Tag: inflation

In the third of our series on the distinction between nominal and real values we show its importance when analysing retail sales data. In the UK, such data are available from the Office for National Statistics. This blog revisits an earlier one, Nominal and real retail sales figures: interpreting the data, written in October 2023. We find that inflation-adjusted retail sales data reveal some stark patterns in the sector. They help contextualise some of the challenges faced by high streets up and down the UK.

The Retail Sales Index

Retail sales relate to spending on items such as food, clothing, footwear and household goods. They involve sales by retailers directly to final consumers, whether in store or online. Spending on services such as holidays, air fares and train tickets, insurance, banking, hotels and restaurants are not included, as are sales of motor vehicles. The Retail Sales Index for Great Britain is based on a monthly survey of around 5000 retailers across England, Scotland and Wales and is thought to capture around three-quarters of turnover in the retail industry.

Estimates of retail sales are published in index form. There are two indices published by the ONS: a value and volume measure. The value index reflects the total turnover of business, while the volume index adjusts the value index for price changes. Hence, the value estimates are nominal, while the volume estimates are real. The key point here is that the nominal estimates reflect both price and volume changes, whereas the real estimates adjust for price movements to capture only volume changes.

The headline ONS figures for May 2024 showed a rise by 2.9 per cent in the volume of retail sales, following a 1.8 per cent fall in April. In value terms, May saw a 3.3 per cent rise in retail sales following a 2.3 fall in March. Monthly changes can be quite volatile, even after seasonal adjustment, and sensitive to peculiar factors. For example, the poor weather in April 2024 helped to depress retail spending. It is, therefore, sensible to take a longer-term view when looking for clearer patterns in spending behaviour.

Growth of retail sales

Chart 1 plots the monthly value and volume of retail sales in Great Britain since 1996. (Click here to download a PowerPoint of the chart). In value terms, monthly spending in the retail sector has increased by 169 per cent since January 1996, whereas in volume terms, spending has increased by 77 per cent. Another way of thinking about this is in terms of the average annual rate of increase. This shows that the value of spending has risen at an annual rate of 3.5 per cent while the volume of spending has risen at an annual rate of 2.0 per cent. This difference is to be expected in the presence of rising prices, since nominal growth, as we have just noted, reflects both price and volume changes.

Chart 1 helps to identify two periods where the volume of retail spending ceased to grow. The first of these is following the global financial crisis of the late 2000s. The period from 2008 to 2013 saw the volume of retail sales stagnate and flatline, with a recovery in volumes only really starting to take hold in 2014. Yet in nominal terms retail sales grew by around 14 per cent.

The second of the two periods is from 2021. Chart 2 helps to demonstrates the extent of the struggles of the retail sector in this period. It shows a significant divergence between the volume and value of retail sales. Indeed, between April 2021 and October 2023, while the value of retail sales increased by 8.0 per cent the volume of retail sales fell by 11.0 per cent.

The recent value-volume divergence reflects the inflation shock that began to emerge in 2021. This saw consumer prices, as measured by the Consumer Prices Index (CPI), rise across 2022 and 2023 by 9.1 per cent and 7.3 per cent respectively, with the annual rate of CPI inflation hitting 11.1 per cent in October 2022. Hence, while inflation was a drag on the volume of spending it nonetheless meant that the value of spending continued to rise. Once more this demonstrates why understanding the distinction between nominal and real is important. (Click here to download a PowerPoint of the chart).

To illustrate the longer-term trend in the volume of retail spending alongside its volatility, Chart 3 plots yearly retail sales volumes and also their percentage change on the previous year.

The chart nicely captures the prolonged halt to retail sales growth following the global financial crisis, the fluctuations caused by COVID and then the sharp falls in the volume of retail spending in 2022 and 2023 as the effects of the inflationary shock on peoples’ finances bit sharply. This cost-of-living crisis significantly affected many people’s disposable income. (Click here to download a PowerPoint of the chart).

Categories of retail sales

We conclude by considering categories of retail spending. Chart 4 shows volumes of retail sales by four broad categories since 1996. (Click here to download a PowerPoint of the chart). These are food stores, predominantly non-food stores, non-store retail and automotive fuel (i.e. sales of petrol and diesel “at the pumps”).

Whilst all categories have seen an increase in their spending volumes over the period as a whole, there are stark differences in this rate of growth. Perhaps not surprisingly, the most rapid growth is in non-store retail. This includes online retailing, as well as market stalls and catalogues.

The volume of retail spending in the non-store sector has grown at an average annual rate over this period of 6.3 per cent, compared with 2.6 per cent for non-food stores, 1.2 per cent for predominantly food stores and 1.0 per cent for automotive fuels. The growth of non-store retail has been even more rapid since 2010, when the average annual rate of growth in the volume of purchases has been 10.2 per cent, compared to 1.8 per cent for non-food stores, 1.0 per cent for automotive fuels and zero growth for food stores.

If we focus on the most recent patterns in the categories of retail sales, we see that the monthly volume of spending in all categories except non-store retail is now lower than the average in 2019. Specifically, when compared to 2019 levels, the volume of spending in non-food stores in May 2024 was 2.6 per cent lower, while that in food stores was 4.4 per cent lower, and the volume of spending on automotive fuels was 10.8 per cent lower. In contrast, spending in non-store retail was 21.2 per cent higher. Yet this is not to imply that this sector has been immune to the pressures faced by their high-street counterparts. Although it is difficult to disentangle fully the effects of the pandemic and lockdowns on non-store retail sales data, the downward trajectory in the volume of retail sales in the sector that occurred as the economy ‘reopened’ in 2021 and 2022 continued into 2023 when purchases fell by 3.5 per cent.

Final thoughts

The retail sector is an incredibly important part of the economy. A recent research briefing from the House of Commons Library reports that there were 2.7 million jobs in the UK retail sector in 2022, equivalent to 8.6 per cent of the country’s jobs with 314 040 retail businesses as of January 2023. Yet the importance of the retail sector cannot be captured by these statistics alone. Some would argue that the very fabric and wellbeing of our towns and cities is affected by the wellbeing of the sector and, importantly, by structural changes that affect how people interact with retail.


Research Briefing

Statistical bulletin



  1. Which of the following is/are not counted in the UK retail sales data: (i) purchase of furniture from a department store; (ii) weekly grocery shop online; (iii) a stay at a hotel on holiday; (iv) a meal at your favourite café or restaurant?
  2. Why does an increase in the value of retail sales not necessarily mean that their volume has increased?
  3. In the presence of deflation, which will be higher: nominal or real growth rates?
  4. Discuss the factors that could explain the patterns in the volume of spending observed in the different categories of retail sales in Chart 4.
  5. Discuss what types of retail products might be more or less sensitive to changes in the macroeconomic environment.
  6. Conduct a survey of recent media reports to prepare a briefing discussing examples of retailers who have struggled or thrived in the recent economic environment.
  7. What do you understand by the concepts of ‘consumer confidence’ and ‘economic uncertainty’? How might these affect the volume of retail spending?
  8. Discuss the proposition that the retail sales data cast doubt on whether people are ‘forward-looking consumption smoothers’.

Gold has always held an allure and with the price of gold on international markets trending upwards since October 2022 (see Figure 1: click here for a PowerPoint), people seem to be attracted to it once again. The price reached successively higher peaks throughout 2023 before surging to above $2300 per oz in 2024 and peaking at $2425.31 per oz on 20 May 2024.

While gold tends to become attractive during wartime, economic uncertainty and bouts of inflation, all of which have characterised the last few years, the sustained price rise has perplexed market analysts and economists. The rally had been expected to peter out over the past 20 months. But, as the price of gold rose to sustained higher levels, with no significant reversals, some analysts have speculated that it is not the typical short-term factors which are driving the increased demand for and price of gold but more fundamental changes in the global economic system.

This blog will first discuss the typical short-term factors which influence gold prices before discussing the potential longer-term forces that may be at work.

Short-term factors

So, what are the typical short-term economic forces which drive the demand for gold?

The most significant are the real rates of interest on financial assets. These rates represent the opportunity cost of holding an asset such as gold which offers no income stream. When the real return from financial assets like debt and equity instruments is low, the demand for and price of gold tends to be high. In contrast, when the real return from such assets is high, the price of gold tends to be lower. An explanation for this is that real rates of return are strongly related to inflation rates and investors perceive gold as a hedge against inflation since its price is positively correlated with a general rise in prices. Higher unexpected inflation reduces the real rate of return of securities like debt and equity whose value is derived from cash flows anticipated in the future. In such circumstances, gold become an attractive alternative investment. As inflationary expectations decline, real returns from financial assets should rise, and the demand for gold should fall.

The relationship between real returns, proxied by the yield on US 10-year TIPS (Treasury inflation-protected securities), and gold prices can be used to examine this explanation. Real returns rose steadily in the aftermath of the COVID-19 pandemic. Yet the price of gold, which rose during the early stages of the pandemic in 2020, has not fallen. Instead, it has remained at elevated levels for much of that time (see Figure 2: click here for a PowerPoint).

There have been short periods when changes in real returns seemed to have a high correlation with changes in gold prices. In late 2022, for example, falling real rates coincided with rising gold prices. The same pattern was repeated between October and December 2023. However, when real returns rose again in the New Year of 2024, in response to stubbornly higher expected inflation and the expectation of ‘higher-for-longer’ interest rates, particularly in the USA, gold prices continued to rise. Indeed, across the 5-year period the correlation coefficient between the two series is actually positive at 0.268, showing little evidence supporting this explanation for the pattern for the gold price.

Real returns in the USA, however, may not be the correct ones to consider when seeking explanations for the pattern of gold’s price. Much of the recent demand is from China. Analysts suggest that Chinese investors are looking for a safe asset to hold as their economy stagnates and real returns from alternatives, like domestic property and equity, have decreased. Further, there are some concerns that the Chinese currency, the renminbi, may be undervalued in response to the sluggish growth. Holding gold is a good hedge against inflation (currency depreciation produces inflationary pressure). Consequently, the Chinese market may be exerting pricing power in relation to real returns in a way not seen before (see the Dempsey and Leng FT article linked below).

However, some analysts suggest that the rise in price is disproportionate to these short-term factors and point to potential long-term structural changes in the global financial order which may produce significant changes in the market for gold.

Long-term factors

Since 2018, there have been bouts of gold purchasing by central banks around the world. In contrast to the 1990s and 2000s, central banks have been net purchasers since 2010. The purchasing fell back during the coronavirus pandemic but has surged again, with over 1000 metric tonnes purchased in both 2022 and 2023 (see Figure 3: click here for a PowerPoint).

Analysts have pointed to similarities between the recent pattern and central bank purchases of gold during the late 1960s and early 1970s (see The Conversation article linked below). Then, central banks sought to diversify themselves from dollar-denominated assets due to concerns about higher inflation in the USA and its impact on the value of the US dollar. Under the Bretton Woods fixed exchange rate system, central banks could redeem dollars for gold from the US Federal Reserve at a fixed rate. The pressure on the USA to redeem the gold led to the collapse of the Bretton Woods fixed exchange rate system.

While the current period of central bank purchases does not appear to be related to expected inflation, some commentators suggest it could signal a regime change in the global financial system as significant as the collapse of Bretton Woods. The rise of Chinese political power and the resurgence of US isolationist tendencies portend an increasingly multipolar geopolitical scene. Such concerns may cause central bankers to diversify away from dollar denominated assets to avoid being caught out by geopolitical tensions. Gold may be perceived as an asset through which investors can hedge that risk better.

Indeed, the rise in demand among Chinese investors may indicate a reluctance to hold US assets due to their risk of seizure during heightened geopolitical tensions between China and the USA. Chinese holdings of US financial assets as a percentage of GDP are back to the level they were  when the country joined the World Trade Organisation (WTO) in 2001 (see the Rana Foroohar FT article linked below). Allied to this is an increasing tendency to repatriate gold bullion from centres such as London and New York.

Added to these worries about geopolitical risk are concerns about traditional safe-haven assets – government debt securities. US government budget deficits and debt levels continue to rise. Similar patterns are observed across many developed market economies (DMEs). Analysts are concerned such debts are reaching unsustainable levels (economist.com). The view is that at some point, perhaps soon, a tipping point will be reached where investors recognise this. They will demand higher rates of return on these government debt securities, pushing yields up and prices down (bond yields and prices have a negative relationship).

In expectation of this, investors may be wary of holding such government debt securities and move to hold gold as an alternative safe-haven asset to avoid potential capital losses. However, there has been no sign of this behaviour in bond prices and yields yet.

Finally, there are economists who argue that the increased demand for gold is caused by a different regime-change in the global economy. This is not one driven by geopolitics, but by changing inflationary expectations – from a low-inflation, low-interest-rate environment to a higher-inflation, higher-interest-rate environment.

Some of the anticipation relating to inflation is derived from the persistent fiscal stimulus, evidenced by the higher government debt levels described above, coupled with the long period of monetary stimulus (quantitative easing) in developed market economies during the 2010s.

Further, some economists highlight the substantial capital investment needed for the green transition and reindustrialisation. While the financing for this capital investment may absorb some of the excess money flowing around financial markets, the scale involved will create a great demand for resources, fuelling inflation and raising the cost of capital as borrowers compete for resources.

Finally, the demographic forces from an aging population will also cause inflationary pressures. Rising dependency ratios across many developed market economics will create shortages, particularly of labour. This persistent scarcity of labour will continually drive up wages and prices, fuelling inflation and the demand for gold.


The recent surge in the price of gold has led to great interest by investors, financial market analysts and economists. At first, there was a perception that the price increase was similar to recent history and driven by short-term decreases in the real rate of return from financial assets, which reduced the opportunity cost of holding gold.

However, as the upward trend in the price of gold has persisted and does not seem to be explained by changes in real interest rates, economists have considered other reasons that might signal longer-term significant changes in the global financial system. These relate to changing geopolitical risk derived from an increasingly multipolar environment, concerns about the sustainability of government debt levels and expectations of persistently higher inflation in the world economy.

Only time will tell whether these explanations prove correct. If inflationary pressures subside, particularly in the USA, and if real returns from financial assets rebound, a decrease in the demand for and price of gold will suggest that the previous rise was driven by short-term forces.

If prices don’t fall back, it will only fuel the debate that it is a sign of significant changes in the global financial order.




  • Gold
  • Trading Economics


  1. Explain the relationship between real returns and inflation for financial securities like debt and equity.
  2. Why is gold perceived to be an effective hedge against inflation?
  3. Contrast the factors which influenced the demand for gold in the period which preceded the end of Bretton Woods with those influencing demand now?
  4. What has happened to the price of gold since this blog was published? Is there any evidence for the profound changes in the global economic order suggested or was it the short-term forces driving demand after all?

The UK Chancellor of the Exchequer, Jeremy Hunt, delivered his Spring Budget on 6 March 2024. In his speech, he announced a cut in national insurance (NI): a tax paid by workers on employment or self-employment income. The main rate of NI for employed workers will be cut from 10% to 8% from 6 April 2024. This follows a cut this January from 12% to 10%. The rate for the self-employed will be cut from 9% to 6% from 6 April. These will be the new marginal rates from the NI-free threshold of £12 750 to the higher threshold of £50 270 (above which the marginal rate is 2% and remains unchanged). Unlike income tax, NI applies only to income from work (employment or self-employment) and does not include pension incomes, rent, interest and dividends.

The cuts will make all employed and self-employed people earning more than £12 750 better off than they would have been without them. For employees on average incomes of £35 000, the two cuts will be worth £900 per year.

But will people end up paying less direct tax (income tax and NI) overall than in previous years? The answer is no because of the issue of fiscal drag (see the blog, Inflation and fiscal drag). Fiscal drag refers to the dampening effect on aggregate demand when higher incomes lead to a higher proportion being paid in tax. It occurs when there is a faster growth in incomes than in tax thresholds. This means that (a) the tax-free allowance accounts for a smaller proportion of people’s incomes and (b) a higher proportion of many people’s incomes will be paid at the higher income tax rate. Fiscal drag is especially acute when thresholds are frozen, when inflation is rapid and when real incomes rise rapidly.

Tax thresholds have been frozen since 2021 and the government plans to keep them frozen until 2028. This is illustrated in the following table.

According to the Institute for Fiscal Studies, the net effect of fiscal drag means that for every £1 given back to employed and self-employed workers by the NI cuts, £1.30 will have been taken away as a result of freezing thresholds between 2021 and 2024. This will rise to £1.90 in 2027/28.

Tax revenues are still set to rise as a percentage of GDP. This is illustrated in the chart. Tax revenues were 33.2% of GDP in 2010/11. By 2022/23 the figure had risen to 36.3%. With neither of the two changes to NI (January 2024 and April 2024), the OBR forecasts that the figure would rise to 37.7% by 2028/29 – the top dashed line in the chart. After the first cut, announced in November, it forecasts a smaller rise to 37.3% – the middle dashed line. After the second cut, announced in the Spring Budget, the OBR cut the forecast figure to 37.1% – the bottom dashed line. (Click here for a PowerPoint of the chart.)

As you can see from the chart, despite the cut in NI rates, the fiscal drag from freezing thresholds means that tax revenue as a percentage of GDP is still set to rise.


Information, data and analysis


  1. Would fiscal drag occur with frozen nominal tax bands if there were zero real growth in incomes? Explain.
  2. Find out what happened to other taxes, benefits, reliefs and incentives in the 2024 Spring Budget. Assess their macroeconomic effect.
  3. If the government decides that it wishes to increase tax revenues as a proportion of GDP (for example, to fund increased government expenditure on infrastructure and socially desirable projects and benefits), examine the arguments for increasing personal allowances and tax bands in line with inflation but raising the rates of income tax in order to raise sufficient revenue?
  4. Distinguish between market-orientated and interventionist supply-side policies? Why do political parties differ in their approaches to supply-side policy?
  5. What is the Conservative government’s fiscal rule? Is the Spring Budget 2024 consistent with this rule?
  6. What policies were announced in the Spring Budget 2024 to increase productivity? Why is it difficult to estimate the financial outcome of such policies?

Since 2019, UK personal taxes (income tax and national insurance) have been increasing as a proportion of incomes and total tax revenues have been increasing as a proportion of GDP. However, in his Autumn Statement of 22 November, the Chancellor, Jeremy Hunt, announced a 2 percentage point cut in the national insurance rate for employees from 12% to 10%. The government hailed this as a significant tax cut. But, despite this, taxes are set to continue increasing. According to the Office for Budget Responsibility (OBR), from 2019/20 to 2028/29, taxes will have increased by 4.5 per cent of GDP (see chart below), raising an extra £44.6 billion per year by 2028/29. One third of this is the result of ‘fiscal drag’ from the freezing of tax thresholds.

According to the OBR

Fiscal drag is the process by which faster growth in earnings than in income tax thresholds results in more people being subject to income tax and more of their income being subject to higher tax rates, both of which raise the average tax rate on total incomes.

Income tax thresholds have been unchanged for the past three years and the current plan is that they will remain frozen until at least 2027/28. This is illustrated in the following table.

If there were no inflation, fiscal drag would still apply if real incomes rose. In other words, people would be paying a higher average rate of tax. Part of the reason is that some people on low incomes would be dragged into paying tax for the first time and more people would be paying taxes at higher rates. Even in the case of people whose income rise did not pull them into a higher tax bracket (i.e. they were paying the same marginal rate of tax), they would still be paying a higher average rate of tax as the personal allowance would account for a smaller proportion of their income.

Inflation compounds this effect. Tax bands are in nominal not real terms. Assume that real incomes stay the same and that tax bands are frozen. Nominal incomes will rise by the rate of inflation and thus fiscal drag will occur: the real value of the personal allowance will fall and a higher proportion of incomes will be paid at higher rates. Since 2021, some 2.2 million workers, who previously paid no income taxes as their incomes were below the personal allowance, are now paying tax on some of their wages at the 20% rate. A further 1.6 million workers have moved to the higher tax bracket with a marginal rate of 40%.

The net effect is that, although national insurance rates have been cut by 2 percentage points, the tax burden will continue rising. The OBR estimates that by 2027/28, tax revenues will be 37.4% of GDP; they were 33.1% in 2019/20. This is illustrated in the chart (click here for a PowerPoint).

Much of this rise will be the result of fiscal drag. According to the OBR, fiscal drag from freezing personal allowances, even after the cut in national insurance rates, will raise an extra £42.9 billion per year by 2027/28. This would be equivalent of the amount raised by a rise in national insurance rates of 10 percentage points. By comparison, the total cost to the government of the furlough scheme during the pandemic was £70 billion. For further analysis by the OBR of the magnitude of fiscal drag, see Box 3.1 (p 69) in the November 2023 edition of its Economic and fiscal outlook.

Political choices

Support measures during the pandemic and its aftermath and subsidies for energy bills have led to a rise in government debt. This has put a burden on public finances, compounded by sluggish growth and higher interest rates increasing the cost of servicing government debt. This leaves the government (and future governments) in a dilemma. It must either allow fiscal drag to take place by not raising allowances or even raise tax rates, cut government expenditure or increase borrowing; or it must try to stimulate economic growth to provide a larger tax base; or it must do some combination of all of these. These are not easy choices. Higher economic growth would be the best solution for the government, but it is difficult for governments to achieve. Spending on infrastructure, which would support growth, is planned to be cut in an attempt to reduce borrowing. According to the OBR, under current government plans, public-sector net investment is set to decline from 2.6% of GDP in 2023/24 to 1.8% by 2028/29.

The government is attempting to achieve growth by market-orientated supply-side measures, such as making permanent the current 100% corporation tax allowance for investment. Other measures include streamlining the planning system for commercial projects, a business rates support package for small businesses and targeted government support for specific sectors, such as digital technology. Critics argue that this will not be sufficient to offset the decline in public investment and renew crumbling infrastructure.

To support public finances, the government is using a combination of higher taxation, largely through fiscal drag, and cuts in government expenditure (from 44.8% of GDP in 2023/24 to a planned 42.7% by 2028/29). If the government succeeds in doing this, the OBR forecasts that public-sector net borrowing will fall from 4.5% of GDP in 2023/24 to 1.1% by 2028/29. But higher taxes and squeezed public expenditure will make many people feel worse off, especially those that rely on public services.


  • Fiscal drag
  • Sky News Politics Hub on X, Sophy Ridge (22/11/23)

  • Fiscal drag
  • Sky News Politics Hub on X, Beth Rigby (22/11/23)


Report and data from the OBR


  1. Would fiscal drag occur with frozen nominal tax bands if there were zero real growth in incomes? Explain.
  2. Examine the arguments for continuing to borrow to fund a Budget deficit over a number of years.
  3. When interest rates rise, how much does this affect the cost of servicing public-sector debt? Why is the effect likely to be greater in the long run than in the short run?
  4. If the government decides that it wishes to increase tax revenues as a proportion of GDP (for example, to fund increased government expenditure on infrastructure and socially desirable projects and benefits), examine the arguments for increasing personal allowances and tax bands in line with inflation but raising the rates of income tax in order to raise sufficient revenue?
  5. Distinguish between market-orientated and interventionist supply-side policies? Why do political parties differ in their approaches to supply-side policy?

We have examined inflation in several blogs in recent months. With inflation at levels not seen for 40 years, this is hardly surprising. One question we’ve examined is whether the policy response has been correct. For example, in July, we asked whether the Bank of England had raised interest rates too much, too late. In judging policy, one useful distinction is between demand-pull inflation and cost-push inflation. Do they require the same policy response? Is raising interest rates to get inflation down to the target rate equally applicable to inflation caused by excessive demand and inflation caused by rising costs, where those rising costs are not caused by rising demand?

In terms of aggregate demand and supply, demand-pull inflation is shown by continuing rightward shifts in aggregate demand (AD); cost-push inflation is shown by continuing leftward/upward shifts in short-run aggregate supply (SRAS). This is illustrated in the following diagram, which shows a single shift in aggregate demand or short-run aggregate supply. For inflation to continue, rather than being a single rise in prices, the curves must continue to shift.

As you can see, the effects on real GDP (Y) are quite different. A rise in aggregate demand will tend to increase GDP (as long as capacity constraints allow). A rise in costs, and hence an upward shift in short-run aggregate supply, will lead to a fall in GDP as firms cut output in the face of rising costs and as consumers consume less as the cost of living rises.

The inflation experienced by the UK and other countries in recent months has been largely of the cost-push variety. Causes include: supply-chain bottlenecks as economies opened up after COVID-19; the war in Ukraine and its effects on oil and gas supplies and various grains; and avian flu and poor harvests from droughts and floods associated with global warming resulting in a fall in food supplies. These all led to a rise in prices. In the UK’s case, this was compounded by Brexit, which added to firms’ administrative costs and, according to the Bank of England, was estimated to cause a long-term fall in productivity of around 3 to 4 per cent.

The rise in costs had the effect of shifting short-run aggregate supply upwards to the left. As well as leading to a rise in prices and a cost-of-living squeeze, the rising costs dampened expenditure.

This was compounded by a tightening of fiscal policy as governments attempted to tackle public-sector deficits and debt, which had soared with the support measures during the pandemic. It was also compounded by rising interest rates as central banks attempted to bring inflation back to target.

Monetary policy response

Central banks are generally charged with keeping inflation in the medium term at a target rate set by the government or the central bank itself. For most developed countries, this is 2% (see table in the blog, Should central bank targets be changed?). So is raising interest rates the correct policy response to cost-push inflation?

One argument is that monetary policy is inappropriate in the face of supply shocks. The supply shocks themselves have the effect of dampening demand. Raising interest rates will compound this effect, resulting in lower growth or even a recession. If the supply shocks are temporary, such as supply-chain disruptions caused by lockdowns during the pandemic, then it might be better to ride out the problem and not raise interest rates or raise them by only a small amount. Already cost pressures are easing in some areas as supplies have risen.

If, however, the fall in aggregate supply is more persistent, such as from climate-related declines in harvests or the Ukraine war dragging on, or new disruptions to supply associated with the Israel–Gaza war, or, in the UK’s case, with Brexit, then real aggregate demand may need to be reduced in order to match the lower aggregate supply. Or, at the very least, the growth in aggregate demand may need to be slowed to match the slower growth in aggregate supply.

Huw Pill, the Chief Economist at the Bank of England, in a podcast from the Columbia Law School (see links below), argued that people should recognise that the rise in costs has made them poorer. If they respond to the rising costs by seeking higher wages, or in the case of businesses, by putting up prices, this will simply stoke inflation. In these circumstances, raising interest rates to cool aggregate demand may reduce people’s ability to gain higher wages or put up prices.

Another argument for raising interest rates in the face of cost-push inflation is when those cost increases are felt more than in other countries. The USA has suffered less from cost pressures than the UK. On the other hand, its growth rate is higher, suggesting that its inflation, albeit lower than in the UK, is more of the demand-pull variety. Despite its inflation rate being lower than in the UK, the problem of excess demand has led the Fed to adopt an aggressive interest rate policy. Its target rate is 5.25% to 5.50%, while the Bank of England’s is 5.25%. In order to prevent short-term capital outflows and a resulting depreciation in the pound, further stoking inflation, the Bank of England has been under pressure to mirror interest rate rises in the USA, the eurozone and elsewhere.


Blogs on this site

Information and data


  1. How may monetary policy affect inflationary expectations?
  2. If cost-push inflation makes people generally poorer, what role does the government have in making the distribution of a cut in real income a fair one?
  3. In the context of cost-push inflation, how might the authorities prevent a wage–price spiral?
  4. With reference to the second article above, explain the ‘monetary policy conundrum’ faced by the Bank of Japan.
  5. If central banks have a single policy instrument, namely changes in interest rates, how may conflicts arise when there is more than one macroeconomic objective?
  6. Is Russia’s rise in inflation the result of cost or demand pressures, or a mixture of the two (see articles above)?