UK monetary policy in the context of global spillovers – speech by Catherine L. Mann

Speech

1: Introduction

Monetary policymakers around the world are facing difficult trade-offs – strong inflationary pressures even as demand slows. Nuances in their strategies are based on the degree to which the preponderance of the inflationary pressures emanate from external or domestic sources. Although by now, domestic pressures are evident almost everywhere. Similarly, there are strategy distinctions depending on how much demand is slowing, relating to initial conditions pre-Covid, fiscal responses during Covid and as it recedes, as well as associated gaps between production, employment, and expenditure measures of activity. Each central bank is evaluating their policy direction as appropriate for their own economies based on the assessment of domestic indicators – all talk “data-driven” decision-making.

However, amongst the data and relationships important for central bank decision makers is the global financial factor – that is financial spillovers from one economy to another precipitated by differing policy paths, as channelled through interest rates, asset prices, and the foreign exchange rate. In the current context, with a number of central banks embarking on tightening paths, but to different degrees, the global factor may be particularly relevant.

A priori it is ambiguous as to how domestic policy should react to higher policy rates abroad – raise policy rates commensurate with the foreign tightening path to contain the currency depreciation at an additional cost to activity in the medium term, or undertake a more modest or gradual rate increase to moderate the impact on activity but at the cost of more currency depreciation and inflation in the near term.

Research finds that the UK, open and with substantial cross-border financial flows, is particularly exposed to these spillovers (Cecchetti et al., 2020). Considering the ambiguity in appropriate policy noted above, an evaluation of historical data reveals that in past experience, the Bank has raised interest rates only modestly in the face of the global factor, which prioritizes medium-term activity at the cost of higher inflation in the near term.

A key question is whether the historical reaction function is appropriate for today’s economic situation, where inflation is hitting double digits. To consider alternatives, I will show two stylized scenarios for policy paths that differ from the historical response. One takes an activist path and is willing to reverse rates. One follows a more gradual path and is more averse to rate-reversals. These have differing outcomes for inflation in the near term, price stability over the horizon, output in the medium-term, and volatility in currency markets.

These are very stylized scenarios and in no way represent MPC thinking, but, along with other data, research, and projections, they did inform my policy decision to vote for an increase of Bank Rate of 50 basis points at the last meeting. In the current context with historic inflation rates already evident, and with a large central bank (at least one!) pursuing a robust tightening, the UK’s exposure and sensitivity to global financial spillovers could exacerbate the inflation-activity trade-off currently facing the Bank of England. In my view, a robust policy move, based on both my assessment of the domestic conjuncture and being attuned to the global factor, reduces the risk that domestic inflation already embedded is further boosted by inflation imported via a Sterling depreciation.

2: Economic backdrop to the policy challenge

Before evaluating global spillovers, it is useful to take stock of where we are and how we got here. The dominant feature of both domestic and global economic landscapes is inflation rates in advanced economies not observed in decades. A sequence of global shocks has let prices rise at historic rates – the initial Covid shock and fiscal responses powering a goods-market rotation, supply bottlenecks, and surging prices for goods; reopening as Covid’s variants receded, but at different paces and following different strategies, such as China’s zero-Covid strategy; supporting elevated prices of goods and energy; the Russian invasion of Ukraine spurring even higher energy and food prices.

These global shocks affect economies differentially on account of initial conditions (such as the strength of demand, characteristics of labour markets, and the degree of accumulated savings), as well as exposure to the shocks (such as through energy infrastructure and importance of supply-chains and trade with China), and finally domestic institutional characteristics (including for example, Brexit and the Ofgem mechanism in the UK context).

In the end, the composition of domestic inflation facing central banks – among which, the Fed, the ECB, and the Bank of England – has unique characteristics but for all of these three inflation rates are far above their respective targets (Chart 1). Underneath the headline numbers there is some nuance, that is, while the European economies are more exposed to the current gas and energy price shocks, US inflation has been driven more by domestic demand and capacity pressures. UK goods price inflation is even stronger than in the US or the Euro area. For all, global shocks have, to a greater-or-lesser degree, become embedded via second-round effects in domestic inflation, and therefore require a monetary policy response.

Chart 1: Inflation in the United Kingdom ^(a), United States ^(b) and Euro area ^(c)

Year-on-year percent changes

Footnotes

• Source: ONS, Refinitiv Datastream, and Bank calculations. Notes: Dotted lines show 2011-2019 average inflation for the respective country. Latest observation: April 2022.

But inflation is just one side of the trade-off; the evolution of activity is the other. All three economies are projected to slow, although there are conjunctural differences across countries, as well as different possible fiscal actions. As seen in Chart 2, US output is nearly back to its pre-Covid trend on the back of strong fiscal stimulus in 2021, and consumption of goods well beyond the patterns of the prior decade. The Euro area has had a less strong recovery out of Covid and is more exposed to consequences of war in Ukraine, but has again reached its pre-Covid level of GDP. The UK has also regained pre-Covid activity in GDP terms, but not when it comes to employment, and its GDP is well below trend. Given persistent supply shocks, pre-Covid trends may however not be attainable.

For these three economic areas, the contrast between the output and inflation trajectories illustrate how significant the supply side impact of the global shocks has been. Even so, the balance of inflation rising versus activity slowing differs among these three economies. Therefore the policy appropriate to meet the central bank’s objective also will differ, which raises the topic of the global factor and spillovers.

Chart 2: Real GDP in the United Kingdom ^(a), United States ^(b) and Euro area ^(c)

Index 100 = 2011 Q1

Footnotes

• Source: ONS, Refinitiv Datastream, and Bank calculations. Notes: Dotted lines show 2011-2019 log-linear trend GDP for the respective country. Latest observation: 2022 Q1.

3: Monetary policy reactions so far

The sequence of global shocks and domestic second-round effects have required monetary policy pivots. In 2021, most central banks in advanced economies did not remove accommodation, being concerned about the fragility of the recovery, below trend growth, and weak employment. Further, at that time the bout of inflation was predicted to be short-lived and mainly driven by a one-off increase in goods and energy prices.^{footnote [1]}

However, with persistently strong goods imbalances and, importantly, the subsequent shocks, global inflationary pressures intensified, as did concerns that inflation was becoming embedded in medium-term expectations and future price-setting, in a manner which would not be consistent with inflation targets. Therefore, central banks have shifted to removing accommodation via their policy rate and in some cases, their balance sheets. The Bank of England was the first major central bank to move in December (after the conclusion of the Bank’s asset purchase programme, which I voted to end early), followed by the Bank of Canada in March, and the Federal Reserve and Reserve Bank of Australia in May. The ECB has not yet increased interest rates and is still a net-buyer of government securities but has signalled that it likely would begin raising rates at its July meeting.

Markets are pricing significant further tightening despite a darkening outlook (Chart 3). Traders’ expectation of the policy paths, particularly for the US and UK, is one of near-term tightening to contain inflation but then backing-off as demand slows: The medium-term resting point (e.g. 5y5y nominal) is somewhat below the peak in policy rates. The pace of tightening in the near term and how much policy might need to reverse differs according to their assessment of the starkness of the trade-off, and in particular, their assessment of second-round effects of the global shocks on domestic pressures on inflation.

Chart 3: International policy rates and instantaneous forward curves

Percent per annum

Footnotes

• Source: Bloomberg and Bank calculations. Notes: Solid lines show Bank Rate for UK, the upper end of the Fed Funds Rate target range for US and the ECB’s deposit facility rate for EA. Dashed lines show the latest instantaneous forward curve from 16 June 2022, dotted lines the curve from 01 June 2022. Forward curves are based on OIS contracts and are corrected for the spread between effective overnight rate and policy instrument in the respective country. Latest observation: 17 June 2022.

For the UK, traders’ expectations reflect the MPC’s challenge of managing the inflation-output trade-off – the “narrow path” outlined by Andrew Bailey (2022). While the MPC sets policy according to domestic macroeconomic conditions, as a so-called small open economy, the UK does not exist in a vacuum. Global supply and value chains, but also global financial markets will transmit what happens abroad into the UK, too.^{footnote [2]} The MPC takes these international spillovers into account when setting domestic policy. But, have these spillovers become more important? Certainly for global goods prices, but also apparently for the global financial factor.

For the UK, data and surveys already show a rising importance of global spillovers for domestic financial conditions. Chart 4a shows that international factors have played an important role in driving market rates as seen through the lens of the Bank’s Rigobon decomposition.^{footnote [3]}

Chart 4: International spillovers into UK rates ^(a) and policy expectations ^(b)

Contributions to percentage point changes (LHS) and percent per annum (RHS)

Footnotes

• (a) Source: Bloomberg and Bank calculations. Latest observation: 02 June 2022.
• (b) Source: Bloomberg and Bank calculations. Notes: Green dotted lines show the 25^th and 75^th percentile of responses as reported in the June 2022 Market Participants Survey. Latest observation: 17 June 2022.

Furthermore, as shown in the right-hand side panel, there is a significant and persistent gap between the market curve and the median expectation of Bank Rate as reported in the Bank of England’s Market Participants Survey. When asked about this gap, respondents say that a large part is associated with expectations of how international factors might influence UK monetary policy, in addition to UK-specific drivers and market liquidity challenges. Both the decomposition and the survey assessment are reflections of the market’s view based on historical experience – in other words, the market’s view of the shocks as well as the MPC’s reaction function.

4: Quantifying monetary policy spillovers

It is well documented that the global factor is disproportionately associated with US macroeconomic and financial conditions, due to the sheer size of the US economy, the outsized importance of the Dollar as a reserve and invoicing currency, and the role of US government securities as safe haven assets.^{footnote [4]} On these bases, too, reigns the importance of Federal Reserve policy.

Therefore, in this speech on spillovers, I will focus on the effect of US monetary policy on macroeconomic and financial conditions in the UK. While economic and financial conditions in the rest of Europe certainly matter for the UK, as does ECB policy, research on the global factor does not yield such an outsized impact, and the policy outlook is more ambiguous at this point. So, the task today is to estimate the likely effect of a US tightening on the UK macroeconomy, and to consider alternative policy paths that UK monetary policymakers might consider in reaction.

While the domestic effects of monetary tightening are (relatively) well-established^{footnote [5]}, the net effect on economies abroad is a priori ambiguous. On the one hand, via slowing US domestic demand, US monetary tightening will reduce demand for goods and services produced abroad. The global demand channel causes a slowdown in activity and disinflation.^{footnote [6]} On the other hand, all other things being equal, a monetary policy tightening in the US ought to appreciate the Dollar vis-à-vis foreign currencies as compensation for holding Dollar-denominated assets rises and capital flows to the US increase.

For the foreign economy, this means capital outflows (or reduced capital inflows) and a depreciating currency. As imported goods become more expensive in terms of the foreign currency, this global financial channel will tend to have an inflationary effect in the non-US economy. To the extent that the depreciation makes exports from this country more attractive on the world market there may be a boost to exports that offset the global demand slowdown. Inflationary pressures from US tightening have been documented especially for emerging market economies and have been found to be large and significant^{footnote [7]} but the relative price effect on export volumes apparently is mitigated by a number of factors including dollar invoicing and being part of a multinational supply-chain.

In sum, the global demand channel should induce the same signs in output and inflation at home and abroad (i.e. slowing activity, disinflation) while the global financial channel would induce the opposite sign in the foreign economy (i.e. increasing activity, inflation). Therefore, the net effect for the non-US economy is not determined a priori. Additionally, all other things are not usually equal in the real world. Instead, which way activity and inflation break in the foreign economy depends critically on the reaction of monetary policy in that economy.

There are two stages to our analysis which focuses on the UK. The first stage identifies the effect of a monetary tightening on US variables and their spillovers to the UK, where the sign, as noted above, is ambiguous. In the next section, I evaluate policy reactions of the MPC – the one embodied in the data, and then two stylized alternatives to the endogenous path.

Step one assesses the historical effect of a Fed tightening on the UK. My colleague Lennart Brandt and I estimate a structural vector autoregression including both US and UK variables identified by an external instrument for US policy.^{footnote [8]}

In terms of the domestic response, that of US variables to US tightening, the model yields plausible results in line with the literature for both signs and magnitudes. The red lines in Chart 5 show that a shock which increases the US 3-months Treasury bill rate by 100 basis points decreases the level of real economic activity by 3 percent by the end of the second year. It also decreases the price level by about 0.4 percent by the end of year 3, although this effect is statistically insignificant in the sample.

For the UK, using historical data, it turns out, that a US tightening has been inflationary rather than disinflationary. Even though output in the UK falls by nearly as much as in the US (the blue line in the left panel), the price level initially jumps and is persistently higher throughout (the blue line in the right panel) adding about half a percentage point to inflation at the end of the first year. This inflationary effect is consistent with the effect on the bilateral exchange rate: Here, a US tightening leads to a Sterling depreciation of 4½ percent by year 2.

Chart 5: Impact of a US monetary tightening by 100bps – Level of real activity ^(a) and level of consumer prices ^(b)

Percent compared to baseline

Footnotes

• Source: Bank calculations. Notes: LHS panel (a) shows the impulse response function of the level of real activity in UK and US in reaction to a US monetary policy shock which increases the US 3-months Treasury bill rate by 100 basis points. RHS panel (b) shows the response of the CPI price level to the same shock.^{footnote [9]} In both panels, lines are pointwise medians and shaded areas are 68-percent credibility bands across all posterior draws of the respective IRF.

Importantly, because these use historical data, these reactions are conditional on a data-based estimate of the reaction of UK monetary policy in the model. On average, over the past, UK short term rates rise immediately after the shock (by 27 basis points, so by about a quarter of the US response) but fall thereafter, reaching a trough of -74 basis points at the end of year 3.^{footnote [10]} Thus, on net the UK policymaker in the model as estimated from the data, chooses to add stimulus as a result of US tightening, in order to offset the negative output effects of the global demand channel at the cost of temporarily higher inflation and a persistently higher price level.

The rates differential between the US and the UK remains in favour of the US throughout, and this differential is the deciding factor for the financial channel which is why the bilateral exchange rate traces out a persistent depreciation of Sterling as a result of the shock. To stabilize prices and alleviate the inflationary pressure coming through the exchange rate, UK policymakers would need to roughly go along with the tightening from the US. Of course, by doing so, they would exacerbate the fall in output. The MPC reaction function based on the historical data does not do this.

To conclude, past monetary policy spillovers from the US – as seen through the lens of this model and the historical data – have been trade-off inducing shocks for the UK. A Fed tightening depresses output both at home and abroad but in fact puts upward pressure on UK prices through the global financial channel.

It is important to note that this is just one model (and over one time period) which I have taken to illustrate the issue facing me, as a monetary policymaker. It is not necessarily the view of other MPC members, nor do these calculations represent the mechanisms and multipliers used in the Bank’s forecasting process.^{footnote [11]}

5: Scenarios for the UK monetary policy reaction

Models like the one outlined above only reflect some average response of policy and macroeconomic variables to an unanticipated shock. They need not reflect the reaction of these variables at exactly this moment. The experience of the past two years should remind us that historical regularities may not hold forever – as I outlined in my previous speech (Mann, 2022b).

More importantly the way these spillovers actually manifest in UK variables of inflation and activity depends critically on the actual reaction of the MPC – I still have a job to do! While UK monetary policy is endogenous from the perspective of the model, in reality it is independent. There is no mechanism forcing the current MPC to act in accordance with its historical behaviour. So, going back to the challenge presented by the global factor in a tightening cycle. Roughly speaking, the domestic policymaker faces two choices: Either to try and stabilise economic output at the cost of higher inflation or to offset the inflationary impact at the cost of larger output losses.

To assess alternatives for how UK monetary policy could react to the given Fed shock and how those alternatives might change macroeconomic outcomes, I will go through a couple of very stylized scenarios. They are all predicated on the same US monetary policy shock as shown above, i.e. a shock that raises short-term interest rates in the US by 100 basis points on impact. They differ, however, by the way the UK policymaker chooses to bring on-shore the external shock. The technical strategy to evaluate these alternative reaction functions requires the identification of a separate UK-domestic monetary policy shock which I can use to impose a certain path of UK policy rates.^{footnote [12]} Together with US monetary policy which continues to work in the background, this alternative reaction (alternative to that which is estimated from historical data) leads to different paths for UK activity and consumer prices.

First, consider Chart 6. On the left-hand side it shows the different paths for UK short-term rates. All scenarios are set up such that the rate is constrained to certain values for a period of time after which it is allowed to again freely adjust. Note that these scenarios are of course very stylised and extreme examples of possible policy paths. These certainly do not represent the MPC’s policy intentions. Instead they are supposed to illustrate the sensitivities of macroeconomic conditions to size and timing of a UK monetary policy reaction to a US policy tightening.

Chart 6: Dynamic multipliers of UK variables implied by a US monetary policyshock and a suitably calibrated response of UK monetary policy – Level of UK short-term rates ^(a) and level of Sterling-Dollar exchange rate ^(b)

Basis points (LHS) and percent compared to baseline (RHS)

Footnotes

• Source: Bank calculations. Notes: LHS panel (a) shows the impulse response of the level of UK short-term interest rates in reaction to a US monetary policy shock which increases the US 3-months Treasury bill rate by 100 basis points conditional on different paths of UK monetary policy. RHS panel (b) shows the response of Sterling to the same US shock and the same UK reaction. A value above zero represents a Sterling appreciation compared to baseline, a value below zero a depreciation

As a benchmark, the blue solid line shows the reaction as implied by the historical experience estimated in the spillovers model of the previous section. In this case, the UK policymaker raises interest rates by about a quarter percentage point for a brief period but quickly reverses rates. Two other scenarios are considered. One scenario (blue dashed line) raises the policy rate by 25 basis points per quarter to gradually match the hike in the Fed policy rate, then holds rates steady for another year. This path stands for a policymaker who opts for a wait-and-see approach and who is reluctant to put policy into reverse after they have begun tightening. The second scenario (red dashed line) shows an “activist” policy path in which UK short-term interest rates rise by exactly as much as the Fed rate hike, and are held at that level for one year before reversing.

The right-hand side of Chart 6 then shows what these different rate paths imply for the value of Sterling, which is a key part of the transmission of the global factor. Using the reaction function estimated from historical data (solid blue line), Sterling depreciates almost right away as consistent with the assumed interest rates differential. In the other two scenarios, however, Sterling remains stronger for the first year, in the activist scenario (dashed red) even markedly appreciating shortly after policy rates are raised. Although it does depreciate by more further down the line which is consistent with the steep fall in policy rates necessary to return the economy to equilibrium after the Fed shock. In the activist scenario, Sterling is more volatile, countering the inflation in the near term, but depreciating over the medium term consistent with the demand slowdown.

A look at UK macro outcomes underlines why these profiles for the policy rate and FX make sense: Chart 7 shows the reaction of UK activity and consumer prices corresponding to the interest rates paths of Chart 6a. The solid blue lines are the same as the ones in Chart 5 because these are the ones based on the reaction function of the UK policymaker and endogenous macroeconomic responses to a US monetary policy shock as estimated from the historical data.

Chart 7: Dynamic multipliers of UK variables implied by a US monetary policyshock and a suitably calibrated response of UK monetary policy – Level of UK real activity ^(a) and level of UK consumer prices ^(b)

Percent compared to baseline

Footnotes

• Source: Bank calculations. Notes: LHS panel (a) shows the impulse response of the level of UK real activity in reaction to a US monetary policy shock which increases the US 3-months Treasury bill rate by 100 basis points conditional on different paths of UK monetary policy. RHS panel (b) shows the response of the UK CPI price level to the same US shock and the same UK reaction.

When we layer on top the effects of an alternative path for UK monetary policy, we see two things: First, the MPC could choose to offset the inflationary impact of a US tightening. Matching the size of the US tightening (red dash) stabilises the price level as far out as year 2. As expected, however, this comes at the cost of a fall in output beyond what is implied by the historical data in the spillovers model. From the third year onwards, the level of UK output is below the endogenous benchmark.

But, second, we can also see why it is important to react in a timely fashion to a US monetary policy shock that causes the UK price level to jump on impact. Reacting with gradual increases (blue dash) and, more importantly, delaying the policy reversal leads to higher costs in output in the second year and an inflation undershoot as policy is assumed to be constrained for a longer period of time. (If the hold period is 6 months instead of 12 months, the story is qualitatively the same.) In contrast, immediately reacting to the jump (red dash), holding to cement the inflation deceleration, and then reversing in order to moderate the deterioration in output (which comes through the interest rate, global demand, and trade channels) comes at little additional inflationary cost. In considering alternative paths, policy needs to be responsive to the economic context as well as to be nimble. If near-term inflation is the dominant concern, then the activist path addresses that. If medium-term output losses are the concern, then policy needs to reverse promptly.

To wrap up this section, let me again stress that the interest rate paths shown here are neither prediction nor promise of what the MPC might or should do in the real world. Instead, they serve to illustrate the nature of the trade-off that the MPC faces.

6: Discussion in the current context

The scenarios outlined here are extremely stylized. Nevertheless, in the current environment of the inflation-output trade-off and global monetary tightening, they help inform my policy decision.

First, with regard to characterizing the inflation-output trade-off: Incoming data, by some accounts, suggest an increasingly stark trade-off in terms of rising and persistent inflation versus deteriorating real income. However, there are important nuances to judging these data.

To me, the incoming data on inflation show increasingly domestic embeddedness, persistence, and momentum: 90% of CPI categories are rising at rates greater than 2012-2019, and the distribution of expected inflation outcomes have shifted rightward and with a fatter right tail (Mann, 2022b).

On the other hand, even though higher energy and food prices (as well as overall inflation) clearly are hitting real incomes, countervailing factors importantly and increasingly are likely to support consumption spending in the near term. These include the two fiscal packages, strong employment, wide-spread bonuses as well as robust wage growth, strong housing values, accumulated savings, quality trade-down, and borrowing through credit cards among other schemes. All told, to the extent that consumption growth remains stronger than expected based on real income, this would support firms’ pricing expectations and decisions, and add to domestic upside risks to inflation.

Taking my judgement that the domestic conjunctural situation is characterized by very high inflation and various supports to consumer purchasing power relative to real income, I now turn to the global factor: If the Fed tightens at the currently expected pace, and the ECB musters an increase soon, the scenarios outlined above suggest additional depreciation pressure on Sterling that could add to inflation particularly in the near term. Using the reaction function based on historical data with about a ¼ response to the posited Fed tightening would add about half a percentage point to inflation in the first year. While the MPC aims to stabilize inflation at the 2% target in the medium term (Broadbent, 2021), given the likely double digit inflation, being mindful of the near term implications of the global factor for inflation is particularly relevant.

I voted for a 50 basis point increase at the last MPC meeting. In my view, a more robust policy move, based on both domestic conjuncture and commensurate with the global factor, reduces the risk that domestic inflation already embedded is further boosted by inflation imported via a Sterling depreciation. I open the door to a policy rate reversal in the medium term when the domestic supports to demand fade and when weakness in external sources of demand bite. In my view this monetary policy path supports an inflation-output combination superior to that of the historical reaction.

Acknowledgments

I would like to thank, in particular Lennart Brandt, as well as Andrew Bailey, Robin Braun, Emma Brooksbank, Ambrogio Cesa-Bianchi, Josh Martin, Nick McLaren, Michael McLeay, Silvia Miranda-Agrippino, Marco Pinchetti, Galina Potjagailo, Andrea Rosen, Michael Saunders, Fergal Shortall, Katie Taylor, Silvana Tenreyro, and Danny Walker for their comments and help with data and analysis.

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