The Bank of England’s honest acknowledgement on Thursday that the most effective solution to the UK’s inflation problem lies in international diplomacy rather than domestic monetary policy reveals the fundamental limits of central bank action in the face of geopolitical shocks. The monetary policy committee voted unanimously to hold rates at 3.75%, with Governor Andrew Bailey explicitly stating that reopening energy supply lines disrupted by the Iran war was the most direct way to address the inflation threat. The Bank, he acknowledged, could respond to the consequences but could not address the cause.
The limits of monetary policy in this situation are real and important to understand. Raising interest rates reduces inflation primarily by reducing consumer spending and business investment, thereby reducing demand and taking pressure off prices. But when inflation is driven by a supply constraint — in this case, disrupted energy markets — rate hikes work only by reducing demand, which comes at a cost to employment and economic output. The Bank cannot create more oil or gas through monetary policy; it can only reduce the demand for it.
Governor Bailey’s candour about these limits reflected an institutional honesty that is both credible and important for public understanding of what the Bank can and cannot achieve. He said the Bank retained the tools to prevent the energy shock from becoming entrenched inflation but acknowledged that those tools worked through demand reduction rather than supply enhancement. His preferred solution — diplomatic resolution and supply chain restoration — was clearly outside the Bank’s power to deliver.
Financial markets focused on the tools the Bank does have rather than the limits it acknowledged. UK gilt yields rose, the FTSE 100 fell, and the pound strengthened against the dollar as traders priced in rate hikes before year end. The market’s response reflected an assumption that the Bank would use its available tools regardless of their limitations.
For the UK public, understanding the limits of monetary policy in addressing supply-side inflation is important for managing expectations. The Bank can slow the inflationary consequences of the war but cannot eliminate them quickly or without cost. The government’s role in addressing energy costs through fiscal support and longer-term energy security measures is therefore at least as important as the Bank’s monetary response to the current shock.