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The policy tightening

One justification for low interest rates is that fiscal policy will be tightened significantly. This could be good news in the short-term for investors, but not perhaps in the longer-term.
The policy tightening

Many of you are exasperated by the Bank of England’s reluctance to raise interest rates in the face of rising inflation. There is, though, an under-appreciated reason for this reluctance. It is that the job of tightening policy is going to be done by fiscal rather than monetary means.

The OBR forecasts that cyclically-adjusted net borrowing will fall from 9.7 per cent if GDP this year to 3.3 per cent in 2023-24. That’s a tightening of 6.4 percentage points of GDP, more than anything we saw under the Thatcher or Cameron governments. It’ll be achieved by a combination of spending restraint and tax rises; the OBR has forecast that the share of taxes in GDP will rise to its highest since the late 1960s – and that was before the recent announcement of a hike in national insurance contributions.

This squeeze might not be motivated by a desire to hold down inflation, but that will be its effect. Higher interest rates reduce inflation by depressing demand. But fiscal policy also reduces demand and so cuts inflation.

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