- Energy prices are currently the biggest driver of UK inflation. But domestic pressures are a growing concern
- Higher interest rates can’t change energy prices, but they might stop inflation from lingering
The Bank of England (BoE) has faced no shortage of criticism this year. But one question is particularly on the nose: if high inflation rates are driven by rising energy prices, will increasing interest rates make any difference? The answer is 'probably', albeit mostly in the longer term.
As the chart shows, energy prices are currently the major driver of UK inflation, with the price of gas doubling since Russia’s invasion of Ukraine. The BoE now expects inflation to peak at 13 per cent later this year, and for energy prices to account for half of this. Higher imported goods prices are also piling on the pressure, as are other factors. August’s monetary policy report identified no shortage of drivers, citing higher transport and utility costs, supply shortages and the recovery from the pandemic as ongoing issues.
But inflation is not just a supply-side problem, and there is evidence that home-grown pressures are beginning to weigh more heavily on the monetary policy committee’s (MPC) decision making. On 4 August the BoE made its biggest rate hike in 27 years, a move it justified by arguing that “there is a risk that a longer period of externally generated price inflation will lead to more enduring domestic price and wage pressures”.
Raising interest rates will not change the path of soaring energy prices. But the move can aim to influence so-called ‘second-round effects’. If the first-round impact was the energy price spike, the second-round effects are the spillovers arising from it – particularly the response of wages and prices.
August’s Monetary Policy Report highlighted that “underlying wage growth is rising and survey evidence suggests that firms are passing a larger share of costs into prices to protect margins”. By tightening monetary conditions, the BoE hopes to dampen some of these second-round impacts. This is a well-trodden policy path, in accordance with International Monetary Fund orthodoxy: since the 1970s, a policy adage has set out that central banks should accommodate first-round effects but respond more decisively to second-round impacts.
Closely linked is the issue of inflation expectations. Through wage demands and price hikes, inflation is partly influenced by what we expect it to be: the BoE reports that expectations have now (understandably) risen far above the 2 per cent inflation target. The August monetary policy report found that businesses and households now expect annual inflation of around 6 per cent, and average weekly earnings are growing at almost the same rate.
This means that moderating expectations matters more than ever. The BoE still expects inflation to be relatively short-lived – falling back to target in two years’ time as gas and commodity price pressures gradually dissipate.
But if inflation expectations remain elevated, there is a risk that companies and workers will continue to demand higher prices and wages – even after the underlying pressures have lifted. In this case, inflation won’t drop back down to target levels, but persist over the longer term. Unsurprisingly, expectations got plentiful coverage in the monetary policy report, with the BoE stressing that “the committee will continue to monitor measures of inflation expectations very closely and act to ensure that longer-term inflation expectations are well anchored around the 2 per cent target”.
In short, these hikes won’t stop inflation in its tracks. But the BoE hopes that they might stop high inflation from lingering after supply-side pressures lift. Berenberg senior economist Kallum Pickering agrees, arguing that while the latest hike “will do little to dampen the likely further rise in inflation near term, it should help to contain inflation expectations”, adding that “this will reduce the risk that high inflation persists once its mostly external triggers have faded”.
In theory, then, there should be a longer-term gain for this monetary pain. But with inflation projected to remain above 9 per cent for the next 12 months, we will face a long wait to see whether it materialises.
