Report published by The Bank of England – August 2018
Our role is to set interest rates to influence the amount of spending in the economy in order to ensure inflation (the pace of price rises) returns to our 2% target sustainably.
The reason we focus on low and stable inflation is that it is vital for a stable economy that supports growth and jobs.
If we set interest rates too low, then the economy will run too hot, and inflation will stay above our target. But if we set interest rates too high or raise them too rapidly then the economy will be too weak, and inflation will fall below our target.
During the financial crisis, people reined in their spending and many lost their jobs. We had to cut interest rates to exceptionally low levels to support spending and jobs. Over the past few years, our economy has needed interest rates to stay very low as we recovered from the global financial crisis. But things have been changing.
Last November, we raised the official interest rate we set, known as Bank Rate, from 0.25% to 0.5%. And now we have raised it to 0.75%.
If the economy continues to perform as we currently expect, it will probably be growing about as fast as it can without overheating. In that case, we think we would need to raise interest rates further, reducing the amount of support we are providing to the economy. But we expect those increases to be gradual. And interest rates will probably need to stay lower than the 4-5% they used to be for some time to come. That’s primarily because there have been some big structural shifts in the global economy that are likely to persist.
A rise in interest rates might seem like a bad thing, especially if you have a lot of debt. But it would be a sign of an economy growing about as fast as it can, and one that is able to support higher wages. And small increases in interest rates now can avoid the need for bigger ones later.
Inflation is above our target
The prices of the things you buy have been going up by more than our 2% target on average over the past year.
That’s been mainly due to the big fall in the pound following the Brexit vote.
The lower pound has meant that things businesses get from abroad cost more. Businesses have been passing those rising costs on to their customers. So that has meant higher prices in the shops. Most of the increase in prices due to the fall in the pound has now happened though.
The price of oil on world markets has also risen over the past year, pushing up prices for petrol at the pumps. Because of that, we think inflation picked up a bit in July.
But unless oil prices keep on rising, inflation should continue to fall back towards our 2% target.
Prices have been rising by more than our 2% target over the past year
Over 2017, prices were rising faster than wages meaning people were not able to afford as much. That is now starting to change.
Pay rises for most have been pretty low. But recently wages on average have started to rise faster than prices again. That is easing the squeeze on people’s living standards.
That squeeze should ease further over the next few years. The share of people out of work is at its lowest level for more than 40 years. And there are a lot of job vacancies. This means that companies need to compete hard with each other to recruit and retain workers. One way they do that is by offering higher pay.
The pressure in the jobs market means we’re expecting to see bigger, more widespread pay rises in coming years. That greater spending power should support growth in the economy.
Pay has started to rise faster than prices, easing the squeeze on living standards
The world economy is also growing relatively robustly, although it slowed a bit at the beginning of the year. Growth abroad benefits the UK by increasing demand for our exports . And it should encourage companies to invest to meet this extra demand.
We thought the dip in UK growth earlier in the year was probably temporary, but we couldn’t be sure until we saw what happened next. The latest data suggest that growth has recovered since then and that the dip was mostly due to the bad weather.
We think our economy is probably growing about as fast as it can without overheating. Find out more about how fast the UK economy can grow.
A few years ago many people were out of work and looking for jobs. So there was scope for the economy to grow quite quickly as a lot of those people found work.
Now, with a record number of people in work and businesses finding it hard to recruit people, there isn’t much more economic growth that can come simply from unemployed people finding work.
Instead, it will mostly need to come from higher productivity – people already in work producing more. But productivity has barely risen over the past decade.
There is a limit to how fast the economy can grow before it leads to higher inflation
In May, we said that if the economy performs broadly as we expect, then we would need to reduce the amount of support we are providing to make sure inflation returns sustainably to the 2% target. We thought that would probably require modest rises in interest rates over the next few years.
Since then, the economy has developed broadly as expected. So we have removed a little of the support, raising interest rates from 0.5% to 0.75%.
If the economy continues to perform as expected, we think we will need to raise interest rates a bit more over the next few years. We expect any rises in interest rates to happen at a gradual pace and to a limited extent. Interest rates are likely to remain substantially lower than a decade ago.