The route back to 2% inflation − speech by Michael Saunders

Given at the Resolution Foundation
Published on 09 May 2022
Michael Saunders talks about the outlook for the UK economy and inflation. He then sets out his views on interest rates.

Speech

Let me give you the main points upfront.

  • Inflation, and key measures of longer-term inflation expectations, are uncomfortably high. Alongside large gains in prices of energy and consumer goods, domestic inflation pressures have been rising in recent quarters, evident in trends in capacity strains, longer-term inflation expectations, underlying pay growth and services inflation.
  • The strength of external costs is eroding real incomes and is likely to cap real spending. But, by creating a long period of above-target inflation, these external cost increases also may exacerbate the rise in inflation expectations and hence, with the tight labour market, could make it harder to ensure domestic inflation pressures return to a target-consistent pace.
  • Against this backdrop, the MPC has recently raised rates by nearly 100bp. At our most recent policy meeting, most MPC members (including myself) judged that, based on our updated assessment of the economic outlook, some degree of further tightening in monetary policy may still be appropriate in the coming months.
  • I put considerable weight on risks that, unless checked by monetary policy, domestic capacity and inflation pressures would probably be greater and more persistent than the central forecast in the recent MPR. As a result, my preference has been to move relatively quickly to a more neutral monetary policy stance.

GDP growth in Q1 this year was probably stronger than the MPC expected a few months ago, leaving GDP roughly 1% above the Q4-19 level, just before the pandemic. Unemployment has returned to the pre-pandemic level, just below 4%, and has not been lower since the mid-1970s. Less welcome, inflation has risen sharply, with headline CPI inflation at 7.0% YoY on the latest (March) figures, and core at 5.7%. The QoQ annualised rates are running at around 7¼% for headline CPI and 6½% for core (see figure 1). The BoE staff forecast is that the upcoming April figures (published on 18 May), which will include the recent rise in the Ofgem price cap, will show headline CPI inflation at around 9% YoY.

Figure 1. UK – Headline and Core CPI QoQ Annualised (seasonally adjusted)

Footnotes

  • Sources: ONS and Bank of England.

As last year, the ongoing inflation pickup partly reflects higher energy prices, including effects linked to Russia’s invasion of Ukraine. The direct effect of energy prices on the CPI is already substantial and is likely to rise further during this year. Part of the inflation pickup reflects buoyant consumer goods prices, resulting from the global imbalance between strong demand for consumer goods and constrained supply. But the rise in inflation has become more broad-based, and partly reflects domestic cost and capacity pressures, because the recovery in activity has exceeded the economy’s potential supply. Capacity use in firms is well above average. The labour market is very tight – and has continued to tighten in recent months – with elevated readings for firms’ recruitment difficulties and a high level of vacancies.

It is not straightforward to disentangle the influence of these (and other) factors. One approach is through decompositions of CPI data, apportioning items as being driven more by external and domestic factors. For example, one might attribute the surge in non-energy consumer goods prices mainly to external factors. Conversely, the rise in core services inflation – which is relatively less affected by global factors – points to the role of domestic factors (see figure 2). These distinctions between domestic and external factors are not definitive. Energy prices have some effect on services prices. And it is notable that non-energy consumer goods prices as a whole have risen much more sharply in the UK than the Euro Area over the last year, which may point to some role for domestic factors in goods price inflation.

Figure 2. UK – Measures of Service Sector Inflation

Footnotes

  • Note: The first five series are year-on-year percentage changes. EOHO = Eat Out to Help Out. The Agents’ scores are ordinal series on a scale of -5 to 5, whereby a higher figure implies stronger price pressures. The latest figures are March 2022 for the CPI series, Q1 2022 for services producer prices, and April 2022 for the Agents’ scores. Sources: ONS and Bank of England.

Another approach is to examine what firms are saying. A recent survey by the BoE Agents found that firms generally expected to raise prices by more over the next 12 months than over the previous 12 months, with much of that increase expected to take place in the next three months.footnote [1] Firms in the consumer services sector expected a particularly notable increase in price inflation. They reported increasing prices relatively little so far, but expected prices to rise by 6%, on average, over the coming year. Across the whole sample, the most common factor reported by firms in explaining the rises in prices (past and future) is labour costs, followed closely by materials and goods prices, utility prices, transport costs and general inflation (see figure 3).

Figure 3. UK – Agents’ Survey of Factors Affecting Firms’ Selling Prices (Net Balances)

Footnotes

  • Note: The chart shows the net balances of firms that report each factor as affecting their selling prices over the last 12 months and their expected price changes over the next 12 months. Reports of ‘slight’ changes were given a 50% weight relative to reports of ‘major’ changes when calculating these balances. Source: Bank of England.

I also want to highlight some recent work done by colleagues at the BoE, using results from the Decision Maker Panel of firms (see Appendix for details). This work suggests that external factors accounted for most of the rise in inflation over the last year, with large effects from energy input prices (especially among energy-intensive firms), supply shortages and import prices (see figure 4).footnote [2] Costs relating to Brexit appear to have played some role, although this effect has recently diminished as one-off cost increases start to drop out of the annual comparison. Domestic factors (demand, labour shortages) accounted for around a third of the rise in inflation over the last year. One must be careful not to lean on this disaggregation too strongly. But the rough split, with a large effect from external factors but also a significant rise in domestic pressures, looks plausible to me.

Figure 4. UK – Contributions to Changes in Inflation Since 2019 Q4 Based on DMP Survey

Footnotes

  • Note: Contributions are derived from firm-level regressions using DMP response data. Based on the question: “Looking back, from 12 months ago to now, what was the approximate percentage change in the average price you charge, considering all products and services?” Further details included in an Appendix. Source: Bank of England.

At first glance, it may seem surprising that domestic cost and capacity pressures have escalated so much, and the labour market is so tight, given that real GDP is only slightly above the Q4-19 level. If potential GDP had grown in line with its pre-pandemic pace (around 1½% YoY) since Q4-19, then one would expect the economy to still have some slack.

However, since Q4-19, the economy’s potential output has fallen well below its previous trend.

The workforce has shrunk by 440,000 people (1.3%) since Q4-19, and is 2.5% below the January 2020 forecast (see figure 5). The scale and persistence of this drop in labour supply has been a surprise to many forecasters, including us. The interplay between Brexit and the pandemic has reduced net inward migration (and hence population growth), while participation has fallen markedly (especially among people aged 50-64 years). Since Q4-19, the number of people aged 16-64 years that are outside the workforce and do not want a job has risen by 525,000 (1.3% of the 16-64 age population). This largely reflects increases in long-term sickness (roughly 320,000 people) and retirement (90,000), with smaller contributions from lower participation among students (65-70,000) and short-term sickness (30-35,000 people). The share of the 16-64 population who are outside the workforce and do not want a job because of long-term sickness is a record high, with an especially sharp rise among women (see figure 6). I suspect much of this rise in inactivity due to long-term sickness reflects side effects of the pandemic, for example Long Covidfootnote [3] and the rise in NHS waiting lists.

Figure 5. UK – Workforce (Millions of People)

Footnotes

  • Note: The latest figure is for the three months ended February 2022. Sources: ONS and Bank of England.

Figure 6. UK – Per cent of Adult Population Aged 16-64 Who Are Outside the Workforce and Do Not Want a Job Because of Long-term Sickness

Footnotes

  • Note: Latest figures are for the three months ended February 2022. Sources: ONS and Bank of England.

The economy’s potential output may have been further reduced since Q4-19 by weakness in business investment and adverse effects from Brexit on productivity. Moreover, changes in the composition of labour supply and spending (in terms of sector, skills and geography) may have exacerbated mismatch between supply and demand in the labour market.

It also is possible that Brexit has steepened the UK wage and price Phillips curves, by reducing the contestability of the UK labour and product markets, limiting the extent to which domestic capacity strains and specific skill shortages can be eased through imports and inward migration. It is too early to be definite about this but, if so, it could have increased the extent to which excess demand lifts pay and prices.footnote [4]

The rise in inflation is already creating spillovers to the economy, including second-round effects on wages and costs. Longer-term inflation expectations measured from households or financial markets have risen further and are uncomfortably high (see figure 7). There are signs that pay deals have picked up markedly this year.footnote [5] The BoE Agents report that the tight labour market is the main driver pushing up pay deals, but the high rate of actual and expected inflation is also a major factor. Business surveys suggest that firms expect to continue to raise their selling prices rapidly, and there is little sign that firms’ pricing strategies are constrained by the 2% inflation target. Uncertainty over inflation has risen, especially among firms affected by supply and labour shortages and in energy-intensive sectors.

Figure 7. UK – Measures of Longer-Term Inflation Expectations

Footnotes

  • Note: The measure of household inflation expectations is the YouGov/Citigroup survey of inflation expectations for the next 5-10 years. The financial markets measure is the 5x5 RPI breakeven until end-2019, 5x3 breakeven since then. The May 2022 data point represents the average of the daily 5x3 RPI breakevens until 4 May. Sources: ONS, YouGov/Citigroup and BoE.

The rise in inflation is eroding consumers’ real incomes, and BoE staff forecast that household real disposable income will fall by around 1¾% this year – the second largest drop on record. Consumer confidence has fallen sharply in recent months, probably reflecting this prospective squeeze on real incomes and perhaps the rise in inflation uncertainty.

It is notable, however, that so far firms in general seem more upbeat than consumers. Business surveys, including the BoE Agents, suggest that activity continues to grow quite rapidly, while firms’ hiring intentions are well above average and redundancy notifications remain low.

The outlook

The central forecast in the May MPR is (as usual) conditioned on the market interest rate path, and assumes that wholesale energy prices follow the path implied by futures for the next six months and are stable thereafter. In that forecast, there is a further sizeable rise in the Ofgem price cap in October and hence CPI inflation rises above 10% later this year. Weakness in real incomes hits spending and, with softer activity, firms reassess their staffing plans and cut back on hiring abruptly. As a result, unemployment starts to rise later this year. Supply constraints ease through reduced bottlenecks in global goods markets and some recovery in UK workforce participation. Even so, it is worth noting that in the MPR, the level of the workforce remains below the pre-pandemic peak (early 2020) throughout the forecast period (to mid-2025). With further monetary policy tightening (reflecting the market curve used for the MPR), and a modest widening in credit spreads, demand slows and falls well short of the recovery in supply. Inflation is still slightly above the 2% target two years out, but falls a greater margin below the 2% target 3 years ahead.footnote [6]

Table 1. UK – May 2022 MPR Projections:

Projections

2022 Q2

2023 Q2

2024 Q2

2025 Q2

GDP, YoY

3.2

0.0

0.2

0.7

CPI inflation

9.1

6.6

2.1

1.3

LFS unemployment rate

3.6

3.9

4.6

5.5

Excess supply/Excess demand

-1¼

-1¾

-2¼

Bank Rate (market path)

1.0

2.5

2.4

2.0