By Professor Ronald MacDonald, Research Professor of Macroeconomics and International Finance at the University of Glasgow.
Since the onset of the financial crisis in 2007 most advanced economies, including the UK, have faced constraints in their use of fiscal policy to address the recessionary impact of the crisis.
This has meant the policy of Quantitative Easing (QE) – the policy of creating a sea of liquidity and historically low (almost zero) interest rates – has had to pick up the slack by incentivizing business investment and imparting consumer confidence.
The policy has also had crucial unintended consequences of creating one of the longest running equity bull markets, generating record and dangerous borrowing levels by consumers and a distorted level of net savings in the economy.
Today’s interest rate rise, in response to a persistent above target inflation rate, essentially represents the start of the unravelling of the policy of QE and is designed to curb inflation given that the UK economy currently appears relatively resilient, although many Brexit uncertainties still exist.
Since QE has been a unique experiment, how it’s unwinding will affect the economy is unclear. Its immediate impact will clearly be on the 8 million or so people whose indebtedness levels are flashing red at the moment and this, combined with the weak growth, if any, of real wages in the UK, could stall the UK economy.
The best possible outcome of this relatively modest rate rise would be that it leads to an orderly move away from indebtedness to increased savings, although that remains to be seen.
Whether the current change will be enough to arrest inflation is another question and the answer to that will in part depend on what happens to sterling and how prolonged any such effect is.
In particular, will the rate rise be able to compensate for the Brexit uncertainty effects that look set to be on going into the future.
The outcome of this rate rise may well necessitate further rate rises if the current change fails to have the intended effect on inflation, although such rises would clearly have to be tempered by the state of the economy and fiscal constraints.
Indeed, given these constraints, if this rate rise does not have the desired inflationary effect a more radical change may be required in terms of the actual target used by the Bank of England.
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