Britain’s Central Bank hasn’t got a clue.
The Bank of England’s (BOE), nine-member strong Monitory Policy Committee voted last week to hold the base rate at 5.25%. This was the first time in two years that all nine committee members either voted to keep interest rates unchanged or lower them. There were no votes to increase the base rate, as was the case in the previous meetings. This indicates that a reversal of the current monetary policy is likely on the cards in Q2 of this year. However, has the Bank already damaged the economy and household finances through its policies?
On Wednesday last week, inflation fell to 3.4% from 4%, a stronger-than-expected fall than most economists had forecast. The government and the BOE quickly pointed out that their “plan” of cutting inflation is working. Both are happy to claim that their policy decisions are making inroads into cutting inflation when this is far from why inflation is falling.
Inflation is falling due to external factors and not higher interest rates:
The BOE admits that inflation throughout 2023 fell due to tumbling energy and imported goods prices. The price of oil has fallen to $86 a barrel, below the level before Russia invaded Ukraine.
Chart 1.1 below highlights how the BOE’s calculations directly correlate inflation (CPI) and energy prices. The graph shows that inflation has only increased or decreased throughout 2022/23, when energy prices have either risen or fallen, highlighting a direct correlation between high and low inflation because of energy prices.
Core inflation is high because of BOE’s policies:
Core inflation, which strips out volatile items such as food and energy, stood at 4.8%, way higher than the BOE’s target of 2%. As the graph below highlights, the main contributors to core inflation being so high directly result from the high interest rates imposed by the BOE. Housing and household services, i.e. private rents, along with owner occupiers housing costs, i.e. mortgage costs, were the most significant contributors towards core inflation being so high. This begs whether interest increases did little to cut inflation and contribute to the squeeze homeowners and renters feel.
What have been the consequences of high interest rates?
Economic Stagnation:
The UK’s GDP grew by just 0.1% in 2023 and is forecast to grow by just 0.3% this year, the weakest annual change in real GDP since the financial crisis in 2009 (excluding 2020, the pandemic year). A report published this week by KPMG suggests that the UK will not squeeze out any meaningful growth next year and is estimated to grow by 0.9% in 2025. That is less than 1.5% growth in three years and the lowest among the G7 countries. The report highlights that higher unemployment, weak business investment, and higher interest rates will keep the economy constrained for the next two years.
Higher Taxes:
The report also highlights that underlying weakness in the UK economy and a sharp rise in debt interest spending has squeezed the public finances despite the tax burden being on course to reach its highest level since the Second World War. “Balancing the books against the backdrop of higher spending demands could be achieved either through stronger growth or higher taxes. With a relatively weak prospect for GDP growth, some of the recent tax cuts may need to be reversed after the election,” which means even higher taxes due to higher interest rates. How, you might ask?
Government borrowing in February increased by £ 8.4 billion because of a rise in benefits and debt interest payments. As a result of higher interest rates, the government has to pay more on the debt it owes, and this risks overshooting the official targets. In a report published by the Office for National Statistics (ONS), they highlight that debt interest spending has increased rapidly since 2021, meaning that the government has diverted expenditure away from the delivery of public services and has had to put up taxes to reduce the fiscal deficit which is at its highest on record.
Mortgage arrears have increased by 50%:
According to new data, arrears levels among mortgage borrowers have worsened as homeowners coming off fixed-rate deals are forced to re-mortgage on far less favourable terms. Borrowers are in arrears on £20.3 billion worth of mortgages, an increase of 9.2 per cent on the previous quarter and 50.3 per cent higher than a year earlier. The proportion of the total loan balances with arrears, relative to all outstanding mortgage balances, increased from 1.12 per cent to 1.23 per cent, which is the highest for eight years.
Enriched the Big Four banks:
BOE’s policy has directly enriched the banks that the taxpayer helped bail out in the 2008 financial crisis. Higher interest rates mean Britain’s Central Bank has to pay banks more to hold risk-free financial assets. When returns on the bonds the Bank purchased are lower than the interest paid on reserves, the Central Bank is left with a hole in its accounts that the government fills.
This setup makes Britain different. No other major economy, says the economist Daniela Gabor, depletes Treasury coffers to boost banks’ balance sheets. Taxes are at record levels because, in part, interest rates are so high. It is a scandal that the big four banks recorded profits last year of £44bn, roughly the amount received from the government, at a time when Britain was enduring the longest hit to living standards in history.
The bank policy has led to economic stagnation and forced the government to spend less on public service and put up taxes to service its debt interest. All the while they are having little to no impact on inflation. When energy and food prices go up, they are basic staples that one needs to survive and cannot do without, there is very little the bank can do about taking the demand for energy and food away by putting up interest rates. All that high-interest rates have achieved is putting further pressure on households through ill-thought policies, leading to more arrears and financial distress.
Did the BOE have to put interest rates up so high?
One thing is certain: interest rates could not have stayed as low as 0.10% and needed to rise as we exited the pandemic and returned to everyday life. The big question is whether they need to rise as high as 5.25% and cause one of the biggest squeeze on living standards. As we highlighted above, the interest rates have played little to no role in controlling the CPI but have contributed to core inflation (CPIH) being much higher than the BOE’s target. If the interest rates were not as high as they are, we would have seen substantial falls in core inflation data, too, but this has not happened.
Higher interests should have controlled CPIH as these are less volatile factors like food and energy and can be influenced by higher borrowing costs. They are likely to take demand out of the economy directly due to monetary policy. As CPIH has not fallen because of the BOE’s monitoring policy. In that case, the Bank failed to control inflation and actively contributed to economic stagnation, higher unemployment, and higher taxes due to its policy, thereby enriching the big four banks.
As has previously been the case, the Bank hasn’t been proactive in its policy decisions but reactive, and we expect this to continue. The BOE needs a severe overhaul to ensure that effective policy decisions can benefit the economy and the tax payer. The BOE has directly contributed to the biggest squeeze on living standards in history, and for that, it should be held accountable.