The cost of living crisis has many roots – primarily higher energy bills and other post-Covid import and supply issues, about to be exacerbated by the self-inflicted hurt of dues higher to national insurance.

For us in the UK, this amounts to what economists call a ‘real’ problem, which has its roots in the world of costs and trade.

In contrast, the inflation crisis has its roots in strong aggregate demand relative to limited aggregate supply, fueled by loose monetary policy – very low interest rates and strong money supply growth, aided by quantitative easing.

It can be considered a largely monetary phenomenon. Some people readily imagine that tighter monetary policy can solve both problems at once, reducing price inflation while leaving wage inflation intact.

There may be a few occasions where this is indeed the temporary result of a stricter policy. But in general, that’s not how things work.

Compression of the economy by higher interest rates lowers the rate of increase in prices and wages. Monetary policy cannot therefore remedy the crisis in the cost of living.

On the other hand, although the origins are largely elsewhere, the government could potentially do something about it by changing its energy policy, the pursuit of net zero and its planned tax hikes.

Monetary policy can deal with inflation – although, as we know from experience, its impact can be brutal, variable and sometimes extremely costly.

There is a lot of misunderstanding about how monetary tightening works. It is sometimes claimed that there is a direct link between changes in the money supply and inflation. Except in special circumstances – usually when inflation is extremely high and expectations of future inflation dominate changes in the current rate – it doesn’t work that way.

On the contrary, a tighter monetary policy decreases aggregate demand and thus alters the balance between demand and supply, exerting downward pressure on prices.

Sometimes inflation goes down quite easily, but often not. Under these conditions, the tightening of monetary policy will induce a sharp fall in production, perhaps equivalent to a recession. There is a real danger that something like this will happen now.

So how high will interest rates have to go? Next year, as the major cost increases driven by this year’s supply are no longer factored into the annual comparison, inflation is expected to fall.

The Bank estimates that it will be back to the 2% target by the second quarter of 2024. In this case, interest rates could indeed peak at the 1.5% level that underpins these forecasts. But this will only happen if wage inflation does not react strongly to the pressure on the standard of living.

Some people have suggested that high wage inflation is actually a good thing. They are deceived.

If higher wages are fully justified by higher productivity, then yes, that’s a good thing, and we need a lot more of that. But there are no signs of increased productivity now. Rather the opposite.

If wage inflation picks up in the coming months, far from being a sign that the cost of living crisis is easing, it will be a
clear indication that the inflation crisis is getting worse. Then what ? It is important to think about what happens to real interest rates, that is, the nominal rate adjusted for the rate of inflation.

In November, the Bank of England forecast inflation to peak at around 5%. He now expects the peak to be 7.25pc.