The path to 2 per cent − speech by Silvana Tenreyro

Given at Society of Professional Economists Annual Conference London
Published on 11 November 2022

In this speech Professor Silvana Tenreyro explains how energy prices affect inflation, and how that can depend on the strength of the labour market. She discusses how government and financial-market responses to the economic shock may inform the Monetary Policy Committee’s decision on interest rates. 

She sets out how these factors interact, and explains why in her assessment it was necessary to raise interest rates by 0.25 percentage points at the November 2022 Monetary Policy Committee Meeting.

Speech

These are extremely challenging times for the global economy, and the UK economy in particular. We have been going through a period of extraordinary volatility in financial markets, and in the outlook for the UK economy. And this has come on the back of a period of successive, enormous shocks, starting with the Covid pandemic, and now dominated by energy prices.

In the face of such extraordinary events, one might expect an extraordinary response. But today I want to argue that while monetary policy will need to take into account all of the effects of these large economic shocks, and the responses to them of fiscal policy and financial markets, we should do so in a thoroughly ordinary way. As always, we should be guided by our remit. We need to bring inflation back to the 2% target sustainably.

This resolute focus on the inflation target is the key thing I would like to stress today. The goal of monetary policy is not to offset in their entirety movements in energy prices, nor changes in the exchange rate, gilt yields or mortgage rates. While all affect the economy, we do not target any of them directly. Sometimes their movements will reflect market volatility, and sometimes they will reflect more persistent, real adjustments. It is not within the power of monetary policy to prevent those adjustments from taking place.

We need instead to calibrate our response through the lens of our remit. What is the impact on demand? On supply? And on inflation? And that will tell us where interest rates need to go. Different MPC members will make different assessments of those impacts. They may therefore also come to different policy decisions. This was the case in November, when I voted for a smaller increase in Bank Rate than the rest of the committee. But we are all agreed on where we are heading: on the path back sustainably to our 2% inflation target.

I will emphasise three points:

  • Energy price increases push up inflation in the near term. But in the medium term, they have disinflationary effects through lower real incomes, lower demand and higher unemployment. These need to be balanced against any second-round effects that could slow the fall in inflation.
  • Following shocks, monetary policy will return inflation to the 2% target. When shocks cause movements in asset prices such as gilt yields or the exchange rate, policy need only offset the effect on inflation, not prevent those movements entirely.
  • Monetary policy has tightened significantly this year, but most of its effects on demand have yet to occur. Too high a path for Bank Rate therefore risks oversteering inflation below target in the medium term.

The shock: energy prices

The main driver of high inflation this year has been an extraordinary increase in global energy prices. As Chart 1 shows, a large part of the above-target inflation in the UK right now is accounted for by the direct mechanical effect of high energy prices on consumer prices. And a further share comes from indirect effects, since energy is an important input in the production of many goods and services.footnote [1]

Chart 1: Energy prices have been the main driver of above-target inflation

Contributions to difference in CPI inflation versus 2012-19 average (a)

Percentage points

Footnotes

  • Sources: Bloomberg Finance L.P., Department for Business, Energy and Industrial Strategy, ONS and Bank calculations.
  • (a) Data to September 2022. Bank staff projection from October 2022 to December 2022. Fuels and lubricants estimates use Department for Business, Energy and Industrial Strategy petrol price data for October 2022 and then are based on the sterling oil futures curve.

The appropriate monetary policy response to energy shocks is not automatic. Increases in energy prices have several different effects, which can push inflation in different directions. Figure 1 illustrates these channels. Their effects operate at different horizons, which is important, since the main impacts of monetary policy come after a lag, so we need to be able to account for the relative strength of these channels in the future. And that relative strength will depend on the size and nature of the energy price shock, as well as on broader economic circumstances. Those include the backdrop in the labour market, the response of fiscal policy, and any responses in financial markets. Each quarter the MPC uses its forecasts to assess the balance of these different effects, so it can set monetary policy to bring inflation sustainably to 2% in the medium term.

Figure 1: Stylised transmission of an energy price shock to UK inflation

The first, direct effect, of energy-price increases is straightforward. Energy prices are determined on globally traded markets. These wholesale energy prices are passed on directly to petrol prices paid by consumers, as well as to the prices charged on household gas and electricity bills.footnote [2] When these rise, they directly push up on UK consumer price inflation. Energy only makes up 7% of the CPI basket.footnote [3] But because energy prices have been increasing around 60% over a 12 month period, they directly contribute about 4 percentage points to the sharp increase in UK inflation (Chart 1).footnote [4]

The second channel is indirect supply-chain effects through firms’ input costs. The production of many goods, but also of some services (e.g. transport services or restaurants) require a substantial amount of energy. And even for firms where energy makes up only a small share of their total costs, such a huge increase in energy prices can still lead to a material cost increase. Firms also use intermediate inputs in production, the prices of which may also have increased owing to rising energy prices. In 2019, energy accounted for 2.3% of the input costs for the firms that produce non-energy goods and services in the CPI basket.

These indirect effects from firms’ input prices are always an important part of the transmission of energy-price movements. But pass-through this time may have been amplified by the sheer size of the shock, which is likely to have limited firms’ ability to absorb such large cost increases via lower profit margins. Bank staff estimates suggest that around ¾ of a percentage point of current CPI inflation from other categories of goods and services comes from the indirect effects of higher energy prices.

What do these direct and indirect effects imply for monetary policy? The key observation is that the main effects of monetary policy come through with some delay. Estimates of the speed of policy transmission vary, but typically suggest that the largest impact of policy on inflation comes somewhere beyond the first year.footnote [5] That makes responding to these short-lived price-level impacts counterproductive, since they drop out of the annual inflation calculation by the time the policy impact is at its peak. Trying to offset them would be liable to cause more inflation volatility rather than less, making it more difficult to meet the inflation target in the medium term.footnote [6]

Instead, my policy decisions have focused on the final two channels in Figure 1 – inertia, or second-round effects, and lower real incomes. These capture the potential effects of the energy price shock on medium-term inflation. They push the appropriate policy response in opposite directions, so assessing both the size and even the direction of the appropriate policy response depends on quantifying each channel.

So-called “second-round effects” refer to a variety of mechanisms that lead to inertia from domestic wage and price setting, which, if persistent enough, could push up on inflation into the medium term. These are typically a product of various rigidities in real wages, profit margins and relative wages and prices. Similar channels could arise from increases in short-term inflation expectations, although survey measures of these are closely correlated with actual inflation. This makes it difficult to identify any independent influence of forward-looking short-term expectations, over and above backward-looking inertia.footnote [7]

To explain where this inertia comes from, note that the energy-price shock has worsened the UK’s terms of trade, making the country poorer. To the extent higher energy prices persist, the loss in national real income must ultimately be absorbed via some combination of lower real wages and lower profits for the economy overall. If every worker and firm’s real wages and profits fully adjusted to the energy price shock instantly, then there would be no further inflationary impact after the direct and indirect effects dropped out.

The second round effects arise because in reality, some firms or workers will receive higher nominal revenues or incomes, rather than adjusting downwards. For example, some price contracts are indexed to CPI or RPI inflation; some firms have offered higher than usual pay increases, or additional pay rounds, to help with higher energy costs; and more generally measured inflation is often used as a reference point in salary negotiations. If these increases are not offset by even larger real wage or price declines elsewhere, then in aggregate we see real wage or real profit resistance, which will slow the speed with which wages and domestically driven prices fall back to target-consistent levels.footnote [8]

Second-round impacts on domestic wage and price setting need to be balanced against the disinflationary effect of lower real incomes, the final channel in Figure 1. In the UK, the evidence suggests that large or persistent increases in energy prices should lead to large falls in demand relative to supply, resulting in higher unemployment and downward pressure on real wages, ultimately weighing on inflation in the medium-term.footnote [9] For a net energy importer like the UK, the fall in real incomes is simply a reflection of the deterioration in our terms of trade.

Demand is likely to fall even if energy prices fall back, albeit by less than if they stay high persistently. This is what happens in the MPC’s November MPR forecast, which is conditioned on the fall in energy prices implied by futures markets. If increases in energy prices are temporary, or people expect them to be so, they may seek to smooth their consumption by borrowing more, or reducing savings. In basic representative agent models, there is little effect on consumption of temporary falls in real income for this reason. But in reality, a significant share of households are credit constrained, or consume partly or fully out of current income. This means that a temporary fall in real incomes can still lead to a material fall in consumption. A recent paper by Bank colleagues (Chan, Diz and Kanngiesser, 2022) shows how in a (TANK) model with heterogeneous agents, such a channel leads to a larger drop in consumption and a less inflationary shock (Chart 2).footnote [10]

Chart 2: Model responses to an energy-price shock

Impulse response functions from Chan, Diz and Kanngiesser (2022) (a)

Footnotes

  • Source: Chan, Diz and Kanngiesser (2022).
  • (a) Cyan lines show responses in a Representative Agent New Keynesian (RANK) model where the representative household faces no borrowing constraints. Orange lines show responses in a Two-Agent New Keynesian (TANK) model where one type of household is credit-constrained. The nominal policy rate in the model is set using a Taylor rule.

The appropriate policy response to the energy shock has hinged on the balance of these two offsetting effects on medium-term inflation. The channel from lower real incomes to demand is larger in net energy importers like the UK than in the US.footnote [11] It also depends on households’ ability or willingness to maintain consumption and therefore demand by cutting back on energy and energy-intensive goods and services – their elasticity of substitution. If this is small, then the impact on demand is likely to be larger.

The strength of inertia in domestic wage and price setting will depend to a large degree on the energy shock itself. The larger and more persistent the increase in energy prices, the bigger are likely to be the second-round effects. Over the decades, structural changes to the UK economy have reduced the typical scale of second-round effects, for a given increase in inflation. But as the energy-price shock has built over the past year, so too has the likely scale of any inertia. Partly as a result, I have judged that some policy tightening has been required.

Higher interest rates cannot necessarily prevent second-round effects from occurring. Some, for example from types of indexation, are a mechanical consequence of the large direct and indirect effects of higher energy prices.footnote [12] However tighter monetary policy can lean against their impact on inflation. By weakening demand and increasing the amount of slack, policy can help push down on domestic wage and price pressures where those wages and prices are not indexed, counterbalancing the inertia that resulted from the energy price shock.

It is also possible that some second-round effects interact with the state of the labour market.footnote [13] For example, perhaps some workers in a tight labour market can push for wage rises in line with inflation when it is easier to find an alternative job.footnote [14] If so, the ultimate impact of any energy-price increase also depends on conditions in the labour market.

The backdrop: the labour market

A key backdrop for our response to the energy price shock is that the UK labour market tightened considerably as the economy emerged from the pandemic, and remains tight in absolute terms. The unemployment rate fell to 3.5% in the three months to August, its lowest level since 1974 (Chart 3). The number of unemployed people has fallen below its pre-Covid level, and there continue to be more vacancies than there are unemployed.

Chart 3: Unemployment has fallen and inactivity has increasedUnemployment rate and inactivity rate for those aged 16 and over

Footnotes

  • Sources: ONS.

One factor behind the labour market tightening is the marked increase in the number of inactive people – those without a job and not actively seeking one. The UK stands out among most other developed economies in this respect. While the inactivity rate has fallen below its 2019 average in the median OECD country, in the UK inactivity remains above its level in 2019.footnote [15] As much as three quarters of the increase in labour market tightness relative to pre-Covid can be accounted for by this rise in inactivity, which has been concentrated among people aged 50 to 64. Recent work by my colleague Jonathan Haskel suggests that it has been partly driven by an increase in long-term sickness.footnote [16]

The tight labour market is one reason for high rates of pay growth. Private sector regular pay accelerated over 2022, with annual growth at 6.2% in the three months to August, well above target-consistent levels. Although real wages are still falling, it is likely that some of the increase in nominal wages also reflects second-round effects stemming from high headline inflation. For example, contacts of the Bank’s Agents note that in addition to the tight labour market, inflation is increasingly a significant driver of pay awards. It is also possible that second-round effects are larger than otherwise because of a tight labour market. But it is difficult to disentangle these different drivers quantitatively – a tight labour market; second-round effects; or interactions between the two.

Chart 4: Vacancies and employment indicators starting to weaken

Indicators of vacancies and employment (a)

Footnotes

  • Sources: KPMG/REC UK Report on Jobs, S&P Global/CIPS, ONS and Bank calculations.
  • (a) KPMG/REC series is the total vacancies index. ONS vacancy survey shows three-month averages.

How quickly wage growth falls back will depend both on the size of second-round effects, and on how quickly the labour market loosens. The labour market typically responds with some lag to changes in demand, so it is likely to be too early to see any effect of the downturn on unemployment. But in response to the recent and prospective falls in spending, there are now initial signs that the labour market is starting to loosen. A growing number of contacts of the Bank’s Agents report pausing recruitment, for example. There are also firmer signs of a weakening in vacancies and employment survey indicators (Chart 4).

The response: fiscal policy

The impacts of the energy shock around the world have also led to large fiscal-policy responses. No policy can prevent sharply higher energy prices making energy importers, such as the UK, poorer. This is the unavoidable consequence of an increase in the price of the goods we import relative to those we produce. But policy can seek to smooth that impact over time, as well as to influence how the burden is distributed across the economy. Fiscal policy is the appropriate tool to do this: it can be more targeted than monetary policy; and crucially for distributional decisions, it is carried out by representative governments.footnote [17]

For monetary policy, the question, as always, is how much Bank Rate needs to respond to fiscal policy to ensure inflation remains on a path to 2% in the medium term. Normally, this would be relatively straightforward: fiscal policy is a textbook demand shock, and we understand well the plausible range of its effects on output and inflation. But the answer now is more complicated than usual, given the different nature of the UK Energy Price Guarantee (EPG) – and similar support schemes abroad – relative to typical fiscal news. Adding to this, in the UK there has been unusually high uncertainty in recent months about the overall fiscal stance. This has been both in light of and reflected in extreme volatility in markets. I will now discuss each of these complications in turn.

First, the EPG will have two-sided impacts on inflationary pressures, unlike standard tax cuts and spending increases. In the medium-term, the EPG offsets part of the energy-driven reduction in demand, by limiting the fall in real incomes. In that aspect it behaves in a similar way to an automatic stabiliser, mitigating disinflationary pressures. But in the near-term, as a price freeze, it also limits the peak in measured CPI inflation. We now expect this to rise to around 11% in Q4, compared to 13% in our August forecast.

By smoothing through the near-term peak in measured inflation, the EPG reduces the likely size of any second-round effects from headline inflation to domestic wages and prices.footnote [18] This is true even though the UK as a whole is still paying the same for energy. That is because much explicit and implicit price and wage indexation in the economy depends on measured inflation rates, even if they do not capture the true economic cost for the whole economy.

As with energy price changes, monetary policymakers must judge which of these two effects is likely to have a larger impact on medium-term inflation. For my own part, my votes as energy prices increased have put weight on the impact from high near-term headline inflation on inertia. By partially offsetting these, the EPG allows us to focus more on the balance of demand and supply in the medium term.

Second, there has been far more volatility and uncertainty than usual around the overall fiscal stance. This has led to changes in my assessment of the appropriate setting of monetary policy, as the fiscal outlook has altered. At our September MPC meeting, it looked likely that there would be a significant fiscal loosening in the forthcoming Growth Plan. Given subsequent developments, it is now likely that the stance of fiscal policy will be tighter than I had previously assumed.

Third, monetary policy also has to consider the appropriate response to the extreme market volatility that took place around fiscal developments in recent weeks. While triggered by a fiscal event, this has clearly reflected changes in risk premia in UK assets, over and above the usual expected monetary response to changes in fiscal policy. Supporting this interpretation, sterling and long-term interest rates moved in opposite directions. If the cause were instead monetary-policy expectations, the currency would tend to appreciate as rate expectations increased. Moreover, using standard fiscal multipliers, it would be hard to explain such a large movement in yields, especially as some of the plans were known in advance.

There have been many potential explanations expounded for why the risk premium on UK assets moved around so much over the past weeks. From my perspective, the precise source of these market moves is not of great importance. Whatever the cause, we can observe the moves in financial markets, and work out how they impact our forecasts for demand, supply and inflation. Those forecasts can then inform our policy decisions, as they did following the recent episode.

The response: financial markets

Volatility in UK financial markets over September and October was evident across different asset classes, but was particularly marked in pricing of sterling, and of UK government debt. Although risk premia have been an obvious UK specific driver, the moves also came in the context of increased volatility in global financial markets.

Chart 5: UK government bond yields rose sharply relative to others

Ten-year nominal government bond yields (a)

Footnotes

  • Sources: Refinitiv Eikon from LSEG and Bank calculations.
  • (a) Data to 9 November 2022.

The interest rate on 10 year UK government debt (gilts) increased by over 1 percentage point between September 22 and September 27 (Chart 5). Over subsequent weeks, it has retraced those moves entirely – falling back first after the Bank of England’s interventionfootnote [19], and then further in response to political developments and announcements about changes in fiscal plans. Similar movements were evident in shorter maturity interest rates most relevant for UK household lending, while there was even more extreme volatility in longer-dated bonds, where liquidity issues were most acute. At the same time, the sterling ERI fell by 2.5% in a day on September 23, but despite a volatile period, had more than recovered by our November MPC meeting, and is now at around its pre-fall level (Chart 6).

Chart 6: Sterling fell sharply in September, but has since recovered

Sterling effective exchange rate index (ERI) and selected bilateral exchange rates (a)

Footnotes

  • Sources: Refinitiv Eikon from LSEG and Bank calculations.
  • (a) Data to 9 November 2022.

When considering how to respond to financial market moves, the MPC takes the actions necessary to return inflation sustainably to target. As an inflation-targeting central bank, we need respond only to the extent that they affect the inflation outlook. Neither gilt yields nor sterling are intermediate targets. Both impact inflation, but not identically to how monetary policy does. If we were to try to use monetary policy to implicitly target financial-market variables, that would therefore be at the expense of our inflation target, not in support of it.

So how should monetary policy respond to an increase in the risk premium, were it to re-emerge? Monetary policy can do little about the risk premium itself. What we can do is set Bank Rate in a way that offsets its various impacts on inflation.

Taking each variable in turn, a higher risk premium on UK government debt increases longer-term government yields. These are mirrored in higher yields on UK corporate debt and reference rates for bank lending. These feed through to a higher price and lower availability of credit, as we saw in October. This tightening in credit conditions weighs on demand more than supply, reducing inflationary pressures. Such developments, all else equal, typically require looser policy than otherwise to leave inflation unchanged.

In contrast, a fall in sterling due to a higher risk premium pushes up on import prices, as well as providing a boost to demand from higher net exports. Both effects push up on inflation, so they require tighter policy than otherwise. But that does not imply aiming to restore the previous (or indeed any specific) level of sterling. If sterling assets are riskier, the exchange rate needs to adjust, and the role of the MPC is to manage that adjustment in a way that ensures 2% inflation, not to try to prevent it.

The same point applies to the recent strength in the dollar against sterling and most other currencies. One major reason for relative dollar strength is that the UK terms of trade – the prices of the goods and services we export relative to those we import – have worsened against the US, mainly because the US has not experienced as large an increase in energy costs (Chart 7). A worsening UK terms of trade implies the UK real exchange-rate must depreciate. This will happen via some combination of a nominal exchange-rate depreciation, which will increase import prices; or via a recession, which will generate the real depreciation by reducing domestic inflationary pressures.

Chart 7: The UK terms of trade have worsened against the US

Terms of trade