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

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.

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.

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).

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.

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 Covid^{footnote [3]} and the rise in NHS waiting lists.

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.

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]}

There are many uncertainties around that forecast. The economy is being affected by a series of major shocks (Brexit, pandemic and energy prices), as well as longer-term effects from population ageing. The outlook will depend on how these shocks develop, interactions between them, as well as the (inevitably uncertain) responses of households, businesses and financial markets.

There are some downside risks to activity and prices relative to that MPR forecast, especially from the possibility that worries over job losses and credit risks might lead to a sharper rise in household savings and/or bigger rise in credit spreads that could weigh further on demand. In this case, disinflationary forces – and the possibility of a medium-term undershoot of the 2% inflation target – could eventually prove even greater than the MPR forecast.

But, while recognising those downside risks, at present I put more weight on risks of a more persistent period of excess demand and above-target inflation than the central forecast in the May MPR. My hunch is that (as recently) activity will be more resilient than the MPR forecast. For example, if consumers regard this year’s squeeze on real incomes as a one-off, they may be more likely to reduce their savings to a greater extent over the forecast period (supporting consumption), especially given the sharp rises in accumulated savings and household wealth in recent years.^{footnote [7]} At the same time, supply constraints may be more persistent. In particular, I suspect that workforce participation may well undershoot the MPR forecast, given the rise in long-term sickness and possible effects of Long Covid. Either or both of those shocks could shift labour market dynamics. Rather than a vicious circle in which weak consumer confidence drags down spending and triggers job losses, we may see a more benign circle whereby firms will be reluctant to shed workers even if growth slows – partly because they have a sizeable backlog of unmet hiring needs at present and partly because they may worry they will find it difficult to find new staff in the future. In this case, continued low unemployment and strong labour demand would support household incomes and limit the weakness in spending.

Moreover, continued above-target inflation this year and in 2023 may, unless accompanied by tighter monetary policy, lift inflation expectations further and leave a lasting imprint on inflation expectations in coming years. In this case, even if the output gap closes, firms’ pricing strategies and pay growth would probably remain above target-consistent rates.

Such a scenario – continued tight labour market, elevated or rising longer-term inflation expectations – would, unless offset by tighter monetary policy, probably threaten to cause a more persistent inflation overshoot than the MPR forecast.

Monetary policy

As you know, the MPC’s mandate is to return CPI inflation to the 2% target on a sustained basis in a way that supports output and jobs. Monetary policy cannot prevent the surge in energy prices from lifting inflation near term and thereby reducing real wages and profits (for non-energy producing sectors). In line with our remit, the role of monetary policy is to ensure that inflation expectations are well anchored, and that domestic cost and capacity pressures are consistent with a return of inflation to the 2% target over time as the effects of the energy price surge fade.

As domestic capacity strains have increased, the MPC has tightened policy over recent months. We have increased Bank Rate in steps to 1% and embarked on a gradual rundown of the stock of purchased assets by ending reinvestment of maturing bonds held by the APF. Consistent with the MPC’s previous guidance, the MPC has asked Bank staff to work on a strategy for UK government bond sales, and will provide an update at its August meeting. In addition, at our recent policy meeting, most MPC members (including myself) agreed 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.”

As discussed, my view is that, conditioned on the same interest rate path, risks would be tilted on the side of greater and more persistent domestic capacity and inflation forces than the MPR forecast.

But I also want to emphasise the need to consider the potential costs if the economy does not develop as expected.^{footnote [8]} In broad terms, the MPC faces two alternative risks. One is that monetary tightening which is sufficient to lean against near-term inflationary pressures may exacerbate the prospective squeeze on activity and leave inflation well below target further ahead. The other is that if monetary policy does not adequately lean against inflation pressures, then we may see a prolonged period of above-target inflation that causes longer-term inflation expectations to become further detached from the 2% inflation target. That could ultimately require a sharper adjustment in monetary policy and the economy to return inflation to target, and result in an even worse outcome for real incomes and living standards.

In my view, we should lean strongly against the latter risk (inflation expectations), because if it materialises (not a negligible risk, in my view) then the process of re-anchoring price expectations could be very costly in economic terms.^{footnote [9]} Such a scenario also could limit the scope for prompt monetary easing the next time the economy needs support. The MPC’s ability to use monetary policy to provide effective support to the economy in 2020 rested on the credibility of the UK’s inflation targeting framework. That credibility is not infinite and cannot be taken for granted.

Conversely, if we hike faster now and then find the economy develops in such a way that medium-term inflation risks tilt heavily to the downside of the 2% target, then the Committee could reassess the policy outlook accordingly. That scenario is not my central expectation. But if it did materialise, I suspect we would be in a better position than now in terms of inflation expectations.

Against this backdrop, my preference in recent months has been to move relatively quickly towards a more neutral stance in order to prevent the recent trend of higher inflation expectations and rising pay growth from becoming more firmly embedded.^{footnote [10]}

Nevertheless, my recent votes for a 50bp hike (in February and May) do not automatically imply that I would definitely vote for a 50bp hike in the event that further tightening is required. My policy votes will depend on the economic outlook, and risks around the outlook, at the time. All else equal, the case for policy to move in a larger step is probably greater when Bank Rate is clearly below neutral. Nor do those recent votes for faster tightening early on necessarily imply that I believe the terminal rate (ie the level of rates at the end of a tightening cycle) will be above the yield curve used for the May MPR. Indeed, to the extent that quicker tightening early on could help ensure that the nexus of inflation expectations, pay growth and firms’ pricing strategies return to being consistent with the 2% inflation target, this might help limit the overall tightening cycle (relative to what would otherwise be the case).

Whichever way the economy develops, the MPC will, as always, remain focussed on returning inflation to the 2% target in a way that supports output and jobs, in line with our remit.

The views expressed here are not necessarily those of the Bank of England or the Monetary Policy Committee. I would particularly like to thank Matt Swannell and Katie Taylor for their help in preparing this speech. I have received helpful comments from Lena Anayi, Gillian Anderson, Andrew Bailey, Tom Belsham, Phil Bunn, Jonathan Haskel, Frances Hill, Josh Martin, Huw Pill, Fiona Shaikh, and Ivan Yotzov, for which I am most grateful.

References

APPG Coronavirus (2022), ‘Long Covid Report’, All-Party Parliamentary Group on Coronavirus, March 2022.

Bloom, N, Bunn, P, Mizen, P, Smietanka, P, Thwaites, G and Young, G (2017), ‘Tracking the views of British businesses: evidence from the Decision Maker Panel’, Bank of England Quarterly Bulletin, Bank of England, 2017 Q2.

Bunn, P, Anayi, L, Bloom, N, Mizen, P, Thwaites, G and Yotzov, I (2022), ‘Firming up Price Inflation, Expectations and Uncertainty’, mimeo, Bank of England.

House of Commons Library (2021), ‘Coronavirus: Long Covid’, Commons Library Briefing Paper, CBP 9112, January 2021.

House of Commons Library (2022), ‘General Debate on the impact of Long Covid on the UK Workforce’, Commons Library Debate Pack, CDP-2022-0063, March 2022.

IMF (2022), ‘United Kingdom: 2021 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for the United Kingdom’, IMF Staff Country Reports, IMF, Country report No. 2022/056.

Mann, C L (2022), ‘A monetary policymaker faces uncertainty’, speech given at online webinar.

ONS (2022), ‘Prevalence of ongoing symptoms following coronavirus (COVID-19) infection in the UK’, published 6 May 2022, ONS.

PHOSP-COVID Collaborative Group (2022), ‘Clinical characteristics with inflammation profiling of long COVID and association with 1-year recovery following hospitalisation in the UK: a prospective observational study’, The Lancet Respiratory Medicine, The Lancet.

Pill, H (2022), ‘Monetary policy with a steady hand’, speech given at Society of Professional Economists online conference 2022, webinar.

Ramsden, D (2022), ‘Shocks, uncertainty, and the monetary policy response’, speech given at National Farmers’ Union Conference, Birmingham.

Tetlow, R (2018), ‘The Monetary Policy Response to Uncertain Inflation Persistence’, FEDS Notes, Washington: Board of Governors of the Federal Reserve System, August 29, 2018.

Thomas, C, Carsten, J, Patel, P, Quilter-Pinner, H and Statham, R (2022), ‘Health and prosperity: Introducing the Commission on Health and Prosperity’, IPPR.

Appendix: Firm-level insights on inflation drivers from the DMP survey

The Decision Maker Panel (DMP) is a survey of Chief Financial Officers from small, medium and large UK businesses operating in a broad range of industries. It is used by the Bank to monitor developments in the economy and to track businesses’ views. The survey asks about recent developments and expectations for the year ahead in sales, prices, employment and investment.

The survey was set up in August 2016 by the Bank of England together with academics from Stanford University and the University of Nottingham. It was designed to be representative of the population of UK businesses and all results are weighted by employment and industry.^{footnote [11]} There are over 9,000 panel members and typically around 3,000 survey responses in each wave.

Figure 4 makes use of firm-level data from the DMP to try and quantify the various factors that are pushing up on inflation at present. The decompositions are generated using a set of firm-level regressions. These include inflation as the dependent variable and firm-level data on other potential determinants of inflation as explanatory variables (with the latter backed out from other questions in the DMP survey). These explanatory variables include:

• the effects of Covid on both demand growth and unit costs;
• measures of supply and labour shortages;
• import intensity;
• the effects of Brexit on unit costs;
• and the percentage of costs that are accounted for by energy.^{footnote [12]}

The equations include time and firm fixed effects. The equations are estimated on a quarterly basis between 2017 Q1 and 2022 Q1 and are based on around 30,000 individual data points for 4,700 unique firms. The coefficients from these regressions are used to quantify the contributions from different factors to changes in inflation since the end of 2019 (as shown in the decomposition chart). The other bars represent the residual that is not explained by these factors.

This analysis, conducted by Bunn et al. (2022), is due to be published in more detail in a forthcoming working paper.