The MPC's remit and trade-off management

The MPC’s remit as a flexible inflation targeting mandate

The objectives in the MPC’s remit – summarised in Box A – can be interpreted as a flexible inflation targeting mandate. This follows from two features of the remit. First, the remit makes clear that low and stable inflation is the best contribution that monetary policy can make in the medium to long run. This is consistent with the lessons of history that persistent attempts to use monetary policy to stimulate real activity ultimately lead to high inflation with material real economic costs.

Second, the remit also makes clear that attempts to keep inflation at target following shocks may cause ‘undesirable volatility in output due to the short-term trade-offs involved and the Monetary Policy Committee may therefore wish to allow inflation to deviate from the target temporarily’. That is, monetary policy should have concern for both deviations of inflation from target and volatility of output in the short run.

There is strong evidence in favour of a flexible inflation targeting interpretation from parliamentary discussions,^{footnote [1]} academic interpretations of the remit,^{footnote [2]} statements by government,^{footnote [3]} and the interpretations of many MPC members since the MPC’s inception in 1997.^{footnote [4]} Perhaps the clearest example is from the monetary policy framework review undertaken by HM Treasury in 2013:

‘Under inflation targeting, central banks aim, in the longer term, to support growth by maintaining price stability, while in the shorter term to minimise the variability of inflation and output. […] Monetary policy in the UK has operated under flexible inflation targeting since 1992.’ (HM Treasury, (2013), page 3)

Flexible inflation targeting can be formalised by a presumption that policymakers seek to minimise a ‘loss function’ that includes deviations of inflation from target (π _t+s – π*) and output from ‘potential’ (y _t+s – y*_t+s):

\[L_t=E_t\sum_{s=0}^{\infty}{\beta^s\left[\left(\pi_{t+s}-\pi^\ast\right)^2+{\lambda\left(y_{t+s}-y_{t+s}^\ast\right)}^2\right]}\]

where 0<β<1 is a discount factor and λ is the policymaker’s preference for output stability relative to inflation stability.

While this formalisation of flexible inflation targeting is one of many possible formalisations, it has the virtue of both simplicity and consistency with the academic literature, making it useful as a device to provide a lens through which to think about the monetary policy problem.

This particular formalisation can also be related to the MPC’s remit. The instruction to avoid ‘undesirable volatility in output’ implies that not all fluctuations in output are undesirable (in the sense of harming welfare), which is why output variability appears in output `gap’ form. This instruction also implies that, in general, λ should be regarded as positive (ie λ>0). And the `quadratic’ formulation follows if ‘volatility’ is interpreted as variability.^{footnote [5]}

Beyond implying that the weight on output gap stabilisation should generally be positive, the remit does not specify what value λ should take. Indeed, the remit can be viewed as an incomplete contract between the government and the MPC, specifying some key broad parameters or constraints, but leaving discretion to the MPC over precisely what it is seeking to achieve and how it intends to set policy in pursuit of that.

Importantly, this framework of ‘constrained discretion’ comes with various accountability mechanisms, requiring the MPC to explain its approach and giving the government an opportunity to provide more direction in certain circumstances. When inflation is close to target and shocks are small, the remit can be interpreted as permitting almost complete discretion. For larger shocks that result in inflation moving one percentage or more away from the target, the Governor is required to write an open letter to the Chancellor explaining the reasons why inflation has moved away from target, the outlook for inflation, the policy action that the MPC is taking, the horizon over which the MPC judges it appropriate to return inflation to the target, the trade-off that has been made with respect to output variability, and how this approach meets the government’s monetary policy objectives.^{footnote [6]} In response, the Chancellor opines on whether an appropriate balance has been struck in the judgements that have been made. This can subject the implied choice of λ to public scrutiny.

Flexible inflation targeting mandate + a Phillips curve = trade-off management

If the MPC’s mandate is flexible inflation targeting, then ‘trade-off management’ follows if output and inflation are connected via a Phillips curve type relationship.^{footnote [7]}

The Phillips curve has a long history in macroeconomics. It is named after AW Phillips who noticed that there was an inverse relationship between money wage inflation and unemployment in the United Kingdom between 1861 and 1957.^{footnote [8]} It has subsequently become a cornerstone of modern monetary economics, underpinning both modern macroeconomic models and the practice of monetary policymaking in central banks.

The concept of trade-off management that arises from the existence of a Phillips curve can be illustrated in a simple diagram, shown in Figure 1. This particular variant derives from a static model in which deviations of inflation from target depend positively on an output gap and an exogenous disturbance, and in which the policymaker’s loss function is a single-period version of the equation above.^{footnote [9]} While this model is not at all realistic, this simple characterisation of the Phillips curve and loss function has value because of ‘how it teaches us to think about’ the monetary policy problem ‘in quite an informal way’.^{footnote [10]}

Figure 1: Simple representation of trade-off management

The upward sloping ‘PC’ line represents the Phillips curve, capturing a positive relationship between the output gap and inflation. The downward sloping ‘TC’ line represents the optimal trade-off between deviations of inflation from target and the output gap arising from minimisation of the policymaker’s loss function subject to the Phillips curve.^{footnote [11]} It slopes downwards when λ>0 because lower losses are always achieved by a combination of deviations of inflation from target and an output gap than from eliminating deviations of either variable (given the quadratic from of the loss function).

The PC and TC lines both pass through the origin, 0. This represents a point of ‘divine coincidence’ when inflation is at target and output is equal to potential. An upward shift in the Phillips curve from PC to PC’ arising from a positive exogenous ‘cost push’ disturbance to inflation results in a shift from point 0 to point B. To achieve lower losses and deliver better outcomes monetary policy optimally trades off higher inflation against a negative output gap. For that reason, shocks of this sort are sometimes called ‘trade-off inducing’. Larger trade-off inducing shocks push the Phillips curve out further, leading to larger trade-offs.

Point B can be contrasted with points A and C. Point C would be optimal if λ=0, so-called ‘inflation nutter’ preferences.^{footnote [12]} Alternatively, point A would be optimal if λ=∞, representing a policymaker who is concerned only with stabilising the output gap. As discussed above, the remit does not prescribe what λ should be, but it is reasonable to interpret the MPC’s remit as implying point B should generally be preferrable to points A or C.^{footnote [13]}

In each of the cases A, B and C, an active monetary policy response is required to deliver the desired trade-off. Monetary policy is presumed to operate via ‘demand management’, captured in an ‘IS curve’ that determines the output gap as a negative function of the real interest rate (ie the policy rate minus expected inflation, which in this simple static model is presumed to be the same as realised inflation). The direct effect of the trade-off inducing shock is to increase inflation, while leaving the output gap unchanged. In the absence of a policy response, the indirect effect of the shock is to increase expected inflation, thereby lowering the real interest rate and creating a positive output gap (which further increases inflation). Consistent with this, a policy tightening is required to deliver an equilibrium at point A with a closed output gap. It then follows that a larger policy tightening is required to deliver an equilibrium at point B, and an even larger tightening to deliver point C with inflation at target.

Although in some ways trivial in this highly stylised model, these comparisons of alternative equilibrium outcomes highlight that trade-off management requires an active response by the central bank. When the Phillips curve shifts to PC’, the policy problem is to choose the best point on PC’. It is true that, since it is impossible to deliver inflation at target and close the output gap simultaneously, all feasible points are associated with losses. Monetary policy must manage a difficult situation. However, such language is arguably too passive. To achieve the best feasible outcome (eg point B) requires a tightening of monetary policy to balance the incidence of losses between inflation and output. Failure to tighten policy sufficiently would generate an outcome on the portion of PC’ in the orange excess demand quadrant of the diagram, where losses can be unambiguously reduced via tighter policy. Conversely, excessive tightening would drive the economy into the aqua deficient demand quadrant and outcomes would be similarly suboptimal. So, the arrival of a trade-off inducing shock does not automatically result in an observed trade-off between inflation and output (with above-target inflation and below-potential output or vice versa). It is the role of monetary policy to create that trade off.

Trade-off management in practice

Figure 2 plots annual UK CPI inflation relative to 2%, the current target measure, against estimates for the output gap between 1970 Q1 and 2025 Q4, splitting the sample into three separate periods. Between 1970 and 1992, there was no single and clear operating framework for monetary policy or macroeconomic policy more generally in the United Kingdom.^{footnote [14]} Consistent with that, inflation was often high and both inflation and output were highly variable over that period. While there were periods of high inflation alongside weak output, there were also periods of both high inflation and strong output, which clearly do not conform to notions of appropriate trade-off management.

Figure 2: Annual inflation against estimates of the output gap

Footnotes

• Note: Observations are quarterly from 1970 Q1–2025 Q4 and derive from ONS data and Bank calculations. Annual inflation on the y-axis is measured as the four-quarter percentage change in the quarterly CPI minus 2%. From 2004 when the target measure of inflation for the MPC became 2% as measured by the annual percentage change in the CPI, this therefore measures deviations of inflation from target. From the inception of the MPC in May 1997 to 2004 the inflation target was 2.5% measured by the RPIX. Prior to that monetary policy was conducted by the UK Government with a 2.5% RPIX inflation rate as the target from June 1995 and a target range for RPIX inflation of 1% to 4% following the adoption of inflation targeting in the United Kingdom in October 1992. Prior to that, there was no official inflation target. The output gap estimate from 1987 Q3–2005 Q4 is taken from the Bank’s forecast database consistent with the February 2026 Monetary Policy Report. Prior to 1987 Q3 the output gap is computed as the cycle from a Hodrick-Prescott filter of quarterly GDP data (with a standard smoothing parameter of 1600) using data from 1955–2007 to avoid well-known end-point problems with the filtering. Both the GDP and CPI series were taken from the Bank of England’s historical dataset, Research datasets.

The period from the adoption of inflation targeting in the United Kingdom in 1993 Q1 to just before the Global Financial Crisis in 2007Q4 is sometimes known as the Great Stability. Inflation was low and very stable, demonstrating the success of first inflation targeting and then the operation of monetary policy by an independent central bank with the inception of the MPC in 1997. Aside from a short period during the early to mid-1990s as the UK economy recovered from the early 1990s recession, output gaps over this period were likely relatively small. Compared to the period before and the period that followed, the incidence of trade-off inducing shocks was relatively low, and trade-off management was not much in evidence.^{footnote [15]}

The period that followed the Great Stability, beginning with the Global Financial Crisis and encompassing the Euro Area Crisis, the EU referendum, Brexit, Covid, and Russia’s invasion of Ukraine has been much more volatile. These large, mainly global shocks have had material consequences for the supply-side of the economy, inducing trade-offs that monetary policy has had to manage. This is in evidence in Figure 2, where many of the points lie in the north-west quadrant with inflation above target and output estimated to be below potential, indicating that the MPC has been actively managing trade-offs.

While there are periods shown in Figure 2 that conform to the simple depiction of trade-off management from Figure 1, it is also clear that monetary policy in practice is not as straightforward as simply selecting a point where a fixed trade-off criterion intersects with the Phillips curve. While the very simple theory on which the analysis in Figure 1 is based establishes some useful principles for real-world monetary policymaking,^{footnote [16]} there are (at least) three important aspects of the practical application of trade-off management that are not captured by the analysis. First, the static presentation abstracts from policy transmission lags: the real-world analogues to the Phillips curve and IS curve are dynamic. Through the lens of the flexible inflation targeting loss function, overall losses due to deviations of inflation from target and output from potential are evaluated over the indefinite future. So, the expected future paths of the output gap and inflation as shocks unfold are relevant for managing the trade-off over time. For example, it may be appropriate to open up a future negative output gap if that reduces near-term inflation via a forward-looking Phillips curve relationship. In that case, it might be optimal for monetary policy to create an intertemporal trade-off between a near-term inflation overshoot and a subsequent output gap.

Second, structural change in the economy and state contingency of the behaviour of households and businesses imply that trade-off management should vary over time. For example, it is possible to show that monetary policy should trade-off smaller deviations of inflation from target in exchange for a larger output gap when inflation is more intrinsically persistent.^{footnote [17]} Related to that, the central bank’s preference for output variability relative to inflation variability (ie λ) may also change. For example, given the primacy of the inflation target in the MPC’s remit and the observation that the best and only contribution that monetary policy can make in the long run is price stability, it may be appropriate to respond more forcefully to inflation (ie act with a lower λ) if higher inflation risks becoming embedded via expectations and so-called ‘second-round effects’.

Third, monetary policy operates against a backdrop of material uncertainty about all aspects of the economy, including the transmission of policy itself. As a result, delivering ‘optimal’ management of a trade-off is not possible and outcomes will differ from that which may have been intended. In particular, the output gap is not an observable or measurable economic concept. Estimates of the output gap are highly uncertain and can be revised significantly over time as new information and even estimation techniques become available. This renders assessment of the relationship between the output gap and inflation uncertain, even with the benefit of hindsight.

An application of trade-off management in response to global energy price shocks

As Figure 2 makes clear, trade-off inducing shocks have been more frequent in the past 20 years than they were in the 15 years preceding that. One type of trade-off inducing shock that has hit the global economy several times in recent years is shocks that have led to a contraction in the global supply of energy and an increase in global energy prices. This type of shock is trade-off inducing because it leads to an increase in inflation, while also leading to a deterioration in the terms of trade for countries that are net importers of energy like the UK, thereby weighing on output.

There is nothing that monetary policy can do to prevent higher energy prices from affecting household and business.^{footnote [18]} The task for monetary policy is to ensure that inflation returns sustainably to target, while striking an appropriate balance in managing the short-run trade-off between inflation and activity. While the key principles from the textbook discussion of trade-off management above apply, an energy price shock differs from a ‘cost-push shock’ in several ways that are relevant for the policy response. In thinking through how monetary policy might seek to respond to an energy price shock, it is helpful to consider three separate transmission channels to inflation, following the taxonomy set out in Box G of the April 2026 Monetary Policy Report:

• Direct effects. The prices of some items in the consumption basket, like petrol and utilities, are very closely linked to the sterling price of global commodities. As a result, increased global commodity prices have a fairly mechanical and, in some cases, quite a rapid effect on headline consumer price inflation. There are two candidate reasons why monetary policy should ‘look through’ these direct effects on inflation. First, theory suggests that it is inefficient to attempt to offset inflation generated by changes in prices of goods and services that are relatively flexible by reducing inflation in sectors with ‘stickier’ prices, since the latter action generates costly reductions in output in those sectors. This suggests that it may be appropriate to respond to direct effects with a higher value of λ. Second, lags in the monetary transmission mechanism imply that the disinflationary effects of a policy tightening may come into effect largely once the direct effects of an energy price rise have disappeared from headline inflation. A monetary tightening in response to the direct effect of an energy price shock could therefore produce an unnecessary contraction in activity with inflation below target in the medium term.
• Indirect effects. Energy is an ‘upstream’ input in the supply chain and therefore feeds into production costs across a wide range of sectors. If these costs are passed through to prices along the supply chain, an energy price shock leads to more broad-based inflation. To the extent that these effects are well-approximated by a ‘cost-push’ shock, like that depicted in Figure 1, monetary policy would be expected to respond to inflation induced via these cost increases in the ‘usual’ way. This might be consistent with a moderate value of λ above 0 but less than 1.
• Second-round effects. Wage and price-setting behaviour may adjust to higher inflation triggered by the energy price shock. Greater inflation persistence may emerge through increased indexation to past inflation and stickier inflation expectations (particularly if they become more sensitive to headline inflation). In the other direction, higher inflation may prompt firms to adjust prices more frequently, thereby steepening the Phillips curve.^{footnote [19]} If adverse wage and price dynamics become embedded in behaviour, it would be appropriate to lean harder against inflation. In these circumstances, it may also be appropriate to adopt a lower value of λ, to prioritise the stabilisation of inflation at target, anchor inflation expectations and normalise price and wage-setting behaviour, consistent with the primacy of price stability in the remit.

This discussion highlights both the intertemporal and state-contingent aspects of trade-off management. The peak increase in inflation caused by an increase in global energy prices typically occurs in the first 12 months following the shock, as both direct and indirect effects push inflation up in a fairly mechanical and predictable way. If lags in the monetary transmission mechanism imply that policy largely affects inflation beyond this horizon, it may be appropriate for monetary policy to look through those effects. By contrast, the effect of an energy price shock on inflation beyond that horizon is more uncertain and depends on both the persistence of the increase in energy prices and on the size of any second-round effects via price and wage setting, which in turn is likely to depend on prevailing conditions in the economy. As a result, the appropriate way of managing a trade-off arising from an energy price shock is state dependent and so will vary over time.

As set out by Governor Bailey in his speech at the May 2026 Reykjavik Economic Conference, these considerations are apparent in the MPC’s policy strategy and deliberations following the global rise in energy and commodity prices caused by conflict in the Middle East.

Conclusion

The MPC’s remit can be interpreted as a flexible inflation targeting mandate. The primacy of price stability in the remit reflects that the best and only contribution that monetary policy can make in the long run is low and stable inflation. In the short run, however, flexible inflation targeting involves balancing temporary deviations of inflation from target with deviations of output from potential in response to trade-off inducing supply shocks.

The best achievable trade-off depends on the nature of the shock, structural and behavioural features of the economy, and policymaker preferences for output variability relative to inflation variability. Since all shocks are different and since structural and behavioural features of the economy vary over time, the way in which a policymaker approaches trade-off management should also vary over time.

The remit affords discretion, constrained by the long-run achievement of the inflation target, in how the MPC approaches trade-off management, including in the preference attached to output stability relative to inflation stability. In response to larger shocks, the remit also includes specific accountability mechanisms that subject the MPC’s approach to public and parliamentary scrutiny.