How the Bank of England’s rate rises lost their power

Supermarkets were hit hard by inflation: beset by huge spikes in global food prices, vast leaps in energy bills and demands for pay rises from staff, grocers faced significant cost increases during the pandemic and the turmoil that followed.

This was swiftly passed on to customers: food price inflation peaked at almost 20pc a year ago.

One might, then, expect shop bosses to be pleased the Bank of England has taken action to address the crisis by tackling inflation.

Yet Archie Norman, chairman of Marks & Spencer, did not sound especially grateful when discussing the Bank’s actions last week.

“What we’ve proved in the last three years is that monetary policy is totally ineffective,” he said.

Since December 2021, Bank officials, led by Andrew Bailey, have increased rates from a low of 0.1pc to 5.25pc – a level not seen since 2008 – in an effort to get price rises back to more manageable levels.

Inflation has fallen from a peak of 11.1pc in October 2022 to 4pc in January. That could tempt the Monetary Policy Committee (MPC), which sets rates, to congratulate itself at its next meeting this Thursday.

Yet Norman and others believe the slowdown in inflation is nothing to do with the Bank’s actions and instead almost entirely because of global factors that Threadneedle Street cannot influence.

“There’s a marginal effect, but inflation was driven by global macro prices,” Norman said in an interview with Bloomberg.

Rate rises in the UK, he pointed out, “had no bearing on the price of gas. It had no real bearing on the price of food”.

Martin Beck at EY Item Club says pushing up borrowing costs “hasn’t worked, but it hasn’t needed to because inflation was a transitory problem anyway”.

They have a point. The inflation crisis was largely driven by the turmoil in global markets created by the pandemic and then impact of the invasion of Ukraine on energy prices.

But supply chains have recovered and new sources of gas and oil have been located, so inflation has come down again.

The fall in global energy prices has helped bring the price of petrol down from a high of £1.91 per litre in July 2022 to £1.40.

Household energy bills are also falling and expected to drop again next month. 

Economists predict this will drag headline inflation back to, or even below, the Bank’s 2pc target.

Food inflation is still running at 7pc on the year but the prices of some key staples are falling. A four-pint bottle of milk, for instance, now costs £1.51 on average, down 17p from a year ago according to the Office for National Statistics.

Ben Broadbent, deputy governor of the Bank, has acknowledged that these falling prices have not had a great deal to do with interest rates.

“Most of the disinflation we have had – in fact, all of it over the last year – has been in tradeable prices, on energy and tradeable goods,” he told MPs on the Treasury select committee last month.

Not only has falling inflation been driven largely by factors outside of the Bank’s control, there are fears that its power to influence prices at all through its traditional monetary policy tools may be waning.

The structure of the UK economy has changed in recent decades in ways that inhibit the Bank’s efforts.

Just under 30pc of households today have a mortgage, down from more than 40pc two decades ago. That means fewer people are immediately exposed to rate rises, giving the Bank’s policy less bite.

Most of those who do have mortgages fixed their interest rates at a time when borrowing costs were extremely low, meaning rate rises pass through much more slowly than in the past, when more households were on floating rates.

That effect was so strong that last year savers gained more from higher rates than borrowers lost in mortgage payments – the opposite of what the Bank wanted to achieve.

The majority of mortgage holders have now rolled on to higher rate deals but several million are still on fixes that expire over the next two years.

Fears about the Bank’s policy impotence are being stoked by continued high service inflation. Overall services price inflation – at 6.5pc – has only come down from a peak of 7.4pc in the middle of last year and edged back up again in December and January. Before Covid it ran at around 2.5pc.

The Bank believes it can affect prices in the service sector relatively directly through interest rates. This is because most services are typically provided more locally – you cannot import a haircut, for instance, or order a restaurant meal from abroad.

And yet, as Broadbent told MPs last month: “We have services inflation over 6pc. We have wage growth of over 6pc. Both of those are probably almost twice the rates we think are consistent with a stable inflation target.”

Services costs are rising rapidly everywhere you look: care home fees are up by one-tenth. Cinema tickets have risen almost 7pc. Car insurance is up one-third. Even funerals cost 8pc more than they did a year ago.

Surging prices have been driven by a tight job market, which has given staff the power to demand higher wages to cope with inflation. This is passed on to customers through higher prices.

Ian Stewart, chief economist at Deloitte, notes that households had a big pile of savings built up during Covid that let them keep spending even as prices rose.

Catherine Mann, an MPC member, told a recent Financial Times conference that “a lack of consumer discipline” – effectively a failure to rein in spending – has allowed companies to keep ramping up prices.

Companies, similarly, had high cash balances that let them keep spending on wages despite higher borrowing costs.

At the same time the Government has borrowed extremely heavily to support the economy through the pandemic, the energy crunch and even today. This has sustained wage growth and spending in the public sector.

However, there are signs that this dynamic is beginning to burn itself out as high borrowing costs finally start to weigh.

Yael Selfin, chief economist at KPMG UK, says: “All of that is a little behind us – we have lower vacancies, inflation is well below wage growth, and people are recovering that purchasing power, so we do expect wage growth to ease gradually.”

Even still, the classic signs that a huge rise in rates have slammed the brakes on the economy are not yet evident – unemployment is lower than it was a year ago, house prices have not dropped and Britain has had the mildest possible recession rather than a serious crunch.

Beck points to this as evidence of the Bank’s ineffective tools.

“If it had worked, we would probably have had a very severe recession given the extent of interest rate rises. But in reality we have not.”

That does not necessarily mean the inflation crisis will persist.

“Pay growth has slowed quite a bit on more timely measures, but that is less to do with interest rates and more that wages tend to follow price rises on the way up and down,” Beck says. “Inflation has come down of its own accord.”

For officials at the Bank, however, this crisis has raised difficult questions about whether they have the right tools to do the job next time inflation rears its ugly head.