Are interest rates the Bank of England’s business? 

Today’s decision to keep the Bank of England base rate unchanged at 5% sparked reactions ranging from derision to celebration, highlighting the fractured state of the UK’s economy. But let’s be clear: the current approach to managing inflation and interest rates is outdated. It unfairly burdens businesses, homeowners, and renters while overlooking the complex and varied nature of inflation across different sectors.

The Bank of England’s use of the base rate to control inflation is relatively recent. Established in 1694, the Bank originally served as the government’s banker and debt manager. It wasn’t until the 1970s and 1980s, amidst soaring inflation, that it began using the base rate to combat inflation. Before this, the Bank focused on banking stability and lending policies. The concept of using interest rates to control inflation gained traction after the crises of the 1970s, especially the “stagflation” that plagued the British economy during that period. So what had been seen merely as a tool became the main focus of central bank strategy. In 1997, the Bank of England was granted independence to set interest rates, tasked primarily with meeting a government-set inflation target.

While this strategy initially worked well, its flaws have become increasingly evident. The blanket adjustment of interest rates fails to account for the varying impact of inflation across different sectors. It assumes that inflation uniformly affects the economy, which is simply not true. This one-size-fits-all policy has caused small business owners, renters, and mortgage holders to suffer, while other industries’ inflationary complexities go unaddressed.

Compounding these issues is the Bank’s use of quantitative easing (QE). Since the 2008 financial crisis, QE has injected a staggering £895 billion into the UK economy. The idea was to boost economic activity by increasing the money supply and encouraging lending. However, while this influx of money stabilised markets, it also drove up asset prices, particularly in property and equities. As QE inflated asset values, it benefited those who already owned substantial assets, while wages lagged.

This dynamic has weakened the link between the real economy and asset values. Those without assets struggle to enter the property market or invest, while the asset-rich see their wealth grow independently of their contributions to the productive economy.

Using the housing market to control inflation is like trying to sprint on a broken leg. The UK’s housing market suffers from exorbitant prices, undersupply, and an unstable rental market. Each interest rate adjustment (or lack there of) sends shockwaves through this market, often doing more harm than good.

Contrast this with the grocery sector over the past 50 years, which has experienced gradual deflation. Advances in productivity and global supply chain development have reduced average household spending on food from around 32% in the 1950s to under 10% today. Meanwhile, in housing, limited innovation and persistent undersupply have caused costs to soar. In the 1950s, the average household spent about 12% of its income on housing; today, it’s closer to 30%.

The outcome is a housing market increasingly divorced from the real economy, turning the UK into a nation of asset-rich “haves” and income-tied “have-nots”. Wealth is now defined more by what you own than by what you earn. This poses a significant problem: the UK cannot expand its economy traditionally—by boosting industry and commerce, which generate the tax revenue needed to fund essential public services.

If interest rates aren’t the answer to controlling inflation, what is? One solution could be through dynamic taxation, specifically using VAT (Value Added Tax). The Government should control the overall VAT revenue, currently around £4,800 per household and 16.8% of tax income, accounting for about 6.2% of GDP. However, an independent authority would set sector-specific VAT rates based on inflationary pressures in each industry.

Changes in VAT rates would need to be implemented thoughtfully, as they take time to ripple through the economy. The tax setting authority would need to work closely with commerce and industry to allow businesses to make long-term decisions without fearing abrupt VAT hikes. Clear rules and stability are essential to avoid destabilising sectors, as illustrated by the current debate around the proposed VAT on private school fees. Regardless of the policy’s merit, the threat of a sudden VAT increase highlights how vital it is to manage such changes gradually.

The current system also hampers banks’ ability to lend based solely on risk. Banks are constrained by state policies on inflation and interest rates, creating a less dynamic lending market. By allowing banks to set interest rates with customers and businesses based solely on risk, we could foster a more competitive and responsive financial sector.

This shift would transform the Bank of England’s role from “lender of last resort” to an active monitor of banks’ risk profiles. The Bank would have the authority to demand increased liquidity reserves if a bank’s loan book appeared overextended, thereby preventing financial crises like the one in 2008. Knowing bailouts are off the table would also encourage more cautious lending.

The notion that inflation is a singular force impacting the entire economy simplifies a multifaceted issue. Each sector experiences inflation differently, and our policies must reflect this complexity. By managing inflation through dynamic VAT rates and freeing banks to lend based on risk, we can create a more balanced, responsive economy, breaking the UK’s “asset-rich, capital-poor” cycle.

For too long, politicians have claimed to support growth and economic expansion. Yet, to truly achieve this, they must understand the economy’s multifaceted nature. Ironically, for a politician who claimed to champion laissez-faire economics, Liz Truss believed the answer lay solely in Downing Street. But a modern economy doesn’t — or shouldn’t — work like that. There’s no simple switch in the Treasury that can magically bring growth. The Government should recognise that growth isn’t about top-down control, but about creating an environment where businesses can thrive. Only by engaging with the economy’s complexities can we break free from low growth, high debt, and stagnation. It’s time to move beyond outdated economic doctrines and embrace an approach that reflects the diverse reality of modern capitalism.

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