Economic outlook − speech by Huw Pill

Speech

It is a great pleasure to be here in Sheffield this evening.

Thanks are due to the Managing Director’s Club, the University of Sheffield and Sheffield Hallam University for inviting me to speak today.

Thanks also to Alex Golledge and Paul Mount – the Bank’s agents in Yorkshire and Humberside – for organising a fantastic series of events for us in Sheffield and Doncaster, of which this is one of the highlights.

And thanks to all of you, too, for joining us this evening.

These are challenging times, for the economy, for economic policymakers and for all of us facing the cost of living crisis.

At 9.1% in May, UK inflation is uncomfortably high. The MPC’s latest forecasts suggest inflation is set to rise further towards the end of the year, as international commodity prices rises stemming from Russia’s invasion of Ukraine filter through to UK utility and food prices.

For a monetary policymaker charged with achieving a 2% inflation target, this is clearly an undesirable situation.

Acting to achieve the MPC’s 2% inflation target is now more important than ever. The MPC is committed to returning inflation to target in a sustainable way over the medium term.

In the first instance, that has required – and still requires – tighter monetary policy. But it also requires that tightening be measured and proportionate, calibrated appropriately to the economic situation at hand.

The MPC has already embarked on the tightening required. Since I joined the MPC last September, we have: halted the Bank’s asset purchases; raised Bank Rate cumulatively by more than one percentage point to 1.25%; and started to shrink the asset portfolio accumulated via quantitative easing (QE).

We are now considering whether to start selling gilts, as well as implementing further interest rate increases.

These measures represent a shift away from the very accommodative stance of monetary policy originally established in the face of the global financial crisis and maintained, more or less, ever since – in the face of the European sovereign debt crisis, the fallout from the Brexit referendum, and the Covid-19 pandemic.

The implementation of these measures reflects an orderly adjustment in monetary policy through time, part of the ongoing transition out of the highly accommodative stance of the past to a stance appropriate for the present.

In my remarks today, I will outline my view of the economic situation and the implications for monetary policy in bringing inflation back to its 2% target. In doing so, I hope to offer a transparent view about the challenges that face the MPC today and what we can do, and are doing, to deal with them.

The economic outlook

UK inflation currently stands at its highest level it has been since 1982. How have we found ourselves in this position?

External shocks A big part of the story is the impact of a series of external economic disturbances – what economists call ‘exogenous economic shocks’ – that have driven up international goods and energy prices.

On the basis of the MPC’s May forecasts (and in an accounting rather than economic sense), around three-quarters of the overshoot in inflation in 2022 Q4 is expected to be driven by energy (representing nearly a half of the overshoot) and core goods, with that figure rising to nearly 90% when food, beverages and tobacco are included.

Bottlenecks have emerged in international markets. These stem from a combination of, on the one hand, changes in the global pattern of consumer demand and, on the other, disruptions to global supply chains. Both phenomena have their roots in the Covid pandemic.

Lockdowns both forced a switch from spending on face-to-face services towards consumer durables and interfered with the production and distribution of those goods globally. The price of tradable goods – for which the UK is essentially a price taker – have been driven up as a result.

Belying tentative signs that bottlenecks were easing towards the end of last year, new lockdowns in China and the invasion of Ukraine have exacerbated supply disruptions through the spring, prolonging the inflationary impulse. And, as we all know, the invasion of Ukraine has also had a profound inflationary impact on international energy prices, as well as boosting other commodity prices in particular for food.

As I argued in a talk I gave yesterday in London,^{footnote [1]} these external price shocks have several important features influencing the outlook for the UK economy and the prospects for monetary policy.

1. They genuinely were ‘shocks’. In other words, they could not have been (and were not) anticipated.
2. They were large. For example, European wholesale gas prices have risen by more than 300% over the past year.^{footnote [2]}
3. They fed through to UK inflation relatively quickly.^{footnote [3]} Crucially, their impact on inflation occurred before the lags inherent in the transmission of monetary policy actions to inflation unwind.^{footnote [4]} This implies that monetary policy could not offset the impact of shocks on UK inflation completely – some volatility in inflation is unavoidable.
4. They were ‘trade-off’ inducing. Not only did higher goods and energy prices drive up UK inflation directly (since they are included in the CPI basket), but they also implied a squeeze on UK households real spending power. The global price shocks increased the relative price of what the UK imports (in net terms) from the rest of the world (mainly services) compared with what the UK exports (goods and energy): what economists call a ‘deterioration in the terms of trade’. Simply put, the price of what the UK is selling has fallen relative to what the UK is buying, leaving UK residents worse off.

Two important implications for monetary policy follow from these characteristics of the shock to the UK economy.

First, even a very activist MPC policy could not have prevented some short-term inflation volatility in UK inflation emerging in the face of external (say, energy) price shocks.^{footnote [5]} And when those shocks are large, the amplitude of the inevitable volatility will be large. This story still accounts for a large part of the recent elevated level of UK inflation.

Second, the deterioration in the terms of trade stemming from higher international goods and energy prices represents a real shock to the UK economy. Monetary policy cannot reverse that real shock on a lasting basis.

Should recent developments in global markets prove persistent, the recent sharp rises in global energy prices will necessarily weigh on UK real aggregate income and spending. This is something monetary policy is unable to prevent.

Reflecting these two points, the role of monetary policy (as reflected in the MPC’s remit) is to ensure that, as the inevitable real economic adjustment occurs, it does so in a manner consistent with achieving the 2% inflation target sustainably over the medium term, while minimising undesirable volatility in output and employment.

Domestic developments A complicating feature of the UK economic landscape is that these external price shocks have coincided with tightness in the labour market and the strength of corporate pricing power, at least in some sectors.

This raises the threat of second-round effects becoming established in UK price and wage-setting behaviour. Understandably, price setters and those wage bargaining are likely to try to offset the impact of higher headline inflation on their real spending power by seeking to re-establish profit margins or higher wages in order to preserve their real incomes.

While such a process can have important distributional effects, ultimately it cannot offset the unavoidable decline in UK real aggregate income stemming from the deterioration in the terms of trade. But attempts by one group to dodge the impact of this aggregate decline by passing it onto other groups:

• both threatens to squeeze the income of those with least bargaining power – likely concentrated in the lower part of the income distribution;
• and may impart a self-sustaining momentum to UK inflation, as different groups seek to outbid each other for a larger share of a smaller-than-expected overall pie, creating incompatible nominal demands that can only be reconciled by higher aggregate inflation.

Crucially, this process threatens to create more persistent inflation dynamics in the UK, which continue even after the original impetus from external sources has dissipated or even reversed. Such behaviour would threaten a more sustained deviation of inflation from target, going beyond the realisation of the shorter-term volatility that I have already mentioned.

The MPC’s May forecast anticipates that the real income squeeze coming from higher international energy and goods prices will slow domestic demand, and eventually result in the emergence of economic slack, an easing of corporate pricing power, higher unemployment and a looser labour market. All this helps to cool the domestically generated price, wage and cost pressures, on which the MPC is rightly focused.

The question is whether this economic weakness will be enough to contain inflation alone. The MPC has taken the view that monetary tightening has been required to ensure that inflation returns to target. I would anticipate that we will see more policy tightening ahead.

The key open question is the scale, pace and timing of any further tightening, given both the current elevated level of inflation and the potential weakening of the economy (and inflationary pressures) further out.

By nature, the more persistent components of UK inflation driven by second-round effects are those most relevant for monetary policy in this context.

Because they are persistent, they can be addressed by monetary policy, despite the long and variable lags in policy transmission. And if the MPC is to return inflation to its 2% target in a sustainable way, then it is precisely these persistent components of any deviation of inflation from target that need to be resisted the most.

Monetary policy implications It is for this reason that the MPC’s most recent communication has emphasised the Committee’s preparedness to act forcefully, if necessary, to indications of more persistent inflationary pressures.

At least on my part, this statement reflects a willingness – should circumstances require – to adopt a faster pace of tightening than we have seen implemented in this interest rate cycle so far.

It simultaneously emphasises the conditionality of any such change in the pace of tightening on the flow of new data and analysis we have seen over the past few months and will receive in the coming weeks.

And it flags that the focus of attention will be on indications of more persistent inflationary pressures, which, in my view, places emphasis on potential second-round effects in price and wage setting behaviour.

Much remains to be resolved before we vote on our August policy decision. How I vote on that occasion will be determined by the evolution of the data and my interpretation of it. But I hope that this discussion helps to lay out the main features of my monetary policy ‘reaction function’ at present.

References

Broadbent, B (2021). ‘Lags, trade-offs and the challenges facing monetary policy,’ speech given at Leeds University Business School, 6 December

Cloyne, J. and P. Hürtgen (2016). ‘The macroeconomic effects of monetary policy: A new measure for the United Kingdom,’ American Economic Journal: Macroeconomics 8(4), pp. 75-102.

Friedman, M. (1961). ‘The lag in effect of monetary policy,’ Journal of Political Economy 69(5), pp. 447-466.

Harrison, R., R. Thomas and I. de Weymarn (2011). ‘The impact of permanent energy price shocks on the UK economy,’ Bank of England staff working paper no. 433.

Pill, H. (2021). ‘UK Monetary Policy – ‘Crossing the river by feeling the stones’, speech given at the Confederation of British Industry, Newcastle-upon-Tyne, 26 November.

Pill, H. (2022a). ‘Returning inflation to target,’ speech given at Kings College, London and Qatar Centre for Global Banking and Finance conference, 6 July.

Pill, H. (2022b). ‘Monetary policy with a steady hand,’ speech given at the Society of Professional Economists online conference, 9 February.

Tenreyro, S. (2022). ‘The economy and policy trade-offs,’ 2022 Dow Lecture, given at the National Institute of Economic and Social Research, 23 February.