in the UK has begun to fall, the economy is growing and unemployment is low.
But inflation is still too high. In June, prices were 7.9% higher than a year ago, well above our target of 2%.
As the UK’s central bank, an independent body, our job is to keep price rises in the UK low and steady. The best way we can make sure inflation comes down and stays down is to raise interest rates. So that’s what we’re doing.
We’ve raised our interest rate to 5.25% this month.
Higher mean higher costs for some people. We know that is not easy when there is already a lot of pressure on their finances.
But if we don’t raise interest rates now, high inflation could stay with us for longer. That hits everyone, particularly those who can least afford it.
We expect inflation to fall further to around 5% this year and meet our 2% target by early 2025. That means prices would still be rising, but they would be only rising gradually.
Inflation is falling, but it is still too high
Inflation in the UK has begun to fall. In June, prices were 7.9% higher than a year ago. That is down from 11.1% last October. One of the main reasons for this fall is that energy prices have stopped rising.
But inflation is still too high. It is well above our target of 2%.
High inflation has been caused by a series of big shocks.
The first shock was the Covid pandemic. While people had to stay at home, they started to buy more goods rather than services. But the people selling these goods have had problems getting enough of them to sell to customers. That led to higher prices – particularly for goods imported from abroad.
The second shock was Russia’s invasion of Ukraine, which led to large increases in the price of gas. It also pushed up the price of food. Poor harvests in other countries made the situation worse. Food prices in June were 17% higher than a year ago.
The third shock was a big fall in the number of people available to work. That was linked to the Covid pandemic. It’s meant that employers have had to offer higher wages to attract job applicants. Many businesses have had to increase their prices to cover those costs. That includes firms in the services sector, where wages are the largest part of businesses costs.
High inflation affects everyone, but it particularly hurts those who can least afford it.
We are focused on bringing inflation back down to our 2% target and keeping it there.
Inflation is falling, but it is still too high
We’ve raised interest rates to make sure inflation keeps on falling and stays low
Our job is to make sure that inflation returns to our 2% target. The best way we can make sure inflation comes down and stays down is to raise interest rates on mortgages, loans and savings.
Today we have raised interest rates to 5.25%.
In total, we have raised our interest rate to 5.25% from 0.1% since December 2021.
Higher interest rates make it more expensive for people to borrow money and encourage them to save. That means that, overall, they will tend to spend less. If people on the whole spend less on goods and services, prices will tend to rise more slowly. That lowers the rate of inflation.
We know that means that many people will face higher borrowing costs. Around one in three households in the UK have a mortgage. But high inflation that lasts for a long time makes things worse for everyone, particularly those who can least afford it.
We have raised interest rates to help inflation return to our 2% target
We expect inflation to fall markedly further this year and meet our 2% target by early 2025
We expect inflation to fall further, to around 5% by the end of this year.
The prices of some things such as food are likely to rise faster than this. But energy bills should come down more as gas prices have fallen a lot recently.
Higher interest rates will help to reduce the demand for goods and services in the economy. And this will help slow the rate of inflation down further.
We expect inflation to keep falling next year and meet our 2% target by early 2025.
That means prices would still be rising, but they would be only rising gradually.
We expect inflation to fall further this year and meet our 2% target by early 2025
Monetary Policy Report
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 2 August 2023, the MPC voted by a majority of 6–3 to increase Bank Rate by 0.25 percentage points, to 5.25%. Two members preferred to increase Bank Rate by 0.5 percentage points, to 5.5%, and one member preferred to maintain Bank Rate at 5%.
The Committee’s updated projections for activity and inflation are set out in the accompanying August Monetary Policy Report. These are conditioned on a market-implied path for Bank Rate that rises to a peak of just over 6% and averages just under 5½% over the three-year forecast period, compared with an average of just over 4% for the equivalent period at the time of the May Report. The sterling effective exchange rate is around 4% higher than in the May Report.
Underlying quarterly GDP growth has been around 0.2% during the first half of this year. Bank staff expect a similar growth rate in the near term, reflecting more resilient household income and retail sales volumes, and most business surveys over recent months. Some more recent indicators show signs of weakening, however, including the July S&P Global/CIPS UK composite PMI.
The labour market remains tight but there are some indications that it is loosening. The LFS unemployment rate rose to 4.0% in the three months to May, somewhat higher than expected in the May Report, and the vacancies to unemployment ratio has continued to fall, although the latter still remains above historical averages.
Annual private sector regular pay growth increased to 7.7% in the three months to May, materially above expectations at the time of the May Report, and three-month on three-month growth in this measure of pay has picked up further. Earnings growth is nevertheless expected to decline in coming quarters, to around 6% by the end of this year, although there is uncertainty around this near-term outlook.
Twelve-month CPI inflation fell from 8.7% in May to 7.9% in June, lower than expected at the time of the Committee’s previous meeting. Within this, core goods and services CPI inflation were both lower than expected, although the downside news in the latter, which is more likely to be informative about persistent inflationary pressures, was much smaller. Compared to the May Report projections, June CPI inflation was in line with expectations.
CPI inflation remains well above the 2% target. It is expected to fall significantly further, to around 5% by the end of the year, accounted for by lower energy, and to a lesser degree, food and core goods price inflation. Services price inflation, however, is projected to remain elevated at close to its current rate in the near term.
In the MPC’s August most likely, or modal, projection conditioned on market interest rates, CPI inflation returns to the 2% target by 2025 Q2. It then falls below the target in the medium term, as an increasing degree of economic slack reduces domestic inflationary pressures, alongside declining external cost pressures. The Committee has decided in this forecast to bring some of the upside risks to inflation from persistence into its modal projection, pushing up on this inflation projection in the medium term relative to the May Report.
The Committee continues to judge that risks around the modal inflation forecast are skewed to the upside, albeit by less than in May, reflecting the possibility that the second-round effects of external cost shocks on inflation in wages and domestic prices take longer to unwind than they did to emerge. Mean CPI inflation, which incorporates these risks, is 2.0% and 1.9% at the two and three-year horizons respectively.
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. Monetary policy will ensure that CPI inflation returns to the 2% target sustainably in the medium term.
Recent data outturns have been mixed. However, some key indicators, notably wage growth, suggest that some of the risks from more persistent inflationary pressures may have begun to crystallise. At this meeting, the Committee voted to increase Bank Rate by 0.25 percentage points, to 5.25%.
Given the significant increase in Bank Rate since the start of this tightening cycle, the current monetary policy stance is restrictive. The MPC will continue to monitor closely indications of persistent inflationary pressures and resilience in the economy as a whole, including the tightness of labour market conditions and the behaviour of wage growth and services price inflation. If there were to be evidence of more persistent pressures, then further tightening in monetary policy would be required. The MPC will ensure that Bank Rate is sufficiently restrictive for sufficiently long to return inflation to the 2% target sustainably in the medium term, in line with its remit.
1: The economic outlook
CPI inflation remains well above the 2% target, having fallen back to 7.9% in June in line with expectations in the May Monetary Policy Report. Both services and core goods CPI inflation have been stronger than expected, although news in the latter is in general less likely to imply persistent inflationary pressures. The Committee expects CPI inflation to continue to fall, to around 5% by the end of the year, owing to lower energy, and to a lesser degree, food and core goods price inflation. Annual private sector regular pay growth has increased further, to 7.7% in the three months to May, materially above expectations in the May Report. The near-term outlook for regular pay growth is uncertain, but the MPC expects it to decline to around 6% by the end of this year.
Sharp increases in energy, food and other import prices over the past two years have had second-round effects on domestic prices and wages. These second-round effects are likely to take longer to unwind than they did to emerge, and the MPC has placed weight in its recent forecasts on the risk that they might persist for longer. The Committee now judges that some of this risk may have begun to crystallise. As a result, the MPC has decided to bring some of the upside risks to inflation from persistence into its most likely, or modal, projection. In this forecast, and assuming Bank Rate follows the path implied by financial markets, an increasing degree of slack in the economy and declining external cost pressures lead CPI inflation to return to the 2% target by 2025 Q2 and to fall below target in the medium term, but to a lesser degree than projected in the May Report. The Committee continues to judge that the risks to the modal forecast are skewed to the upside, but by less than in May. Taking account of this skew, mean CPI inflation is 2.0% and 1.9% at the two and three-year horizons respectively.
Past increases in Bank Rate, and the higher path of market interest rates on which the forecast is conditioned, will weigh to an increasing degree on UK activity and inflation in coming quarters. GDP growth is expected to remain below pre-pandemic rates in the medium term, also reflecting relatively weak potential supply and a waning boost from fiscal policy. Relative to the May projection, quarterly GDP growth is expected to be weaker throughout much of the forecast period, particularly during 2024 and at the beginning of 2025.
The UK economy has been in excess demand over recent quarters, but an increasing degree of economic slack is expected to emerge after the middle of next year. The labour market remains tight but there are some indications that it is loosening. The LFS unemployment rate rose to 4.0% in the three months to May and the vacancies to unemployment ratio has been falling since mid-2022, although the latter still remains above its 2019 Q4 level. In the MPC’s August projection, the unemployment rate is projected to rise to just under 5% by 2026 Q3. Both aggregate spare capacity and unemployment increase by somewhat more in the Committee’s latest projections than in the May Report, reflecting the weaker path of GDP.
Table 1.A: Forecast summary (a) (b)
2023 Q3 | 2024 Q3 | 2025 Q3 | 2026 Q3 | |
|---|---|---|---|---|
GDP (c) | 0.8 (0.6) | 0.3 (0.6) | 0.3 (0.8) | 1.1 |
Modal CPI inflation (d) | 6.9 (7.0) | 2.8 (2.9) | 1.7 (1.0) | 1.5 |
Mean CPI inflation (d) | 6.9 (7.0) | 3.1 (3.7) | 2.0 (1.8) | 1.9 |
LFS unemployment rate | 4.1 (3.8) | 4.3 (3.9) | 4.8 (4.4) | 4.8 |
Excess supply/Excess demand (e) | ½ (0) | -½ (-¾) | -1¼ (-1) | -1½ |
Bank Rate (f) | 5.3 (4.7) | 6.0 (4.2) | 5.2 (3.7) | 4.5 |
Footnotes
- (a) Figures in parentheses show the corresponding projections in the May 2023 Monetary Policy Report.
- (b) Unless otherwise stated, the numbers shown in this table are modal projections and are conditioned on the assumptions described in Section 1.1. The main assumptions are set out in Monetary Policy Report – Download the chart slides and data – August 2023.
- (c) Four-quarter growth in real GDP.
- (d) Four-quarter inflation rate. The modal projection is the single most likely outcome. If the risks are symmetrically distributed around this central view, this will also provide a view of the average outcome or mean forecast. But when the risks are skewed, as in the current forecast, the mean projection will differ from the mode.
- (e) Per cent of potential GDP. A negative figure implies output is below potential and a positive that it is above.
- (f) Per cent. The path for Bank Rate implied by forward market interest rates. The curves are based on overnight index swap rates.
1.1: The conditioning assumptions underlying the MPC’s projections
As set out in Table 1.B, the MPC’s projections are conditioned on:
- The paths for policy rates implied by financial markets, as captured in the 15-working day average of forward interest rates to 25 July, which are higher than in the May Monetary Policy Report (Chart 2.3). In particular, the market-implied path for Bank Rate in the United Kingdom rises to a peak of just over 6% and averages just under 5½% over the next three years, compared with an average of just over 4% for the equivalent period at the time of the May Report.
- A path for the sterling effective exchange rate index that is around 3½% stronger on average than in the May Report, but is depreciating gradually over the forecast period given the role for expected interest rate differentials in the Committee’s conditioning assumption.
- Fiscal policy that evolves in line with announced government policies to date, including the most recent measures in the Spring Budget.
- Wholesale energy prices that follow their respective futures curves over the forecast period. Since May, gas and crude oil futures curves have moved slightly lower. Significant uncertainty remains around the outlook for wholesale energy prices.
- Household energy prices that, from 2023 Q3, move in line with Bank staff estimates of the Ofgem price cap implied by the path of wholesale energy prices (Section 2.6), having previously been determined by the Energy Price Guarantee.
Table 1.B: Conditioning assumptions (a) (b)
Average 1998–2007 | Average 2010–19 | Average 2020–21 | Average 2022 | 2023 | 2024 | 2025 | |
|---|---|---|---|---|---|---|---|
Bank Rate (c) | 5.0 | 0.5 | 0.1 | 2.8 | 5.8 (4.8) | 5.9 (4) | 5.0 (3.7) |
Sterling effective exchange rate (d) | 100 | 82 | 80 | 78 | 82 (79) | 81 (79) | 81 (78) |
Oil prices (e) | 39 | 78 | 62 | 88 | 79 (81) | 75 (76) | 72 (72) |
Gas prices (f) | 29 | 52 | 169 | 201 | 113 (137) | 139 (148) | 114 (123) |
Nominal government expenditure (g) | 7½ | 2¼ | 9 | 4¼ | 4 (4½) | 3 (2¾) | 1½ (1½) |
Footnotes
- Sources: Bank of England, Bloomberg Finance L.P., Office for Budget Responsibility (OBR), ONS, Refinitiv Eikon from LSEG and Bank calculations.
- (a) The table shows the projections for financial market prices, wholesale energy prices and government spending projections that are used as conditioning assumptions for the MPC’s projections for CPI inflation, GDP growth and the unemployment rate. Figures in parentheses show the corresponding projections in the May 2023 Monetary Policy Report.
- (b) Financial market data are based on averages in the 15 working days to 25 July 2023. Figures show the average level in Q4 of each year, unless otherwise stated.
- (c) Per cent. The path for Bank Rate implied by forward market interest rates. The curves are based on overnight index swap rates.
- (d) Index. January 2005 = 100. The convention is that the sterling exchange rate follows a path that is half way between the starting level of the sterling ERI and a path implied by interest rate differentials.
- (e) Dollars per barrel. Projection based on monthly Brent futures prices.
- (f) Pence per therm. Projection based on monthly natural gas futures prices.
- (g) Annual average growth rate. Nominal general government consumption and investment. Projections are based on the OBR’s March 2023 Economic and Fiscal Outlook. Historical data based on NMRP+D7QK.
1.2: Key judgements and risks
1.2: Key judgement 1
Past increases in Bank Rate, and the higher path of market interest rates on which the forecast is conditioned, weigh to an increasing degree on the UK economy in coming quarters. GDP growth remains below pre-pandemic rates in the medium term, also reflecting relatively weak potential supply and a waning boost from fiscal policy.
UK GDP is expected to have grown by 0.1% in 2023 Q2, slowed by the additional bank holiday for the King’s Coronation. Underlying quarterly growth is judged to have been around 0.2% during the first half of this year and Bank staff expect a similar rate in the near term. This is consistent with most business surveys of output over recent months, and developments in household income and retail sales volumes.
Given the continued resilience of economic activity over recent months, the Committee has increased somewhat its judgement from recent forecast rounds to boost the expected path of demand. This reflects a number of factors, including the possibility of lower precautionary saving by households than previously assumed, in turn related to a lower risk of job loss given the continued strength in labour market activity (Key judgement 2).
The pass-through of past increases in Bank Rate, and the latest, significantly higher, market-implied interest rate path on which the forecast is conditioned (Section 1.1), nonetheless push down on GDP over the forecast period. As well as increasing the cost of borrowing, Bank Rate rises affect asset prices, incomes and the exchange rate, all of which will influence the decisions taken by firms and households. This is discussed in more detail in Section 2.3.
The Committee is continuing to monitor closely the impact of the significant increases in Bank Rate so far. Both the GfK consumer confidence index and the flash S&P Global/CIPS UK composite PMI fell quite sharply in July, following the 0.5 percentage point increase in Bank Rate at the June MPC meeting. Realised and expected real sales growth in the latest Decision Maker Panel were unchanged in the three months to July, however. In the most recent period, a greater number of contacts of the Bank’s Agents reported a slowing in the outlook for activity, with the increase in interest rates having played a role.
Taking account of all announced government plans, the positive impacts of past fiscal loosening measures on the level of GDP unwind, which generally pulls down on GDP growth over much of the forecast period.
In the Committee’s August projection, GDP growth is projected to weaken into 2024, as past increases in Bank Rate, and the path of market interest rates on which the forecast is conditioned, weigh on demand to an increasing degree. GDP growth recovers over the second half of the forecast period, although it remains below pre-pandemic rates in the medium term. As well as the impact of higher interest rates, this reflects relatively weak potential supply (Key judgement 1 in the February 2023 Report) and a waning boost from fiscal policy.
Calendar-year GDP growth is expected to be ½% in 2023 and in 2024, and ¼% in 2025 (Table 1.D). Four-quarter GDP growth picks up to just over 1% by 2026 Q3 (Chart 1.1).
Relative to the May Monetary Policy Report projection, quarterly GDP growth is expected to be weaker throughout much of the forecast period, particularly during 2024 and at the beginning of 2025. The level of GDP is around ¾% lower by the end of the forecast period. That lower level reflects the projected impact of the higher path of market interest rates on which the forecast is conditioned and, to a lesser degree, the estimated impact of the exchange rate appreciation (Section 1.1). These factors have been offset partially by the Committee’s judgement to boost demand, given the continued resilience of economic activity over recent months.
Chart 1.1: GDP growth projection based on market interest rate expectations, other policy measures as announced
Footnotes
- The fan chart depicts the probability of various outcomes for GDP growth. It has been conditioned on Bank Rate following a path implied by market yields, but allows the Committee’s judgement on the risks around the other conditioning assumptions set out in Section 1.1, including wholesale energy prices, to affect the calibration of the fan chart skew. 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 growth 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 growth 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 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 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.
In the GDP projection conditioned on the alternative assumption of constant interest rates at 5.25% over the forecast period, growth is broadly similar on average across the forecast period to the MPC’s projection conditioned on market rates, as the market curve is higher than the constant rate assumption in coming quarters but then falls below it further out.
Within the components of GDP underpinning the August most likely, or modal, projection conditioned on market interest rates, calendar-year household spending is expected to rise by ½% in 2023, and by ¾% in 2024 and 2025 (Table 1.D). Real post-tax household labour income is projected to grow modestly over the forecast period. In part reflecting the Committee’s judgement to boost demand, the household saving ratio, which has remained above its pre-pandemic level, is expected to decline moderately, towards a level that is broadly consistent with its past relationship with wealth, interest rates and unemployment. The medium-term paths of both consumption and household income are nonetheless somewhat weaker than in the May Report.
Business investment is expected to rise by 1¾% in 2023, to fall by 2% in 2024 and to increase by 1¾% in 2025. This is broadly similar across the whole forecast period to that in the May Report.
In large part reflecting the transmission of higher interest rates, housing investment is expected to fall significantly, by around 6% in both 2023 and 2024, and by 3% in 2025. This profile is weaker than in the May Report.
UK-weighted world GDP is projected to be slightly lower in the near term than in the May Report, accounted for primarily by weakness in the euro area and in China. Near-term activity in the United States is expected to be slightly stronger, however. As in the United Kingdom, global growth is being pulled down by the higher market-implied path of interest rates. Overall, global GDP is expected to grow at a moderate pace throughout the forecast period, broadly unchanged from the May Report in the medium term. In the MPC’s modal projection, annual UK-weighted world GDP growth is projected to rise from 1½% to 2% over the forecast period (Table 1.D). That compares with average annual growth of around 2½% in the decade prior to the pandemic.
The risks around the projection for UK GDP growth are judged to be broadly balanced.
There are risks in both directions around the central projections for household spending and GDP, including related to the Committee’s judgements to boost the expected path of demand in light of recent strength in the labour market. Spending could be stronger than expected if some households choose to save less or run down existing stocks of savings to a greater extent. As set out in Annex 1 of this Report, external forecasters’ average medium-term projections for GDP remain stronger than the MPC’s, particularly in 2025. Conversely, demand could be weaker than expected if some people become more worried about their job security and try to build up their savings to a greater extent, or if there is less scope for some households to run down existing stocks of savings that have already been eroded in real terms by high inflation. Were the weaker trend in the most recent readings of some indicators of activity to continue, there could be a downside risk to the MPC’s near-term GDP projection.
There are also risks related more particularly to the transmission of monetary policy. There may be the potential for remortgaging behaviour to slow or weaken the transmission of higher interest rates to the economy, including if more households than usual choose to extend the terms of their mortgage than choose to shorten their terms. Such behaviour would have to be more widespread than in the past to have a material impact on the transmission of policy, however, and there are limits on how far mortgagors are able to extend terms. There could also be changes in the response of consumption to higher interest rates, for example if some mortgagors who need to refinance in the future take, or are already taking, advance actions to prepare for spending more on interest costs.
Regarding the housing channel of monetary policy, several factors should limit the impact of higher interest rates on mortgage defaults and therefore may reduce downward pressure on house prices from any forced sales of owner-occupied properties. For example, the Financial Policy Committee’s mortgage market measures and the Financial Conduct Authority’s (FCA’s) responsible lending requirements have increased borrower resilience, and robust capital and profitability mean that UK banks have options to offer forbearance. In addition, mortgage lenders, the Chancellor of the Exchequer, and the FCA agreed new support measures for residential mortgage holders as part of the Mortgage Charter published on 26 June. There could, however, be greater sales of properties by buy-to-let investors, given the sector’s larger size relative to previous downturns and the range of factors currently putting pressure on investors’ profitability, although market exits from landlords have not so far been on a scale that is likely to have a material impact on overall house prices (Section 2.1 of the July 2023 Financial Stability Report).
More generally, the MPC’s aggregate projections are constructed based in large part on the average relationships over the past between Bank Rate, other financial instruments and economic activity. The Committee will continue to keep all of these relationships under review, including how they may have changed during the current monetary policy tightening cycle.
1.2: Key judgement 2
The UK economy has been in excess demand over recent quarters, but an increasing degree of economic slack is expected to emerge after the middle of next year.
The Committee continues to judge that there has been a significant margin of excess demand in the economy over recent quarters, in part reflecting the weakness of potential supply. That excess demand can be accounted for by both the tightness of the labour market and a higher than normal degree of capacity utilisation within companies. In part reflecting the resilience of activity over recent months, there is judged to be greater excess demand currently than expected in the May Report.
There are nevertheless some indications that the labour market is loosening (Section 2.5). The LFS unemployment rate rose to 4.0% in the three months to May and is also expected to have been at that level in 2023 Q2. This is 0.2 percentage points higher than expected in the May Report. The vacancies to unemployment ratio has been falling since mid-2022, although it remains above its 2019 Q4 level. The Bank’s Agents have reported that recruitment conditions remain tighter than normal for most of their contacts, but that they have eased significantly for lower-skilled roles.
The unemployment rate is expected to be slightly above 4% during the second half of 2023, slightly below the latest estimate of the medium-term equilibrium rate of unemployment. Based on a simple extrapolation of recent trends, the ratio of vacancies to unemployment could return to its pre-pandemic level around the turn of the year. This would, nevertheless, still leave the ratio somewhat higher than its historical average.
A fall in the labour market inactivity rate has been the counterpart to a continued rise in employment rate over recent quarters, which has in turn boosted activity in the economy (Key judgement 1). According to the current vintage of ONS data, the participation rate is now only 0.3 percentage points below its 2019 Q4 level. In addition to a continuation of the recent trend for students to be more active in the labour market, recent data suggest that fewer people are becoming inactive due to early retirement or because they need to look after family (Chart 2.13). The number of people who are inactive due to long-term sickness has remained elevated, however. In light of recent news, the Committee has revised up its view of the sustainable level of labour market participation. However, this has not affected its view of the overall degree of excess demand in the economy.
Although aggregate supply is expected to remain relatively weak, the headwinds to demand, including from the path of market interest rates on which the forecast is conditioned, lead to an increasing degree of economic slack emerging in the Committee’s projections after the middle of next year. Companies are expected to respond to this weakness by retaining their existing inputs, while using them less intensively and hoarding labour for a prolonged period. As a result, in the MPC’s August modal projection, the unemployment rate is projected to rise in 2024 and then increase fairly gradually thereafter such that it reaches just under 5% by 2026 Q3 (Chart 1.2). The margin of aggregate excess supply is expected to widen to 1½% of potential GDP by the end of the forecast period (Table 1.A). Both aggregate spare capacity and unemployment increase by somewhat more in the Committee’s latest projections than in the May Report, reflecting the weaker path of GDP (Key judgement 1).
Chart 1.2: Unemployment rate 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 Bank Rate following a path implied by market yields, but allows the Committee’s judgement on the risks around the other conditioning assumptions set out in Section 1.1, including wholesale energy prices, to affect the calibration of the fan chart skew. The coloured bands have the same interpretation as in Chart 1.1, and portray 90% of the probability distribution. The fan begins in 2023 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 4.0% in the three months to May, and is projected to remain at that level 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 projections conditioned on the alternative assumption of constant interest rates at 5.25% over the forecast period, the unemployment rate rises to a similar degree on average over the forecast period to the MPC’s projection conditional on market rates, as the market curve is higher than the constant rate assumption in coming quarters but then falls below it further out.
The risks around the unemployment rate projection are judged to be broadly balanced.
The labour market could remain tight for longer than assumed for a number of reasons, including the upside risks around the outlook for demand (Key judgement 1). For a given demand profile, an increase in labour hoarding could prolong the tightness in the labour market, although it may not affect the overall degree of slack in the economy. Conversely, the labour market could loosen more rapidly than assumed, again including because of any downside risks to demand. There is also uncertainty around the extent to which the number of job vacancies can continue to fall without any significant adjustment in employment.
As discussed in the February 2023 Report, it remains difficult to interpret developments in labour market participation, and the extent to which they may be having an impact on spare capacity in the economy. There is also significant uncertainty about the equilibrium rate of unemployment in the economy. Higher-than-expected wage growth after the terms of trade shock that has affected the economy suggests that the medium-term equilibrium rate is likely to be higher. This implies a stronger outlook for wage growth and inflationary pressures all else equal (Key judgement 3). There is also some evidence that the efficiency with which vacancies are matched to those seeking work has decreased over recent years, which would also push up on the equilibrium rate of unemployment. The Committee will undertake a broader review of these issues, and the overall supply capacity of the economy, in its next regular stocktake.
1.2: Key judgement 3
Second-round effects in domestic prices and wages are likely to take longer to unwind than they did to emerge. In the modal forecast conditioned on market interest rates, an increasing degree of slack in the economy and declining external cost pressures lead CPI inflation to return to the 2% target by 2025 Q2 and to fall below target in the medium term, but to a lesser degree than projected in the May Report. The Committee continues to judge that the risks are skewed to the upside, but by less than in May. Taking account of this skew, mean CPI inflation is 2.0% and 1.9% at the two and three-year horizons respectively.
Twelve-month CPI inflation remains well above the 2% target, having fallen back to 7.9% in June in line with expectations in the May Report. In 2023 Q2, CPI inflation averaged 8.4%, slightly higher than the projection in the May Report. Inflation is expected to continue to fall, to an average of 6.9% in 2023 Q3 and 4.9% in Q4 (Table 1.C). That near-term decline is expected to be accounted for by lower energy, and to a lesser degree, food and core goods price inflation.
Reflecting recent wholesale energy price developments, the direct contribution of energy prices to CPI inflation is projected to fall further and then turn more negative from October. At that point, the Ofgem price cap for household gas and electricity bills is expected to fall to slightly below £2,000 per year, compared with the comparable figure of £2,500 in October 2022 that was set by the Government’s Energy Price Guarantee. Over the second and third years of the forecast period, the direct energy contribution to inflation is expected to be generally around zero or slightly negative, based on the downward slope of wholesale futures curves.
Food price inflation has remained extremely high, falling from just under 20% in March to 17.3% in June. Based in part on evidence from the Bank’s Agents (Box C), the contribution of food prices to CPI inflation is projected to fall from around 2 percentage points in June to 1.3 percentage points in 2023 Q4. The Committee has retained its judgement from the May Report that, relative to the broader balance of demand and supply in the economy, food prices will on average boost CPI inflation by around an additional 1 percentage point in coming quarters, although this is not expected to persist further out.
Core goods CPI inflation picked up to around 6½% in 2023 Q2, even as other, potentially leading, indicators of goods prices have continued to weaken (Section 2.6). For example, annual input and output producer price inflation moderated to -2.7% and 0.1% respectively in June. Bank staff expect core consumer goods price inflation to ease gradually during the rest of this year.
Four-quarter UK-weighted world export price inflation, excluding the direct effect of oil prices, is expected to have turned negative in 2023 Q2 and to remain so over coming quarters. This reflects the indirect effects of lower energy prices, the continued unwinding of supply chain bottlenecks and weak producer price inflation. Recent weakness in Chinese tradable goods prices appears broadly consistent with such an outlook. World export price inflation is projected to be slightly positive in the second half of the forecast period, broadly unchanged from the May Report.
On the other hand, UK import prices have continued to rise over recent quarters and have been stronger than past relationships with world export prices and the sterling exchange rate would have suggested. The Committee has made a judgement to allow this unexplained strength in the level of import prices to persist over the forecast period. The continued recent appreciation of the sterling exchange rate (Section 1.1) will, however, put some downward pressure on import price inflation, and over time on CPI inflation, relative to the May Report. Overall, import prices are projected to fall by 4½% in 2023, by 3¼% in 2024 and to rise by ½% in 2025 (Table 1.D).
Services CPI inflation, developments in which are more likely to indicate persistent inflationary pressures, increased to over 7% in 2023 Q2, and is now contributing more to headline inflation than other high-level components (Chart 2.18). That probably reflects resilient demand, the strength of nominal pay growth and, to a lesser degree, non-labour input costs. Services inflation was stronger than expected in the May Report, although some of this news can be accounted for by components that have historically been less informative about underlying inflationary pressures (Section 2.6). Services price inflation is projected to remain elevated in the near term, at around 7% (Chart 2.19).
Annual private sector regular pay growth has also increased further, to 7.7% in the three months to May, materially above expectations in the May Report. On a three-month on three-month annualised basis, pay growth has risen significantly, to 9.2% in May. Recent outturns appear to have been notably stronger than a standard model of wage growth, based on productivity, short-term inflation expectations and a measure of economic slack, would have predicted.
The near-term outlook for pay growth is expected to be stronger than projected in the May Report. The annual growth rate is nonetheless projected to decline in coming quarters, to around 6% by 2023 Q4, which requires a rapid decline in three-month on three-month growth during the second half of the year. The Bank’s Agents report that pay settlements are expected to ease slightly in the second half of 2023.
The Committee noted in the minutes of its June meeting that there has been significant upside news in recent data that indicates more persistence in the inflation process and which is therefore likely to have implications for the medium-term projection for CPI inflation.
Analysis by Bank staff supports the view that there are non-linearities in the way inflation is reacting to changes in demand. In particular, there is some evidence that the response is greater, to any given increase in demand, when spare capacity is more limited to begin with. Such non-linearities might help to explain some of the recent strength in domestic inflation, given the recent pattern of excess demand. In and of themselves, however, they would not result in greater persistence of inflation. If the labour market continues to loosen, as is expected in the MPC’s central projection (Key judgement 2), equally marked effects on inflation in the other direction would be expected.
More relevant may be the potential asymmetry in the second-round effects of changes in global prices. Steep rises in global goods prices weighed heavily on UK real incomes in 2021 and much of 2022. In an effort to protect falling real incomes, whether wages or profits, employees and domestic firms have sought compensation in the form of higher nominal pay and domestic selling prices. This mechanism can also be considered as broadly equivalent to an increase in the medium-term equilibrium rate of unemployment and hence consistent with a tighter labour market and greater upward pressure on wage and price inflation. As global prices cease to rise, and in some cases reverse, this should in time reduce the corresponding pressure on domestic inflation. But, to the extent that employees and firms are still seeking to recoup lost incomes, second-round effects are likely to take longer to unwind than they did to emerge.
The current circumstances are highly unusual. As such, it is hard to be precise about the extent of this asymmetry. Nevertheless, the Committee has for this reason judged previously that, relative to a modal expectation of significant declines in domestic inflation, there were material upside risks over the medium term. The MPC now judges that some of these risks may have begun to crystallise. In its latest August modal projection, and in addition to other similar judgements in previous Reports, the Committee has made a judgement to increase the persistence of inflation in wages and domestic prices. In addition to the MPC’s judgement to boost demand further in this forecast (Key judgement 1), this pushes up on the medium-term modal CPI inflation projection materially relative to the May Report.
In the MPC’s modal projection conditioned on the higher path of market interest rates as captured in the 15-working day average to 25 July, CPI inflation declines to below the 2% target in the medium term, as an increasing degree of economic slack is expected to reduce domestic inflationary pressures, alongside a slightly negative contribution from energy prices. CPI inflation is projected to return to the 2% target by 2025 Q2, and to be 1.7% at the two-year horizon and 1.5% in three years (Table 1.C and Chart 1.3).
Compared with the May Report modal projection, CPI inflation is expected to return to the 2% target marginally less rapidly in the middle of the forecast period. CPI inflation is higher in the medium term than in May, in large part reflecting the judgements that the Committee has made in this forecast including on the persistence of inflation in wages and domestic prices.
In the MPC’s modal projection, average weekly earnings growth falls to around 2% by the end of the forecast period, as short-term inflation expectations are assumed to fall back and a margin of spare capacity is expected to open up in the labour market in the medium term. This is a broadly similar medium-term profile for earnings to that in the May Report, but is consistent with a stronger path of private sector regular unit wage cost growth (Table 1.D). This takes account of both earnings and productivity per employee, and is a more relevant measure of the labour costs affecting companies’ pricing decisions.
Chart 1.3: 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 Bank Rate following a path implied by market yields, but allows the Committee’s judgement on the risks around the other conditioning assumptions set out in Section 1.1, including wholesale energy prices, to affect the calibration of the fan chart skew. 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.
Table 1.C: The quarterly modal projection for CPI inflation (a)
2023 Q3 | 2023 Q4 | 2024 Q1 | 2024 Q2 | 2024 Q3 | |
|---|---|---|---|---|---|
CPI inflation | 6.9 | 4.9 | 4.3 | 3.3 | 2.8 |
2024 Q4 | 2025 Q1 | 2025 Q2 | 2025 Q3 | ||
CPI inflation | 2.5 | 2.2 | 1.7 | 1.7 | |
2025 Q4 | 2026 Q1 | 2026 Q2 | 2026 Q3 | ||
CPI inflation | 1.6 | 1.5 | 1.5 | 1.5 |
In the modal projection conditioned on the alternative assumption of constant interest rates at 5.25% over the forecast period, CPI inflation is expected to be 1.7% and 1.4% in two years’ and three years’ time respectively. These are broadly similar to the Committee’s forecasts at the same horizons conditioned on market rates, as the market curve is higher than the constant rate assumption in coming quarters but then falls below it further out.
The path for inflation beyond the near term is uncertain, and the risks around the modal projection are judged to remain skewed to the upside, but by less than in the May Report.
There remain considerable uncertainties around the pace at which CPI inflation will return sustainably to the 2% target.
In the near term, a simple mapping between producer and consumer goods prices suggests goods CPI inflation could fall faster than projected (Section 2.6). There are also risks in both directions around the near-term path of wage inflation. Some forward-looking indicators, such as the KPMG/REC UK Report on Jobs indicator, suggest wage growth could slow more sharply in the latter half of 2023 (Section 2.5). It is also possible that recent official earnings data have been boosted temporarily by one-off cost of living payments. The recent run of upside surprises on pay growth could, however, persist.
In the medium term, there remain considerable uncertainties around the Committee’s judgement that second-round effects in domestic prices and wages are likely to take longer to unwind than they did to emerge. On the one hand, these risks may be more balanced following the MPC’s decision this round to take greater account of persistent price and wage-setting pressures in its modal projection. On the other hand, it is possible that the medium-term equilibrium rate of unemployment could increase to a greater degree, owing both to resistance to past losses in real income and to more persistent labour market frictions and mismatch (Key judgement 2). All else equal, this would put greater upward pressure on pay growth and domestic inflationary pressures over the forecast period.
The pace at which CPI inflation falls back to the 2% target will also depend on inflation expectations. An upside risk to the inflation outlook is that households and firms are less confident that inflation will fall back quickly and do not factor such a decline into their wage and price-setting behaviour. Developments in more visible components of inflation, such as energy and food prices, are likely to have an important impact on inflation perceptions and expectations. Since the May Report, most indicators of household and corporate inflation expectations have tended to decline, while medium-term inflation compensation measures in financial markets have risen slightly and remain above their long-term averages. The Committee will continue to monitor measures of inflation expectations very closely and act to ensure that longer-term inflation expectations are well anchored around the 2% target.
In addition, there are upside risks around the modal projection for UK CPI inflation from international factors. There remains the possibility of more persistence in consumer price inflation in the UK’s major trading partners, for similar reasons to the risks of stronger domestic inflationary pressures at home including the tightness of labour markets, and wage and services price inflation remaining elevated for longer than expected. Geopolitical tensions also remain and could continue to cause disruption to the supply of agricultural products.
Overall, the Committee continues to judge that the risks around the modal projection for CPI inflation are skewed to the upside, primarily reflecting the possibility of more persistence in domestic wage and price-setting. This pushes up on the mean, relative to the modal, inflation projections in the forecast. Conditioned on market interest rates, mean CPI inflation is 2.0% and 1.9% at the two and three-year horizons respectively.
Relative to the May Report, the magnitude of this skew is judged to be smaller throughout the forecast period, reflecting the Committee’s decision in this forecast to bring some of the upside risks to inflation from persistence into its modal projection. As the MPC is learning about the extent of medium-term inflationary pressures from indicators of persistence, such as wage growth and services inflation, it has reduced its upward skew on inflation to a slightly greater degree in year two of the forecast period than in year three.
In the mean projection conditioned on the alternative assumption of constant interest rates at 5.25% over the forecast period, CPI inflation is expected to be 2.0% and 1.8% in two years’ and three years’ time respectively.
Table 1.D: Indicative projections consistent with the MPC's modal forecast (a) (b)
Average | Projection | ||||||
|---|---|---|---|---|---|---|---|
1998–2007 | 2010–19 | 2020–21 | 2022 | 2023 | 2024 | 2025 | |
World GDP (UK-weighted) (c) | 3 | 2½ | ¾ | 3 | 1½ (1¾) | 1¾ (1¾) | 2 (2) |
World GDP (PPP-weighted) (d) | 4 | 3¾ | 1½ | 3½ | 2¾ (2¾) | 2¾ (2¾) | 3¼ (3¼) |
Euro-area GDP (e) | 2¼ | 1½ | -½ | 3½ | ½ (¾) | 1 (1) | 1½ (1½) |
US GDP (f) | 3 | 2¼ | 1½ | 2 | 1½ (1½) | ¾ (1) | 1½ (1½) |
Emerging market GDP (PPP-weighted) (g) | 5½ | 5 | 2¼ | 4 | 4 (4) | 3¾ (4) | 4¼ (4¼) |
of which, China GDP (h) | 10 | 7¾ | 5¼ | 3 | 5¼ (5½) | 4½ (4½) | 4¾ (4¾) |
UK GDP (i) | 2¾ | 2 | -1¾ | 4 | ½ (¼) | ½ (¾) | ¼ (¾) |
Household consumption (j) | 3¼ | 2 | -3½ | 5½ | ½ (¾) | ¾ (¾) | ¾ (1) |
Business investment (k) | 3 | 3¾ | -5½ | 10¾ | 1¾ (-¼) | -2 (0) | 1¾ (1½) |
Housing investment (l) | 3 | 4¼ | ¾ | 7½ | -5¾ (-4¼) | -6¼ (-3¾) | -3 (-½) |
Exports (m) | 4¼ | 3½ | -5 | 10 | -2 (½) | ¼ (0) | ½ (½) |
Imports (n) | 6¼ | 4 | -5 | 13½ | -3½ (-3) | 2 (¼) | 1½ (1¼) |
Contribution of net trade to GDP (o) | -½ | -¼ | ¼ | -1 ¼ | ½ (1 ¼) | -½ (0) | -¼ (-¼) |
Real post-tax labour income (p) | 3¼ | 1½ | ¾ | -2¼ | 0 (-½) | ¾ (1¼) | ½ (1) |
Real post-tax household income (q) | 3 | 1½ | 0 | ¾ | 1¼ (1) | -¼ (1) | ¼ (1) |
Household saving ratio (r) | 7¼ | 7¾ | 14¼ | 8½ | 9¼ (8¾) | 8½ (9) | 8 (8¾) |
Credit spreads (s) | ¾ | 2½ | 1¾ | 1 | ½ (1) | ¾ (1¼) | 1¼ (1½) |
Excess supply/Excess demand (t) | 0 | -1¾ | -¾ | 1¼ | ½ (¼) | -¼ (-½) | -1¼ (-1) |
Hourly labour productivity (u) | 2 | ¾ | ¼ | ½ | -¼ (-½) | ¼ (1) | ¾ (¾) |
Employment (v) | 1 | 1¼ | -½ | ¾ | 1 (½) | -½ (0) | 0 (0) |
Average weekly hours worked (w) | 32¼ | 32 | 30¾ | 31½ | 31¾ (31¾) | 31¾ (31¾) | 31¾ (31¾) |
Unemployment rate (x) | 5¼ | 6 | 4¾ | 3¾ | 4 (3¾) | 4½ (4) | 4¾ (4½) |
Participation rate (y) | 63 | 63½ | 63¼ | 63¼ | 63¾ (63¼) | 63¼ (63) | 63 (62¾) |
CPI inflation (z) | 1½ | 2¼ | 2¾ | 10¾ | 5 (5) | 2½ (2¼) | 1½ (1) |
UK import prices (aa) | -½ | 1¼ | 2½ | 13½ | -4½ (-8¼) | -3¼ (-2¾) | ½ (0) |
Energy prices – direct contribution to CPI inflation (ab) | ¼ | ¼ | ½ | 3¾ | -1½ (-1) | ½ (0) | -¼ (-½) |
Average weekly earnings (ac) | 4¼ | 2¼ | 4¾ | 6 | 6 (5) | 3½ (3½) | 2½ (2½) |
Unit labour costs (ad) | 3 | 1¼ | 5¼ | 5¾ | 4¾ (4¼) | 3 (3) | 1¾ (1½) |
Private sector regular pay based unit wage costs (ae) | 1¾ | 1½ | 3¾ | 8¼ | 7½ (6¾) | 4 (3½) | 2½ (2¼) |
Footnotes
- Sources: Bank of England, Bloomberg Finance L.P., Department for Energy Security and Net Zero, Eurostat, IMF World Economic Outlook (WEO), National Bureau of Statistics of China, ONS, US Bureau of Economic Analysis and Bank calculations.
- (a) The profiles in this table should be viewed as broadly consistent with the MPC’s projections for GDP growth, CPI inflation and unemployment (as presented in the fan charts).
- (b) Figures show annual average growth rates unless otherwise stated. Figures in parentheses show the corresponding projections in the May 2023 Monetary Policy Report. Calculations for back data based on ONS data are shown using ONS series identifiers.
- (c) Chained-volume measure. Constructed using real GDP growth rates of 188 countries weighted according to their shares in UK exports.
- (d) Chained-volume measure. Constructed using real GDP growth rates of 189 countries weighted according to their shares in world GDP using the IMF’s purchasing power parity (PPP) weights.
- (e) Chained-volume measure. Forecast was finalised before the release of the preliminary flash estimate of euro-area GDP for Q2, so that has not been incorporated.
- (f) Chained-volume measure. Forecast was finalised before the release of the advance estimate of US GDP for Q2, so that has not been incorporated.
- (g) Chained-volume measure. Constructed using real GDP growth rates of 155 emerging market economy countries, as defined by the IMF WEO, weighted according to their relative shares in world GDP using the IMF’s PPP weights.
- (h) Chained-volume measure.
- (i) Excludes the backcast for GDP.
- (j) Chained-volume measure. Includes non-profit institutions serving households. Based on ABJR+HAYO.
- (k) Chained-volume measure. Based on GAN8.
- (l) Chained-volume measure. Whole-economy measure. Includes new dwellings, improvements and spending on services associated with the sale and purchase of property. Based on DFEG+L635+L637.
- (m) Chained-volume measure. The historical data exclude the impact of missing trader intra‑community (MTIC) fraud. Since 1998 based on IKBK-OFNN/(BOKH/BQKO). Prior to 1998 based on IKBK.
- (n) Chained-volume measure. The historical data exclude the impact of MTIC fraud. Since 1998 based on IKBL-OFNN/(BOKH/BQKO). Prior to 1998 based on IKBL.
- (o) Chained-volume measure. Exports less imports.
- (p) Wages and salaries plus mixed income and general government benefits less income taxes and employees’ National Insurance contributions, deflated by the consumer expenditure deflator. Based on [ROYJ+ROYH-(RPHS+AIIV-CUCT)+GZVX]/[(ABJQ+HAYE)/(ABJR+HAYO)]. The backdata for this series are available at Monetary Policy Report – Download chart slides and data – August 2023.
- (q) Total available household resources, deflated by the consumer expenditure deflator. Based on [RPQK/((ABJQ+HAYE)/(ABJR+HAYO))].
- (r) Annual average. Percentage of total available household resources. Based on NRJS.
- (s) Level in Q4. Percentage point spread over reference rates. Based on a weighted average of household and corporate loan and deposit spreads over appropriate risk-free rates. Indexed to equal zero in 2007 Q3.
- (t) Annual average. Per cent of potential GDP. A negative figure implies output is below potential and a positive figure that it is above.
- (u) GDP per hour worked. Hours worked based on YBUS.
- (v) Four-quarter growth in LFS employment in Q4. Based on MGRZ.
- (w) Level in Q4. Average weekly hours worked, in main job and second job. Based on YBUS/MGRZ.
- (x) LFS unemployment rate in Q4. Based on MGSX.
- (y) Level in Q4. Percentage of the 16+ population. Based on MGWG.
- (z) Four-quarter inflation rate in Q4.
- (aa) Four-quarter inflation rate in Q4 excluding fuel and the impact of MTIC fraud.
- (ab) Contribution of fuels and lubricants and gas and electricity prices to four-quarter CPI inflation in Q4.
- (ac) Four-quarter growth in whole‑economy total pay in Q4. Growth rate since 2001 based on KAB9. Prior to 2001, growth rates are based on historical estimates of AWE, with ONS series identifier MD9M.
- (ad) Four-quarter growth in unit labour costs in Q4. Whole‑economy total labour costs divided by GDP at constant prices. Total labour costs comprise compensation of employees and the labour share multiplied by mixed income.
- (ae) Four-quarter growth in private sector regular pay based unit wage costs in Q4. Private sector wage costs divided by private sector output at constant prices. Private sector wage costs are average weekly earnings (excluding bonuses) multiplied by private sector employment.
Box A: Reviewing the process of quantitative tightening
Since the global financial crisis, quantitative easing (QE) has been an important instrument of monetary policy for central banks, including the Bank of England. The stock of assets held for monetary policy purposes in the Bank’s Asset Purchase Facility (APF) peaked at £895 billion towards the end of 2021, at which time the level of Bank Rate was 0.1%. Reducing that accumulated stock of purchased assets – or quantitative tightening (QT) – was appropriate once Bank Rate moved away from its effective lower bound. That reduction began in March 2022, and the size of the APF currently stands at £786 billion.
As set out in the minutes of the August 2022 meeting, the MPC committed to review the reduction in the APF annually, and as part of that to set out an amount for the reduction in the stock of purchased UK government bonds (gilts) over the subsequent 12-month period. This box forms part of this year’s review, including what the MPC has learned about the impact of QT, and the factors that influence the appropriate pace of stock reduction.
The Committee will vote on the target for gilt stock reduction over the 12-month period from October 2023 to September 2024 at its September 2023 meeting.
The process of unwinding the APF is going smoothly…
In February 2022, the Committee voted to cease gilt reinvestments and initiate sales of sterling non-financial investment-grade corporate bonds. In September 2022, the Committee voted to reduce the stock of gilts held in the APF by £80 billion over the next 12 months, to a total of £758 billion.
This process is going smoothly. Sales of the corporate bond portfolio are now complete, with a small number of very short maturity bonds remaining that will mature fully by April 2024. At the conclusion of the current 12-month programme of gilt stock reduction in September the APF will stand at £759 billion. The impact of QT on financial markets, while difficult to measure precisely, is judged to have been small, and there is no evidence of a negative impact of gilt sales on market functioning across a range of financial market measures (see Ramsden (2023)). That is in line with the MPC’s expectations, but the Committee will continue to learn as the process progresses.
Reducing the size of the APF has the important benefit of reducing the risk of a ratchet upwards in the size of the central bank balance sheet over time if successive policy cycles encounter the effective lower bound on interest rates (for further discussion, see Bailey et al (2020)). That in turn should increase the headroom and flexibility for the central bank to be able to use its balance sheet in the future should that be needed.
The strategy for this process, however, must take into account various economic and market considerations.
…having been guided by a set of key principles.
The key principles for unwind were set out in the August 2021 Report, building on earlier communications that began in 2014. The parameters of the unwind strategy agreed last year were designed with these principles in mind.
First, the MPC intends to use Bank Rate as its active policy tool when adjusting the stance of monetary policy. The parameters of the unwind strategy are amended at a lower frequency than decisions on Bank Rate and are not calibrated with a view to fine-tuning the monetary policy stance.
Second, sales are being conducted so as not to disrupt the functioning of financial markets. Market conditions must be judged appropriate at the time, for example sales are not taking place in periods of extreme volatility.
Third, to help achieve that, sales are being conducted in a relatively gradual and predictable manner over a period of time.
Reflecting these key principles, the tightening impact of unwind has been, and is expected to be, smaller than the loosening associated with asset purchases.
When conducted in a manner consistent with the key principles, the impact of QT is smaller than that of QE. That predominantly reflects the state contingency of the transmission channels, set out in the 2022 Q1 Quarterly Bulletin. In the context of the key principles, several channels are smaller or absent during the unwind process.
First, the process of unwinding the APF is being undertaken only in appropriate market conditions, and in a gradual and predictable manner that does not disrupt the functioning of financial markets. That is illustrated by the experience last autumn, where the Bank delayed the start of gilt sales given market conditions. Asset purchases on the other hand, were at times deliberately made during periods of market stress, such that they helped to improve liquidity and market functioning.
Second, as Bank Rate is the active tool of monetary policy, decisions on the process for unwind are not signalling a need for a higher path for Bank Rate. That is in contrast to QE, when increasing the target stock of purchased assets may have depressed the expected path of Bank Rate.
That finding is supported by a range of empirical evidence which suggests unwind is having some tightening effect on yields, but that this is small.
There has now been over a year of evidence of the impact of QT, including nine months of sales. The impact remains difficult to measure precisely, and the MPC will continue to learn as the process progresses. Nonetheless, the empirical evidence so far supports expectations that the impact of unwind on gilt yields would be small.
First, models of UK term premia can decompose developments in gilt yields into those driven by changes in the term premium, through which unwind is expected to operate, and those reflecting shifts in the expected path of rates. The term premium represents the additional compensation investors demand to hold a longer-term bond relative to a series of shorter-term bonds, and is influenced by a range of factors, including uncertainty around the outlook for the economy and interest rates, as well as gilt supply and demand. These models point to an overall increase in the term premium of around 40 basis points on the 10-year gilt yield since the Committee voted to begin QT, accounting for only a very small proportion of the overall rise in gilt yields (Chart A). QT may be one factor contributing to that increase, but other factors have likely been more important.
Chart A: Decomposition of UK 10-year government bond yield (a)
Footnotes
- Sources: Bloomberg Finance L.P., Tradeweb and Bank calculations.
- (a) The chart uses estimates from a range of internal models of UK term premia to split the 10-year gilt yield into expected rates and term premia contributions. Expected rates reflect investors’ expectations of the average short-term monetary policy rate over the next 10 years, and term premium is defined as the additional compensation investors demand to hold a longer-term bond relative to a series of shorter-term bonds.
Indeed, analytical approaches that attempt to isolate the impact of QT specifically suggest that this is likely to account for only part of the 40 basis point increase, in the region of 10–15 basis points. Market intelligence, including from the Bank’s Market Participants Survey in June 2022, is consistent with an impact of that magnitude.
Event study estimates around QT auctions also point to a limited additional impact from sales specifically. There has been no material difference in daily movements of a range of financial market measures on auction days relative to non-auction days. There is also evidence that unwind has had a limited impact on market functioning; indeed there are some signs that sales may have had a positive effect by alleviating collateral scarcity at short maturities.
The impact on activity and inflation is also likely to have been small.
All else equal, the tightening effect QT has on yields would be expected to lower economic activity and inflation. It is too early to assess this broader impact yet, but based on the UK’s experience of QE, a 10 basis point increase in yields would be associated with a negative impact on activity and inflation of less than 0.2% and 0.1 percentage points respectively.
While it is hard to measure precisely the marginal effect of QT, the MPC’s economic forecasts will be conditioned on asset prices that incorporate announced and expected QT alongside other factors. The MPC will therefore take this effect into account when setting the desired monetary policy stance using Bank Rate. Any tightening effect from QT will lead to a slightly lower path for Bank Rate, all else equal. Given that the impact of QT is judged to have been small, QT is unlikely to have made a material difference to the appropriate path for Bank Rate over the past year.
Sales of the corporate bond portfolio have also been completed successfully.
Alongside the reduction in the stock of purchased gilts, the process of unwinding the portfolio of corporate bonds held in the APF is now largely complete. Similar to gilt unwind, the impact on monetary conditions was expected to be small when conducted at a time when markets were functioning relatively normally. This process has been successful: sales were completed in June, with a small number of very short maturity bonds remaining in the portfolio and maturing fully by 5 April 2024.
The appropriate pace of gilt stock reduction will continue to be guided by the MPC’s key principles.
While there are benefits to reducing the size of the APF, the pace of reduction must be judged appropriate in the context of the key principles. That involves both economic and market considerations.
First, any economic impact must leave sufficient headroom in Bank Rate to deliver the MPC’s desired monetary policy stance. Given a gradual pace of unwind is associated with a small expected economic impact, any required adjustments in Bank Rate are likely to be very small and this should therefore not be a material factor in practice.
Second, the pace of sales should not disrupt the functioning of financial markets. An important component of the annual review process is an updated staff assessment of market capacity and conditions. Given a small economic impact, this becomes a key consideration in determining the pace of stock reduction.
Third, sales must be conducted in a relatively gradual and predictable manner over a period of time. The focus of the MPC is on total gilt stock reduction, comprising both maturing gilts and sales, such that natural variation in maturities may also lead to variation in the pace of sales over time (Chart B). Notwithstanding that, the Committee places some weight on continuity in sales.
The appropriate stock reduction target over the next year will weigh these different factors, and will take into account the experience of the first year of unwind.
The Committee will vote on the target for gilt stock reduction over the 12-month period from October 2023 to September 2024 at its September meeting. Bank Rate remains the MPC’s active tool of monetary policy and will be set to meet the 2% inflation target.
Box B: Monetary policy since the May Report
At its meeting ending on 21 June 2023, the MPC voted by a majority of 7–2 to increase Bank Rate by 0.5 percentage points, to 5%. Two members preferred to maintain Bank Rate at 4.5%.
Business surveys continued to suggest underlying quarterly GDP growth of around ¼% during the middle of this year. LFS employment had increased by 0.8% in the three months to April, higher than expected at the time of the May Report. The counterpart to this strong employment growth had been a further fall in the inactivity rate. The unemployment rate had been flat at 3.8%, in line with the May Report. The vacancies to unemployment ratio had fallen further but remained significantly elevated.
Annual growth in private sector regular average weekly earnings (AWE) had increased to 7.6% in the three months to April, 0.5 percentage points above the expectation at the time of the May Report. Three-month on three-month growth in this measure of pay had also picked up. Indications of future pay growth from the KPMG/REC survey and the Bank’s Agents suggested that AWE growth would ease over the rest of the year, however.
Twelve-month CPI inflation fell from 10.1% in March to 8.7% in April and had remained at that rate in May. This was 0.3 percentage points higher than expected in the May Report. Services CPI inflation had risen to 7.4% in May, 0.5 percentage points stronger than expected at the time of the May Report, while core goods price inflation had also been much stronger than projected.
CPI inflation was expected to fall significantly further during the course of the year, in the main reflecting developments in energy prices. Services CPI inflation was projected to remain broadly unchanged in the near term. Core goods CPI inflation was expected to decline later this year, supported by developments in cost and price indicators earlier in the supply chain. In particular, annual producer output price inflation had fallen very sharply in recent months. Food price inflation was projected to fall further in coming months.
The MPC recognised that the second-round effects in domestic price and wage developments generated by external cost shocks were likely to take longer to unwind than they did to emerge. There had been significant upside news in recent data that indicated more persistence in the inflation process, against the background of a tight labour market and continued resilience in demand.
The MPC would continue to monitor closely indications of persistent inflationary pressures in the economy as a whole, including the tightness of labour market conditions and the behaviour of wage growth and services price inflation. If there were to be evidence of more persistent pressures, then further tightening in monetary policy would be required.
2: Current economic conditions
Global consumer price inflation has been slowing, but remains above central banks’ targets in many countries. That slowing has mainly been driven by developments in energy prices, although food and goods price inflation have also eased a little. In contrast, services inflation has remained strong across advanced economies, which may in part reflect tight labour markets. Market-implied paths for policy rates have risen further since the May Report, particularly in the UK. Interest rates facing households and firms have risen; the effects of this will transmit to economic activity and inflation over time.
Underlying UK GDP growth, which abstracts from the impact of strikes and the additional bank holiday in May, is estimated to have averaged around ¼% per quarter in the first half of 2023, broadly in line with expectations in the May Report. And, on average, indicators point to underlying growth continuing at a similar pace in the second half of 2023.
Employment and participation have risen since the May Report. The labour market remains tight, but there are some indications that it is loosening. Annual private sector regular earnings growth has risen materially faster than projected in the May Report to 7.7%. Wage growth is still expected to slow in the second half of the year, but risks remain to the upside.
Since the May Report, CPI inflation has fallen, dropping from 10.1% in March to 7.9% in June, in line with the projection in May. It remains well above the MPC’s 2% target, however. Inflation is expected to fall further – to 6.9% in 2023 Q3 and 4.9% in Q4 – with three-quarters of that decline owing to a falling contribution from household gas and electricity bills. Easing manufacturing producer price inflation is likely to contribute to somewhat lower consumer goods price inflation, while food price inflation is also expected to fall back. But services price inflation is projected to remain elevated, averaging 7% through the second half of 2023.
Chart 2.1: GDP growth is expected to remain positive but low, the unemployment rate is expected to rise slightly in 2023 Q3 and inflation is expected to have fallen in July
Near-term projections (a)