Raise rates to cut inflation? It may not be so simple

Higher interest rates do, other things being equal, lead to lower inflation – but this effect takes time to work its way through the economy. What doesn’t take time is the rise in mortgage costs when rates go up. So, in the short term, a rate rise increases rather than lowers the cost of living as most people understand it.

The Bank of England’s target measure of inflation is the CPI. This differs from the previous target measure (up to 2003), the RPI-X, but both have in common that they don’t include mortgage interest payments. The RPI measure does include these (the X that RPI-X leaves out).

This table shows correlations between changes to the Bank’s base rate and changes in the three inflation measures:


(Data from the Bank and the ONS; going from January 1997, before which CPI figures are only estimates, to September 2008, after which we had the extraordinary bout of rate-slashing followed by two years and counting of no change.)

So rate rises are, in the short term, associated with barely lower CPI and RPI-X but substantially higher RPI. A 1 percentage point rise in the base rate over the course of up to a year is on average associated with a 0.7–0.9 point rise in RPI.

Of course, there are plenty of things that affect inflation on any measure – the pressures that might prompt a rate rise are likely to persist – so we have to be careful drawing conclusions about causation. But the difference between RPI and RPI-X is very telling. The two measures should be subject to the same pressures except for those to do with mortgage costs. So this comparison is a pretty good control, suggesting that the Bank’s rate rises cause a much bigger short-term rise in the RPI – and in mortgage-holders’ experienced cost of living – than they cause a reduction in the other components of overall inflation.

This means that if the current high inflation (on any measure) is only temporary, as is often suggested, then rate rises are not just an unnecessary response but a positively counterproductive one. If the inflationary pressures (from e.g. the VAT rise and higher energy costs) are going to drop out of the figures before too long, the only real danger is if these permanently raise people’s inflation expectations and fuel a wage-price spiral.

Given that, an extra jump in the RPI via higher mortgage costs would only add to the risk.

(On the other hand, if the inflationary pressures are likely to endure, then the longer-term disinflationary effects of higher rates may outweigh the short-term risk.)