Monetary Policy Summary

The Bank of England’s Monetary Policy Committee (MPC) sets monetary policy to meet the 2% inflation target, and in a way that helps to sustain growth and employment. At its meeting ending on 3 August 2022, the MPC voted by a majority of 8–1 to increase Bank Rate by 0.5 percentage points, to 1.75%. One member preferred to increase Bank Rate by 0.25 percentage points, to 1.5%.

Inflationary pressures in the United Kingdom and the rest of Europe have intensified significantly since the May Monetary Policy Report and the MPC’s previous meeting. That largely reflects a near doubling in wholesale gas prices since May, owing to Russia’s restriction of gas supplies to Europe and the risk of further curbs. As this feeds through to retail energy prices, it will exacerbate the fall in real incomes for UK households and further increase UK CPI inflation in the near term. CPI inflation is expected to rise more than forecast in the May Report, from 9.4% in June to just over 13% in 2022 Q4, and to remain at very elevated levels throughout much of 2023, before falling to the 2% target two years ahead.

GDP growth in the United Kingdom is slowing. The latest rise in gas prices has led to another significant deterioration in the outlook for activity in the United Kingdom and the rest of Europe. The United Kingdom is now projected to enter recession from the fourth quarter of this year. Real household post-tax income is projected to fall sharply in 2022 and 2023, while consumption growth turns negative.

Domestic inflationary pressures are projected to remain strong over the first half of the forecast period. Firms generally report that they expect to increase their selling prices markedly, reflecting the sharp rises in their costs. The labour market has remained tight, with the unemployment rate at 3.8% in the three months to May and vacancies at historically high levels. As a result, and consistent with the latest Agents’ survey, underlying nominal wage growth is expected to be higher than in the May Report over the first half of the forecast period.

Inflationary pressures are nevertheless expected to dissipate over time. Global commodity prices are assumed to rise no further, and tradable goods price inflation is expected to fall back, the first signs of which may already be evident. Although the labour market may loosen only slowly in response to falling demand, unemployment is expected to rise from 2023. Domestic inflationary pressures are therefore expected to subside in the second half of the forecast period, as the increasing degree of economic slack and lower headline inflation reduce the pressure on wage growth. Monetary policy is also acting to ensure that longer-term inflation expectations are anchored at the 2% target.

The risks around the MPC’s projections from both external and domestic factors are exceptionally large at present. There is a range of plausible paths for the economy, which have CPI inflation and medium-term activity significantly higher or lower than in the baseline projections in the August Monetary Policy Report. As a result, in coming to its assessment of the outlook and its implications for monetary policy, the Committee is currently putting less weight on the implications of any single set of conditioning assumptions and projections.

The August Report contains several projections for GDP, unemployment and inflation: a baseline conditioned on the MPC’s current convention for wholesale energy prices to remain constant beyond the six-month point; an alternative projection in which energy prices follow their downward-sloping futures curves throughout the forecast period; and a scenario which explores the implications of greater persistence in domestic price setting than in the baseline. These are all conditioned on announced Government fiscal policies, including the Cost of Living Support package announced in May. There are significant differences between these projections in the latter half of the forecast period. However, all show very high near-term inflation, a fall in GDP over the next year and a marked decline in inflation thereafter.

The MPC’s remit is clear that the inflation target applies at all times, reflecting the primacy of price stability in the UK monetary policy framework. The framework recognises that there will be occasions when inflation will depart from the target as a result of shocks and disturbances. The economy has continued to be subject to a succession of very large shocks, which will inevitably lead to volatility in output. Monetary policy will ensure that, as the adjustment to these shocks occurs, CPI inflation will return to the 2% target sustainably in the medium term.

The labour market remains tight, and domestic cost and price pressures are elevated. There is a risk that a longer period of externally generated price inflation will lead to more enduring domestic price and wage pressures. In view of these considerations, the Committee voted to increase Bank Rate by 0.5 percentage points, to 1.75%, at this meeting.

The MPC will take the actions necessary to return inflation to the 2% target sustainably in the medium term, in line with its remit. Policy is not on a pre-set path. The Committee will, as always, consider and decide the appropriate level of Bank Rate at each meeting. The scale, pace and timing of any further changes in Bank Rate will reflect the Committee’s assessment of the economic outlook and inflationary pressures. The Committee will be particularly alert to indications of more persistent inflationary pressures, and will if necessary act forcefully in response.

In the minutes of its May 2022 meeting, the Committee asked Bank staff to work on a strategy for selling UK government bonds (gilts) held in the Asset Purchase Facility and committed to providing an update at its August meeting. Based on this analysis, the Committee is provisionally minded to commence gilt sales shortly after its September meeting, subject to economic and market conditions being judged appropriate and to a confirmatory vote at that meeting.

1: The economic outlook

1.1: The conditioning assumptions underlying the MPC’s baseline projections

In line with the Committee’s conventions, the baseline projections are conditioned on:

• The paths for policy rates implied by financial markets. Since the May Report, interest rates have increased materially in a number of advanced economies (Chart 2.7). In the UK, the market-implied path for Bank Rate, as captured in the 15-day average of forward interest rates to 26 July, was consistent with Bank Rate reaching 3.0% in 2023 Q2, 50 basis points higher than in May, before falling back to 2.2% by the end of the projection.
• A broadly flat path for the sterling effective exchange rate that is around 3% lower than in May (Table 1.C and Section 2.1).
• Fiscal policy evolving in line with announced Government policies to date. The most recent of these was the May Cost of Living Support package. Bank staff estimate that this will raise the level of GDP by a peak of around ½% in 2022 Q4 and 2023 Q1 before fading (Section 2.2). Fiscal policy as a whole tightens over the projection.
• Wholesale energy prices following their respective futures curves for the first six months of the projection and then remaining constant (Table 1.C). Based on the 15-day average to 26 July, gas futures prices for end-2022 have nearly doubled since the May Report (Chart 2.15) and are almost seven times higher than implied by futures curves a year ago. The recent sharp increases in gas prices are mostly due to Russia’s restrictions on its supply of gas to Europe and the risk of further curbs. Higher gas prices have also led to a sharp pickup in wholesale electricity prices, which have almost trebled relative to a year earlier. Gas prices have continued to be highly volatile and have risen above the 15-day average recently.
• Household energy prices evolving in line with estimates of the Ofgem price cap. Bank staff estimate that Ofgem will raise its retail energy price cap by around 75% in October, compared to the assumption of around 40% in the May Report. That would increase the typical annual household fuel bill from just under £2,000 to around £3,500, three times higher than a year earlier. That is overwhelmingly due to the very substantial rise in wholesale gas futures prices since the cap was last reset in April. To a much lesser extent, it reflects Ofgem’s announced changes to the method for updating the cap, which were shared with the Bank in advance of publication. These changes include putting more weight on the most recent sharp increases in wholesale gas prices. The switch to resetting the cap on a quarterly, rather than semi-annual basis, will only start to affect the price cap from next year.
• Oil prices following their respective futures curves for the first six months of the projection and then remaining constant. Sterling oil prices have fallen since mid-June, reflecting the weaker outlook for global activity, but are almost double their level a year earlier.
• Non-energy commodity prices following their respective futures curves for the first six months and beyond that remaining constant. A wide range of non-energy commodity prices, for example agricultural commodities and metals, have fallen since the May Report, partly reflecting the weaker outlook for global activity.

1.2: Key judgements and risks

Key judgement 1: in the baseline forecast, persistently high gas and other commodity prices continue to put upward pressure on global consumer price inflation and depress global growth in the near term before their effects gradually dissipate.

Inflationary pressures in the UK and the rest of Europe have intensified significantly overall since the May Report, despite the recent falls in oil and non-energy commodity prices, and growth prospects have weakened materially. This reflects the further very sharp increase in wholesale gas prices, due to Russia’s restrictions on its supply of gas to Europe and the risk of further curbs (Section 1.1).

Sustained disruption to global supply chains, and the shift in global demand towards durable goods and away from services, have continued to put significant upward pressure on tradable goods prices. Bank staff estimate that on a UK-weighted basis, four-quarter world export price inflation, including energy, rose to 16% in 2022 Q2. This in turn has boosted consumer price inflation substantially in many countries.

But four-quarter world export price inflation is projected to fall sharply over the next year and turn negative in mid-2023. This is largely due to the recent stabilisation of many commodity prices. It also reflects the Committee’s expectations that global tradable goods prices will start to fall back. That is due to two main factors. The first is that supply chain disruption is assumed to start to ease from Q4 this year, consistent with intelligence from the Bank’s Agents (Box C). Second, global demand is expected to continue to shift away from durable goods to services, particularly in the US.

Russia’s invasion of Ukraine is significantly adversely affecting world activity. The recent tightening in financial conditions also weighs on global activity over the forecast period, though to a much lesser extent (Section 2.1). As a result, in the MPC’s baseline forecast, annual UK-weighted world GDP growth is projected to slow from 5½% in 2021 to 2½% in 2022, 1% in 2023 and 1½% in 2024, below pre-pandemic rates (Table 1.E). This weighs materially on the demand for UK exports, in addition to the adverse direct impact on UK real incomes and spending from higher global energy and tradable goods prices.

There are considerable risks around the projections for global inflation and activity, which largely depend on how current geopolitical tensions evolve.

An upside risk to world prices is that the disruption to the supply of gas from Russia to Europe is even greater than embodied in the Committee’s assumed path for gas prices in the baseline forecast.

An associated risk is that the available supply of other commodities, for example agricultural products and tradable goods, is hampered by more than assumed. That could stem from developments around Russia’s invasion of Ukraine, or if new restrictions are introduced to contain Covid.

Higher commodity and tradable goods prices would put more upward pressure on global consumer price inflation and further restrain global activity. The latter would be exacerbated if accompanied by a further tightening in global financial conditions.

A risk not explicitly captured by the baseline projection for CPI inflation is that the weight of energy prices in the CPI basket is likely to rise over the forecast period, given the large increase in the share of energy spending over the past year. There is considerable uncertainty around how much the weight of energy may rise when the weights are next updated by the ONS in 2023 Q1, how much the weights of the other components of the CPI basket may change, and the overall impact these will have on CPI inflation. There are also uncertainties over how the ONS will treat some of the Government’s energy support measures in the calculation of the CPI, which could pose a downside risk. Overall, the Committee judges that there are upside risks to the CPI projection in the year from 2023 Q1. This risk fades thereafter.

There are also downside risks to world prices. One is that the supply of agricultural commodities is higher than expected following the recent agreement between Ukraine and Russia to resume Ukraine’s grain exports.

Disruption to the supply of commodities and tradable goods could also ease earlier and by a greater extent than assumed, for example if the geopolitical tensions are resolved more quickly or it is easier to substitute away from the affected commodities and tradable goods. This would be consistent with the recent falls in some indicators of supply chain disruption, such as delivery times and some shipping rates, persisting or falling further (Section 2.1).

Box A sets out an alternative projection in which energy prices follow their downward-sloping futures curves throughout the forecast period. In view of the exceptional level of uncertainty, the Committee puts more weight than it normally would on such an alternative projection.

Lower commodity and tradable goods prices would put downward pressure on global consumer price inflation and boost global activity.

Key judgement 2: given the sharp decline in household real incomes, consumer spending falls over the next year and the UK economy enters recession. Consumption falls by less than income, however, as households, in aggregate, reduce their saving. GDP growth is weak thereafter, even though the pressures on real incomes ease somewhat.

Bank staff estimate that underlying quarterly UK GDP growth slowed from 0.9% in 2022 Q1 to 0.5% in 2022 Q2. It is expected to slow further to 0.2% in Q3. This reflects the adverse impact of the very sharp increases in energy, non-energy commodities and tradable goods prices on UK household real incomes and spending.

These pressures will intensify in October when the very large increases in wholesale energy prices feed through to households following the reset of the Ofgem price cap (Section 1.1). As a result, household real incomes are projected to fall further and sharply, and GDP is expected to decline by nearly 1% in 2022 Q4 (Chart 1.1). GDP is forecast to fall further in the subsequent four quarters, as real incomes continue to decline.

In the alternative projection in which energy prices follow their downward-sloping futures curves throughout the forecast period, the UK economy still enters recession, but activity is stronger in the second half of the forecast, as the pressures on real incomes ease to a greater extent. The peak-to-trough falls in output in the baseline and alternative projections are 2¼% and 1½% respectively.

In the baseline projection, calendar year GDP growth is -1½% in 2023 and -¼% in 2024 (Table 1.E). Four-quarter GDP growth picks up to around ½% by the end of the projection (Chart 1.2), as the pressures on household incomes ease somewhat, although GDP growth is well below pre-pandemic rates.

Chart 1.1: GDP projection based on market interest rate expectations, other policy measures as announced

Footnotes

• The fan charts depict the probability of various outcomes for GDP (in Chart 1.1) and GDP growth (in Chart 1.2). They have been conditioned on the assumptions in Table 1.A footnote (b). To the left of the shaded area, the distribution reflects uncertainty around revisions to the data over the past. To the right of the shaded area, the distribution reflects uncertainty over the evolution of GDP (in Chart 1.1) and GDP growth (in Chart 1.2) in the future. If economic circumstances identical to today’s were to prevail on 100 occasions, the MPC’s best collective judgement is that the mature estimate of GDP (in Chart 1.1) or GDP growth (in Chart 1.2) would lie within the darkest central band on only 30 of those occasions. The fan chart is constructed so that outturns are also expected to lie within each pair of the lighter aqua areas on 30 occasions. In any particular quarter of the forecast period, GDP or GDP growth is therefore expected to lie somewhere within the fan on 90 out of 100 occasions. And on the remaining 10 out of 100 occasions GDP or GDP growth can fall anywhere outside the aqua area of the fan chart. Over the forecast period, this has been depicted by the grey background. See the box on page 39 of the November 2007 Inflation Report for a fuller description of the fan chart and what it represents.

Chart 1.2: GDP growth projection based on market interest rate expectations, other policy measures as announced

Footnotes

• See footnote for Chart 1.1.

Real post-tax household income is projected to fall by 1½% in 2022 (Table 1.E), despite the near-term support from fiscal policy (Section 2.2) and the resilience of the labour market (Section 3). Thereafter, it is projected to fall by 2¼% in 2023 before rising by ¾% in 2024.

The Committee continues to assume that some households absorb part of the fall in their real incomes by saving less of their current income or by spending some of their stock of savings. Consistent with this, a quarter of respondents to a recent ONS survey, who are facing a rise in the cost of living, expect to use their savings to support their consumption (Section 2.2). As a result, consumption falls by a little less than household income over the next 18 months. Calendar year household spending growth is -¾% in 2023 before picking up to 1% in 2024. The household saving rate is therefore forecast to decline from 5% in 2022 Q3 to 3½% at the end of next year, lower than its average in the decade preceding the pandemic of 7½% (Table 1.E). It then rises to 4¾% by the end of the projection as households increase their precautionary saving given the projected increase in unemployment (Key judgement 3).

Business investment growth picks up in the near term, as some spending is expected to be brought forward in response to the Government’s capital allowance super-deduction. This masks more underlying weakness, as capital spending is held back over the projection by elevated uncertainty, the weakness in overall demand, the sharp increases in firms’ costs, and the rising path for Bank Rate in the MPC’s conditioning assumption. Business investment growth is negative in years two and three of the forecast period.

Lower UK demand growth over the projection also reflects the slowing in the world economy (Key judgement 1) and the tightening in fiscal and monetary policy, which both evolve in line with their conditioning assumptions (Section 1.1).

In projections conditioned on the alternative assumption of constant interest rates at 1.75%, activity is stronger than in the MPC’s forecasts conditioned on market rates. The UK economy still enters recession, however, as the main driver of the contraction in output is the sharp fall in real incomes.

The risks around the projection for GDP growth in the baseline projection are judged to be balanced.

It is notable that measures of business sentiment, although weaker than at the time of the May Report, remain consistent with activity continuing to grow. This might suggest greater momentum in demand than the MPC is assuming.

Consumer spending could be stronger than projected if the labour market is more resilient (Key judgement 3) or energy prices are lower than assumed in the Committee’s baseline projection (Box A). Both might encourage households to spend more of the additional savings they have accumulated, in aggregate, during the pandemic.

Demand growth could slow by more than expected if households cut back their spending more aggressively in the face of the very significant falls in their real incomes. The stock of savings accumulated by households, in aggregate, during the pandemic should support some households’ ability to smooth consumption temporarily as real incomes decline. But the rise in savings during the pandemic has not occurred evenly – it is more marked among higher-income households – so not everyone may be in a position to do this. Energy and food bills form a larger share of lower-income households’ spending, so their ability to use savings to support their consumption may be limited.

In addition, and even for higher-income households, the deterioration in the economic outlook may increase households’ uncertainty about the future by more than assumed, leading them to increase their precautionary saving and lower their spending further. Higher uncertainty would also tend to lower capital spending by firms.

Key judgement 3: given elevated recruitment difficulties and strong labour demand, firms respond initially to the weakness in spending by using their existing inputs less intensively. So although economic slack emerges in 2022 Q4, the labour market remains tight over the next year and unemployment only starts to rise above its current level in mid-2023. It reaches 6¼% at the end of the forecast period, with slack building to 3¾% of potential GDP.

Most indicators suggest that there is currently a margin of excess demand across the economy as a whole (Table 1.A). Many surveys suggest above-average levels of capacity utilisation. The labour market is tight, with the unemployment rate of 3.8% in the three months to May. That is an historically low level and below the MPC’s assessment of the medium-term equilibrium rate of unemployment of just above 4%. Firms continue to report significant recruitment difficulties and vacancies remain very high (Section 3). The vacancy to unemployment ratio, a measure of labour market tightness, remains elevated, with the stock of vacancies now broadly equal to the stock of unemployed people.

The tightness of the labour market partly reflects the fall in the labour force since the start of the pandemic, and the larger decline relative to its pre-Covid trend, which are in part due to an increase in the number of people with long-term health conditions. The tight labour market also reflects strong labour demand, which is above pre-pandemic levels (Section 3).

The Committee judges that the labour market is currently tighter than previously thought. In particular, it has assumed that the ratio of vacancies to unemployment is giving a better real-time indication of the balance between the demand for and supply of labour than the gap between unemployment and the medium-term equilibrium rate of unemployment (Section 3). The ratio of vacancies to unemployment implies a greater degree of labour market tightness and more upward pressure on wage growth.

Given the intensity of recruitment difficulties amid strong labour demand, firms are expected to respond initially to the weakness in demand by using their existing inputs less intensively. So although economic slack begins to emerge in 2022 Q4, the labour market is expected to remain tight over the next year. This is consistent with the Agents’ latest employment and pay survey.

Unemployment rises from its current level from mid-2023 to 6¼% at the end of the forecast period (Chart 1.3), given the very weak outlook for demand growth. Economic slack rises to 3¾% of potential GDP (Table 1.A).

Chart 1.3: Unemployment projection based on market interest rate expectations, other policy measures as announced

Footnotes

• The fan chart depicts the probability of various outcomes for LFS unemployment. It has been conditioned on the assumptions in Table 1.A footnote (b). The coloured bands have the same interpretation as in Charts 1.1 and 1.2, and portray 90% of the probability distribution. The calibration of this fan chart takes account of the likely path dependency of the economy, where, for example, it is judged that shocks to unemployment in one quarter will continue to have some effect on unemployment in successive quarters. The fan begins in 2022 Q2, a quarter earlier than for CPI inflation. That is because Q2 is a staff projection for the unemployment rate, based in part on data for April and May. The unemployment rate was 3.8% in the three months to May, and is projected to be 3.8% in Q2 as a whole. A significant proportion of this distribution lies below Bank staff’s current estimate of the long-term equilibrium unemployment rate. There is therefore uncertainty about the precise calibration of this fan chart.

In the alternative projection in which energy prices follow their downward-sloping futures curves throughout the forecast period, unemployment and economic slack do not rise by as much as in the baseline projection, given the less weak path of activity (Table 1.B).In projections conditioned on the alternative assumption of constant interest rates at 1.75%, unemployment rises by around ¾ percentage point less than in the MPC’s forecast conditional on market rates.

The risks around unemployment in the baseline projection are judged to be balanced.

The labour market may remain tighter for longer than assumed for a number of reasons (Section 3). If the current tightness in the labour market reflects much more labour being demanded now than is available, there may be room for labour demand to fall for longer before leading to a rise in unemployment. Labour hoarding as demand softens would also prolong the tightness in the labour market. Moreover, the Agents’ employment and pay survey suggests that firms expect employment growth over the next year to be similar to that over the past 12 months. If that transpired, other things equal, the unemployment rate would fall and the labour market would tighten further.

Alternatively, more of the fall in participation rates during the pandemic could prove to be persistent. For example, the share of people with long-term health conditions and the likelihood they participate in the labour market may not return to previous trends or people may continue to retire earlier than expected.

Another risk is that the acute recruitment difficulties firms are facing reflect some frictions in the matching of workers and jobs and have been accompanied by a rise in the medium-term equilibrium rate of unemployment.

The labour market could also loosen more rapidly than assumed. Some recruiters have started to report that greater economic uncertainty is causing some firms to delay hiring decisions. Staff placements in the June KPMG/REC UK Report on Jobs fell back notably, although candidate shortages were also reported to be a factor behind that. The Covid-related factors weighing on participation could also unwind faster than assumed in the baseline projections if, for example, the very recent decline in inactivity continues at the same pace over the coming months. Labour supply growth could also be affected by how households respond to the fall in their real incomes. Households may seek to boost their real incomes through working more, which could involve those currently inactive re-entering the labour market or those already in the labour force seeking to work longer hours.

Key judgement 4: domestic price pressures remain strong over the first half of the forecast, as nominal wage growth strengthens and many companies are able to protect their margins. But the building degree of economic slack moderates these forces and inflation expectations adjust downwards quickly as external pressures abate and inflation itself begins to fall. Domestic pressures therefore fade and, conditioned on the market yield curve, inflation is around the 2% target in two years’ time and well below it in three years.

CPI inflation is expected to rise further and peak at just over 13% in 2022 Q4 (Chart 1.4). That is 3 percentage points higher than forecast in the May Report. This overwhelmingly reflects the sharp increase in gas futures prices since May, due to Russia restricting the supply of gas to Europe and the risk of further curbs. To a lesser extent, it reflects the changes Ofgem have announced to their method for updating the household energy price cap (Section 1.1).

Chart 1.4: CPI inflation projection based on market interest rate expectations, other policy measures as announced

Footnotes

• The fan chart depicts the probability of various outcomes for CPI inflation in the future. It has been conditioned on the assumptions in Table 1.A footnote (b). If economic circumstances identical to today’s were to prevail on 100 occasions, the MPC’s best collective judgement is that inflation in any particular quarter would lie within the darkest central band on only 30 of those occasions. The fan chart is constructed so that outturns of inflation are also expected to lie within each pair of the lighter orange areas on 30 occasions. In any particular quarter of the forecast period, inflation is therefore expected to lie somewhere within the fans on 90 out of 100 occasions. And on the remaining 10 out of 100 occasions inflation can fall anywhere outside the orange area of the fan chart. Over the forecast period, this has been depicted by the grey background. See the box on pages 48–49 of the May 2002 Inflation Report for a fuller description of the fan chart and what it represents.

The direct contribution of energy prices to CPI inflation alone is expected to peak at 6½ percentage points in 2022 Q4 (Chart 1.5). That is substantially higher than in the Committee’s forecasts over the past year, given the successive very sharp increases in global energy prices over this period. Together with higher indirect effects from energy prices, which can affect both goods and services prices, this accounts for most of the much higher outlook for CPI inflation over the first half of the forecast since May.

Chart 1.5: The direct contribution of energy prices to CPI inflation ^(a)

Footnotes

• (a) Energy prices include fuels and lubricants, electricity, gas and other fuels.

Though responsible for much less of the rise in headline inflation, domestic inflationary pressures have also increased and are projected to be a little stronger than previously expected. In particular, it appears that the labour market is currently tighter than the Committee previously assumed (Key judgement 3). Together with a little more upward pressure on pay from higher price inflation, nominal private sector regular pay growth rises by more than in May over the first half of the forecast. This is broadly consistent with the Agents’ survey on employment and pay, which suggests that firms expect pay settlements to average 6% over the next year, higher than the equivalent survey set out in the February Report (Section 2.3). As a result, CPI inflation is a little higher throughout the projection from this judgement.

Evidence from the Agents’ contacts and the DMP Survey suggests that firms generally expect to increase their selling prices markedly, following the sharp rises in their costs, with many seeking to protect their margins. Partly as a result, CPI services price inflation is expected to rise further in the near term.

In the baseline projection, after the expected peak in 2022 Q4, the upward pressure on CPI inflation is expected to dissipate, as global commodity prices are assumed to rise no further, and tradable goods price inflation falls back. Domestic inflationary pressures subside given the building significant degree of economic slack and as inflation expectations are assumed to adjust down quickly as inflation itself falls back.

CPI inflation is projected to fall to 9.5% in a year’s time (Table 1.D) as fading external factors outweigh rising domestic pressures. Inflation then falls sharply to the 2% target in two years’ time, when the direct contribution of energy to CPI inflation is projected to have fallen to zero (Chart 1.5) and domestic factors subside. CPI inflation falls to 0.8% in three years’ time, well below the target, as domestic pressures weaken further.

In the alternative projection in which energy prices follow their downward-sloping futures curves throughout the forecast period, CPI inflation would be around 1 percentage point and ½ percentage point lower at the year two and three points respectively than in the baseline projection (Table 1.B and Box A). That reflects the contribution from energy prices to CPI inflation turning negative at those horizons (Chart 1.5).In projections conditioned on the alternative assumption of constant interest rates at 1.75%, CPI inflation is projected to be 2.5% and 1.3% in two years’ and three years’ time respectively, ½ percentage point higher than in the Committee’s forecast conditioned on market rates (Chart 1.6).

Chart 1.6: CPI inflation projection based on constant interest rates at 1.75%, other policy measures as announced

Footnotes

• This fan chart depicts the probability of various outcomes for CPI inflation in the future, conditioned on the assumptions in Table 1.A footnote (b), apart from for Bank Rate, with this chart conditioned on constant interest rates at 1.75%. The fan chart has the same interpretation as Chart 1.4.

The risks around the inflation projection from domestic factors in the baseline projection are judged to be balanced.

There are significant risks around the central projection for CPI inflation from both global factors, most notably gas prices (Key judgement 1), domestic inflationary pressures, and the interactions between them (Key judgement 4).

Box A sets out the risks from domestic factors and a scenario in which domestic price setting is more persistent than in the MPC’s baseline projection. In that scenario, CPI inflation takes longer to return to the 2% target.

Overall, the Committee judges that the risks around CPI inflation in the baseline projection are to the upside at year one, given the expected, but highly uncertain, increase in the weight of energy prices in the CPI basket that is not explicitly captured in the forecast (Key judgement 1). The risks are judged to be balanced thereafter.

1.3: Comparison of the baseline projections with the May Report forecasts

The level of UK GDP is projected to be 2¾% lower than in the May Report by the end of the forecast period. That largely reflects the adverse impact on UK and world activity of the further sharp increases in wholesale gas prices, and to a much lesser extent, the impact of the higher market paths for interest rates. The measures contained in the Government’s May Cost of Living Support package partly offset these (Section 2.2).

Excess demand is a little higher at the start of the forecast than assumed in May (Table 1.A), reflecting a judgement that the labour market is tighter than previously assumed (Key judgement 3 and Section 3). Given the much weaker outlook for demand, economic slack increases by more thereafter, ending the forecast at 3¾% of potential GDP, 1½ percentage points greater than in May. Unemployment stays close to its current historically low level up to 2023 Q1, consistent with the Agents’ employment and pay survey (Box C and Section 3). It rises to 6¼% at year three, compared with 5½% in May.

Nominal private sector regular wage growth is expected to be higher than in the May projection over the first half of the forecast, reflecting a judgement that the labour market is tighter than previously assumed (Key judgements 3 and 4).

CPI inflation is expected to rise further and peak at just over 13% in 2022 Q4. That is much higher than forecast in May. This overwhelmingly reflects the sharp increase in gas futures prices since May, due to Russia restricting the supply of gas to Europe and the risk of further curbs. To a much lesser extent, it reflects Ofgem’s announced changes for updating the household energy price cap (Section 1.1). Together with higher indirect effects from energy prices, this accounts for most of the much higher outlook for CPI inflation over the first half of the forecast.

At the year two point, CPI inflation is similar to May, as the judgement to raise the profile for wage growth (Key judgement 4) is offset by the greater degree of economic slack. As economic slack builds by much more than in May, CPI inflation is around ½ percentage point lower at the end of the forecast period.

2: Current economic conditions

Chart 2.1: GDP growth is expected to pick up in Q3, unemployment is projected to remain broadly flat, and inflation is expected to rise further

Near-term projections ^(a)

Footnotes

• Sources: ONS and Bank calculations.
• (a) The lighter diamonds show Bank staff’s projections at the time of the May 2022 Monetary Policy Report. The darker diamonds show Bank staff’s current projections. Projections for GDP and the unemployment rate are quarterly and show Q2 and Q3 (May projections show Q1 and Q2). Projections for CPI inflation are monthly and show July to September (May projections show April to June). GDP and unemployment rate 2022 Q2 projections are based on official data to May. CPI inflation figure is an outturn.

2.1: Global developments and financial conditions

Global GDP growth has been slowing, and is expected to remain weak in the near term.

Global GDP growth has been slowing since the middle of last year (Chart 2.2). The level of UK-weighted world GDP is expected to have been broadly unchanged in 2022 Q2, following growth of 0.3% in Q1. Growth is projected to remain weak in Q3. While global growth has slowed, recent outturns and the near-term projection are broadly in line with expectations in the May Report. The projection further out is notably weaker than in May, however, reflecting the higher current and forward prices for energy and, to a lesser extent, tighter financial conditions (Section 1).

In the euro area, GDP increased by 0.7% in Q2 according to the flash estimate, up from a 0.5% increase in Q1, but still much weaker than growth outturns in mid-2021. The slowdown partly reflects materially higher energy and food prices, partly driven by the war in Ukraine (Box B of the May 2022 Report), which weighed on household real incomes and consumer spending. The war and supply chain disruption have also pushed up tradable goods prices. These adverse supply shocks, which are also hitting the UK economy, are expected to continue to drag on growth. In the July releases, euro-area consumer confidence declined sharply to a new record low, and the flash S&P Global PMI fell into contractionary territory.

In the United States, GDP fell in Q2, the second consecutive quarter of negative growth. While the fall was mainly driven by lower stockbuilding, domestic demand growth also slowed. In response to rising domestic inflationary pressures, which appear stronger than in the euro area (Chart D, Box E), the FOMC has tightened monetary policy markedly. Financial conditions have tightened as a result, and that is expected to weigh on activity.

Chart 2.2: Global GDP growth has been slowing since the middle of last year

UK-weighted world GDP growth ^(a)

Footnotes

• Sources: Refinitiv Eikon from LSEG and Bank calculations.
• (a) See footnote (c) of Table 1.E for definition. Figures for 2022 Q2 and Q3 are Bank staff projections. These projections do not include the Advance Estimate of US 2022 Q2 GDP and the Preliminary Flash Estimate of euro-area 2022 Q2 GDP which were released after the data cut-off.

In China, quarterly GDP growth was negative in Q2, following strict regional restrictions on activity imposed in response to Covid-19 outbreaks. But growth is expected to rebound in Q3 owing to policy support measures and the lifting of restrictions. This contributes to the small pickup in quarterly UK-weighted global growth expected in Q3 (Chart 2.2).

Labour markets remain tight, putting upward pressure on nominal wage growth.

Labour markets have been tightening across the US, euro area and the UK for some time, and they remained tight in the most recent data. That tightness is particularly apparent in the UK (Section 3) and the US, where unemployment rates are low (left panel of Chart 2.3). In the euro area, the unemployment rate is higher, but it still fell to a new record low of 6.6% in May.

Tight labour markets have probably contributed to the pickup in measures of wage growth across the UK, US and euro area. Wage growth has increased most notably in the US and UK (right panel of Chart 2.3), and may explain why services inflation in these countries is stronger (Chart D, Box E). Euro-area negotiated wage growth remains much lower, despite an increase in the latest data.

Chart 2.3: Labour markets remain tight in advanced economies, particularly in the US and UK, which has pushed wage growth up

Unemployment rates and annual nominal wage growth in the UK, US and euro area ^(a)

Footnotes

• Sources: Bureau of Labor Statistics, ECB, Eurostat, ONS, Refinitiv Eikon from LSEG and Bank calculations.
• (a) Unemployment rates are monthly data to May in the UK and euro area, and to June in the US. Wage measures are monthly US average hourly earnings to June, monthly UK underlying pay growth, using Bank staff estimates to adjust private sector regular pay growth for furlough and compositional effects, to May, and quarterly euro-area negotiated wages to 2022 Q1. The diamond shows the Bank staff projection for UK underlying pay growth in June 2022.

Global inflation remains elevated.

Inflation rates remain elevated in many countries. Box E compares the drivers of the rise in consumer price inflation across the US, the euro area and the UK. Global factors, such as the rise in commodity prices, and the impact of bottlenecks on tradable goods prices, have played an important role.

Since May, European spot natural gas prices have risen by around 70% (Chart 2.4), as flows of natural gas from Russia have fallen and amid heightened concerns that supply will remain restricted in coming months. Europe has made up for some of the shortfall in Russian supply through alternative sources. However, there are concerns that supply from these alternative sources may be difficult to increase much further if Russian supply continues to fall.

Chart 2.4: European wholesale gas prices have risen by around 70% since the May Report

International wholesale gas prices ^(a)

Footnotes

• Sources: Bloomberg Finance L.P. and Bank calculations.
• (a) Daily data to 26 July. The Dutch Title Transfer Facility pricing point is used for the European price. European spot gas prices have risen by substantially more than in the US reflecting the segmentation of the global gas market.

By contrast, other commodity prices have started to decline. Oil prices have fallen since the middle of June (Chart 2.5). Models estimated by Bank staff suggest that this reflects weaker prospective demand. Reflecting similar drivers, industrial metals prices have fallen back by almost 30% since the May Report (Chart 2.5). Agricultural goods prices have fallen by almost 20% as supply has increased in regions outside Russia and Ukraine, and as fears of restricted Ukrainian supply have abated somewhat.

Chart 2.5: Oil, agricultural and metals prices have fallen back

US dollar commodity prices ^(a)

Footnotes

• Sources: Bloomberg Finance L.P., Refinitiv Eikon from LSEG, S&P indices and Bank calculations.
• (a) Daily data to 26 July. Calculated using S&P GSCI US dollar commodity price indices, the ‘Agricultural goods’ series is based on the total agricultural and livestock S&P Commodity Index and the ‘Oil’ series is based on US dollar Brent forward prices for delivery in 10–25 days’ time.

The latest indicators are consistent with continuing supply chain disruption, partly reflecting the lockdowns in China and the war in Ukraine. An indicator of global supply constraints, derived from PMIs such as delivery times and stocks of finished goods, remains elevated (Chart 2.6).

There are some tentative signs that global supply bottlenecks are starting to ease, however. In June, supply constraints in China loosened (Chart 2.6) and PMI manufacturing delivery times fell back across regions. Moreover, some indicators of shipping costs, such as the Baltic Dry Index and the Freightos Baltic Container Index, have fallen back from their peaks. And there are some signs of a gradual slowdown in US goods consumption.

In the MPC’s baseline projection, higher gas prices and upward pressure from global bottlenecks are expected to keep global inflationary pressures strong in the near term. As these pressures then fade, four-quarter world export price growth is projected to fall sharply over the next year (Section 1).

Chart 2.6: Indicators of supply chain constraints point to continuing disruption, although supply constraints in China have eased

Indicators of supply constraints ^(a)

Footnotes

• Sources: IHS Markit, JPMorgan, Refinitiv Eikon from LSEG and Bank calculations.
• (a) Indicators are estimated by Bank staff using principal component analysis on a range of PMIs for supply constraints in the manufacturing sector (supplier delivery times, stocks of purchases, stocks of finished goods, input prices and backlogs of work). Before principal components are estimated, these indicators are regressed on the new orders PMI to control for movements in demand. Latest data are for June 2022.

Many central banks have tightened monetary policy since May, including a large increase in US policy rates…

Many central banks have continued to tighten monetary policy. In the US, the FOMC increased the target range for the federal funds rate by 75 basis points in both June and July to 2.25%–2.50%, following a 50 basis points rise in May. These were the largest increases in a single meeting since 1994. At its June meeting, the ECB Governing Council announced an end to its net asset purchases as of 1 July 2022 and, at its July meeting, it increased its key interest rates by 50 basis points, the first rate rises since 2011. In June, the MPC voted to increase Bank Rate for the fifth consecutive meeting, by 25 basis points, to 1.25%.

…and market pricing implies that policy rates will rise further in the near term.

Market-implied expectations for policy rates have risen since the May Report (Chart 2.7). The market-implied path in the euro area over the next three years is 25 basis points higher on average than in the run up to the May Report, rising to 1.5% in 2025. The market-implied path for policy rates in the US continues to embody a sharp rise in rates in the near term to a peak of 3.5% in 2023. It then falls to around 2.5% at the three-year horizon.

Chart 2.7: Financial markets are pricing further increases in policy rates

International forward interest rates ^(a)

Footnotes

• Sources: Bloomberg Finance L.P. and Bank calculations.
• (a) All data as of 26 July 2022 except for ECB deposit rate and Federal funds rate which are to 27 July 2022. The August and May curves are estimated using instantaneous forward overnight swap rates in the 15 working days to 26 July 2022 and 26 April 2022 respectively. Federal funds rate is the upper bound of the target range.

In the UK, the market-implied path rises to a peak of 3.0% in 2023 Q2. As in the US, the market curve is then downward sloping further out. On average, the market path is around 30 basis points higher over the next three years than in the run-up to the May Report.

The path for Bank Rate implied by the latest Market Participants Survey remains lower than the market curve. The median central expectation of the peak level is 2.5%, 50 basis points higher than in May. Survey respondents attributed the gap, in part, to the balance of risks being skewed towards a higher path for Bank Rate (Rosen (2022)), particularly at the short end of the curve.

Medium-term measures of inflation expectations derived from financial markets have fallen back.

Medium-term measures of inflation expectations derived from financial markets have fallen since the May Report in the UK, US and euro area (Chart 2.8). That may reflect the weaker global growth outlook and lower prices for some commodities. It may also reflect tighter monetary policy and expectations of further rate rises in the near term (Chart 2.7). These measures remain above their 2010–19 averages in the UK and euro area, but in the US they have fallen a little below.