In the space of 18 months, Bank of England base rates have risen from historical lows to 5%, with more expected.

It’s a remarkable turnaround for an economy accustomed to ultra-low borrowing costs – the rapid increase in rates have seen soaring mortgage costs and threatens to push an already struggling economy into recession. Yet real interest rates are still negative. But, after underestimating Inflation, are the Bank of England now at risk of over-compensation creating a deeper recession than is necessary?

Time delays

Firstly, monetary policy is like driving a car, where you only get to look out the back window and when you turn the steering wheel there is an 18-second delay before the wheels turn. We can only view past economic data and estimate what may happen in the future. But, the delay is crucial. The previous interest rate rises have not even affected the economy yet. In June 2023 56% of mortgage holders had not seen any change in mortgage payments. Even if interest rates were say cut by 0.5% next month, millions would still be seeing huge increases in monthly mortgage payments next year.

The Bank of England shows how over 1 million homeowners will be faced with £500 increase in monthly payments next year. For households past rate rises is the equivalent of a 6p increase in the basic rate of income tax. All this will create strong deflationary effects on the economy. Further rate rises on top of this, risk pushing the steering wheel too much in the opposite direction.

Secondly inflation is finally falling and will continue to fall over the next 12 months, whatever the Bank of England do. On the inflation front, there are some reasons to be cautiously optimistic. Food prices actually fell last month.

The decline in oil and gas prices has been a real boon, leading to lower petrol prices. Although still very high, energy prices are being cut. Thirdly, we have seen rapid falls in inflation in Europe and the US. China is close to deflation. And although the UK inflation performance has been undoubtedly one of the worst in the OECD, UK inflation generally tracks the global trend in inflation and so will benefit from global changes (assuming of course, no new geopolitical shock which remains distinct possibility). Fourthly, the recent rise in interest rates have caused a rise in the value of the Pound which makes imports cheaper and depresses export demand. And on top of this drastic rise in interesting rates will cause lower spending and lower business investment all of which will lead to lower growth and lower inflation in the future.

Now, it is important to state inflation is still a real problem, a fall in the inflation rate can give a slightly misleading impression. This graph shows the index of consumer prices and how prices are still going up, it is just at a slightly lower rate. It is exactly the same data as the more common inflation rate. Also, the Bank of England will point to strong nominal wage growth and underlying core inflation being particularly stubborn. Just because the inflation rate is falling, we shouldn’t forget it is still well-above the target. But, although there is a long way to go, the main point is that increasing interest rates now, are not going to do too much to accelerate the decline in inflation. There’s diminishing returns from Higher rates with the prospect of higher unemployment.

The third reason is that the previous interest rate rises will have a very powerful effect. Rising house prices have caused large mortgage balances, which means that even a small change in rates has a big impact on disposable income. I’ve mentioned this a few times, but increasing interest rates to 6%, is equivalent to raising rates to 13% in the 1990s. From this perspective, we’ve gone from zero to effectively 12-13% in less than two years! To understand this. The rise in interest rates means that mortgage payments as a share of disposable income are rising to levels last seen before the 1991 and 2009 recessions. The point is, that if the Bank want to squeeze household income, they have already done it.

2% Target and wide goals

The fourth reason is that we have to bear in mind the negative impact of a recession. The UK economy has been stagnating for a couple of years. The shock rise in rates are further discouraging investment and risk creating a recession and rising unemployment. It is important to bring inflation down, but we shouldn’t obsess over a 2% target. The 2% target was chosen in the 1990s, when conditions were more favourable but there is no academic consensus this is the holy grail of target inflation. Plenty of economists argue a better target maybe 3-4%, at least when the economy is recovering from external shocks. This is not to minimise the value of bringing inflation down. Lower inflation will help improve real wages. But, the last thing workers need is an unnecessary recession and a rise in unemployment.

Unequal effect of interest rates

The fifth reason is the higher interest rates are having a very unequal effect. The higher rates particularly affect the young and those on low/middle incomes. It is not just higher mortgage payments, but higher student loans, higher credit card payments and the indirect effect on higher rents. Those who have paid off most of their mortgage are relatively unaffected.

Even though real interest rates are negative with inflation higher than interest rates. Savers are seeing higher nominal interest income. The unequal effect of interest rates is a limitation of monetary policy and there’s not much the Bank can do about that, but it is worth bearing in mind the Bank are being helped to some extent by fiscal policy, UK tax rates are close to historical high levels with the freezing of income tax thresholds causing a rise in effective income tax rates.

Credibility – Good reason?

The sixth reason is that some fear the motivation for the very rapid rises in interest rates is partly to restore the Bank of England’s inflation credibility. Unfortunately, their forecasts for inflation last year were overly optimistic. Part of this was external factors beyond their control like higher gas prices, but their models also underestimated the second-round effects on wages, profit push inflation and domestically induced inflation. Central Bankers do place great store by credibility and so the rush to raise interest rates may be at least partly influenced by efforts to restore credibility.

Falling House Prices

The seventh reason is that higher interest rates are causing a fall in house prices, which does have benefits for long-term affordability, but as house prices fall, it will have its own negative effect on economic growth, reducing inflationary pressures and increasing the risk of recession even more.

Conclusion

It’s easy to criticise the Bank of England, and I don’t particularly envy their job. But, if I was on the MPC I would definitely have waited to see the effect of past interest rate increases on the economy, rather than tighten further. We are at the stage of diminishing returns from higher interest rates. Those with debt are going to have to cut spending significantly to meet the higher debt interest payments. This will slowdown the economy as the Bank of England want. But, now ever higher interest rates are like squeezing a dry sponge, there’s not much more inflation that can be reduced without a significant rise in unemployment.