The UK Economic Backdrop ahead of the Bank’s Monetary Policy Report
With the Bank of England publishing its Monetary Policy Report on Thursday, our Deputy Director for Macroeconomic Modelling and Forecasting, Professor Stephen Millard, spoke to Associate Economist Paula Bejarano Carbo to get her thoughts on what it might contain and on inflation and monetary policy in the United Kingdom more generally.
On Thursday, the Bank publishes its Monetary Policy Report. Before we discuss what might be in it, perhaps you could first talk me through the economic background into which the report will be released.
The United Kingdom’s economy in 2023 has so far been characterised by: low growth, high inflation, a tight labour market and elevated interest rates.
Low growth: NIESR’s latest GDP tracker noted that the economy has largely flatlined following the initial stages of post-pandemic recovery; the latest data show that monthly GDP fell by 0.1 per cent in May and this figure is estimated to be only 0.2 per cent above its February 2020 level. In line with this longer-term trend of low economic growth, our tracker estimates GDP to have remained flat in the second quarter of 2023.
High inflation: The latest ONS figures indicate that the annual rate of consumer price index (CPI) inflation was 7.9 per cent in May, above the Bank of England’s 2 per cent inflation rate target for the 23rd consecutive month. Concerningly, core CPI (CPI excluding energy, food, alcoholic beverages, and tobacco) remained elevated at 6.9 per cent in May while the rates of inflation of services and non-energy industrial goods have plateaued around 7 per cent since late 2022, indicating that we have yet to see a significant turning point in underlying inflationary pressures in the economy despite falls in the headline rate.
Tight labour market: Though vacancies fell by 85,000 in the three months to May while the unemployment rate increased to 4.0 per cent (its pre-pandemic level), the latest data suggests that the labour market remains tight, seeing as the unemployment to vacancy ratio remains low at 1.3. Long-term ill health continues to weigh down on labour market participation: the number of people reported to be economically inactive because of long-term sickness was 412,329 in the three months to May, compared to a pre-pandemic (three months to February 2020) figure of 15,112. Taken together, the latest data suggest that strong wage growth will likely contribute to keeping inflation elevated in the coming months.
High interest rates: At its June meeting, the MPC opted to raise the Bank Rate by 50 basis points, brining it to 5 per cent. Though necessary to tame inflation, elevated borrowing costs have tightened financial conditions and exposed vulnerabilities in financial markets.
What do you think the Report might say about current inflation and the prospects for inflation over the coming couple of years?
As discussed in our July CPI tracker, the latest data tell us that recent falls in the annual CPI rate have been driven by energy price rises ‘falling out’ of the CPI basket from April 2023 onwards. For example, the fall in the annual inflation rate from 8.7 per cent in May to 7.9 per cent in June was generated by a drop in the cost of motor fuels. It is likely that there will be a further fall in this headline CPI rate in July as the Ofgem Energy Price Cap decreased significantly on 1 July.
With energy price inflation softening, the drivers of inflationary pressures have shifted towards rising food prices (the annual rate of food inflation was 17.3 per cent in May), and non-energy goods and services prices (both around 7 per cent). The latest data also tell us that inflationary pressures have permeated to the domestic economy: the GDP deflator, which is a good measure of domestically-generated inflation, was 6.5 per cent in the first quarter of 2023.
Taken together, it is likely that the Report will see these data and assess that, though headline inflation will continue to decrease in the coming months, the ‘true’ underlying rate of inflation remains elevated at around 6 to 7 per cent (well over the Bank of England’s target of 2 per cent). Further, we have yet to see a sustained fall in these measures of underlying inflation.
Elevated measures of underlying inflation generally indicate that inflation will remain persistent, i.e. fall more gradually than expected. So, though monetary tightening will stifle inflation in the medium-term, inflation may fall at a slower pace than expected in the short-term.
What does this inflation outlook mean for the future path of interest rates?
Broadly speaking, it is useful to think of the distinct measures of underlying inflation – core inflation, the GDP deflator, and services and non-energy industrial goods inflation – as attempts to get a feel for where inflation ‘really’ is, once transitory shocks (like volatile energy price movements) drop out of the CPI basket. As such, we can think of these measures as picking up the inflation that the MPC wants to, and can, return to the 2 per cent target through use of its conventional monetary instrument. That they have been stagnant at around 6 to 7 per cent is a concern in that it implies a possible need to tighten monetary policy by more than the MPC have already. It is therefore possible that we will see a further hike by 25 basis points on Thursday.
That said, with the Bank Rate already at 5 per cent, the MPC has already done most of the ‘heavy lifting’ needed to bring inflation back to target in the medium-term. It is important to remember that, since the transmission of monetary policy to the economy operates with a lag, monetary policy is inherently forward-looking. It is the inflationary outlook in about two years’ time that matters for monetary policy decision-making, rather than the latest CPI data (though evidently it is essential to understand where we are in order to judge where we are going). So, though it’s possible that the MPC will opt for one or two more rate hikes, we are probably close to the peak of this monetary tightening cycle and can expect the Bank to hold this peak for some months before loosening (conditional on future inflationary developments).
The Bank has been criticised for its poor communication of monetary policy; how might it look to improve?
As you said in your NIESR discussion paper on ‘Central bank communication’, it is important that central banks communicate “where we are now, where might we be going and what this means for policy” in order to “steer” markets’, and the public’s, economic expectations in line with the central bank’s own beliefs. Given that the latest market curves see the Bank Rate peaking at either 5.75 per cent or 6 per cent, probably above the path the MPC will (and should) take to get inflation on target in the medium-term, it is likely that the Bank has not communicated the above three points clearly enough. As Jagjit Chadha said in his Open Letter to Andrew Bailey, if it is the case that the MPC is opting for a Bank Rate path that is less aggressive than markets expect because of the output-inflation trade-off, it ought to be clear in communicating that; failing to do so risks incurring further criticism as well as further adverse market reaction.
To this end, as you suggested in your NIESR discussion paper, the MPC could consider publishing a forecast for the path of interest rates in its Reports, as is done in other central banks, such as the Norges Bank and the Svergies Riksbank. Though there are worries that this approach might tie central banks’ hands to a certain path, it’s true that central banks can take a ‘Delphic’ approach with such a forecast and state “likely or intended monetary policy actions based on the policymaker’s potentially superior information about future macroeconomic fundamentals and its own policy goals”. This would help adjust markets’, and the wider public’s expectations, to a particular, but not definite, trajectory.
Regardless of whether the MPC opts in favour of this Delphic approach, and even regardless of where the Bank Rate Peaks, it is evident that the MPC needs to communicate more clearly and let markets as well as the public know when it thinks that it’s done enough to bring inflation back to target.