Interest rates: short-term pain for long-term gain?

As the Bank of England raises interest rates by half a percentage point – the highest jump since 1995 – Dr Nikolaos Antypas looks at what this could mean for the UK economy.

The Bank of England (BoE) raised interest rates from 1.25% to 1.75% last week, the largest raise for over two decades. The increase in rates comes as a response to the high inflation prints, which reflect excess demand for products and services against available supply. Since borrowing is expected to become more expensive, the demand for products and services is expected to decrease as well, relieving the demand pressure (which can change fast) on supply, which is usually less flexible.

The move by BoE is is expected to have the intended effect over time, but this may come at a cost for the average consumer, and it will affect households with lower discretionary income even more. The increased energy bills and rising food expenses have already left UK households with a lower buffer, if any, to absorb increased costs; the expected rise in mortgage rates and, thus, monthly payments can stress household finances even further.

A range of adverse scenarios sees the effect of inflation, and any measures aimed at tackling inflation, accelerating the advent of a recession. The inability of households to meet fixed obligations may lead to lower discretionary spending, which will lead to lower income for companies and their suppliers, thus leading to a vicious circle of downsizing and lower national income until the recession is reversed. The political question is whether UK households can withstand the financial heat until the economy expands again.

The vicious circle can start its descent even with a minor portion of the population facing problems with, say, mortgage payments. However, with 28% of UK households owning property with mortgages, per the census by the Office for National Statistics, we can expect the effect to be larger than the minimum impact required to start the downward economic circle.

History has taught many and painful lessons of inflation and ways to alleviate it, but the medicine is not pain free. Implementation by BoE, along with the UK government's fiscal policy measures, can make all the difference between a soft and... not so soft landing towards recovery and economic growth.