Winning the UK’s inflation battle will require more than just interest rate hikes

The UK is grappling with one of the most stubborn inflationary challenges worldwide, exacerbated by labour market dynamics and declining real wages which will require structural reforms to bolster Britain’s productive potential and reverse the weak growth outlook.

UK annual CPI was 8.7% in the year to May 2023, more than fourfold higher than the Bank of England’s (BoE) 2% target. Bank of England Governor Andrew Bailey said the UK inflation rate will drop “markedly” in the second half of this year, but warned the full impact of existing interest rate increases has yet to hit the economy. Chancellor Jeremy Hunt admitted that the UK’s historically tight labour market was “pushing up inflation even further”. Job vacancies are still above one million despite a decline of 85,000 in the three months to June, according to the latest Office for National Statistics (ONS) data. Markets anticipate the BoE will raise interest rates by a further 150 basis points to dampen inflation, implying a peak base rate of 6.5%, which compares to 4% by the European Central Bank and 5.5% by the Federal Reserve.

However, while the use of interest rate increases as the premier tool to dampen inflation is ubiquitous in central banking, it is a blunt tool at best. Rate increases do not directly address the root causes of the UK’s inflation problem, which is driven by structural factors (e.g. a declining UK labour force due to a post-pandemic spike in long-term sickness and early retirement) and external shocks (e.g. historically high energy and commodity prices caused by the Ukraine war, as well as supply chain pressures post-Covid and trade frictions post-Brexit). It is self-evident that a higher base rate, which principally increases mortgage and credit card payments for British consumers, does not alter that equation. Furthermore, both external and structural forces are exacerbated by lagged effects, as the transmission of monetary policy to the broader economy takes time, as noted by BoE’s Andrew Bailey.

To read in full click here