Will interest rate rises accelerate fall into recession? - InterestRate.co.uk
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Will interest rate rises accelerate fall into recession?

While there is uncertainty about the size of the forthcoming interest rate hike, rates will rise when the Bank of England’s Monetary Policy Committee (MPC) meets this week. The consensus seems to be a 0.25% increase to 1.50%, although some observers believe there could be a 0.5% hike on the cards. Last month inflation grew from 9.1% to 9.4%, with a move into double digits inevitable even after recent interest rate rises. This prompts the question; will further interest rate rises accelerate the fall into recession?

Stuck between a rock and a hard place

The Bank of England is stuck between a rock and a hard place. Do nothing, and inflation will catapult well into double figures. But, on the other hand, take an aggressive stance on interest rates, and the economy could tip into recession. In reality, inflation needs to be tackled first. But unfortunately, part of the problem is energy prices, which are out of the Bank’s control.

inflation

Will inflation come down naturally?

Unless wage inflation matches the consumer price index, the measure of consumer price inflation, demand for products and services will eventually dry up. This will reduce economic activity, slash consumer spending, and bring some businesses crashing down, leading to skyrocketing unemployment. Consequently, while there is a risk that an aggressive interest rate policy will tip the UK into recession, this policy is the lesser of two evils.

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The Bank of England is taking a more proactive approach to inflation, increasing interest rates so that borrowing is more expensive. This will eventually lead to a reduction in consumer borrowing, reduced spending and place more pressure on household income. This is seen as a “more controlled” approach to reducing consumer demand, which is feeding inflation. Once inflation is more under control, the Bank of England MPC will no doubt review the situation again.

Could we see a more aggressive approach to interest rates?

Just recently, the US Federal Reserve increased US base rates by 0.75%, with at least one similar move expected before the end of the year. This would see a massive increase in US base rates, albeit from historic lows, reining in consumer spending at a frantic pace. Consequently, there is a growing belief that the Bank of England MPC will need to take an even more aggressive approach to UK base rates. Unless they follow their US counterparts, they will fall behind in relative terms in the race to control inflation.

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There’s also the currency issue, with the sterling dollar exchange rate falling by around 10% over the last few months. If US interest rates rise faster than the UK, this will attract savers to the US, strengthening the dollar and weakening the pound. Ironically, a lower sterling exchange rate would push up the cost of imports and the inflation rate.

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It is a calculated risk

If you take a step back and look at the current situation in isolation, the Bank of England MPC will inevitably increase UK base rates over the coming months. While not all of the inflationary pressure is under their control, there are still supply chain issues with excessive demand pushing prices higher. Leaving inflation to move well into double digits would be economic suicide, so interest rates need to rise.

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While many were surprised at the 0.5% increase in GDP announced in May, this switch back into growth is expected to be short-lived. Once several one-off impacts are removed, with the worst of the energy crisis still yet to come, there is every chance the UK could tip into a technical recession. A more aggressive monetary policy, with interest rates rising much quicker, would starve inflation of consumer demand but may result in a short sharp recession. Whatever the Bank of England MPC decides, there is a lot of pain in store for the UK economy!