With the UK seemingly entering a period of stagflation, it’s clear that the Bank of England has taken the right course of action by raising interest rates earlier this week – a necessary move to help tackle the challenge faced by policy makers stemming from post-pandemic fuelled demand against a supply-constrained economy.
But we’re not out of the woods yet.
With the UK now weaning itself off Russian oil, the UK’s supply issues are likely to worsen, particularly against a backdrop of lockdowns in China making supply matters even trickier.
The bottom line is this. Monetary policy alone cannot generate supply, it can only act to alleviate price pressure by lowering demand – and all at the risk of recession if rates are raised too rapidly. This leaves policy makers in a bind. The key lies in normal people trusting the Bank of England to keep a grip on inflation. If they don’t, workers will continue to demand higher wages and a wage-price spiral will take hold.
Avoiding recession and a period of long-term inflation – which is dangerously close – rests now in policy being supported by consistent messaging from the Bank of England, that can be easily understood by the broader population.
Associate Professor of Finance at the University of Chicago Booth School of Business