BoE raises interest rates to 1.25%: How will it affect UK inflation?

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Highlights

  • The Bank of England on Thursday announced the fifth consecutive hike in interest rates.
  • The central bank was under pressure to take aggressive steps after the US Federal Reserve announced a 0.75 percentage point hike in the benchmark borrowing rate on Wednesday.

As part of measures to control decade-high inflation levels, the Bank of England (BoE) has raised the interest rates to 1.25% from 1%. It is the first time after 2009 that the interest rates have breached the 1% mark in the UK. Moreover, this is also the fifth straight hike in a row by the BoE.

During the Monetary Policy Committee (MPC) meeting on Thursday, the central bank said if required, it would 'act forcefully' to indications of persistent inflationary pressures.

The Committee also raised its forecast for peak inflation in October, saying it may reach slightly above 11%. It also expects the UK economy to contract in the current quarter.

Pressure had been mounting on the BoE after the US Federal Reserve decided to hike the interest rates to keep inflation in check. On Wednesday, the US central bank raised the benchmark borrowing rate by 0.75 percentage points, the biggest hike since 1994.

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The challenge before the BoE is to tame inflation without a major economic slowdown that might eventually cause a recession. Earlier, BoE governor Andrew Bailey had warned that the central bank must walk a 'very tight line' between curbing inflation and triggering a recession.

How do interest rates affect inflation?

Central banks around the world hike interest rates when inflation is high. The process is reversed when inflation is low. When there is high liquidity in the system, people tend to spend more, causing retailers to hike their prices due to higher demand. On the other hand, low liquidity pushes people to cut down on spending, reducing the demand. In theory, this encourages people to save more as they get a better return for the money saved. The aim is to lower the demand over time and allow the prices to stabilise.

It is important to note that high inflation is not a direct result of the changes in interest rates. There are several other factors behind rising prices like production costs, a surge in demand, the supply of money, etc. Interest rates are only revised to manage inflation.

What is the current situation in the UK?

Inflation in the UK is at its highest in the last 40 years. It reached 8% in April after the new energy cap came into effect on 1 April, pushing electricity bills up significantly. Amid the Russia-Ukraine conflict, fuel prices are touching fresh highs frequently. As a result, input costs have risen, and businesses are passing on these costs to customers.

The central bank had earlier estimated that the inflation rate might climb to 10% by the end of this year after the next revision in the energy price cap, which is scheduled to happen in October. It has now raised the prediction to more than 11%.

 

Tags: Interest rates, Bank of England

 


 


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