Costas Milas is Professor of Finance at the University of Liverpool. In this article, he explains why a series of sharp rate hikes in the UK is doing more harm than good.

For nearly 15 years, the Bank of England’s main policy rate is likely to rise above its inflation target by the end of 2022.market expected The central bank’s monetary policy committee will raise interest rates to nearly 2 percent by the end of the year. If that happens, it would mean a surge of 125 basis points in interest rates over the next nine months.

But will benchmark borrowing costs rise as policymakers and financial markets imagine?

Monetary bureaucrats are definitely talking tough. But tough talk doesn’t necessarily lead to tough action. Threadneedle Street residents, alarmed by the latest inflation figures but concerned that tighter monetary policy could be a drag on growth, are likely to pray that gnashing of teeth will suffice.

By pushing up the domestic exchange rate and lowering the cost of imports, the expectation of higher interest rates can indeed reduce inflation itself. But the impact may not be large.

This Sterling Effective Exchange Rate (taking into account changes in the exchange rate of sterling against the UK main trading partner) has appreciated 0.93% since December 2021, when the Bank of England began tightening policy.Eventually (i.e. in three to five years) around 20% to 30% exchange rate movement pass through UK consumer price index. So, in theory at least, we should see a drop in the CPI between 0.19% and 0.28%. That’s not enough to ease what Premier Andrew Bailey has called a “historic” cost of living crisis.

Talk is cheap. The impact is small. You get what you pay for.

However, the question remains: Is raising interest rates sharply and rapidly, potentially more costly in terms of their impact on growth and financial stability, worth the cost? In short: no.

To explain why we need to study the so-called output gap — a measure of excess demand — and the underlying supply in the economy. When output is above potential and there is excess demand, inflation should rise. When output falls below potential, prices come under downward pressure as supply floods the system.

Central banks use the output gap to judge whether their actions can push inflation back to their 2% target. And, it’s fair to assume demand is now in “excess” after the UK rolled out massive fiscal and monetary stimulus to combat the fallout from the pandemic. At the same time, however, the output gap is very sensitive to headwinds. Among them, uncertainty. Uncertainty hurts economic growth as businesses delay their investment decisions and consumers are less willing to spend. This has weighed on both supply and demand, but the impact on demand is more immediate – so it’s more of a concern for policymakers now contemplating a series of rate hikes.

The graph below depicts the impact of this uncertainty.

It shows the output gap measured by the UK Office of Budget Responsibility and a composite index of uncertainty that I constructed by pooling information from four measures.This first Monitor how many UK newspaper articles contain various related terms such as ‘uncertainty’, ‘economy’ and ‘deficit’.This second A measure of financial stress, it looks at volatility in the pound and the UK stock and bond markets.This third – Measures to monitor stock market volatility in light of the development of the pandemic.This fourth – A measure of global geopolitical risk.

Let’s look back at the recent past.

Uncertainty has risen markedly in four areas: the 9/11 terrorist attacks in 2001, the global financial crisis from 2007 to 2009, the UK’s decision to leave the EU in 2016, and the early stages of the 2020 pandemic. In all these times, but Brexit, this uncertainty then widens the output gap between actual demand and potential supply. After the outbreak of the Ukrainian war, the measure increased again.

Research by me and my colleagues at the University of Liverpool supports the conclusions drawn from the graph, Discover Rising uncertainty could dampen UK economic activity for up to 20 months.

The output gap is often discredited. The gap between current demand and potential supply is notoriously difficult to measure. It would be unwise for monetary policymakers to base their decisions on the size of the gap, judged by the OBR or any other agency.

Former MPC member Kristin Forbes and colleagues also warn The inflationary impact of a positive output gap, as currently estimated by the OBR, is stronger than the equivalent deflationary impact of a negative output gap.

Inflation is more than three times the Bank’s target and is set to rise further in the coming months.

All of these factors lead us cautiously to attribute too much power to any one indicator of the economic outlook.

However, given Russia’s brutal invasion of Ukraine, it is reasonable to assume that rising uncertainty will lead to a sharp decline in the UK’s positive output gap in the coming months, opening the door for a rapid reversal of inflationary pressures. That should provide some food for thought for officials keen on a series of sharp rate hikes.

The Bank’s policymakers are facing one of the toughest challenges since gaining independence 25 years ago. As the Greek scientist Thales of Miletus put it, “The past is certain, the future is vague”. At some point in recent decades, this claim was as true as it is today. However, MPCs must act on the basis of their reasonable idea of ??what might happen next.

Monitoring changes in uncertainty indicators won’t provide policymakers with a crystal ball, but it could shed more light on the outlook for the UK economy.