Does Monetary Policy Work?

Inflation written on a blackboard with an upwards arrow
Author: Samuel Beckingham
Updated: Jun 28, 2023
6 minutes read

On Thursday last week, the Bank of England raised the interest rate from 4.5% to 5% in an attempt to curb stubbornly high levels of inflation. This action of monetary policy has caused great issues for most of the UK, but is it an effective tool and does it work?

Despite the Bank of England (BoE) being independent from the government, there is a clause in The Bank of England Act, 1998 that allows the government to simply overrule any decision the BoE implements. By raising interest rates to their highest level since the 2008 financial crisis, the government is under the impression that the UK population has too much money to spend.

The way monetary policy works is by reducing people’s spending power. It’s a tool that’s deliberately meant to hurt and squeeze incomes to stop rampant spending within the economy. By skyrocketing mortgages, an old view of textbook economics is applied that views wages rising faster than prices, which tries to dampen demand.

This view of inflation relies on the fact that wages increase faster than costs. In real terms, wages have been stagnant in the UK for a long time, hence the influx of public sector strikes that started at the end of 2022. Even though the government granted pay rises to most workers, they were hesitant about the impact it would have on inflation. However, there are also external factors at play.

There are three obvious external factors that have taken root in inflation. These are an increase in demand after Covid, the impact of Brexit and the war in Ukraine. While analysis into the impact of these three events could fill entire textbooks, it’s clear that external influences on inflation cannot effectively be impacted by monetary policy within the country.

Stubborn inflation has been impacted by various supply chain disruptions and extra costs imposed at the borders after Brexit. It’s also been prevalent because of profiteering from massive corporations looking to increase their levels of profit. While not every company has been focused on doing this, some of the big players have.

The final issue comes from the BoE itself. By pushing up the cost of money, this also pushes up inflation. As more people are struggling to get onto the property ladder - young people especially - the impacts of monetary policy fall shorter than expected. Rent is heavily impacted by these decisions, with any increases passed onto tenants. This in itself has the potential to raise inflation further.

Additionally, anyone suffering from less disposable income will look for ways to increase theirs. If employers grant wage rises, this will be less than the inflation rate that businesses are affected by, which causes inflation to grow. Any savings rates that banks offer are designed with savers in mind, which also causes households to have more disposable income. With good savings rates, households suddenly have more money to spend, which increases price rises according to the current view of economics.

If high interest rates dampen demand and slow the economy, then is the reverse also true? Interest rates have been at lows in the UK between 2009 and 2020, not having gone above 0.75% in that time. With the textbook view of economics, logic would dictate that these low interest rates would mean spending power is increased, which would cause inflation to soar, but this has not been the case.

Instead, both internal factors (from the disastrous Liz Truss mini-budget at the end of 2022) and external factors have contributed to raising prices at an alarming rate. It’s also evident that many of these factors are external because most countries on the world stage are suffering from high levels of inflation.

So if raising interest rates causes inflation to actually increase (hence the stubbornness), this begs the question: does monetary policy really work? Is the UK doomed to be forced into a recession as lower income households are impacted the most? If further rises are to come, the problem will only get worse.

Should interest rates be frozen for a while to see if monetary policy is having any effect, or should they be dropped slowly and gradually to ease markets? These are all big problems that have no easy answer.