Remarks
Thanks very much to our hosts at Asia House today. It is a great pleasure to be here and have the opportunity to discuss the outlook for UK monetary policy with such a distinguished group.
Transformation
The monetary policy function at the Bank of England has recently been the subject of a review by ex-Federal Reserve Chair (and Nobel laureate in economics) Ben Bernanke. The results of this review were published as Forecasting for monetary policy making and communication at the Bank of England.
The recommendations embodied in this review point to a need for reform: both in how the Bank of England’s Monetary Policy Committee (MPC) operates, and in the support provided to the Committee by Bank of England staff. Such change is entailed by a need to respond to the challenges posed by structural changes to the economy. Among these changes number (inter alia): the global financial crisis; the Covid-19 pandemic; the Russian invasion of Ukraine, and its impact on international energy and food prices; events in the Middle East; climate change; and the technological possibilities and threats of artificial intelligence. (The list could go on.)
Strategy - Piecemeal change to the existing policy framework is no longer sufficient to address emerging new challenges. A comprehensive approach that internalises the spillovers among data analyses, macroeconomic forecasting, interest rate choices and policy communication is required. ‘The whole is greater than the sum of the parts’.
We need to be conscious of how all these elements fit together. In our internal discussions at the Bank of England, we have often used the metaphor of a single thread hanging off an expensive sweater. It is tempting to pull on that hanging thread to restore the pristine appearance of the sweater. And sometimes such an approach works. But the danger exists that pulling on the single thread leads to a wider unravelling of the cloth. In the extreme, the whole garment might disintegrate in our hands.
This metaphor cautions against making cosmetically appealing short-term changes to the policymaking framework, for fear that they may have wider and deeper side effects over time that go well beyond what had originally been envisaged. The UK monetary policymaking framework may have run that risk in the past – and paid the penalty on occasion. Developing a better understanding of how policy measures and choices interact with one another – of the structural relationships among them, to use the economic jargon – is the only way of managing this risk.
Change - Any new monetary policy strategy for the UK also needs to embody a judicious mix of the old and the new.
It would obviously be ill-advised to discard those elements of the existing policy framework that have performed well in recent challenging times. Among these I would list many of the basic institutional features of the UK system: an independent MPC; a price stability mandate for monetary policy established in legislation; operationalisation of that mandate in the form of a quantified target for inflation; and accountability of MPC members to Parliament. Retaining these elements is key: ‘we don’t want to throw the baby out with the bath water’.
As reflected in last month’s valedictory speech of my sadly now former colleague (indeed former boss) Ben Broadbent – and also in last Monday evening’s valedictory of my equally sadly soon-to-be-former colleague (but not boss) Jonathan Haskel – this institutional framework has proved central to the considerable improvement in UK monetary policy performance over recent decades.
These two eminent economists both provide compelling evidence that the contrast between: (1) on the one hand, the prompt return of UK inflation to target following the significant external impulses generated by Covid and the invasion of Ukraine; and (2) on the other hand, the higher and much more persistent profile of UK inflation following the 1970s oil price shocks, owes much to these institutional improvements.
But equally, while retaining these benefits of institutional innovations associated with the adoption of inflation targeting, we also need to recognise the need for changes to the strategy in the face of changes in context and circumstance. And we must be open to learning from the experience and guidance of others.
Together with members of the Bank of England’s modelling team, I was privileged to spend time last week with my former colleagues at the European Central Bank in Frankfurt. We drew valuable lessons from their experiences and expertise. A few weeks ago, the Centre for Central Banking Studies at the Bank of England hosted a workshop for central bank chief economists at which Prof. Bernanke very generously offered views on his recent report, triggering a rich discussion of the strategic challenges facing macroeconomic forecasting and monetary policy.
Not only do such events offer an opportunity for mutually beneficial exchanges of views and ventilation of ideas within the central banking community, but also – in those areas where Prof. Bernanke has identified that the Bank of England has work to do – they allow us to draw on the experience of others, avoid the pitfalls of implementing incremental changes to the framework, short circuit the costly process of learning-by-doing, and leapfrog directly to more modern methods.
Patience - All these efforts take time. There is a premium on having the patience to ensure that multiple difficult, interrelated and therefore complex decisions are taken correctly.
I have spoken in the past of the need to ‘get the basics right’ in reforming the MPC’s monetary policy strategy. Our external audiences will inevitably focus on the visible aspects of the strategy that are central to policy communication. But these may be among the last to change in response to the recommendations of Prof. Bernanke’s review: the form of policy presentation should follow the substance of policy formulation, not lead it.
A good decision is easier to communicate and rationalise than a poor decision. Expending effort on cosmetic issues at the expense of getting the fundamental analyses and decision processes right is to have ‘the tail wagging the dog’.
All this implies a natural sequencing of reform efforts: start by getting the enabling and foundational aspects of data collection and management right; then develop the models and frameworks to analyse the data; move on to designing the processes required to ensure policy makers are presented with the analysis in a manner and according to a schedule that maximises the likelihood they will take the best decision; assess how those policy decisions and their rationale should be presented to external stakeholders, including financial market participants, the media and the general public; and finally design a mechanism to collect feedback, so the impact of those decisions and their communication can be assessed.
But in practice all these efforts will proceed – and indeed are already proceeding – in parallel. Making them consistent is a significant organisational challenge. And, of course, we are not starting from scratch.
To illustrate, today the Bank of England is publishing its annual Outreach Report, which describes the role and impact of the Bank’s various outreach programmes in facilitating conversations with our various communities: the Citizens Panel, the Youth Forum and the Community Panels.
Over the past couple of years, I have been closely involved in this important work, which entails both collecting information and perspectives from our stakeholders – notably about the effects of persistently higher energy prices on UK households’ cost-of-living – as well as offering opportunities to present the sometimes difficult rationale for monetary policy decisions to hard-to-reach audiences. These efforts embody both data collection and policy communication – and, as such, they do not easily fit within the sequencing that would be followed if designing the new monetary policy strategy involved starting with a blank piece of paper, completely from scratch.
Conjuncture
For all the emphasis I have placed on the renewal of the MPC monetary policy strategy, the MPC must also conduct monetary policy today. This brings me to the current monetary policy conjuncture.
As I am sure you all well know, the MPC voted to leave Bank Rate unchanged at 5¼% at its last meeting in June.
Of course, it is welcome news that the MPC’s target variable – headline UK CPI inflation – has returned to the 2% target in May. But the MPC’s remit makes clear that the inflation target holds at all times. It is not enough to meet the target in a transitory or fleeting way. Rather the MPC must achieve the inflation target on a lasting and sustainable basis.
Given the famous long and variable lags in monetary policy transmission, this requires that the MPC adopt a medium-term orientation and forward-looking approach in its formulation of monetary policy. That naturally points in the direction of placing an inflation forecast close to the centre of its policy discussion, as has indeed been the case for many years.
But when forecasting inflation becomes difficult – as has proved to be the case at the Bank of England and elsewhere over the past decade – an approach that places the inflation forecast at the centre of its policy framework comes under stress. That has been recognised in one of the key recommendations made by Prof. Bernanke in his view – to downplay the role of the MPC’s baseline inflation forecast in the discussion and presentation of its policy decisions.
Of course, if one analytical tool is to be downplayed, there must be other tools upon which to place greater reliance. Prof. Bernanke has emphasised the role to be played by scenarios and policy simulations.
As an intermediate and pragmatic step to address the difficulties with forecasting in the face of the profound structural shocks to the UK economy, in recent years the MPC has emphasised that it is focused on the persistent component of overall inflation, since it is this component which – by nature – will still be embodied in price developments at the horizon where monetary policy decisions taken today have their greatest impact on inflation. In so doing, the MPC maintains its necessarily medium-term and forward-looking orientation.
More specifically, the MPC has emphasised three key indicators of inflation persistence: labour market tightness; pay growth; and services price inflation. On the basis of recent outturns, at the margin recent developments in these indicators have hinted towards some upside risk to my assessment of inflation persistence.
But these are noisy data series. More generally, the MPC has long recognised that it is difficult to distinguish the signal about underlying persistent inflation dynamics from the inevitable noise in any one release when assessing the news in the month-to-month data flow.
Viewed through this lens, it is hard to dispute the case that inflation persistence in the UK continues to prove – well – persistent. That is perhaps to be expected.
The difficulty in extracting signals about changes in the low frequency persistent component of inflation from noisy higher frequency indicators has not disappeared. Nor is it likely to in the coming months.
More data will come before we take our next policy decision at the MPC meeting on 1 August. But we have to be realistic about how much any one or two releases can add to our assessment.
While the MPC must remain open to the possibility that compelling new evidence could emerge which would lead the Committee (or individual members of it) to a revised opinion, it should also remain cautious in seeing any single data as either a necessary or sufficient trigger for that re-assessment.
In parallel with these various kinks in the data flow, time is also passing. And with monetary policy in restrictive territory, the extent to which the MPC is bearing down on underlying inflation also has a time dimension. The total quantum of monetary policy restriction is partly determined by the length of time that Bank Rate is held at a restrictive level. So the MPC’s interpretation of the data needs to be placed against an assessment of how restrictive the overall stance of monetary policy is and has been, as well as a view on how that restriction is being transmitted to price developments.
It is easy to get frustrated with this. But it is important that the MPC maintains the right strategic orientation – and remains true to the framework it has articulated to deal with current challenges. Unless we have reason to shift to a new framework for policy discussions, there is a premium on acting consistently within our established machinery. It takes a framework to beat a framework.
The challenges associated with forecasting notwithstanding, the MPC continues to make substantial progress.
The current restrictive monetary policy stance continues to bear down on the persistent component of UK inflation. The MPC needs to ensure that the degree of cumulative restriction in the monetary policy stance is sufficient to ensure that the persistent dynamic in recent inflation indicators is squeezed out of the system in a way that is consistent with a timely and sustained return of CPI inflation to the 2% target.
At annual rates still not far from 6%, annual services price inflation and wage growth continue to point to an uncomfortable strength in those underlying inflation dynamics.
But the latest data also remains consistent with the view that these inflationary pressures have now been contained, and may be starting to revert towards levels that are more consistent with the achievement of the inflation target.
The challenge for the MPC is to get the balance right: enough monetary policy restriction to achieve the inflation target, but neither too much nor too little for fear of destabilising the economy. ‘Twas ever thus.
Until the transformation agenda in response to the Bernanke review bears fruit, what complicates matters is how the outlook for inflation persistence stemming from analysis of the evolution of our three ‘key indicators’ can be reconciled with the MPC’s macroeconomic forecast – and, in particular, the inflation outlook at the policy-relevant two- to three-year horizon. The MPC’s judgements around inflation persistence are crucial to determining the shape and profile of the inflation forecast at that horizon.
Notwithstanding Prof. Bernanke’s recommendation to downplay the baseline inflation forecast, in the meantime being clear about the character of these judgements about inflation persistence and how their evolution informs the MPC’s inflation forecast remains important.
Behind the MPC’s inflation persistence judgement lies a structural view of price and wage setting behaviour in the UK economy. We don’t simply need to observe developments in the key indicators, but rather we need to explain – both to ourselves and to our various external audiences – why there is greater persistence in current inflation dynamics than our standard model framework would imply, even after we have taken account of the extent of slack in the economy.
Based on that view, I will propose a few potential ways to interpret the inflation persistence judgements embedded in the forecast.
On one view, these judgements could reflect decaying second round effects in price and wage inflation following the big external shocks associated with the pandemic and Russia’s invasion of Ukraine. Those effects may take longer to decay than any second-round effects embodied in conventional models and frameworks, but they are not fundamentally different – it is simply a question of the half-life of those second-round effects just being somewhat longer.
In this case, the challenge for the MPC is to decide whether to let this greater persistence play out or to act to bring inflation down more quickly while accepting the cost in terms of activity and employment that this implies. In other words, the MPC faces a traditional ‘trade-off’ situation.
On another view, the inflation persistence judgments could represent a more permanent change to price, wage and margin setting behaviour, perhaps associated with changes in the pay structure, different competitive dynamics in the markets for labour, product and services, or with high degrees of real income resistance.
For any given level of slack in the economy, the momentum of nominal dynamics in price / wage / cost / margin setting behaviour may simply be stronger.
In that scenario, ultimately the MPC will be left with no choice but to maintain a restrictive monetary policy to weigh against such incipient stronger inflationary dynamics for the 2% inflation target is to be achieved on a lasting basis. That is the Committee’s mandate.
Viewed through his lens, the persistence judgements represent a deterioration in the supply side of the UK economy: they capture an under-estimation of the NAIRU (or equivalently an over-estimation of potential output).
It is apparent from this discussion that the character of inflation persistence has implications for the conduct of monetary policy.
When drawing implications from the evolution of the ‘key indicators of inflation persistence’ for the MPC’s monetary policy assessment, it is important to address what those indicators tell us about the nature of inflation persistence. This goes beyond a quantitative mapping from those indicators into an inflation forecast. A more structural interpretation of inflation persistence is required. And further work is needed to provide this.
In particular, separating households’ inflation perceptions from households’ and firms’ short-term inflation expectations – and then seeking to separate both from inflation itself – remains a difficult empirical challenge. Distinguishing ‘catch-up dynamics’, which might be expected to dissipate over time (even if relatively slowly), from ‘de-anchoring dynamics’ that might have a more long-lasting character and represent a deterioration on the supply side, remains key.
This all said, in the absence of any big new shocks, the “when-rather-than-if” characterisation of prospective Bank Rate cuts still seems appropriate.
The views expressed in these remarks are not necessarily those of the Bank of England or the Monetary Policy Committee.
I would particularly like to thank Saba Alam and Iris Hall for their help in the preparation of these remarks.
The text has also benefitted from helpful comments from Andrew Bailey, Jamie Bell, Sarah Breeden, Fabrizio Cadamagnani, Alan Castle, Clare Lombardelli, Jonathan Haskel, Rich Harrison, Adrian Paul, Kate Reinold, Fergal Shortall and Danny Walker for which I am most grateful.
Opinions (and all remaining errors and omissions) are my own.
