The outlook for inflation and monetary policy - speech by Michael Saunders

Given during an online webinar
Published on 03 December 2021
Michael Saunders talks about the outlook for the UK economy and what he thinks it means for prices. He then sets out what it all may mean for interest rates.


In this speech, I want to discuss recent developments and prospects for the economy and monetary policy. I want to make five main points

  • At the November monetary policy meeting, the MPC (myself included) judged that, provided the incoming data, particularly on the labour market, are broadly in line with the central projections in the November Monetary Policy Report, it will be necessary over coming months to increase Bank Rate in order to return CPI inflation sustainably to the 2% target.
  • Relative to that MPR forecast, my view is that (conditioned on the market rate path and assumptions on the pandemic and public health measures used for that forecast) risks are on the side of a more persistent period of excess demand and above-target inflation, reflecting greater domestic cost and capacity pressures.
  • Given this, at the November MPC meeting I voted to tighten monetary policy by curtailing the asset purchase program and raising Bank Rate to 0.25%. If the economy develops as I expect, then some additional tightening, on top of such a move, probably will be needed fairly soon.
  • But policy is not on auto pilot. The pace, and scale, of any monetary policy changes will depend on economic developments and the outlook. In particular, at the December meeting, a key consideration for me will be the possible economic effects of the new Omicron Covid variant, and the potential costs and benefits of waiting to see more data on this before – if necessary – adjusting policy.
  • It is likely that any rise in Bank Rate will be limited given that the neutral level of interest rates remains low. Provided we do not delay too long, it should be a case of easing off the accelerator rather than applying the brakes.

The economy’s recent trends

Let’s start with the recent developments in the economy in terms of activity, the labour market, inflation and potential output.

At end-2019, before the pandemic, the economy was in reasonable balance, with inflation close to the 2% target, unemployment just below 4% and underlying pay growth at 3%-3½% YoY. Since then, the economy has been affected by two big developments. The first, of course, is the pandemic and the measures designed to tackle it. The other is Brexit (which occurred at end-January 2020) and the UK-EU Trade and Cooperation Agreement (TCA, which was agreed in late 2020 and provisionally applied from 1 January 2021), which have resulted in a marked reduction in the UK economy’s openness, notwithstanding trade agreements reached with non-EU countries.

The initial effects on the economy of the pandemic were far greater than those of Brexit. In Q1 this year, both GDP and total hours worked were 8-9% below their pre-pandemic levels. Moreover, the pandemic initially caused demand to fall more than supply. Hence, together with the demand-driven drop in global oil and energy prices (and temporary tax effects), CPI inflation fell well below the 2% target last year and early this year. With ample spare capacity, inflation well below target and tighter financial conditions (as a perceived rise in credit risk led to wider credit spreads) the MPC loosened monetary policy markedly during last year.footnote [1]

As Covid-related restrictions eased, activity recovered substantially. The level of GDP in September was still slightly below the pre-pandemic level (ie Q4-19) although, allowing for the further growth in the economy since then, the gap now is probably smaller.footnote [2]

Figure 1. UK – Percentage Changes in GDP, Employment and Hours Worked Since Q4-19


  • Sources: ONS and BoE.

At the same time, even with the recent rise in gilt yields, financial conditions are considerably looser than late last year and early this year. In particular, bank lending spreads have fallen back to around pre-pandemic levels, reflecting the reduction in the perceived credit risk of borrowers, the decline in banks’ wholesale funding spreads, and surplus liquidity particularly in the ring-fenced banks.footnote [3]

The recovery in activity continues to be uneven across several dimensions.footnote [4]

Goods versus services. Among major advanced economies, aggregate spending on goods recovered much faster than spending on services late last year and early this year. More recently, there has been some rotation of spending back to services – which grew strongly in Q3 for the advanced economies as a whole – and spending on goods fell in the last quarter. Even so, aggregate spending on goods across advanced economies remains well above pre-pandemic levels, while spending on services is still below.

Figure 2. Advanced Economies – Level of spending on goods and services in pandemic and 2008/09 recession as per cent of pre-crisis level, solid line = pandemic, dotted line = 2008/09 recession


  • Note: In the pandemic, data are shown relative to the average level in Q4-19. For the 2008/09 recession, they are shown relative to Q4-2007. AE average is weighed average of data for US, EU, Japan, UK and Canada. Sources: Eikon from Refinitiv and BoE.

Less global. The UK economy has become less globalised, with effects from the pandemic exacerbated by Brexit. For example, compared to the 2019 average, trade flows (imports plus exports as a share of GDP) in the UK have fallen by far more than in any other G7 country. Indeed in Q3 this year, the UK’s trade flows (as a share of GDP) were the lowest since 2009. By contrast, among the EU countries, trade as a share of GDP has largely recovered to pre-pandemic levels. Moreover, UK firms report greater frictions in the process of importing and exporting.footnote [5] The UK labour market also has become less global: there has been a marked drop in the numbers of EU nationals working in the UK, and firms report greater difficulties in hiring EU staff to work in the UK.

Figure 3. UK and Main EU Countries – Trade Flows (Imports Plus Exports) as per cent of GDP


  • Note: Main EU Countries are Germany, France, Italy and Spain. Data measured in real terms. Figures for 2021 are the average for the year to date. Sources: ONS, Eikon from Refinitiv and BoE.

Public versus private. Within the UK, there has been a marked rise in public sector employment, reflecting in part the expansion of pandemic-related health spending.footnote [6] As a result, total employment has recovered significantly more than private sector employment.

Across the economy as a whole, it appears that demand has recovered more than supply, such that – even though GDP remains below its pre-pandemic level – the expansion has been limited by widespread capacity constraints. For example, CBI surveys suggest that the share of firms reporting output is constrained by shortages of skilled or professional labour is relatively high in both manufacturing and services. Likewise, high shares of manufacturers also report shortages of plant capacity and materials. Conversely, the share of firms in services and manufacturing reporting activity is constrained by a lack of demand or orders is the lowest for decades.

Consistent with this, the labour market has tightened further and indeed now appears stretched by historic norms. Unemployment and under-employment have fallen back close to pre-pandemic lows, and short-term unemployment is at a record low.footnote [7] The ratio of vacancies to unemployment, and the BoE Agents’ survey measure of firms’ recruitment difficulties, are both at a record high. There are signs that the tightening in the labour market is being reflected in higher pay, especially in new hires (see for example, the REC/KPMG survey). Underlying AWE growth (adjusted for composition effects and flows on/off furlough) across the economy has risen to around 4½% YoY, clearly above the pre-pandemic pace. The recent rate of underlying pay growth is estimated to have been above the MPC’s expectations and higher than implied by models of labour market fundamentals. It also is probably a little above the pace consistent with the inflation target, assuming hourly productivity growth remains close to the pre-pandemic trend of around 1% YoY.

Figure 4. UK – Measures of Labour Market Tightness


  • Note: The blue line is the average of various surveys of labour market tightness, derived from business surveys by the CBI, BCC, REC, and BoE Agents. Each survey is measured as standard deviations from its 2000-21 average. Sources: CBI, BCC, REC, ONS and BoE.

Figure 5. UK – REC Survey of Pay Growth and YoY Change in Average Weekly Earnings


  • Note: REC series have been mean-variance adjusted to AWE private sector regular pay over 2000-2019. Underlying AWE private sector regular pay excludes furlough and compositional effects. Sources: REC/KPMG Report on Jobs, ONS and BoE.

Against this backdrop, inflation data have remained strong in recent months. The QoQ annualised pace of core CPI inflation has picked up from below 2% in Q1 this year and just below 3½% in Q2 to around 4½% in the latest data, and is around the highest pace of the last 20 years. The QoQ annualised rate of headline inflation is slightly higher, around 5%.

As was the case a few months ago, the pickup in headline CPI inflation partly reflects higher energy prices, especially household gas prices. The rise in wholesale gas prices over recent months will, unless it quickly reverses, feed through to another sizeable rise in the Ofgem price cap in April, lifting YoY CPI inflation further. The rise in gas prices has little effect, of course, on core CPI inflation.

Inflation (both headline and core) also has been lifted by global capacity pressures in manufactured goods, caused by buoyant global spending on goods (reflecting the rotation of demand towards goods during last year and early this year, discussed earlier) and some disruptions to global supply chains. These effects have continued to feed through to the UK through strong gains in prices of non-energy consumer goods (especially consumer durables) in the CPI.

Figure 6. UK – QoQ Annualised Rates of CPI Inflation


  • Note: Data are seasonally adjusted. Latest data are for the three months ended October. Sources: ONS and BoE.

But the rise in inflation has broadened in recent months. As the labour market has tightened, there has been a further rise in domestic cost and price pressures. For example, a range of measures suggest that core CPI services inflation – which is less affected than goods prices by global cost trends – has risen above its 2018-19 average. The same applies to service sector producer price inflation and the BoE Agents’ scores of service sector inflation. At the same time, guides to longer term inflation expectations (especially those for households and financial markets) have drifted up.

Figure 7. UK – Measures of YoY Services Inflation


  • Sources: ONS and BoE.

At first glance, it may seem surprising that capacity pressures in the UK have worsened to this extent when, as noted, GDP is probably not above its pre-pandemic level.

It is of course possible that recent GDP data will be revised up, as often happens.

But the broader point is that since Q4-19, potential output has been significantly reduced by the twin impacts of Brexit and the pandemic (including the measures designed to tackle the pandemic).

Some of this has come through lower productivity. The MPC has judged that Brexit is likely to reduce the level of potential GDP by about 3¼% over time, largely through adverse effects on productivity from reduced investment and trade openness.footnote [8] Much of this loss is likely to be concentrated in the early period after Brexit (ie since January 2020), as firms adjust to the new trading relations. The pandemic has probably also caused some loss of productivity through lower business investment and erosion of workplace skills, perhaps offset partly by gains from more widespread working from home.footnote [9] In all, GDP per hour worked in Q3 this year was just 0.1% up from Q4-19, undershooting even the modest trend in the preceding years.footnote [10]

In addition, the workforce has been reduced by an outflow of EU nationals and lower workforce participation.footnote [11] The participation rate among the 16-64 age group has fallen from 79.5% in Q4-19 to 78.8% in Q3 this year, with notable declines among people aged 18-24 years and the over 50s.footnote [12] This decline in participation has cut 270k (0.8%) off the workforce over that period, and the shortfall is even greater compared to the rising pre-pandemic trend in participation. At the same time, LFS data suggest the number of EU nationals in the workforce has fallen by 8% (200k) since Q4-19, cutting 0.6% off the UK workforce.footnote [13] In all, the workforce in Q3 this year was 250,000 (0.7%) below the Q4-19 level, and 750,000 (2.2%) below an extrapolation from Q4-19 of the previous rising trend.footnote [14]

Figure 8. UK – Workforce (Millions of People)