Inflation in the UK is currently at its highest since the last 40 years at a staggering 10.7%, which is gruesomely above the 2% inflation target set by the Bank of England. But what is the reason behind such high rates, and what is being done to combat them?
In the November monetary policy report, the Bank of England established the Russian invasion of Ukraine as a cause of the changing inflation rates, stating that ‘the Russian shock is now the largest contributor to UK inflation by some way’, although along with supply chain problems after the pandemic, and a shrinkage of the UK labour force.
However, the most evident cause for inflation does seem to be the shortage of gas supply due to the Russia-Ukraine war. Russia is one of the world’s top 3 producers of natural gas and oil and owns the largest gas reserve. The role of Russia in Europe’s natural gas supply has always been major, and according to IEA official figures, in December 2021, Russia exported 7.8 mb/d of oil, and in 2021, exported approx. 210 bcm of natural gas through its pipeline. However, after locking heads with Ukraine, and after little backing from the ‘collective west’, Russia decided to completely switch off the Nord Stream 1 pipeline until sanctions were lifted, hugely affecting supplies for natural gas to major nations. A diminished supply of energy meant energy providers had no other choice but to increase their prices, and that too drastically, and by October, energy bills had increased by around 80%, and inflation followed.
So, what is the Bank of England doing to tackle inflation?
The Bank of England has clearly communicated that it will practice monetary policy, through alteration of the total money supply present in the economy, in order to lower prices and return inflation back to the 2% target, which the bank believes is the bedrock of a stable and predictable economy. However, the mix of high inflation and weak activity leading up to a recession is a challenging backdrop for monetary policy.
An increase in the rate of interest is the foundation of contractionary monetary policy, and will simply force the cost of borrowing upwards, discourage spending in the economy and eventually result in diminishing demand and with all firms reducing their prices, to remain competitive.
Therefore, in the August MPC (Monetary Policy Committee) report, the Bank of England expressed that it would increase the bank rate, to 1.75% by 0.5 percentage points.
In the more recent November MPC report, the bank further increased the bank rate to 3.0%, and just a few days ago, the rate has seen yet another rise, to 3.5%. Being the 9th consecutive increase to the bank rate since December 2021, with the rate being raised by 3.4 percentage points during that period. Although this may have a significant impact on people’s lives, with many households facing higher mortgage rates and businesses facing higher loan rates, the bank deemed this necessary with the extent of inflation, stating that if they don’t act to prevent persistent inflation, worse consequences will require larger increases in interest rates. According to MPC forecasts, inflation is expected to start to fall back sharply from the middle of 2023, but to ensure that happens, the bank rate might have to go up further.
Furthermore, as part of open market operations, selling short term government bonds can also pull money out of the economy, and through contractionary measures, spending slumps and prices plummet.
Accordingly, as per the August report, the central bank started its process of quantitative tightening and provided an update on its strategy to begin selling the gilts held in the asset purchase facility, deciding to commence gilt sales shortly after the September policy meeting. The committee also concluded that over the first 12 months of the sale program, an appropriate reduction in the stock of gilts was to be worth around £80 million.
Although market forecasts and projections remain very unpredictable and heavily dependent on the uncertainties surrounding global energy prices, such measures as part of contractionary monetary policy should soon start to have an effect, with the Bank of England estimating inflation to start declining around the middle of next year, based on their outlooks generated.
Comments