Second, changes in the policy rate can influence the exchange rate. All else equal, increases in UK interest rates may drive flows of money into sterling from foreigners seeking better returns, causing the currency to appreciate. That may reduce the competitiveness of UK exports, restricting demand for them. However, this effect is not always easy to see in practice. Plenty of other things can influence the exchange rate at the same time. For example, changes in UK rates may be offset by larger movements elsewhere, or swings in global investors’ appetite for risk.
Third, changes in the policy rate can influence asset prices. We discuss this in detail below, but the short point is that changes in asset prices may affect consumers’ spending decisions. They are much more likely to spend freely when asset prices rise rapidly than when they stagnate or fall. Economists call this the wealth effect.
How can higher interest rates dampen inflation?
Even in the era of unconventional monetary policy, the policy rate remains the Bank of England’s key tool in achieving its 2 per cent inflation target.
As we discussed above, higher interest rates should encourage saving and discourage borrowing, slowing consumption and investment demand. In theory, this should ease domestically driven price pressures.
When demand is weak, firms will have a harder time raising prices and workers will find it more difficult to demand higher wages, cooling inflation. (The other channels may contribute too – expectations for slower growth ahead, a stronger exchange rate and falling asset prices may also limit domestic demand.)
Unfortunately, the policy rate is a blunt instrument. It influences the domestic economy – the decisions of households and firms in the UK. But the biggest causes of today’s high inflation are global. Energy prices have surged around the world, reflecting the strong recovery in the global economy, production restraint from OPEC, and worries about the fallout from the Russia/Ukraine situation. Meanwhile, global supply chains have struggled to cope with extraordinary pandemic-induced demand for goods coupled with disruption at key ports.
Clearly, a higher policy rate in the UK will neither ease geopolitical strains in global energy markets, nor unload ships at congested ports on the other side of the world any faster. So, as the Bank of England’s Chief Economist acknowledged in a speech this month, policymakers face an unenviable trade-off.
