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 15 June 2016 the MPC voted unanimously to maintain Bank Rate at 0.5%. The Committee also voted unanimously to maintain the stock of purchased assets financed by the issuance of central bank reserves at £375 billion.
Twelve-month CPI inflation was 0.3% in May and remains well below the 2% inflation target. This shortfall is due predominantly to unusually large drags from energy and food prices, which are expected to attenuate over the next year. Core inflation also remains subdued.
The MPC set out its most recent detailed assessment of the economic outlook in the May Inflation Report. Relative to those projections, there has been limited news on the outlook for the global economy. Growth in the United Kingdom’s major trading partners is expected to continue at a modest pace over the next three years. In China and other emerging markets, the prospects for activity are little changed and medium-term risks remain to the downside. Commodity prices have risen since the Committee’s May Report, however, with sterling oil prices in particular having increased by around 10%.
In the weeks since the May Report, an increasing range of financial asset prices has become more sensitive to market perceptions of the likely outcome of the forthcoming EU referendum. On the evidence of the recent behaviour of the foreign exchange market, it appears increasingly likely that, were the UK to vote to leave the EU, sterling’s exchange rate would fall further, perhaps sharply. This would be consistent with changes to the fundamentals underpinning the exchange rate, including worsening terms of trade, lower productivity, and higher risk premia. In addition, UK short-term interest rates and measures of UK bank funding costs appear to have been materially influenced by opinion polls about the referendum. These effects have also become evident in non-sterling assets: market contacts attribute much of the deterioration in global risk sentiment to increasing uncertainty ahead of the referendum. The outcome of the referendum continues to be the largest immediate risk facing UK financial markets, and possibly also global financial markets.
While consumer spending has been solid, there is growing evidence that uncertainty about the referendum is leading to delays to major economic decisions that are costly to reverse, including commercial and residential real estate transactions, car purchases, and business investment. As the Committee has previously noted, potential referendum effects are making economic data releases more difficult to interpret, and the Committee is being more cautious in drawing inferences from them than would normally be the case.
The MPC’s projections in the May Inflation Report were conditioned on continued UK membership of the EU. On that assumption, returning inflation to the 2% target requires balancing the drag on inflation from external factors and the support from gradual increases in domestic cost growth. Fully offsetting that drag over the short run would, in the MPC’s judgement, involve too rapid an acceleration in domestic costs which would risk being excessive and lead to undesirable volatility in output and employment. Given these considerations, the MPC intends to set monetary policy to ensure that growth is sufficient to return inflation to the target in around two years and keep it there in the absence of further shocks.
Consistent with the projections and conditioning assumptions set out in the May Report, including a gentle rise in interest rates over the forecast period, the MPC judges that it is more likely than not that Bank Rate will need to be higher by the end of the forecast period than at present to ensure inflation returns to the target in a sustainable manner. All members agree that, given the likely persistence of the headwinds weighing on the economy, when Bank Rate does begin to rise, it is expected to do so more gradually and to a lower level than in recent cycles. This guidance is an expectation, not a promise. The actual path Bank Rate will follow over the next few years will depend on economic circumstances.
As the Committee set out last month, the most significant risks to the MPC’s forecast concern the referendum. A vote to leave the EU could materially alter the outlook for output and inflation, and therefore the appropriate setting of monetary policy. Households could defer consumption and firms delay investment, lowering labour demand and causing unemployment to rise. Through financial market and confidence channels, there are also risks of adverse spill-overs to the global economy. At the same time, supply growth is likely to be lower over the forecast period, reflecting slower capital accumulation and the need to reallocate resources. Sterling is also likely to depreciate further, perhaps sharply. This combination of influences on demand, supply and the exchange rate could lead to a materially lower path for growth and a notably higher path for inflation than in the central projections set out in the May Inflation Report. In such circumstances, the MPC would face a trade-off between stabilising inflation on the one hand and output and employment on the other. The implications for the direction of monetary policy will depend on the relative magnitudes of the demand, supply and exchange rate effects. The MPC will take whatever action is needed, following the outcome of the referendum, to ensure that inflation expectations remain well anchored and inflation returns to the target over the appropriate horizon.
Against that backdrop, at its meeting on 15 June, the MPC voted unanimously to maintain Bank Rate at 0.5% and to maintain the stock of purchased assets, financed by the issuance of central bank reserves, at £375 billion.