When all you have is a hammer

The primary objective assigned to central banks today is to keep prices stable. However, the ongoing US-Israeli war on Iran, growing geopolitical fragmentation, climate change, and energy market volatility are increasingly driving supply-side inflationary pressures, which monetary policy cannot tackle. The UK government has rightly begun to take a more active role in addressing both broader inflation and reducing the costs of prices and bills, but these efforts must be expanded, institutionalised, and combined with an effective long-term strategy to reduce our exposure to external shocks.

The blunt tool

Central banks effectively rely on a single tool for tackling inflation - interest rates. The problem with this is that inflation today is largely driven by supply shocks, and not by the average household having too much money in their pockets to spend or invest. Since interest rates aim to address inflation on the demand side by increasing unemployment and depressing wages, monetary policy is ill-equipped to deal with the inflation we currently face.

Prior to the war on Iran, the global economy had already faced several significant supply shocks in just a few years: supply chain bottlenecks from the pandemic, rising temperatures and extreme weather events affecting food production, and the Russian invasion of Ukraine. Each of these supply shocks resulted in significant price pressures across the economy, leading to a worsening cost-of-living crisis in the UK and much of the world.

In response to rising inflation, the Bank of England began to increase interest rates in late 2021 and maintained them at a high level, only starting to cut rates in the summer of 2024. While inflation did eventually start to come down, it still remains above the target rate of 2%, and research by the IMF shows that there is little evidence that countries which raised interest rates in response to the energy shock in 2022 were more effective at tackling inflation than those that did not.

The enduring myth of a wage price spiral

As this was a supply crisis, it should come as no surprise that inflation only started to fall once global energy and food prices declined. Nonetheless, Governor Andrew Bailey argued in 2022 that higher interest rates were necessary to prevent rising prices becoming ingrained, since higher interest rates are supposed to increase unemployment and thus stop wages from rising. However, decades of weakening labour power has resulted in a reduced bargaining position for workers and thus significantly lowered the likelihood of a ‘wage price spiral’. 

According to the Director of the International Energy Agency, the energy crisis resulting from the war on Iran is worse than the energy shocks of 1972, 1979, and 2022 put together. At the same time, inflation driven by the impacts of climate change and nature loss, such as droughts, will only increase in the future. Not only is monetary policy incapable of dealing with these inflationary shocks, but high interest rates are likely to be counterproductive and further exacerbate the problem.

Why would high interest rates be counterproductive?

Forecasts suggest that the UK will suffer the highest hit to growth and the joint-highest inflation in the G7 as a result of the fallout from the war on Iran. This is largely a consequence of our dependence on imported fossil fuels (aka ‘fossilflation’), which could be reduced by expanding domestic renewable energy. However, renewables investment is particularly sensitive to high interest rates. This is because though savings are made once operational, renewables require a large amount of investment up-front, meaning that financing costs make up a high proportion of overall project costs.

Higher interest rates would constrain the government’s capacity to invest in the green transition or intervene to protect households. For example, the government could deliver lower prices for essential goods and services by bringing them into public ownership, but higher interest rates would make this more difficult. 

It would also lead to further windfall profits for commercial banks, who receive the base interest rate on all of their risk-free reserves held at the Bank of England, resulting in losses for the Bank that the Treasury backstops. The OBR expects that these direct fiscal transfers from the Treasury to the Bank will continue at an average of £18.6 billion annually until 2030-31, reducing space for public spending under the Chancellor’s fiscal rules.

Furthermore, there is little left that can be squeezed from people’s expenditures, as years of austerity followed by a continued cost-of-living crisis has had devastative impacts on living standards across the country, which high interest rates only would worsen. If we understand ‘tackling inflation’ also to mean protecting households, then a different path is necessary.

Learning lessons, or repeating mistakes

If we want to protect households from the rising costs of essentials, we should learn from recent targeted policies which have been successful at mitigating price rises in key input sectors. These can protect households while preventing price pressures from propagating to the wider economy more effectively than monetary policy is able to.

‘Unconventional’ policies such as price controls can and do work if applied strategically. Suffering from above average inflation prior to Russia’s invasion of Ukraine, Spain implemented price controls on energy and rents, caps on public transport costs, and removed VAT on some essentials, resulting in the second-lowest inflation rate in the Eurozone. Greece also implemented price controls on a ‘household basket’ of goods, which has been effective at containing the rising costs of essentials.

Taking measures to stop companies profiteering from the fallout of war would also signal that action will be taken to prevent ‘profit-price spirals’. These are a form of sellers’ inflation, in which supply shocks facilitate a mechanism for hiking prices beyond the increase in costs. For example, supermarkets doubled their profits in 2022 compared to pre-pandemic levels by raising prices more than their costs increased. Without effective intervention, not only will this disproportionately hurt those who already are the most vulnerable to rising prices, but the price-setting behaviour of profit-maximising firms would itself drive inflation higher.

Windfall taxes on companies that have profited off the supply shocks can be used to fund policies to protect households, as we and 40 other organisations called for last month. Clawing back the unearned windfall gains made by banks due to higher interest rates, and strengthening the windfall tax on fossil fuel companies, would be a good start. Positive Money has been campaigning for windfall taxes on the record-breaking profits this has handed banks, and our calculations show this would have raised £12.5bn in 2025.

Reducing our vulnerability to energy shocks

Here, we might again learn something from Spain: its massive investment in renewable energy between 2019 and 2024 meant that energy prices were 40% lower in 2024 than they otherwise would have been, according to the Banco de Espana. Our green energy investments are also bearing fruit, as increased wind power capacity has saved UK consumers £100bn since 2010 and shielded households from the worst of the price shocks in the first month following the attacks on Iran. 

However, we remain dependent on imported fossil fuels, and must increase the share of renewables in our energy mix further to reduce our vulnerability to external energy shocks.

To achieve this, we need better coordination between the Bank of England and the government, with monetary policy supporting an ambitious green industrial strategy rather than hampering it through elevated interest rates. Adopting a more conscious credit policy that steers bank lending towards productive activities, such as renewable energy, is also critical. 

This would help to reduce the UK’s vulnerability to energy shocks in the future, while windfall taxes, price controls, and targeted interventions would ensure that everyone can afford the basic essentials also during a global supply shock. Once prices fall, it should be a priority to build up strategic stockpiles of food and energy to reduce the impact of extreme volatility in global markets.

It is welcome that the energy secretary agrees that we must “double down on Net Zero” in the face of the current shock. It is also positive that the Government appears willing to take targeted actions to reduce inflation while protecting households, for example by reducing energy bills. These are steps in the right direction, but we should go further by expanding and institutionalising the ‘unconventional’ policy measures which can bring inflation down while protecting households.

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