The Bank of England is navigating a narrow path between thrusting the UK economy into full-scale recession through further monetary tightening and easing off from its task of bringing down the inflation rate to 2%. Huw Pill, the Bank’s chief economist and executive director for monetary analysis and research, told an OMFIF audience on 16 October that the Bank might still have work to do to reduce inflation further. He left open how the Bank may still be thrown off course by the disturbed international environment.
Headline inflation falling, but some components proving persistent
The latest figures from the Office of National Statistics show that headline inflation in the UK is falling, with the consumer price index at 6.7% in September, holding steady from August. The most significant decrease in the monthly change was due to declining prices in the food and beverages category, while petrol and diesel contributed the most to the upward pressure on the inflation rate.
For now, markets are pricing in a high likelihood that the BoE will hold rates steady at 5.2% at the next meeting in November. But Pill insisted that ‘the [Bank of England’s] mandate is not to have declining inflation. It is to achieve the 2% target on a lasting and sustainable basis,’ adding that ‘We probably have work some to do in order to get back to 2%.’
The UK’s inflation remains highest among G7 economies. Over the long term, there are signs of more ‘persistent components of inflation’, which include ‘that part of inflation which will still be there at the 18-month to two-year horizon’.
Labour market looks tight, but data more difficult to interpret
According to Pill, the persistent components of inflation are associated with domestic pricing decisions, domestic cost dynamics and domestic wage-setting behaviour in the UK. The labour market still appears tight. ‘Official average weekly earnings data… looks very high, and has tended, if anything, to surprise to the upside.’
The underlying reason for wage growth will determine whether a monetary response would be needed. ‘Stronger wage growth driven by the right reasons – like stronger productivity growth – would certainly be something I’d welcome,’ Pill explained. But a wage-price spiral in response to the cost of living crisis ‘would be a cause for greater concern’.
More generally, labour market data are proving more difficult to interpret than in previous cycles. ‘Whether the tightness in the labour market is better represented by the unemployment gap, the level of vacancies or the ratio of vacancies to unemployment or the number of quits in the economy’ is unclear. ‘These are all indications which historically actually move quite nicely together,’ reflected Pill. ‘They have not moved as closely together over recent times, and that reflects some of the magnitude of big supply shocks.’ For the BoE, he admitted that these converging metrics has been a ‘big challenge for us to try and understand’.
Transmission of monetary policy less clear than in previous cycles
The length and depth of the current tightening cycle will also be influenced by the timing and effectiveness of monetary policy transmission. Pill was asked several times about the stated view of Swati Dhingra – the most consistently dovish of the Bank’s nine-person monetary policy committee – that only 20 to 25% of the monetary tightening since the Bank started raising rates at end-2021 had so far worked through. In answer, Pill indicated that the amount of effective tightening was appreciably higher than that range, although he did not give a more precise estimate.
Mortgage rates are still the primary metric of the impact of rate hikes on the wider economy, but this mechanism has become more complex than in other tightening cycles. Pill commented that, ‘on the one hand, the structure of the mortgage market has changed considerably. Mortgage rates are refinanced every two or five years. That is different from the world of 30 years ago where mortgage rates were very closely tied to the bank rate itself’. This complicates policy transmission, potentially causing lags.
At the same time, he pointed out that the BoE ‘are able to monitor [monetary policy transmission] much more closely, because we now have data on every mortgage’. More robust supervisory capabilities allow for a more granular understanding of the housing market and, therefore, a more finely calibrated policy response.
Uncertainty and economic shocks may spur revaluation of risk models
Monetary policy implementation has become more difficult in face of multiple exogenous shocks. Pill noted that as the supply side has become more uncertain, the ability to work out where excess demand is in the economy has become more complex.
To add, risk factors are compounding. On the frequency of macroeconomic shocks, Pill reflected, ‘The key question for us is, are these shocks at the tail end of a distribution, which will go back… to a normal bell shape? Or should we be thinking about a very different distribution of shocks?’ This question will be especially pertinent if violence in the Middle East escalates.
Spearheading this effort is Ben Bernanke, who is conducting a review of the BoE’s forecasting during times of major uncertainty. The review started this summer and is due to conclude next year, with the results set to be released in spring 2024. ‘I would hope that we would be able to see something and act on it relatively promptly, in the spring,’ stated Pill.
A reassessment of risk scenarios would also need to be effectively communicated to the public. At present, the Bank’s communications still revolve around a single fan chart. They may need to reconsider this, as we are clearly in a world of bigger shocks.
Taylor Pearce is Senior Economist at OMFIF.
The entire discussion is available to watch on demand here.