did not appeared because people were literally forbidden from enjoying clubs, bars, outdoor activities etc and hence just sit on their resources. Once economy reopened which just happened to coincide with escalation of war all that pent up demand was released which is what causes the demand $\endgroup$
    – 1muflon1
    Commented May 24, 2023 at 16:45
  • $\begingroup$ portion of the inflation. That is primarily what BoE is reacting to, war may factor somewhat into their decision making but they are not doing it because of it alone $\endgroup$
    – 1muflon1
    Commented May 24, 2023 at 16:45

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