Five options to get the UK back to 2% inflation

Bank of England (BoE) governor Andrew Bailey has said inflation will fall “markedly” this year, as he signalled that the central bank is likely to raise interest rates once again in an attempt to reach its 2% inflation target.

Bailey made the comments at the annual Mansion House bankers’ dinner, attended by Chancellor Jeremy Hunt and Rishi Sunak, insisting that falling energy and food prices would drive down inflation over the rest of the year.

“It is crucial that we see the job through, meet our mandate to return inflation to its 2% target, and provide the environment of price stability in which the UK economy can thrive,” said Bailey in his speech, admitting that inflation was “unacceptably high”.

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So far, the government has relied on the central bank to return inflation to the mandated target. The main tool in the BoE’s arsenal is raising interest rates – which it has done 13 times since December 2021 – increasing the cost of borrowing from 0.1% to its current level of 5%.

But with inflation remaining at a stubborn 8.7% in May, the wisdom of the BoE’s strategy has been questioned by some economists.

The Week takes a look at five options available to the UK.

Raise rates again and risk recession

In May, Chancellor Jeremy Hunt said he was comfortable with the central bank doing whatever was needed to bring down inflation, even if that could cause a recession, telling Sky News: “Yes, because in the end, inflation is a source of instability”.

The power to raise interest rates lies with the Bank of England. But the markets are predicting that interest rates could climb to a high of 5.5% by the end of the year, despite rates already being at their “highest level since the middle of the global financial crisis in 2008”, said Politico.

Make changes to tax and spending

One “very unpalatable” option for the government is to raise taxes or to raise taxes and make cuts to public spending – essentially a second round of austerity.

Laura Suter, head of personal finance at AJ Bell, told The Mirror the government could “opt to raise taxes, cut Government spending or cut back on the cost-of-living payments” to “reduce household spending further”. But with households already at “breaking point” this would be a “politically unpleasant” move ahead of a general election.

A policy paper presented to HM Treasury last autumn made the argument for the UK to address inflation through fiscal policy rather than relying solely on interest rate adjustments. The paper, by Cambridge economics and history fellow Charles Read, highlighted the potential risks of rapidly raising interest rates, including the possibility of a financial crisis in the shadow banking sector.

Instead, fiscal policy changes such as reducing value-added tax (VAT) could directly impact prices without destabilising the banking sector, he suggested. Funding these measures could involve eliminating tax benefits primarily benefiting the wealthy, such as the capital gains tax discount.

Quantitative Tightening

Another tool the BoE could consider is increasing its quantitative tightening (QT) programme as a means to reduce demand and control inflation.

During the pandemic, the central bank employed quantitative easing (QE) by purchasing bonds and injecting money into the economy, leading to lower interest rates and increased inflation.

Alice Haine, a personal finance analyst at Bestinvest, suggested to The Mirror that if QE was “so effective at stimulating the economy” then QT could “have the reverse effect”. The central bank could accelerate the pace of reducing its government bond holdings through QT, she suggested.

Price controls

This has been a “more successful tack” taken by France, after President Emmanuel Macron capped how much state energy companies could charge their customers last January, with the government subsidising the financial gap, said The Guardian.

The controls were subsequently lifted when gas and electricity prices began to fall, leaving inflation in France at “almost half the rate” seen in the UK in 2022.

Lower energy prices in Europe have eased overall price pressures, but the cost of food has continued to “soar”, said the Financial Times (FT). Countries such as Croatia and Hungary have introduced food price caps, while France has negotiated a “looser agreement” with food retailers to offer essential items at the lowest price possible.

The UK could consider targeting producers and retailers with price controls to tackle the food inflation rate – a major driver of overall inflation – suggested The Guardian, but it would be “difficult to monitor prices and impose caps in the internet age”.

Give up on the 2% target

It would be a “radical idea” but central banks like the BoE and the Federal Reserve could give up on their 2% inflation targets, said Investors’ Chronicle. Although the BoE makes its case for “low and stable inflation” a 2% target is “relatively arbitrary”.

Economist Olivier Blanchard argued in a 2010 International Monetary Fund paper that policymakers should consider a higher target of 4%, which would give central banks more room to react to economic shocks.

However, the FT’s chief economics commentator Martin Wolf argued that the UK shouldn’t give up on the 2% target, saying “if a country abandons its solemn promise to stabilise the value of the currency as soon as it becomes hard to deliver, other commitments must also be devalued”. Doing so may lead many, both at home and abroad, to conclude that the UK “is unable to keep its promises when things get tough”.