Interest rates,
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ExtractUK CPI 2022 cycle

Evaluate the case for the Bank of England's decision to raise interest rates to combat the 2022–23 inflation. (12 marks)

K · KnowledgeDefine and frame

Cost-push inflation occurs when an external shock — here, imported energy and food costs — raises firms' costs of production, shifting short-run aggregate supply (SRAS) leftward. Monetary policy is the central bank's manipulation of interest rates and money-supply conditions to influence aggregate demand. Bank Rate is the headline policy rate; raising it tightens credit conditions across the economy, dampening consumption (C) and investment (I) and so reducing AD.

A · ApplicationTo the 2022 case

In this case, the inflation is overwhelmingly cost-push: the OBR estimated that roughly three-quarters of the 2022 CPI peak came from energy and food, both supply-driven. The BoE's tool — raising Bank Rate from 0.1% to 5.25% — operates on aggregate demand. It does not address the root cause (the gas price), but it does compress AD enough to prevent the shock from passing through into wage growth and price expectations.

A · AnalysisThe chain

The mechanism runs as follows. A higher Bank Rate raises commercial lending rates and mortgage rates. Higher mortgage rates reduce disposable income for the ~30% of UK households with variable-rate or recently-refinanced mortgages, depressing consumption. Higher business borrowing rates raise the hurdle rate for investment projects, depressing I. Both reduce AD, which on a standard AD-AS diagram pulls the equilibrium price level back down toward the SRAS curve's new (higher) position — closing the inflation gap without needing the supply shock itself to reverse.

Critically, the policy also operates on expectations. If households and firms believe the central bank will act decisively, they price future inflation lower into wage demands and contracts. The MPC was explicit on this — Andrew Bailey repeatedly stressed in 2022–23 that the BoE was willing to "do what is necessary" to bring inflation back to target. That credibility is half of what monetary policy actually does.

E · EvaluationCounter and judgement

Three counter-arguments deserve weight. First, monetary policy operates with a lag of 12–18 months. By the time the BoE's hikes started biting in late 2023, the imported shock had already begun to dissipate — wholesale gas prices peaked in August 2022. The risk is that the BoE over-tightens into a disinflation that was going to happen anyway, and so creates a recession that need not have happened. The 0.1% growth print in 2023 is consistent with this read.

Second, monetary policy is a blunt instrument with distributional consequences. Higher mortgage rates fall heavily on a particular demographic (recent buyers, variable-rate borrowers) while leaving the equity-rich (older homeowners, renters whose landlords pass costs through) less exposed. Fiscal policy, with its ability to target relief, would arguably have been a better instrument — but fiscal credibility had been damaged by the Truss mini-budget, leaving the MPC the only tool with credibility intact.

Third, the supply shock itself was the right target for supply-side policy: energy market reform, strategic gas reserves, accelerated renewables build. None of this is the BoE's job, but it points to the broader case that monetary policy was acting as a substitute for absent policy elsewhere.

Judgement. On balance, the BoE's tightening was justified — not because it addressed the cause of the shock, but because the alternative was to let inflation expectations unanchor. The cost (slow growth, mortgage pain) is real but bounded. The cost of letting 11% inflation become embedded — what happened in 1973–79, when wage-price spirals took a decade to defeat — would have been larger. The right critique is not "they shouldn't have raised" but "they could have stopped earlier".