(Macroeconomics) Bank of England raises interest rates to 3.5% in ninth increase in a year

Mortgage payers are braced for higher borrowing costs, after the Bank of England pushed up its base rate by 0.5 percentage points to 3.5% despite saying inflation has peaked and Britain is about to enter “a prolonged recession”. The Bank hiked interest rates on Thursday for the ninth time in a year, to the highest level in 14 years, but told borrowers to prepare for fresh increases in the new year.

 

Members of the Bank’s monetary policy committee (MPC) voted to increase the cost of borrowing after the consumer prices index (CPI) in November showed annual inflation of 10.7%. Governor Andrew Bailey said a fall in CPI from 11.1% in October represented “the first glimmer” that inflation had begun to ease and he expected a rapid fall, “probably from the late spring onwards”.

 

His comments, which appeared to show further rate rises could peak below
forecasts of 4.5% by the end of next year, sent the pound tumbling against the
dollar by 2 cents.

 

Bailey forecast skill shortages would push wages higher and prevent inflation falling towards the Bank’s 2% target as fast as he hoped.

 

“There is a risk that [inflation won’t fall] in that way, particularly because the labour market and the labour supply in this country is so tight.

 

“And that’s why, really, we had to raise interest rates today, because we see that risk as really quite pronounced.”

 

Debt charity StepChange said higher borrowing costs would plunge more people into debt and called on lenders to show restraint before calling in loans.

 

Bank of England’s Bailey sees ‘first glimmer’ of inflation easing, after lifting interest rates to 3.5% – business live

 

Read more

 

Its chief executive Phil Andrew said households with the least financial resilience faced a double whammy of rising inflation and higher credit costs.

 

“It looks as if housing debt will be a particular pressure facing millions of households in 2023,” he said.Shadow chancellor Rachel Reeves said the rate rise was made in Downing Street, “leaving millions of working people paying a Tory mortgage penalty for years to come”.

 

Financial markets expected the rise, which was heavily trailed by Bailey, and the chief economist, Huw Pill, after they said “more needed to be done” to bring down inflation, before adding that a repeat of November’s 0.75 percentage point rise was unlikely.

 

In a three-way split vote, when two members of the nine-strong MPC voted to keep the base rate on hold and another member pushed for a more aggressive rise, the MPC said there were “considerable uncertainties around the outlook”. While global supply chain blockages have eased, bringing down the price of many commodities and goods since they rose sharply earlier this year, cost pressures have remained throughout global markets.

 

With cold winter weather biting much of Europe, the path of gas prices and the cost of food could rise, keeping inflation higher for longer.

 

The US Federal Reserve and the European Central Bank have signalled that they will ease back on rate rises in 2023 following forecasts that there is a strong prospect of a recession and job losses across the industrialised world.

 

Russia’s invasion of Ukraine continues to disrupt the supply of gas and some foodstuffs, adding to inflationary pressures.

 

The Bank’s report said there were several indicators showing the economy had weakened since the summer. It expects a 0.1% contraction in GDP in the last quarter of 2022, which would put the UK economy officially in recession after a 0.2% contraction in the third quarter. The downturn is expected to last well into 2023, though it will be milder than expected in the Bank’s forecasts last month.

 

Giving a strong indication that the housing market has already weakened, the number of home purchases has fallen to below 60,000 a month, the lowest since 2013.

 

Bailey voted with the majority of MPC members for a 0.5 percentage point rise. Two members of the MPC, the LSE professors Swati Dhingra and Silvana Tenreyro, said the cost of living crisis facing millions of households and previous interest rate rises meant the economy would slow without further rate rises.

 

The article describes the UK ́S central bank's contractionary monetary policy choice, after they increased interest rates for the ninth time in a year, with a 0.5 percentage point hike, resulting in a level of 3.5%, which is the highest it has been in 14 years. This choice was done due to an increase in the CPI, after the UK economy showed in November a high annual inflation of 10.7%.

 

Inflation means the rise of the price level of an economy, leading to a decrease in purchasing power. Monetary policy refers to the way a central bank manages money in the economy, by manipulating the money supply and interest rates, which allows for the achievement of a lower and more stable rate of inflation and unemployment, which are macroeconomic objectives. This contractionary policy choice was done with the aim of achieving these macroeconomic objectives.

 

Since the UK is facing an inflationary gap, the output level is higher than its long potential term, producing above full employment and creating an upward pressure on the consumer price levels.

Choice was involved to decide the best policy to respond to and push for an economic recovery.

The figure1 is showing that the central bank decreased the money supply from MS1 to MS2, with the help of using some tools such as selling bonds in the open market and increasing minimum reserve requirements, allowing more money to be kept in the banks. As the interest rates go upwards from r1 to r2, the quantity of money will shift to the left decreasing from Q1 to Q2, affecting economic growth. As a result, the costs of borrowing will increase, while saving will become more attractive. meaning that investments would decrease and by consequence the aggregate demand. This decrease in borrowing will result in a decrease in business expansion, leading to fewer job opportunities for workers. With more people unemployed, the demand for goods and services will decrease.

Figure 2 showsthat when interest ratesincrease, the total of investments will decrease,stating that both determinants of aggregate demand; consumption and investments, will cause a decrease on aggregate demand AD = C↓ + I↓ + G (X-M)). Therefore, the policy choice of the central bank would close the inflationary gap, exposed from Y1 to Yfe in which RGDP will not exceed the potential GDP, likewise, decreasing the price level from PL1 to pL2 will help get the UK economy into equilibrium, in which the LRAS crosses with the AD2. Hence, the policy choice will help lowering the inflation levels. However, it can be shown in the figure that in the long run, the aggregate demand is shifting to the left while the debt withvery high-interest rates is repaid, situation where consumers stop consuming luxury goods for example, as they are facing debt costs. These loan repayments will get more expensive, as the article states that in 2023, numerous households will experience significant stress due to their housing debt.

 

There are more choices that the UK could take as measure to face the inflationary gap by lowering RGDP and inflation, such as a combination of fiscal and monetary policy. In the case of the fiscal policy, it could be implemented a contractionary fiscal policy by an increase in taxes and a decrease in government spending, which would be more beneficial for long- term effects, while the monetary policy would be more beneficial in the short-term effects. However, implementing fiscal policy, would be taken into consideration in the political parties, as it is a decision imposed by the government, which could rise a political tension against the above-mentioned changes to the economy.

 

Alternatively occurs in the monetary policy as politicians are unable to influence key policy decisions such as cutting or increasing interest rates for stimulating economic growth, the following can be explained due to the reason that the central bank is independent of the UK government. Moreover, the monetary policy allows a relatively quick implementation, as the central bank does not require parliamentary approval to modify interest rates, that is why UK raises interests by 9 time in a year. Ultimately, there is no crowding out as monetary policy doesn’t require borrowing unlike the fiscal that does. Unlike, there would be conflicting goals, such as economic growth puts upward pressure on inflation.

 

The UK opted for a contractionary monetary policy choice, adjusting interest rates incrementally to influence demand and achieve macroeconomic goals. The ability to make small adjustments quickly was cited as the reason for this choice, as evidenced by the UK central bank's ninth interest rate modification of the year.

 

Inman, P. (2022, December 15). Bank of England raises interest rates to 3.5% in ninth increase in a year. The Guardian; The Guardian. https://www.theguardian.com/business/2022/dec/15/bank-of-england-raises-interest- rates-to-35

 

Aggregate demand and supply | DP Macroeconomics - IB Recap. (2020). Ibrecap.com. https://ibrecap.com/DP/Aggregate%20demand%20and%20supply

 

An Overview of Monetary Policy (3.5.1) | SL IB Economics Revision Notes 2022 Membership. (2022). Save My Exams. https://www.savemyexams.co.uk/dp/economics/sl/22/revision-notes/3- macroeconomics/3-5-demand-management-monetary-policy/3-5-1-an-overview-of- monetary-policy/