How do you reduce inflation? Does increasing interest rates combat high inflation, June UK rate, 2022 forecast
The UK inflation rate has hit a new record high, which is denting the purchasing power of households across the country
Inflation is a major driver of the cost of living crisis currently sweeping the UK, as it is eroding the spending power of households.
So what can be done to tackle it - and what role do interest rates play in controlling it?
Here’s everything you need to know.
What is the inflation rate for June 2022?
Inflation, as measured by the CPI, rose 0.3% month-on-month to 9.4% in June 2022.
What this rise means is that something that cost an average of £1 in June 2021 now costs just over £1.09.
However, it has also lowered the value of the money in our pockets.
Inflation is running at such a high rate because the prices of food, energy and fuel have risen dramatically over the last 12 months.
These hikes have been caused by global events, such as the Russia-Ukraine war and high demand resulting from countries rebuilding their economies after Covid, as well as UK-specific changes, like the Ofgem energy price cap.
April’s 54% increase to the Ofgem cap led inflation on the CPI to leap 2% from 7% in March to 9% in April.
With the next price cap - which looks set to see another major increase - due to come into place in the autumn, the Bank of England currently predicts inflation will peak at 11% in late 2022.
However, the UK’s central bank then believes the rate will fall back towards its 2% over the course of 2023.
How do you reduce inflation?
The principal mechanism we have in the UK for reducing inflation is interest rates.
Set by the Bank of England eight times a year, interest rates determine how cheap or expensive it is to borrow money.
If money is cheap to borrow, spending on goods and services tends to increase and prices tend to go up, creating inflationary pressure.
Too much inflation means spending power is dented and people are less likely to spend money, which can lead to a recession, i.e. two consecutive quarters of no economic growth.
If it’s more expensive to borrow, inflation is likely to go down because demand reduces.
But, if inflation drops too low, economic consensus fears that people will not spend as much today because they believe their spending power will increase tomorrow - a scenario which can also lead to a recession.
In theory, raising interest rates - as the Bank of England has already done in 2022 - should take the heat out of the economy because it encourages saving rather than spending.
However, the public body has been criticised by some economists, such as those at free market think tank the Institute for Economic Affairs (IEA) - for not increasing interest rates enough, and failing to hike them fast enough.
The government also has power to influence inflation through its policies.
For example, it can raise or cut taxes - mechanisms which can, respectively, reduce or increase inflation.
But it has to balance measures like this with the real-world impact of inflation on people’s lives, i.e. what we’ve come to know as the cost of living crisis.
The balance it has struck between its responsibility to the economy and to people has frequently been criticised over the last six months.
This was most overtly seen when Boris Johnson’s administration initially batted away suggestions it should do more to help ease the cost of living for the most vulnerable households, arguing that to do so would be inflationary.
However, many economists and politicians from across the political spectrum argued targeted support for the UK’s poorest people would create very little in the way of inflation - an argument that eventually won out when Rishi Sunak drastically increased cost of living support in May 2022.