Monetary policy overload?

Opinion - Hannah Gladwin

High interest rates and quantitative tightening have been the norm in tackling the inflationary struggle in the UK since 2022. Two years later this remains to be the case, despite inflation being at 1.7%, below the government's 2% target. For now, this is not a concern of the Chancellor because it is within 0.5 percentage points of the target, yet if the downward trend continues then questions must be asked to the Monetary Policy Committee as to why this is the case. 

Bank rate was held at 5.25% for almost a year, and subsequently held at 5% for the last two committee meetings. However, the economy has evidently responded and inflation’s downward trend continues. Is it wrong that the MPC is holding interest rates high for this extended period of time? Damaging the business prosperity of the country, singling out variable rate mortgage payers? Some would say this is absolutely the case arguing that low interest rates are essential to the growth of the economy. However, I believe high and stable interest rates pave the way to regaining the UK’s macroeconomic stability. We cannot collapse the bank rate, the moment we see success, it would unwind the progress of the MPC, creating instability and damaging expectations.

Figure 1: Inflation Rates, ONS

To steady inflation we also must steady expectations in the economy. If households and firms recognise that interest rates may soon fall they will delay investments until they become cheaper, whether this be huge business investments or individuals taking out a mortgage. This has the potential to stagnate the economy, running the risk of recession. Therefore, the MPC must manage these expectations keeping conditions in the economy stable whilst ensuring macroeconomic conditions do not falter. Keeping interest rates high but reducing them gradually manages expectations preventing the risk of shocks to the economy. Therefore, I believe the MPC are taking a measured response to the bank rate providing they remain on the trajectory of reducing the bank rate overtime.

Interest rates had been held below 1% since the financial crisis but were brought above this figure for the first time in June 2022. According to a general monetary transmission mechanism, it takes eighteen months to two years for a MPC decision to filter through the economy and impact the inflation rate. We can tell by the figures above this has been the case and therefore this prolonged policy decision has had the desired effect. Therefore, some would argue that the policy has been in place long enough for the economy to react and it is time for interest rates to become stable again. This suggests that the decisions of the MPC today will dictate the inflation rate into 2026, so could we be damaging the economy of the future by trying to manage the economy of today?

Figure 2: Bank Rate, Bank of England.

Interest rates had been held below 1% since the financial crisis but were brought above this figure for the first time in June 2022. According to a general monetary transmission mechanism, it takes eighteen months to two years for a MPC decision to filter through the economy and impact the inflation rate. We can tell by the figures above this has been the case and therefore this prolonged policy decision has had the desired effect. Therefore, some would argue that the policy has been in place long enough for the economy to react and it is time for interest rates to become stable again. This suggests that the decisions of the MPC today will dictate the inflation rate into 2026, so could we be damaging the economy of the future by trying to manage the economy of today?

However, this argument returns to the idea of expectations and how essential these are in dictating the inflation rate. If the MPC looked solely at inflation rates of that month and made the interest rate decision from this then interest rates would be significantly lower. But they must consider how individuals are going to react. If interest rates suddenly dropped, short term consumption and investment in the economy could rocket, pushing inflation back up to unsustainable levels. Therefore, the MPC must take this into consideration and ensure they take the approach which will have the steadiest impact on the economy. The MPC have in fact confirmed this is the action they will be taking; ‘Monetary policy will need to continue to remain restrictive for sufficiently long until the risks to inflation return sustainably to the 2% target in the medium term’. 

This idea of prolonged restrictive monetary policy is where quantitative tightening is significant. The MPC began this policy in February 2022, and the overall aim is to bring down long term interest rates. Therefore, the MPC have the tools to manage inflation in both the medium and longer term allowing them to ensure macroeconomic stability into the future. They are controlling the expectation in the long term minimising the possibility of shock to the economy. 

Overload, is what current monetary policy appears to be on the surface, yet this overload is necessary in ensuring a successful route to a stable economy, despite how it appears that inflation is under control the MPC must solidify this success.