Inflation in the UK remains too high. The annual consumer price inflation rate was 6.7% through September, the same level as the previous month. This is well below the peak of 11.1% reached in October 2022, but inflation’s failure to fall further suggests it is proving far more stubborn than expected.

This could prompt the Bank of England’s Monetary Policy Committee (MPC) to raise interest rates again at its meeting in November, but in my view this would not be entirely justified.

In fact, the rate hikes that began two years ago haven’t been very helpful in fighting inflation, at least not directly. So what’s the problem and is there a better alternative?

Right policy, wrong inflation

Raising interest rates is the MPC’s main tool to bring inflation back to its 2% target. The idea is that this will make it more expensive to borrow money, which is likely to reduce consumer demand for goods and services.

The problem is that the type of inflation seen recently in the UK appears to be less a problem of excess demand and more a result of rising costs for manufacturers and service providers. In contrast to “demand-pull inflation,” it is called “cost-push inflation.”

Inflation rates (UK, USA, Eurozone)

UK = dark blue; Eurozone = Turquoise; US = orange. Trading view

Production costs have increased for several reasons. During the COVID-19 pandemic, central banks have “created money” through quantitative easing to enable their governments to run large budget deficits to finance furloughs and other interventions to help citizens through the crisis.

As countries reopened, it meant people had money in their pockets to buy more goods and services. However, with China still in lockdown, global supply chains were unable to keep up with resurgent demand, causing prices to rise – especially for oil.

Oil price (Brent crude oil, US$)

Trading view

Then came the Ukraine war, which further drove up prices for basic goods such as energy. This made inflation much worse than it would otherwise have been. This is reflected in consumer price inflation (CPI): it was just 0.6% in the year to June 2020, then rose to 2.5% in the year to June 2021, reflecting supply constraints at the end of lockdown. In June 2022, four months after Russia’s invasion of Ukraine, the consumer price index was 9.4%.

The political problem

This begs the question: why has the Bank of England (BoE) raised interest rates if it is unlikely to be effective? One answer is that other central banks have raised interest rates. If the BoE does not reflect interest rate hikes in the US and the Eurozone, investors in the UK could move their money to these other regions because they would get better returns on bonds there. This would lead to a devaluation of the pound against the US dollar and the euro, which in turn would increase import prices and exacerbate inflation.

Part of the problem is that the US has arguably faced more demand-driven inflation, which interest rates are effective against. On the one hand, the USA is less exposed to rising energy prices because it is energy self-sufficient. Additionally, lockdowns during the pandemic were not implemented as uniformly as in other major economies, so there was a little more room to grow.

At the same time, the US was able to reduce inflation more effectively than the UK, again suggesting that the country was combating demand-driven price increases. In other words, the UK and other countries may have been forced to some extent to follow suit and raise interest rates to protect their currencies, rather than to combat inflation.

What next

How damaging were interest rate hikes in the UK? They have not yet caused a recession, but growth remains very weak. Many people struggle with the cost of living, but also with the costs of rent or mortgage. Several million people are expected to be affected by significantly higher mortgage rates as their fixed-rate contracts expire at the end of 2024.

UK GDP growth (%)

Trading view

If raising interest rates doesn’t really help curb inflation, it makes sense to move in the opposite direction before the economy gets even worse. To avoid damage to the pound, leading central banks will need to coordinate their policies so that they cut interest rates in lockstep.

Until this happens, there doesn’t seem to be a quick fix. Good news is that the energy price cap for typical domestic consumption has been reduced from £1,976 to £1,834 per year from October 1st. This 7% reduction is expected to result in consumer price inflation falling significantly towards the end of 2023.

More broadly, the Bank of England may simply have to hope that world events move inflation in the desired direction. A central question will be whether the wars in Ukraine and Israel/Gaza will lead to further cost pressure.

Unfortunately, there is a precedent for a Middle East conflict leading to a global economic crisis: After Syria and Egypt’s joint attack on Israel in 1973, Israel’s retaliation led the OPEC oil cartel to impose an oil embargo. This led to an almost four-fold increase in the price of crude oil.

With oil crucial to production costs, inflation in the UK rose to over 16% in 1974. High unemployment followed, leading to an unwelcome combination that economists called stagflation.

Today, global production is actually less reliant on oil as renewable energy has become an increasingly important part of the energy mix. Nevertheless, a rise in oil prices would further increase inflation and weaken economic growth. So if the Middle East crisis does worsen, we may be stuck with stubborn, incurable inflation for much longer.

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