When will UK interest rate rises start to bring down inflation?

It has been eight long months since the Bank of England first began to raise interest rates in an effort to combat rising inflation, and on Thursday this week (4 August) it is expected to deliver a whopper: a 0.5 percentage point rate hike, the biggest in more than a quarter of a century, which will raise UK interest rates to 1.75 per cent.

Economists assure us that this is the best way of controlling inflation: hiking rates pushes up the cost of borrowing, thus giving people less disposable income, which in turn drives down demand, slowing price rises. And yet, after five rate hikes, inflation stubbornly continues to rise: the latest data, released at the end of last month, shows that prices are currently 9.4 per cent higher than they were this time last year, and economists expect that figure to rise as high as 12 per cent in the coming months.

To complicate things further, the causes of these price rises are, for the large part, outside of the Bank of England’s control. Surging energy prices have been pushed up by the war in Ukraine and have exacerbated rises in the cost of production of food, electronics and just about any other industry which uses gas or electricity in its day-to-day functioning. So when exactly are interest rate rises going to start controlling inflation like we’ve been promised? Or is this rate hike cycle, as some suspect, really just theatre by central bank – a well-meaning yet futile attempt to make us (and whoever will have the keys to Number 10 in September) feel more in control?

The simplest way to figure this out, says James Smith, a developed markets economist at the Dutch bank ING, is to break down the exact causes of inflation. “Currently, electricity and gas alone are contributing two and a half percentage points, petrol is about another one and a half per cent, food is about one per cent and used cars is about half a per cent,” he says.

It may get worse before it gets better, admits Smith: this week the analyst Cornwall Insight predicted Ofgem may be forced to raise the energy price cap to £3,359 and £3,616 respectively in October and January, which will increase inflation further in those months. By October, “gas and electricity will be contributing over five percentage points alone [to the inflation figure],” says Smith.

What can the Bank of England do about it? Martin Weale is a professor of economics at King’s College Business School who used to sit on the Bank’s monetary policy committee (MPC), which sets the interest rate. “There’s not an awful lot that interest rate policy can do about [energy prices],” he admits. “It can’t create extra gas.”

But there is one thing it can do. There are two factors contributing to rising inflation: one is that high energy prices are making people poorer, and the other is that unemployment is unusually low, meaning jobs are very hard to fill. That puts all the power in the hands of workers: if employers can’t fill jobs, they’ll increase wages, which will increase inflation. And that, says Weale, is something the Bank of England does have control over.

“What I think [the Bank] has in mind is trying to ensure that the labour market is sufficiently slack,” he says. By pushing up interest rates, it means employers have less spare cash to meet employees’ demands for pay rises. Workers with less disposable income brings down demand, which in turn helps to control inflation. But that “does mean more unemployment than there is at the moment,” says Weale.

It isn’t a question the MPC will address lightly, he adds. “The sort of questions that the people on the monetary policy committee will be asking themselves is, do we really need to do that? Because of course, with the country becoming quite a lot poorer, people’s spending power is being reduced anyway. There is a view that perhaps the increase in gas prices… takes the demand out of the economy and reduces the pressure for pay increases [anyway].” So it may be that inflation itself controls wage rises – but it looks likely that most of the MPC won’t take that view, and will continue to raise rates, for the next few months at least.

Even after Thursday’s rate hike, inflation will continue to climb for some time because there is usually a “lag” between rate hikes and price rises beginning to slow, says Yael Selfin, the chief economist at KPMG UK. “It generally takes about 18 months for interest rates to influence inflation.”

Selfin expects a few more interest rate rises before the end of this cycle. “Our expectations at the moment are for another rise in September, one in November and another one in February, and then potentially a pause, because by that stage we should hopefully see inflation starting to moderate quite significantly,” she says. Economists expect interest rates to peak between 2.5 per cent and 3 per cent early next year.

But it’s also worth remembering that a drop in the inflation figure doesn’t mean prices are falling – just that they have stopped increasing. Cornwall Insight has cautioned that energy bills could stay above £3,000 a year until at least 2024, which will keep up the pressure on people’s finances. “Inflation coming back to the [Bank of England’s] 2 per cent target isn’t going to make people feel better,” says Weale. “It will just stop them feeling they’re getting worse and worse off.”

Further reading

• Interest rates are fuelling a debt crisis in the developing world
• Can “Trussonomics” work?
• How inflation is worse for women

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