A Bank of England official has said raising interest rates too aggressively could push inflation below the central bank’s target over the coming years.
Departing monetary policy committee (MPC) member and professor at the London School of Economics Silvana Tenreyro today said tightening borrowing costs in an economy that is undergoing a severe external energy price shock can be “counterproductive”.
Speaking at the European Central Bank’s annual central banking conference in Sintra, Portugal, Tenreyro, who last week voted to keep interest rates unchanged at 4.5 per cent, said monetary authorities can lower inflation quicker by raising borrowing costs amid an energy shock.
However, the rate of price increases is likely to fall below the two per cent inflation target thereafter in such a scenario.
Much like the rest of Europe, the UK economy has been hit by international energy markets being jolted by a surge in global demand after the pandemic and Russia turning off gas supplies in response to sanctions imposed after it invaded Ukraine.
That shock drove inflation up to a peak of 11.1 per cent. It is now stuck at 8.7 per cent.
Core inflation – which strips out volatile food and energy prices – has jumped to 7.1 per cent, its highest level in more than 30 years, suggesting domestic factors are now steering the UK’s inflation problem.
Bank of England officials have responded to the more than year-long price surge with 13 straight interest rate rises, including a shock 50 basis point increase last Thursday. Bank rate now stands at five per cent, a near 15-year high.
Tenreyro, who has voted to keep rates unchanged at every MPC meeting since they reached three per cent in November, said that central banks “need to be willing to undershoot the inflation target at 12 months” after the first rate rise if they decide to jack up borrowing costs in response to external energy price shocks.
The Argentine economist said tightening policy may be necessary if workers and firms, in reaction to sky high energy bills, demand wage increases and raise prices to shield their finances.
Central banks’ reply to energy driven inflation depends on the “strength of second round” effects, she said, adding that companies hiking prices and workers asking for high wage increases can “delay the return of inflation to target”.
In the UK, wages have climbed more than seven per cent, though that has mainly been driven by high earners pocketing elevated pay settlements.
Research by experts at the Bank for International Settlements over the weekend found that real wages have fallen quicker amid the current inflation crunch compared to businesses’ profit margins.
Real wages have trailed CPI inflation in the UK for a year and a half.
UK supermarkets have been criticised for failing to pass on cost reductions to customers at the same pace as they raised prices in response to swelling staff, transport and raw material prices. Food prices are up more than 18 per cent over the last year.
Another MPC member, Swati Dhingra, said today that UK prices aren’t being primarily driven by “runaway profit inflation”.