Context 2: Inflationary Pressures and Macroeconomic Policy

Extract D

Source: Official National Statistics (ONS)

Extract E: External shocks and domestic pressures fuel inflation in 2021–2023

For nearly two years, the Bank of England struggled to bring CPI inflation back down to its 2% target. The sudden surge in consumer prices was initially sparked by post-pandemic bottleneck shortages, which were then severely compounded by geopolitical conflict in Europe that drove global natural gas and agricultural commodity prices to record highs. Simultaneously, a depreciating pound sterling raised the cost of essential imported inputs. Domestic policy measures also played a role; while temporary VAT cuts for hospitality had previously dampened price indexes, their expiration and the subsequent return to standard rates added upward momentum to the Consumer Prices Index (CPI).

By late 2022, headline inflation peaked at over 10%. While supply-side pressures have begun to ease, domestic factors have become more entrenched. Service sector inflation and nominal private-sector wage growth have remained stubbornly high, prompting fears that domestic demand-pull pressures may sustain inflation far longer than expected.

Extract F: Can monetary policy alone tame cost-push inflation?

As energy and food prices escalated, a critical concern emerged regarding the anchoring of inflationary expectations. When workers anticipate higher inflation, they demand greater pay hikes to protect their real consumption levels. If employers concede to these demands and subsequently raise their prices to preserve profit margins, a wage-price spiral can take hold. Although labor market tightness has begun to ease slightly, nominal wage growth of over 7% remains inconsistent with the 2% inflation target unless productivity increases dramatically.

To constrain demand and anchor expectations, the Monetary Policy Committee (MPC) raised its benchmark interest rate, the Bank Rate, repeatedly from its historic low of 0.1% to over 5%. However, many economists argue that because the initial price surge was driven by supply-side shocks, raising borrowing costs does little to address import prices, while severely harming mortgage holders and businesses. Critics suggest that alternative interventions, such as targeted fiscal subsidies, energy price caps, or supply-side workforce initiatives, offer more direct ways to counteract inflation without inducing a deep recession.