Cost of living: Why Bank of England has increased interest rates
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The Bank of England (BoE) announced its highest interest rate increase in almost three decades this afternoon, a hike of 0.5 percent to 1.75 percent. Despite the measure, inflation is not predicted to return below the two percent target for two years, and will initially continue to rise before peaking at 13.3 percent in October. With energy prices preventing consumption in the economy, the evidence in support of an impending recession is overwhelming.
The cost-of-living crisis has reduced the ability of consumers to spend money on goods and services, causing the BoE to predict an impending recession.
Andrew Bailey, the Governor of the BoE, blamed energy prices on the prediction, rates which have increased sevenfold since the end of last year.
An economy is said to be in recession when it experiences two successive quarters of negative economic growth.
Scheduled to hit from the final quarter of this year, the BoE forecasts this recession to last as long as that of the early Nineties and 2008 financial crisis.
The sanctions imposed on Russia in the wake of Vladimir Putin’s invasion of Ukraine have led to a retaliatory energy crisis, with restricted supply forcing prices sky high.
External shocks such as these are beyond the control of central banks, whose job it is to manage inflation by setting interest rates.
In the UK, this task falls upon the Monetary Policy Committee (MPC) within the BoE.
The MPC’s target inflation is two percent, as a positive but small rate of inflation is less harmful to the economy than deflation, where prices fall.
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Increasing the interest rate has long been used as a tool for reducing inflation, as it makes borrowing money more costly, discouraging spending on expensive or risky items.
The MPC today voted to raise the interest rate by 0.5 percent to 1.75 percent, its sharpest rate hike in 27 years.
This also creates an environment where a recession is likely, which essentially comes as a trade-off the BoE must, and has chosen between.
In a recession, inflation is expected to come down because falling sales of goods lead to excess demand and falling prices – the same goes for commodities and more valuable assets such as houses.
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In the Great Depression of the early Thirties, UK GDP fell sharply causing negative four percent deflation.
Following the 2008 global financial crisis, the economy contracted by roughly seven percent on the year in early 2009 leading inflation to fall from five percent to two.
However, and most worryingly according to financial experts, the most apt historic comparison to the present is the oil crisis of the early Seventies, where inflation skyrocketed at the same time as the economy collapsed.
The result of an embargo by Organisation of the Petroleum Exporting Countries (OPEC) in October 1973, oil prices tripled and UK inflation spiked to 12.9 percent in March 1974, with output falling by 2.5 percent at the same time.
This scenario, known as stagflation, brought misery to millions of families and was a determining factor in central banks deciding to focus on keeping inflation under control.
Inflation in the UK is already at a 40-year-high of 9.3 percent for June, but the BoE now predicts the rate to peak at 13.3 percent in October.
More than six times their stated target, the MPC expects it to take two years to return to proper levels.
Mr Bailey said: “Returning inflation to the 2 percent target remains our absolute priority. There are no ifs and buts about that.”
Although countries across Europe and around the world are facing similar crises, the outlook is particularly dire in the UK.
Back in June, Mr Bailey warned inflation was set to be higher for longer in the UK, and economic growth weaker.
The UK currently has the highest inflation rate in the G7, an unfortunate accolade Adam Posen, a former member of the MPC, attributed predominantly to Brexit.
Chancellor Nadhim Zahawi said: “The economy recovered strongly from the pandemic, with the fastest growth in the G7 last year, and I’m confident that the action we are taking means we can also overcome these global challenges.”
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