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Is raising interest rates the best way to tackle inflation?

Bank of England

The last few months have been predictably eventful for the Bank of England. Following the 12th consecutive increase, the current base rate is 4.5%, the highest in 15 years, i.e. since the era of the Global Financial Crisis in 2008. The rate is projected to increase up to 5.0% by the end of the year given the expected resilience of high inflation and the surprising resilience of the economy. However, we could expect interest rates to rise higher if inflation persists being high.

A usual question is why the Bank of England, or any other central bank for that matter, raises interest rates in order to curb inflation. The framework, although complex and occasionally incomplete, is based on the foundational economics idea of supply and demand.

When economic activity is high, i.e., companies can sell products and services in the desirable quantities without systematically decreasing their prices, companies are eager to expand production in order to profit from the customer willingness to spend. This "eagerness" leads to companies competing with other companies for the same resources (raw materials, talent, professional services etc).

Many companies are eager to "beat" competition for resources by paying higher prices, such as paying higher salaries or more for the same quantity of raw materials. That creates a domino effect in rising prices as, for instance, employees with higher salaries will spend more in their private life, competing, in turn, with other consumers for products or services that cannot increase in quantity or availability in the short run. Their consumption, then, leads to companies seeking further growth to capture the buoyant demand for their offering. This flywheel effect in increasing prices is what maintains high inflation or, to reflect the widespread effect in the economy, a "high inflationary environment".

Central banks can intervene by making such corporate expansion more expensive, and thus less likely to take place. The increases in the base interest rate aims at making the cost of borrowing higher for companies, thus their expansion plans become more expensive, and the overall proposition of trying to capture more of the market demand for their offering less attractive. As companies expand less, they also compete less with other companies for more resources, and thus the price levels for those resources stabilise. Or so the theory holds.

The mechanism is actually more complicated than the simplistic explanation above, since the economy is a complex system with plenty of room for impact from unpredictable sources. Still, the basic rationale is that making the financing of resources or products, such as mortgages, more expensive, market participants are less willing to spend, thus the vendors of such resources and products do not have to raise their prices to account for the demand growing faster than supply in the short run.

This is the case in countries with high inflation prints at the moment, not just UK. The resilience in the job market, although great for job market participants, contributes to the persistence of inflation and, thus, higher interest rate mandates. A common outcome of such anti-inflationary policies is forcing companies who have over-expanded to accommodate increasing demand, to reduce the size of their operations by downsizing. That, in a similar flywheel fashion, puts pressure on consumers and end-customers, leading to decreased consumption, forcing companies to further downsize; the cycle continues until the balance switches to increasing demand for consumption, and thus resources etc.

The government and affiliated institutions, such as the central banks, aim for the near impossible balancing act of reducing the acceleration of prices to unsustainable levels while avoiding too much decrease in demand, which could spark a recession. The discussions about "soft landing" refer to only few market participants being affected severely; it is expected that some of us will feel the "pain" so that most of us will feel only a minor shake.

So far, it seems that the intervention is working relatively well, meaning that more individuals, families, and companies will not become victims to fast-increasing prices or high financing costs. The final tally will take years to calculate, and who knows what surprises will arise until inflation drops to the long-term goal of 2%; not a dull moment until then.

Dr Nikolaos Antypas

Lecturer in Finance
Published 16 May 2023
Leading insights

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