Why persistent inflation could become a nightmare for Tories

The Bank of England’s decision to raise interest rates by 0.5 per cent to 3.5 per cent was exactly as expected – it really had to be, with inflation at four-decade high – but there is some devil in the details.

One member of the Bank’s nine-strong Monetary Policy Committee voted for an even bigger hike, while two wanted to leave rates where they are; some investors were disappointed so the pound suffered a mild sell-off in the foreign exchange markets. A warning sign, if you like – though of course nowhere near the panic that followed Kwasi Kwarteng’s mini-Budget. The new touch of market disquiet signals a growing conviction that Britain’s inflation problem may be starting to become embedded. And that means even more pressure on the Bank to raise rates further and faster than might otherwise be the case, if the markets were convinced that inflation will inner be squeezed out of the system fairly rapidly.

This reflects the fact that inflation is starting to move from trade goods – food, petrol, even energy prices –  to the service sector, such as restaurant bills or even legal services. Service sector costs are very largely comprised of wages and salaries in the private sector. With annual increases running around 6 per cent, with inflation at 10.7 per cent, it suggests real wages are falling, but not perhaps falling fast enough to bring inflation down quickly.

The outlook for interest rates is therefore growing slightly worse, from the point of view of borrowers, and implies a slightly higher course for rate rises. Of course, if wage expectations moderate, or there is political change in Russia and Iran that would bring energy prices down, then that liturgy would suddenly become brighter. Without such developments, the monetary squeeze will be tighter, and last for longer. The wave of strikes in the public sector over pay suggest that worker resistance to real-terms pay cuts is strong; and the stronger it is the more the Bank will feel obliged to take the buying power of those wages away by hiking mortgage bills and the cost of business borrowing.

Politically, it is the prospect of inflation staying above the two per cent target and higher interest rates persisting into 2024 that is the most alarming for Conservative leaders. Ideally, they would like a tangible easing in price rises and borrowing costs next year, leading to some targeted feel-good tax cuts and encouraging economic headlines in the run-up to the likely summer or autumn general election of 2024.

The hope is that this would achieve a radical enough improvement in the Conservatives’ poll ratings to prevent Labour winning an overall majority, with a hung parliament buying time and presenting new opportunities. But a backdrop of inflation at, say five per cent, unemployment on the rise and a slump in the housing market would surely mean a more decisive rejection of the governing party. The future of the government lies to an unusual extent in the disinterested hands of the Bank of England.