Death spiral
The precedent for this came in the 1970s, when the Yom Kippur War caused a spike in the oil price, creating sharp supply-side inflation. The war soon ended and the oil price reverted back towards its prior level, but inflation remained an issue throughout that decade and beyond due to the initial supply-side inflation creating what economists call a wage/price spiral, as workers, noticing higher prices, demand higher wages in response, which prompts employers to put their prices up.
The second issue is that if prices are rising because of supply-side issues, it can actually cause demand to rise as people make purchases today rather than in future, as they anticipate the item’s price will be higher in future.
Lyons says the reason they are putting interest rates up is to signal to the world that they are determined to address higher inflation, and if people believe inflation will soon fall, then their economic behaviours adjust and a wage price spiral does not happen.
Carrick says the decline of trade unions and the rise of online shopping probably means a 1970s-style spiral will not happen on the same scale.
Lyons says the US Federal Reserve’s decisive language about its plans to increase rates may have the effect of dampening inflation there, but he notes the Bank of England’s communication has been less assured and so may not be having the desired impact.
Jung says the present UK government is pursuing a policy of tax increases, such as to national insurance, and also spending restraint – policies which are disinflationary, whereas other countries continue to pursue higher spending, which would typically be inflationary.
Carrick says Brexit has definitely contributed to higher supply-side inflation in the UK in the short term, relative to other countries, but there is no certainty that such a trend will persist.
Arbdn's Bartholomew says: “Real wages have started to fall now in the UK, and they will keep falling for a while, that is ultimately disinflationary. By putting rates up once, the BoE is trying to manage the inflation without inflicting the pain that higher further rate rises would bring.”
When Bartholomew refers to the “pain”, he is zeroing in on the equation central bankers are doing when they set monetary policy.
The BoE, in common with other central banks across the world, has a target rate of inflation of 2 per cent, while giving consideration to achieving full employment, which in the UK is defined as 4.5 per cent unemployment.
