Oral evidence: Bank of England Monetary Policy Reports, HC 143
Wednesday 7 September 2022
Ordered by the House of Commons to be published on 7 September 2022.
Members present: Mel Stride (Chair); Rushanara Ali; Harriett Baldwin; Anthony Browne; Gareth Davies; Dame Angela Eagle; Emma Hardy; Kevin Hollinrake; Siobhan McDonagh; Alison Thewliss.
Questions 536 - 603
I: Andrew Bailey, Governor, Bank of England; Huw Pill, Chief Economist, Bank of England; Professor Silvana Tenreyro, External Member, Monetary Policy Committee; Dr Catherine L. Mann, External Member, Monetary Policy Committee.
Examination of witnesses
Witnesses: Andrew Bailey, Huw Pill, Professor Silvana Tenreyro and Dr Catherine L. Mann.
Q536 Chair: Good morning. Welcome to the Treasury Select Committee and our hearing on the Monetary Policy Committee’s August 2022 report. We are very pleased to be joined by four members of the MPC, including its chair. Could I ask each, in turn, to introduce themselves very briefly to the Committee?
Andrew Bailey: Andrew Bailey, Governor of the Bank of England.
Professor Tenreyro: Silvana Tenreyro, external member of the Monetary Policy Committee.
Huw Pill: I am Huw Pill, the chief economist at the Bank and a member of the Monetary Policy Committee.
Chair: Catherine joins us from New Hampshire in the United States.
Dr Mann: I am Catherine Mann. I am an external member of the Monetary Policy Committee.
Q537 Chair: Welcome to you all. I am aware that we are very close to your next meeting of the MPC next week, when you will also be telling us something more, perhaps, about interest rates. I did want to put on record our gratitude for the fact that you are still appearing before us, recognising that nothing you say today will be taken by anybody as indicative of anything that might be going to happen next week. That is all fully understand by us.
Could I start with Huw? Good morning. You were a very senior economist at Goldman Sachs. You will be very aware of the comments that they have made on where inflation may go over the coming weeks and months, possibly, in their view at least, in excess of 20%. What do you make of that? Do you think that is within the realms of possibility or is that just a bit of an outlier, do you think?
Huw Pill: The forecast they produced is a mechanical implication of developments in wholesale gas markets, under the assumption that those developments in wholesale gas markets would pass through into utility prices, and thereby into the CPI, according to the rules of the game as they have existed over recent months and years.
It is an illustration of the fact of how big the shock to wholesale gas prices has been over the past year and, moreover, how big the increase was from the assumptions we made in our report, based on market data, towards the end of July. It illustrates how big the changes were from that point to the peak of wholesale gas prices we saw towards the end of August. Now, fortunately, some of that has subsequently reversed.
Q538 Chair: Is that leading you to conclude that this number is not a complete flight of fancy and it is quite possible that inflation could rip up to around 22%, as I think is suggested?
Huw Pill: It is plausible in the sense that the mechanical connection, which is implied by the price cap and the mechanics of that, do lead to a very strong connection. Given the magnitude of changes in wholesale prices that we have seen for gas, and as a result electricity and so forth, that feeding through into utility prices can lead to these types of effects. In other words, it is an illustration of the uncertainties that are created around any forecast for inflation by its dependence, at present, on very volatile developments in wholesale energy prices.
Q539 Chair: It sounds like you are not ruling out inflation going well beyond your current forecast.
Huw Pill: It depends on two things: what happens to wholesale gas prices—that is the mechanics of that—and what happens to the machinery by which those wholesale gas prices are translated into retail gas prices. I do not need to tell people around this table that that is up for consideration at moment in the political sphere, and we, and my former colleagues in the City, will have to be reflective of that. We do not know where that is headed, or what the mechanics of that will be, but given the magnitude of the changes it seems reasonably clear to me that we will see changes. That has definitely been foreshadowed.
Q540 Chair: We have a new Government now. We have a new Chancellor. We think we are about to have an emergency fiscal event. We are hearing that there are going to be some fairly substantial permanent tax cuts, maybe of the order of £50 billion or £60 billion, as some are saying, certainly £30 billion if you take corporation tax and national insurance, for example, plus a huge package of support. Some are speculating as much as £150 billion. When you put all those things together that is a huge number; you can even get up to a quarter of a trillion pounds under some estimates of what might happen. What impact do you think that might have on inflation?
Huw Pill: It depends very much on the details, and we do not have the details as yet. Just to repeat a little bit the implications of my previous answer, wholesale gas prices have behaved in a very volatile way. They have risen very significantly over the past year. Indeed, they have risen very significantly and then fallen quite significantly since we did our August report.
Q541 Chair: I am talking here about massive fiscal stimulus and tax cuts. While you are right that we do not absolutely know the detail, we can be pretty sure that the NI cut will occur and the corporation tax increases will be stopped. We can be pretty certain that there will be multiple tens of billions of pounds popped into supporting consumers and businesses with their energy costs. Is that something that concerns you; do you think it is going to have some effect on inflation; or are you relaxed about that scenario?
Huw Pill: I do think we have to see the details. I do not really want to comment in the absence of those details. What I would do is draw a distinction between two implications for inflation. I would also emphasise that there may be differences between the impact on inflation today, in the short term, and the implications over the medium term.
One thing that seems to be under consideration, at least from what I gather from the headlines that we all see, is a change to the relationship between wholesale gas prices and retail gas prices in a direction that will lower headline inflation relative to what we were forecasting in our August report, where that relationship was based on the mechanics of the Ofgem price cap, and so forth, that we all know about. That, in the short term, would tend to weigh on inflation.
Against that, some of the implications of supporting household incomes, particularly household incomes towards the less well-off households, would tend to support demand in the economy and, other things equal, that would probably lead to slightly stronger inflation. Net net on the implications for headline inflation in the short term, I would expect that to see a decline.
The open question, and perhaps the more important question from a monetary policy point of view, is what the implications are of these changes and the other fiscal changes that you mention, which I do not have good insight into but have also been flagged. What are the implications of those for inflation at what we typically label the monetary policy‑relevant horizon? That is the horizon at which the lags in monetary policy unwind and how decisions we make today affect inflation in the future. There, not only does it depend on the macroeconomic effects of the various fiscal changes that could be envisaged, which I think is the essence of your question, where there is just too much uncertainty to have a strong view right now, given the lack of details, but it would also depend on whether and, if so, how the introduction of some different form of price cap would be exited from.
Q542 Chair: Let us go to that point for a second. We do not know the nature of the support exactly, but it seems to me that speculation is that it could be subsidies going into energy suppliers and effectively freezing the new cap in October at that level, so consumers are protected in that way, with the borrowing, effectively, going into the suppliers to keep the price down, or you could have a model at the other end of the spectrum, where you allow the price subject to the caps to go wherever it goes, and you put direct transfer payments into individuals and businesses to try to support them to cope with that.
Of those two scenarios, is one of them broadly better for inflation than the other and, if so, why?
Huw Pill: They potentially have different implications for inflation in the short term. One thing that we have learned since the publication of our report is that the ONS has decided that the measures, which were more, if I understand you correctly, in the second scenario or the second speculation, to use your word, would not influence CPI inflation, the variable that we are targeting at the Bank. They will not be included in the calculation; their implications will not be taken out of the calculation of CPI. There is an implication for inflation depending on those.
The point I was making in my previous answer is that the very short-term impact on inflation may not be the most important thing from the monetary policy point of view. From the monetary policy point of view, it is about the implication of the package of measures, which I think goes beyond what you have just speculated on, in ways that I would not want to speculate on. It is not my responsibility and I do not think it is really appropriate for me to do so at this occasion. But what are the implications of that for inflation at longer horizons?
Q543 Chair: Thank you very much. That is very helpful. Andrew, as this all plays out, the markets are reacting. I am thinking here about sterling and the bond markets, where we have seen the highest yields on 10-year gilts for about a decade, since 2011, I think. Does that worry you and what do you think is going on there? What concerns might you have around sterling and the bond markets?
Andrew Bailey: We have had volatile markets, and particularly volatile markets in the last six weeks or so. There are a number of reasons for that. An obvious one is the point that Huw has been making, which is that of course we are seeing extreme volatility in energy markets, and I am happy to come back to that point, if you want, with a reflection. That is playing through because it is not just in our markets.
It is not for us to comment on what fiscal policy will be, and we will wait and see what it is and then, as Huw said, factor it into our assessment, but I very much welcome the fact that there will be, as I understand it, announcements this week. That will help to, in a sense, frame policy and that is important. It is important that there is a clear way forward on policy, so I welcome that, because that will be important for markets to understand what is going to happen.
Q544 Chair: Why do you think the markets are getting a bit wobbly on UK debt and a bit sniffy about the pound? What do you think is going on there?
Andrew Bailey: There are a number of things going on. Some of them are UK specific and some of them are not. On the UK specific point, I would just simply make the point that it is welcome that we will have a very clear policy stance, as I expect, by the end of this week.
On the exchange rate, it is important that there are other factors at work there. There are dollar-specific factors. The dollar is strong against almost all currencies at the moment, and that is an important part of it. That reflects the fact, as we have discussed before, that the US and the Federal Reserve are in a different situation. They do not have the same trade-off that we have, and the ECB has, in terms of inflation and activity. They are dealing much more with bringing under control a demand shock in that sense, and obviously taking aggressive action in response to that. You have no doubt seen the speech that Chairman Powell made.
Q545 Chair: Why do you think that the markets are getting a bit twitchy at the moment?
Andrew Bailey: My point was that part of the story is about the strength of the dollar, because you can trace that through. For instance, the movement of sterling is much greater against the dollar than it is against other currencies. There is a part of the story that is not UK specific; it is actually a more general dollar story in the exchange markets.
As I said, there is a UK story. Now, there are one or two reasons for that. I have given one, which is that, as I say, I welcome the fact that the Government are going to set out their policy this week. Secondly, the UK is heavily exposed to gas prices. If you look at the relative exposures, the UK is a—
Q546 Chair: Sorry to stop you. Do you think the markets are concerned about this fiscal event that is about to occur, the magnitude of what might be done, its affordability or its effect on inflation—that it might be quite inflationary? Do you think that there is a concern out there about that and, if there is, could you share any of that?
Andrew Bailey: In my view, at the moment it is more a sense that we have obviously got through the process we have, we understand that process had to happen, and now it is important that we have policy laid out clearly. All I sense is that that will happen, and I welcome that.
Q547 Dame Angela Eagle: Governor, is inflation high because of excessive money supply?
Andrew Bailey: I do not think that you can use the money supply in that sense. I know some people do advocate it as a straightforward and direct indicator of inflation. History tells us that that relationship may have held some time—quite a long time—in the past but it broke down on a number of occasions in more recent history. We use, and do look at elements of, the money supply very carefully.
I will give you one we were looking at yesterday, in fact. We were looking at household M4 as a means of getting a read on the level of excess savings still in the system that built up during Covid. We use it, but I would caution, like many people do, that trying to do a direct relationship with aggregate money supply and inflation has broken down a lot of times over the years, so I would not go there.
Q548 Dame Angela Eagle: Perhaps you would have a word with the new Prime Minister, who gave that as the reason for spiralling levels of inflation during the Tory leadership campaign. A quick seminar might be quite useful at this stage. Do you think, Governor, that the Bank’s remit is outdated?
Andrew Bailey: The inflation target, and the nominal anchor we get from that, is very important. It has proved to be very successful over the years. One thing to observe is that, in the 25 years since this regime came into existence, certainly up until the last few months, inflation has averaged pretty much exactly on target. As I said before, this is by far the biggest shock we are facing during the life of that, but it does not suggest that the regime has failed. It suggests that the regime now has to do its work and respond to a much bigger shock, and I am confident that it will do so and we will do so.
I may be anticipating you; shoot me down if I am. The question of review has come up and I am happy to discuss that. We have not discussed it at all yet. It is good practice from time to time to have reviews, as other central banks do. I would not, in any sense, want to stand in the way of that, but this is not a recognition of the fact that the regime is, in some sense, failing—not at all. We can always learn from the experiences we have, and we have had an awful lot of experiences in the last two and a half years.
Dame Angela Eagle: I am one of those who prefer life to be boring rather than as exciting as we have had to live through in the last few years.
Andrew Bailey: We all have that craving at the moment.
Q549 Dame Angela Eagle: There is no analysis of the state of the UK’s international trade in the latest monetary policy report, but we are a very, very open economy and it is likely that a lot of the inflation we are experiencing, the vast bulk of it, is imported. Do you not think that is a major problem for your analysis—that we do not know what is happening with international trade, or you do not feel able to report on it?
Andrew Bailey: I might bring Huw back in on this. One thing I would say, and Huw follows this closely, is that we have had, and there are, some issues with the trade statistics at the moment. I am not criticising ONS for that, because it has been quite open and actually put in a warning on this, but there was a change in methodology and that has led to difficulties in interpreting them.
Q550 Dame Angela Eagle: Has Brexit also distorted the trade flow, so you do not feel you can measure them properly?
Andrew Bailey: There is a very big puzzle in there on the import side, certainly.
Huw Pill: Just to go back a few steps, the reason why we have high inflation, measured inflation, on the CPI today is a consequence of developments in energy prices. When we talk about an energy crisis, that is having implications for the UK economy across many dimensions. One dimension of that is on to CPI inflation through the mechanics that we discussed in the first question. We are committed, as the Governor has said, to addressing that shock in a way that returns inflation to target, and so it is a time, in my view at least, to emphasise the importance of the target as the anchor rather than consider deviations from that—a new regime.
In returning inflation to target, we will look across all the indicators we need to look at, including money but not just money, because the economy is a complex place where money plays a role, but it does not necessarily play a dominant role, certainly not in all circumstances. That is the mechanism by which, in response to the question, “Will fiscal policies generate inflation?”, we are here to ensure that they do not generate inflation.
Fiscal policies will have their own dynamics, as will other shocks to the economy. As the central bank, our role, mandate and remit is to return inflation to target, and that is what we are trying to do. That is what we are doing; that is what we will do.
Coming specifically to the question on trade, you are right to say—and what I have just discussed illustrates this—that for what is a small open economy, by global standards, shocks occurring at the global level have a very big effect on us, and we need to be able to respond to those nimbly. Our remit in the Bank, at the MPC, is to get inflation back to target. That is the mechanism that we are using. Obviously, the more information we can have about the character and nature of those shocks, whether they are coming through money, through trade or through energy prices, the better job we can do.
We have a very good relationship with the ONS. The ONS is collaborating with us in order to give us the best insights we can have into the developments, including trade developments. As the Governor said, the fact of Brexit has led to a change in the way data are collected. That has led to a break in the series and big jumps, certainly in the import data, but also to some extent in the export data, which renders the trade data difficult to interpret. We are closely collaborating with our colleagues at the ONS to try to resolve that set of issues.
What is also important to see is that the trade data, by its nature, feeds into our assessment of overall activity in the economy. It feeds into our measurement of the national accounts and so forth. At the moment, there is a big so-called adjustment, which is required to reconcile the expenditure measure of activity with the income and output measures of activity. In collaboration with the ONS, we think that the better measure of activity in the economy is actually, in the shorter term, the output measure, and that is less affected by these distortions to the trade data.
In terms of thinking about aggregate activities in the economy, which is a crucial element of how we assess demand and supply pressures and so forth, which is a big driver of our view of inflation, we are, to some extent, insulated from being misguided by the weaknesses in the trade statistics. Certainly, if we want to go into more detail and to understand developments in different elements of expenditure, we need to reconcile or improve the quality of the trade statistics. Hopefully, through time, that will occur as we get used to the new systems, and the ONS, using HMRC sources and other things, can replace the former system provided by the EU.
Q551 Dame Angela Eagle: It might be good to have some idea when you feel that we could rely on your interpretation of trade data in the future as these changes work their way through, because we essentially are a bit blind to what is going on until that is resolved, which is a worry.
Andrew Bailey: Just to illustrate it, the UK measurement of imports from the EU currently does not match with the EU measure of exports to the UK. That is one way of looking at it.
Professor Tenreyro: Just to add to what Huw has said, we also track measures of prices. Tradable goods prices played a big role at the end of the pandemic, with inflation on those tradable goods prices going up quite significantly, because of the rotation in global demand from services to goods. Now, since then we have seen a decline in that tradable goods price inflation, and that is part of the composition of our CPI. What took over was the enormous increase in energy prices that we have seen since the war, and even before, in the build-up to it.
Q552 Dame Angela Eagle: Governor, finally, I just wanted to ask about the contradiction of a new Prime Minister who wants growth and has said she is going to put growth first, while inflation being as high as it is implies a series of quite large increases in interest rates to have some effect on rates of inflation. As you said earlier, the Federal Reserve chair has indicated that in America they will be pursuing a far more aggressive increase in interest rates, which works, as we all know, by reducing economic activity rather than increasing it, and, if you get it wrong, can cause recession and unemployment. How is this square going to be circled in the UK?
Andrew Bailey: Obviously, I cannot speak for the Prime Minister. Let me make a point that may help on that front. When we talk about growth in the UK economy, it is important to look at this in the longer-run context that the trend rate of growth has fallen, certainly over the last 15 years. Now, that is obviously important because that is an underlying driver of growth.
Now, you can map that into the current situation. Again, if you do the US and UK comparison, one reason I said the Federal Reserve is in a different place is that growth in the US economy has now returned to its pre-Covid trend, whereas in the UK we are just above the level pre-Covid. That is a very different situation to be in. Now, we have the trade-off caused by gas prices. The US does not have that same trade-off, so we are, as Huw was saying, in different situations also in that respect.
But the growth point needs to be seen through the longer-term lens: that we have had, as I say, low trend growth; we have had low productivity growth in this country for at least 15 years. It goes back, actually, a bit before the financial crisis. It is not solely a product of the post-financial crisis situation. There is no question that, if we are going to address that, growth is important, and there is not a contradiction in that sense. I would draw this distinction between where we are in the short-term and the underlying issue of growth in the economy.
Q553 Dame Angela Eagle: So possibly a recession to get inflation down and then hoping for increases in trend growth later on.
Andrew Bailey: I hope a recession does not happen, but we have forecast it because we think it is, sadly, the most likely outcome. It is overwhelmingly caused by the actions of Russia and the impact on energy prices.
Dr Mann: Elements of both the Powell speech and the Schnabel speech at Jackson Hole also noted the role of monetary policy in affecting inflation expectations. To the extent that you can affect inflation expectations, you are less dependent on the aggregate demand channel, this squeezing the economy, trying to reduce growth. By affecting expectations in advance, you do not have to depend as much on this aggregate demand channel. With the fact that both of those governors noted the expectations channel, and of course I talked about it extensively in my speech at Kent on Monday, there is a role for monetary policy to affect inflation expectations. That is an important part of our tool chest that we are deploying as part of our strategy in monetary policymaking.
Q554 Chair: Catherine, on that, you voted for the 0.5% increase. Silvana was 0.25%. You have been consistently more hawkish through time in the various MPC meetings. Is it centred on this point that you are making about trying to control those inflationary expectations and their central importance to what the Bank is doing? Do you want to just tell us a bit more about that? Why were you at 50 basis points and Silvana at 25? What is the difference between you?
Dr Mann: There is the data that I look at in order to evaluate whether there is the short-term inflation that Huw, in particular, has talked about, as well as others. The energy price inflation is very real; it is very salient to households; it is very important for business. Those short‑term inflation spikes are becoming increasingly embedded in more domestic-oriented prices. There are a number of different models that we use to evaluate underlying trend inflation and medium-term inflation expectations. The DMP—decision-maker panel—survey, for example, tells us something about that. Our financial market data tells us something about medium-term inflation expectations.
Those medium-term inflation expectations are domestically driven. They have risen. They have been rising for a while. We talk about embeddedness; we talk about inflation persistence. Those two words come from looking at the extent to which these short-term inflation spikes that are coming from external sources become part of the fabric of domestic inflationary forces.
We want to lean against those changes in medium-term expectations, because, once those medium-term expectations become embedded in inflation outcomes, it is more difficult for us to get inflation down and we have to increasingly depend on the aggregate demand channel, the squeezing of the economy. I voted for 50 basis points in a number of different meetings here, because of my view that the external sources of inflation have increasingly become embedded in the domestic inflationary pressures.
Q555 Chair: Silvana, on that point, I am sure you agreed with a lot of that in terms of the mechanisms of what is going on, the second-round effects, and so on. Why were you at 25 basis points? Where is the point of disagreement between you and Catherine?
Professor Tenreyro: My vote was strongly impressed by our forecasts in August and the different assumptions for energy prices. All of this suggested to me that a bank rate at 1.25%, what we had at the time, was more likely than not to bring inflation to target in the medium term, which is our focus. Those forecasts have demand weakening, which we are already starting to see in the data. We also have put in place a significant amount of policy tightening, much of which will feed through to the economy, with some luck.
In my central case, even without a bank rate increase back in August, that would have been enough to bring inflation back to target once the external shock drops out of the calculation. Now, despite that, I voted for an increase of bank rate to 1.5% because I saw similar risks. There are two big risks to the central case. First, there is a lot of uncertainty, as we have just been discussing, and that implies that there is uncertainty on exactly what level of bank rate would be needed. The typical sequence following a tightening of monetary policy is that demand first weakens, then that feeds through to the labour market, and then that goes into wages and prices.
Now, we are at the very start of that sequence with demand weakening. As Catherine said, domestic costs and prices have accelerated recently; they are not slowing yet, so I thought there was a case for raising further until we saw firmer data that we have definitely done enough. Secondly, I share again the concerns that, with a very high rate of headline inflation, that could feed through to the wage price dynamics. There was a case for further tightening to lean against the risk of those second-round effects.
Going back to my central case compared to some of my colleagues, I felt there were more likely to be costs associated with the increase in bank rate. As well as weakening demand further, they are more likely to oversteer inflation below target in the medium term, so I judged that the more gradual pace of tightening would allow us to reduce those risks, because we would see the effects of the data and we can always stop or reassess course before bank rate is too far deep into contractionary territory. It is about going slowly when there is a lot of uncertainty. That was my judgment back in August.
Chair: Thank you. That is very clear.
Q556 Kevin Hollinrake: Huw, you said in your earlier remarks that, net-net, considering everything, what the Government are likely to do and what you have done already, there is now an expectation of a decline in terms of your prediction of headline inflation, presumably something lower than 13%, which is your central forecast, so what kind of decline?
Huw Pill: In the spirit of what the Chair said at the beginning, we have our meeting next week. We have not heard any details. I am reluctant. We will hear more over the next few days. We will produce a forecast for the November meeting and the November monetary policy report. To speculate too much would probably not be very instructive or informative, to be frank.
Q557 Kevin Hollinrake: Silvana, you voted for that lower increase. Do you think now that 1.5% is as high as it needs to go?
Professor Tenreyro: As I said, given the uncertainty, my strategy would be to consider further tightenings until we see firmer evidence that we have progressed in that sequence.
Q558 Kevin Hollinrake: In your view, interest rates should peak at 1.5%.
Professor Tenreyro: We will see the data. Obviously there are many changes put in place right now, and we will have to reassess what that implies for the medium-term inflation expectations, because that is ultimately what we can affect with monetary policy today.
Q559 Kevin Hollinrake: Huw, you said that the majority of inflation is driven by energy prices, but what proportion?
Huw Pill: The easiest thing is to give concrete numbers based on the August monetary policy report, because that is an exercise that was thoroughly worked out and is the basis of this discussion. I want to recognise up front that a lot has happened to wholesale energy prices, in both directions, in the period since then, so there is a need to update. That feeds in against the context of changes in the policy framework for energy prices.
If we take the August monetary policy report as the benchmark, the direct effect of the rise in wholesale energy prices that took place over the year to the assumption added approaching seven percentage points to inflation, in terms of our forecast. Beyond that, there are what we would call indirect effects. The direct effects are essentially the rises in utility and fuel prices. The indirect effects are the consequences of those rises in utility prices on, just to take one example, the price of a meal in a restaurant, because that restaurant has to pay more for its electricity bill.
As a rule of thumb—rules of thumb have their pros and cons—we typically think that that indirect effect is around a third, so you might be adding another two and a half or so percentage points on the basis of that. You are getting to 10 percentage points of the 13%, which one could argue is coming from the impact of this rise in wholesale energy prices. We have discussed a little bit, and Catherine emphasised, the role of expectations. Catherine emphasised the role of second-round effects and the fact that there is a danger, and this is the core of our policy discussion, of this impact coming from abroad becoming embedded in domestic cost developments, price developments and so forth.
I would not want to push back that we do not have work to do. We do have work to do, but it is important to see that the role of energy prices has been massive over the year, leading to that 13% inflation forecast. It goes to emphasise, as is hopefully reflected in both the wider policy debate and the consequence, or the message, of what was in the August monetary policy report, the magnitude of this shock coming from energy prices and the fact that it was a genuine shock, in the sense that, a year or a year and a half ago, at the time when monetary policy decisions could have been taken to offset that, which was before I started working at the Bank, there was no consideration that we were going to see an invasion, we were going to have this development and so forth.
It is this combination that it was a shock, in that narrow sense; it is massive by any historical benchmark; and it has a direct effect on our target variable, CPI inflation in the UK, at a pace that is quicker than monetary policy actions through the channels, at least that Silvana has been emphasising, would feed their way through the system. This is the reason why we have seen this volatility, or rise in inflation, that has been so substantial.
Andrew Bailey: I just want to illustrate Huw’s point with a figure; I find this helpful. If you look at household spending on gas and electricity as a share of household income, to Huw’s point about what is implied in that forecast, it could be seven percentage points higher than it was in 2019 if we go back to pre-Covid. The comparable number in the 1970s is one and a half. That is the measure of this thing.
Q560 Kevin Hollinrake: That may be true, but in all scenarios, even if you left interest rates as they are today, inflation gets back to target within two years. Even at the end of next year it is down back to 4%, and that is your central. I understand why you are doing what you are doing, and you get a lot of criticism for not acting earlier in terms of increasing interest rates, but by your own admission what you are doing is not really affecting the principal drivers of inflation. Yet you are going to inflict a huge amount of pain on the British economy, so you are going to slow down the economy and probably drive it into recession by increasing interest rates, and you are going to put households under a huge amount of pressure. What is the point, just to get inflation back to target a few months earlier?
Andrew Bailey: As I said earlier, and I am afraid I am going to say this quite starkly, the person who is going to put this economy into recession is Vladimir Putin, not the MPC. Let me make that point, because it comes to the points that Silvana and Catherine have made.
Let me start with Silvana’s point. The economy is undergoing a huge shock to real income and that feeds through, as Silvana has said. There is a very good argument, which and others have developed, that, if that happens as you might expect it to, it will bring inflation back down to target through the income effects and the demand effects.
The point Catherine is making, and I voted the same way as Catherine, as you know, is that as we have had, to the points Huw has made, these increasing effects from energy prices. As the actuality and the expectation of headline inflation has gone up so much, Catherine is making the point that there is a very real risk here, and the risks in our forecast are to the upside, I am afraid, at this endpoint in the forecast, that that will have an effect on expectations, which will come through into price setting. That is the reason why I voted in the same way that Catherine did, because I am very concerned that we will get greater inflation persistence through that. I am not being critical; I understand it completely, but people will say, “Well, this is where inflation is going, and we have to protect ourselves against it”. Then it becomes embedded.
Q561 Kevin Hollinrake: A YouGov survey said that people’s expectation of inflation is now actually dropping, so that expectation curve looks different than previously.
Andrew Bailey: Let us pick the expectation story apart for a moment. Short-run inflation expectations, I am afraid, have risen substantially. That is not necessarily surprising, because they tend to follow actual released inflation. It is important to look across all the measures and, if you do not mind me saying so, not to pick out one. We have seen, and this is Catherine’s point, some upward movement in the medium and longer‑term measures of inflation expectations, although not all of them. By the way, the survey of professional forecasters thinks that we will bring inflation back to target, but we have seen some upward movement in medium and longer-term inflation expectations, and that is why we have to be very, very alert to that.
Q562 Kevin Hollinrake: The YouGov survey reports that households’ medium‑term expectations have fallen in three of the last four months.
Professor Tenreyro: Andrew described it nicely in qualitative terms, putting it very starkly as Catherine versus Silvana, but we are talking about degrees here. Obviously, I recognise the risk that higher headline inflation can feed into wage price dynamics. It is a matter of degrees how much weight I am placing, in terms of risks, and how that affects medium-term inflation expectations. That is part of the rationale for me to vote for an increase; it is precisely that risk. Perhaps others put more weight on it, but I agree that that is an important one.
On expectations, typically short-term measures of expectations tend to follow quite closely spot inflation, what is going on with inflation, and so they tend to be very volatile. In a speech I gave a couple of years ago, I set out why those short-term inflation expectations have very little predictive power and little information about future macroeconomic developments. They tend to be more reflective of spot inflation.
Kevin Hollinrake: It is relevant to expectations, which was quoted earlier.
Q563 Rushanara Ali: Governor, could you run us through when people should expect inflation to return to target? I appreciate the uncertainties but, given the target is supposed to be at 2%, and you are predicting up to 13%, when can people expect to see that happen, if you could just remind viewers? Also, how do you see interest rates growth happening? We have seen a very steep increase. Is it going to evolve gradually or be quite dramatic? Those are the two questions our constituents really need to understand in terms of planning, household management and so on.
Andrew Bailey: The second question gets us quite into the territory that the Chair mentioned at the beginning. We would always be cautious about talking about that, and we were particularly cautious at the moment because we are into the meeting cycle. As the Chair said, I am very clear that nothing we say this morning can be taken as a clue on what we are going to do next week, because we have a lot of hours to spend together to talk about that before we get there.
On your first question, going back to the profile that we published in the August report, we have inflation returning and then, as Mr Hollinrake was saying, going somewhat below target, through into the second and third year of the forecast. It is important to bear in mind there is an arithmetical point here: that it is an annual measure of inflation, so that you get these, in effect, built-in annual effects. One of the reasons we have higher inflation persisting into the second half of next year, if you look at the August report compared to the May report, is because of the impact of the sheer rise in energy prices that we have seen in the second half of this year. The basic picture looks the same. It comes down, but it is somewhat delayed coming down, not least because of these arithmetical effects going on.
Now, of course our target is that it should be at target at all times, but we have flexibility in how we bring it back to target. A good deal of that is being driven by the dynamics of the energy market at the moment. To finish on that, the way we forecast energy, and particularly gas, is that we use the first part of the market curve and then we actually fix it flat thereafter. We have taken in recent reports to showing two versions of the forecast, with the second one having the full curve, and the full curve tends to come off rather more than the flat pattern. Unfortunately, neither of them have been particularly close to reality, but the flat pattern has been nearer because of the sheer upward pressure on prices, so that we keep getting this pushing out of the curve. The full futures curve brings inflation down somewhat more quickly. That is essentially the difference between them.
Q564 Rushanara Ali: In a sense, what we have heard so far suggests that there is going to be a major consequence in terms of recession if we do head in the direction that needs to happen. As for how that happens, I appreciate you cannot get into the detail, but, if interest rates go on that upward trajectory, that is very much a real issue.
Just to ask a question in relation to all this, with a new Prime Minister starting her role and speculation around a stimulus, without getting into policy, what would the challenges and dangers be of what the Bank does in trying to act to bring inflation down and what the Government does in terms of a fiscal stimulus and so on?
Lord Hammond, the former Chancellor, said that if tax cuts, some of nearly £2,000, were given to high earners that would deliver an inflationary stimulus. That is just an example of where the Bank’s activities could be in contradiction in terms of what the Government do, and not in sync. At a time of crisis, we need Government policy to be in sync. What are the dangers of that? Where do you see the need for action in terms of making sure that everybody is going in the same direction, to bring inflation down and protect the economy from a deep recession?
Andrew Bailey: It is important to reiterate that monetary policy is operated independently by the Bank of England, and fiscal policy is operated independently by the Government.
Q565 Rushanara Ali: It is not isolated completely; it cannot be insulated, as we have seen.
Andrew Bailey: As Huw said, we take into account fiscal policy as it is set out, adopted and put into place by the Government. Whatever is announced this week, we will do just that.
Q566 Chair: On that point, as we know, monetary policy takes quite a long time to work—18 months, 24 months or whatever. Some of this fiscal stuff may be rather quicker and more of a sugar rush than that. Is this mismatch in timing a problem? You might not be able to respond.
Andrew Bailey: We always do. We will take into account whatever is announced.
Q567 Rushanara Ali: The reality is that a tax break to very wealthy citizens is going to undermine what you do in the Bank, if you are trying to bring inflation down.
Andrew Bailey: Let me just reiterate that we will take into account whatever is announced. That is the appropriate thing for us to do, and that is what we will do. I do not know what is going to be announced, so there is nothing else to go on.
Q568 Rushanara Ali: I will move on to another question. The Bank’s previous economist, Andy Haldane, was warning as early as February 2021 of the risks of a sharp and sustained rise in inflation even as you continue to expand quantitative easing. Do you regret not heeding those warnings?
Andrew Bailey: I have great respect for Andy, and we talked about this a lot when he was on the committee before he left the Bank. Andy was very focused on a number of things. One was the snapback in activity at that point in time—in other words, in overall GDP in this country. Of course there was an initial snapback, but that is unsurprising because there was an historic decline in GDP in the first stages of Covid. Since then, the path of the level of GDP has been very slow. As I said earlier, we are only just above the level of demand that we had pre-Covid, and it has been grindingly slow since then.
I do want to bring in a point Silvana made earlier, which is this global point about the rotation between goods and services, because it is important to understand what the composition of GDP has been. Silvana rightly said earlier that there has been a slower reversal of that switch from services to goods than we expected, but that is a global point. It is most prominent in the US. That is relevant, but, to be fair to Andy, that is not the point he was making at the time. He was making an overall point.
When I look back on it, and I do look back on it a lot, there were some key judgments that we had to make during this time. I do not think it is the judgment about overall demand; it is the judgment about the rotation that has turned out to be important. There were also some critical judgments we had to make about the labour markets, some of which were when Andy was on the Committee, some of which were not. If I may say, Andy was also making a point about the likely path of the rundown of the savings that were built up during Covid. Now, as I said earlier, we were looking at this yesterday. There has certainly been some rundown, but it has not been very large so far.
Professor Tenreyro: You asked about us still carrying out the QE programme. The evidence we have on QE and its effect on the economy is that it is very state contingent. It really depends on the state of the economy. It tends to have a big effect when we face situations like liquidity crises or liquidity shortages. Outside those episodes, the effect of QE on known yields, and hence on inflation and output, tends to be small and short-lived. In a way, the maximum effect came with the financial crisis, perhaps the euro area crisis, and back in March 2020 when we had the dash for cash. Outside of those episodes, the effects on inflation and output should be very small. The argument for continuing to do it is that we were subject to enormous uncertainty, so QE was acting as a backstop. In the event that we had a recurrence of those liquidity effects, QE was there to step in.
Dr Mann: I voted to end QE early—not very early, because I did not join until September, but I voted at the next meeting to end QE earlier than it was originally scheduled to end, in part because I thought it was sending the wrong signal about the conduct of monetary policy. There was a time when we were making the adjustment from a continued accommodative stance to moving in the other direction with regard to monetary policy. Understanding the differences in the way that QE did work, with the initial impact effect and then the flow effect after that, whether you are undertaking it or not sends an important signal.
Professor Tenreyro: In terms of the signalling, however, we were very clear that we would use interest rates as the marginal instrument, so that was the background as well. We were cutting that signalling message at the time by saying that interest rates will be the marginal instrument for monetary policy.
Q569 Rushanara Ali: I would be very interested to know if there are lessons to be learned. There are clearly differences of opinion here on how we go forward in terms of forecasting, given we are so far off. I recognise the Ukraine crisis is a big contributor, but there is such a big gap between the target and where we are heading in terms of 13%. Also, you reassured us previously, Governor, that the increase of inflation was transitory, despite persistent questions and queries about that. I was, among others, sceptical about the transitory nature of inflation. I am going to have to leave.
Andrew Bailey: It is a real pity, because I would be happy to answer the question.
Q570 Chair: I think I know what you would say, but perhaps you would like to tell us.
Andrew Bailey: As we discussed before, I do respond quite forcefully to what I call “with hindsight” judgments, but you are absolutely right. We had to make some very big judgments during this period. I would single out very quickly the point I made earlier about the pace of overall recovery, but a lot of the big judgments have been over supply shocks. This is where time moved on, and I would differ somewhat with Andy.
Now, the transient point is this: we used the “transient” term when we were facing one supply shock, which was the supply chain disruption. That is pretty standard economics with supply shocks. The problem we have had is that one supply shock was then followed, without any break, by an even bigger one, namely the war. It comes to Catherine’s point about expectations. You cannot then say they are transient in the same way, because the time length of these things, even though they may work their way through in the same ways, is just too long. That is the expectations point.
There were big judgments about the labour market we had to make. The two I would single out are, first, whether unemployment was going to rise when the furlough scheme ended; and, secondly, the path of inactivity. Was inactivity going to come down when Covid receded as an issue? It did not seem unreasonable to think that it would, but it has not.
Q571 Gareth Davies: I want to home in a bit more specifically on the gas price element to all of this. Governor, both you and Huw have described or highlighted that the gas market is extremely volatile. Certainly, in August, gas futures are up 74% since May.
Andrew Bailey: It depends what day in August.
Gareth Davies: That is true. Given that you have described the extreme nature of the volatility, and Huw was almost getting animated for a moment there talking about the volatility, it sounds like you feel that the European gas market is out of control.
Andrew Bailey: Of course it has been affected by a huge shock, which is the behaviour of Russia, and we cannot get away from that. What is important, and there is a lot of work going on on this at the moment, is to ask whether that huge shock is causing volatility in the market itself. It is a pretty thin market, by comparison with many other markets that we look at, and there is a lot of time being spent at the moment assessing that, because the consequences of that extreme volatility in the market are on both the buy side and the sell side of the market.
The buy side, in this country, is often the energy suppliers that we all have in our homes. Obviously, the cost of financing those purchases when they are making them goes up a lot, and they have to make those in advance, but it also affects the sell side, which is often both the energy suppliers and the energy trading companies, because the so-called margin calls that are having to be made for, say, hedging in the gas market have now risen hugely.
That is necessarily a function of the increased risk that is in the market, but I talk to a lot of energy suppliers on this, and there is a concern that it is leading to hedging not happening and to the markets becoming very thin. That is important, because we rely on this pricing process, not least of all in the cap-setting process. Obviously, we are not responsible for the gas market, but we look at financial markets a great deal.
Q572 Gareth Davies: It sounds like the market is disorderly.
Andrew Bailey: It is under stress, because if you have a major supplier who is effectively cutting the supply off, and making announcements to that effect, it will be under a lot of stress. It is unsurprising in that sense.
Huw Pill: At the risk of sounding animated, I think it is important to distinguish the perspective Catherine, Silvana and I will bring, which is the perspective of members on the Monetary Policy Committee, on the macro and monetary policy side of the Bank. Of course, it is unhelpful in our forecasting to have volatile variables, which are very hard to forecast by the nature of their volatility. This goes to the Chair’s opening remarks about my former colleagues and how them finding a number that is very high gets them on the front page of lots of newspapers, because they choose the absolute peak in a volatile world. For all the reasons we have been discussing, not least the fact that monetary policy is by nature a low-frequency, medium to long term-oriented tool, we have to look through that volatility. There is a certain amount of complication created by that volatility, which is unavoidable, and there is certainly a lot of activity within the Bank of England, appropriately so, and with colleagues elsewhere in the authorities, to try to ensure that markets remain orderly and so forth.
From the MPC and monetary policy point of view, it is important that we have to look through this volatility. The big story is that a year ago, relative to where we are now, oil price futures with relevance for the Ofgem price gap, which enters the CPI inflation calculation and so forth, have risen. It depends on the specifics, because of the volatility, but they have risen by an order of magnitude, whether it is seven, eight or 11—you can choose different numbers—which will have a massive impact on your precise CPI forecast, but the big story is that they have all gone up. That has an impact on inflation. It is important to emphasise that that increase has also had a big impact on activity.
I just wanted to intervene slightly. If we do fall into a recession, which is what we forecast in our August report, and is certainly potentially possible towards the end of this year, it is important to emphasise, as Andrew has done, that that is a consequence of the impact of higher energy prices on the real incomes of UK residents, because we are a net importer of energy. What we are buying from the rest of the world has gone up in price very significantly relative to what we are selling to the rest of the world, and that has an impact on our purchasing power and, ultimately, on our demand and activity.
We need to be cautious about saying that monetary policy is causing the recession. Monetary policy is trying to manage a way to get back to target in the face of this massive external shock, where that massive external shock has had an impact on inflation and on UK activity. It is precisely the fact that, in the UK, as a net importer, those two impacts go in a painfully opposite direction that is creating the trade-off that we are having to manage. That is the big distinction that Andrew mentioned with what is going on in the US. The US is a net exporter of gas and other forms of energy, and the consequence therefore is that it does not face that trade-off in the same way, and therefore they are perhaps able to speak differently and act differently in terms of monetary policy.
Q573 Gareth Davies: Let us talk about that in more detail. Andrew, when you were in front of us in May, you described how you felt a little bit helpless, given the driver of inflation being imported and a little bit out of your control. If, in the future, given the earlier discussion that the Chair had with you, gas prices do not feed through to consumers and they are actually taken out of this equation, would you then feel more in control of inflation?
Andrew Bailey: We will have to see what happens.
Q574 Gareth Davies: If they do, would you feel helpless still, or would you feel more in control, given that Huw has just said that that is what has been driving the uncertainty and the volatility.
Andrew Bailey: It is an important question. I just want to explain the “helpless” point, because in one sense the answer is yes and in another sense the answer is, importantly, no. The answer is yes in the sense that we cannot control what Vladimir Putin does. Let us be blunt about it. What we can, and must and will, control is bringing inflation back to target as a consequence of whatever does go on, and there is no question about that. We will do that. Let me be very clear: we will stay the course to do that. That is a very important distinction.
If whatever transpires in the period to come causes the gas price to be less volatile and even move downwards, that is a very important input to our process, but I want to be very clear on this “helpless” point that, whatever happens, we will bring inflation back to target.
Professor Tenreyro: Just to reinforce that, monetary policy can always control the inflation rate. The difficulty is that it takes some time to feed through to the economy, but eventually monetary policy can be in control of medium-term inflation.
Q575 Gareth Davies: I accept that. My question and my point is this. If the market prices do not feed through to consumers because of a Government intervention, would you then feel more in control of inflation? Would you feel that you have more ability to impact inflation?
Andrew Bailey: I do not want to prejudge what is announced. It must follow that, if the future path of energy prices is more predictable, as a consequence of any action, that is something we will put to use and take into account. To Huw’s point, and this is the Goldman Sachs point, August was probably the biggest illustration of this. It really did depend on what day of the week you produced your forecast as to what number you got out. These numbers were moving around in the outside forecasts hugely within a short period of time, because of this volatility in the gas market.
Huw Pill: The point you are making, which goes back to the opening questions, is that there is an interaction here between developments in wholesale gas prices and developments in macroeconomic policies other than monetary policy, and we are having to take both those things into account in forming our judgment on how to set interest rates and monetary policy to get inflation back to target. That is a complex interaction. Andrew mentioned that we have done scenarios, for example, with different paths of wholesale energy prices, but understandably, for reasons that you well understand, we have always said that we take fiscal policy as announced fiscal policy, because otherwise we are speculating on things that are other people’s responsibility. In thinking about our policy, of course we have to think about that interaction as it comes.
Going back to where we started off, the key point I want to make is that, for the UK as a net importer of gas, high gas prices have an income implication for the UK as a whole. Now that, given the system we had, fell very heavily on households, given the Ofgem price cap arrangement. We are now changing it. We are shifting where that falls. It depends on what measures are taken and how they are funded, so I cannot really speculate, but the UK, as a whole, at some point has to bear that cost.
The macroeconomic implications are not just about the impact on inflation in the short term. Through the fiscal accounts, for example, which is where the emphasis of the early question was, or potentially other effects, they will have a macroeconomic effect down the line. That is a much more complicated thing that we have to think about, and that will be the judgment we form. That is why I am very cautious about the kneejerk question of, “What is going to happen if we change the cap or we cap at a different level?”, because thinking about how this plays out at the relevant horizons for monetary policy is a more complex thing, where we just do not have any information at the moment.
Q576 Harriett Baldwin: Governor, I want to move on to your published plans in terms of moving to active quantitative tightening. I know they are subject to a vote next week. For some reason, that phrase from Jim Carville, President Clinton’s economic adviser, keeps coming to mind. He said, “When I die, I want to be reincarnated as the bond market, because then I can intimidate everybody”. I just wondered if you could confirm that you are meeting the Chancellor later today.
Andrew Bailey: I am, and I think that has been announced. I can confirm that.
Q577 Harriett Baldwin: Will you be discussing the interaction between your proposals, again, subject to a vote, in terms of quantitative tightening, and the trailed plans from the Government to borrow, potentially, another £200 billion? Is that going to be on your agenda?
Andrew Bailey: We had a short conversation on the phone yesterday evening after he was appointed, and we agreed to meet this afternoon, but there is not an agenda. I would imagine it will be quite a broad discussion, but there is no agenda.
Q578 Harriett Baldwin: Do you think that this issue around your proposals to move into active quantitative tightening, by effectively scheduling the sales of some of the gilts that you hold, needs to be co‑ordinated with the Government’s fiscal plans and potentially with the Debt Management Office, in terms of making it digestible for the markets?
Andrew Bailey: By the way, the MPC has to decide whether it wants to go ahead with this at its next meeting.
Harriett Baldwin: I appreciate that it is subject to a confirmatory vote.
Andrew Bailey: Throughout the process of planning this, we have kept very open lines of communication with the Treasury and the Debt Management Office, which is appropriate particularly from the point of view of the operational and market side of this. This is not about monetary policy, I should say.
Q579 Harriett Baldwin: No, it is about the digestibility of this amount of gilts potentially entering the market in the short term.
Andrew Bailey: Our team keeps this under very close consideration, and we do talk to the Treasury and the DMO about that.
Q580 Harriett Baldwin: It will be on the agenda when you talk to the Chancellor this afternoon.
Andrew Bailey: No, I am not saying it will be on the agenda when I talk to the Chancellor. What I am saying is that we have very open lines of contact with the Treasury and the DMO on this and other relevant subjects.
Q581 Harriett Baldwin: Can I turn to Huw and ask about the estimates that you have made economically in terms of how quantitative tightening can be compared to the kind of tightening that you might do through bank rate changes?
Huw Pill: For the reasons that Silvana already alluded to, we have been cautious about giving—
Q582 Harriett Baldwin: You must have done one.
Huw Pill: Let me explain why we have been cautious and the way we think about this. We published an article in the quarterly bulletin in May, where we undertook an assessment of the impact of quantitative easing. That did offer, although with a certain level of scepticism or at least appropriate confidence bands, a view of how many basis points you might think of as being equivalent to a certain amount of QE. Then we have cautioned about just translating that with a negative sign for QT, for a number of reasons. This just reflects things that Silvana said, so I will not go into enormous detail, but we do think that these types of interventions in markets have their biggest and most important effect when those markets are disrupted, so ensuring the market is functioning better can have the biggest effect.
Q583 Harriett Baldwin: Do you accept that quantitative tightening of the scale that you are potentially agreeing to next week, combined with the amount of additional borrowing that the Government may announce in the next week, could in and of itself be a disruptive force in the gilt market?
Huw Pill: I do not want to repeat things that Andrew has said. The staff who are responsible for considering market functioning and the operational issues at the banks—not in the MPC, but my colleagues who are working on that—are making that assessment in interaction with the other authorities, and so the quantities that will be considered when we come to the confirmatory vote next week have taken that consideration into account.
Q584 Harriett Baldwin: Have they taken into account the potential new announcement from the Government?
Andrew Bailey: We do not know what it is yet, if you do not mind me saying so. So, no, we cannot do that.
Q585 Harriett Baldwin: So you have not.
Andrew Bailey: We will do when we know what it is.
Harriett Baldwin: You will do when you know what it is, before next week’s vote.
Huw Pill: It is important to say that the logic that Silvana is referring to is that QT is not intended, for obvious reasons, to cause a disruption to market. The programme has been predictable, has a gradual element, and reflects the principles that were established prior to my and Catherine’s time. The communication about how QT would be done, published in August 2021, was all conditioned on the logic that we need to behave in a way to avoid disruption. That means that, first, we do not want to create disruption, which is self-evident; secondly, the magnitude of the impact of QT when it is implemented should be smaller than the magnitude of QE when it was implemented, because QE was precisely intended to dampen, avoid or run down market disruption.
Q586 Harriett Baldwin: Can I get you at least to make this statement? Quantitative tightening is a form of monetary tightening. You do agree with that.
Huw Pill: I do agree with that, yes. Quantitative tightening is tightening. Quantitative tightening, in our view, operates through its impact on asset prices. We can observe those asset prices. The notion we have, which is key, is that we have said that the active instrument of monetary policy during the process of tightening is bank rate, the traditional instrument. Whenever we take monetary policy decisions, we are looking at all the data we see, as I said earlier, including asset prices. If we think the impact of quantitative tightening running in the background gradually, predictable and so forth, is making yields in asset markets rise, for example, tightening financial conditions, we can offset the macroeconomic impact of that by doing less with bank rate. We are in control of the overall stance of monetary policy by operating through bank rate.
Q587 Harriett Baldwin: Can I ask you one more question about the unwinding of the countercyclical buffer? You have announced that it is going to go from 0% to 1% in December this year, and from 1% to 2%, potentially, in June next year. How much of a monetary tightening is that as well?
Huw Pill: That is not a monetary instrument.
Q588 Harriett Baldwin: It has no contractionary impact in terms of business lending.
Huw Pill: We will, of course, take that into account, as we take everything into account, but the crucial thing is that the MPC, in terms of its active instrument, meaning the instrument it is using to control policy now, is focused on bank rate, and we will take other things into account in order to do that.
Dr Mann: Among all of the people that we discuss these matters with, we also discuss them with the markets, to get intelligence from the markets about how they think digestibility is going to be going forward, so it is not just on the supply side, so to speak. We also talk to the markets about what they see as their demand for the type of instruments that are either, with quantitative tightening, being sold into market, or that are being issued by the Government. The markets are ultimately the arbiter of the digestibility. When Huw was saying we have all these market prices across the asset classes, these are very important ingredients in our discussion about how digestible these things are.
Q589 Harriett Baldwin: We would be interested to see when you have some analysis of the impact of quantitative tightening, and particularly some of the distributional impacts. If you do have something around that that you are ready to publish, we would love to be alerted to it.
Andrew Bailey: That is fine. We will do that.
Q590 Anthony Browne: My questions are going to be about the remit, which you touched on earlier, but these are slightly more focused questions. The remit of the Bank of England, and indeed the independence of it, came up during the leadership contest, although the Prime Minister clarified that she was not questioning the independence of the Bank of England, but was supportive of a review of the remit.
The remit has changed over time. When it first came in, it was 2.5% and it was RPIX; then it got changed to CPI and it got changed to 2%. It has evolved over time, so there is nothing new about changing the remit. Early on, the Treasury was formally committed to reviewing the remit at every Budget. What is your view of the remit? Do you think it is perfect, or do you think it is worth looking at whether any changes could be made? We know all the arguments about the external supply shock and Russia, but are there any changes that would have led to a smoother path?
Andrew Bailey: Actually, the remit was last reviewed in 2012-13 when some changes were made, particularly in the context of trade-offs, which were very important, and obviously in the current world, so you are right. As I said earlier, I think it is a good thing to review the remit from time to time. Other central banks do that. The Canadians, for instance, have a formalised review every five years. The Federal Reserve and the ECB have reviewed without having a regular schedule, but they do it. It is a sensible and a good thing to do. There was a plan to do one in early 2020, when I was coming in as Governor, which got derailed by Covid, frankly, and we could not do it.
As I was reported as saying a month or so ago, I really do not want to be interpreted as in any sense thinking that it is a bad idea to review the remit. There are, however, some very important elements. The foundational element of the nominal anchor, price stability, is critical and goes with independence, but we are always learning lessons and that is important to do. It is for the Government to choose when and whether to do a review, and what the subject matter would be. As we have been discussing this morning, we have some huge tasks on our hands at the moment in terms of policy itself, but I want to be very clear that, as a general matter, reviewing from time to time is a good thing.
Q591 Anthony Browne: What do you think the terms of a review could or should be? One idea that has been floated is actually not having an inflation target as you mentioned, but having a money supply target. There has also been a long debate about having a nominal GDP target. I was just wondering what you think of having different targets, and whether it is worth even considering.
Andrew Bailey: I do not think that moving to a money target would be a sensible step to make.
Q592 Anthony Browne: Could you explain why?
Andrew Bailey: I said earlier that it has not been a stable relationship over time, and essentially the world moved on to targeting the end outcome, which is inflation, which is much better. Then we have tools to get to that and a whole bevy of analytical approaches to understanding, of which money is part. The appropriate role for money, rather than it being the target, is to be part of the analytical toolkit to understand how we hit the target.
There is a whole debate about nominal GDP targeting. That is not something that is obviously an improvement, but there is a very wide debate on it. It is sensible to have that debate. When we talk about reviewing, it is not just about whether it is an inflation target or a nominal GDP target. There is a lot more to the remit than that, as the 2012-13 review showed. There are some very important questions about how you put it into practice and interpret it.
Professor Tenreyro: If you are interested, the 2013 review had a big discussion of nominal GDP growth targeting, comparing it to the flexible inflation targeting framework that we have. The conclusion in that comparison, which is also the conclusion from the literature, is that these different targets, flexible inflation targeting or nominal GDP growth targeting, do not lead to significantly different outcomes because, in a way, our remit asks us to put some weight on output, so it has some flexibility embedded and some weight put on the activity side. What nominal GDP growth targeting does is fix a weight on growth and so, in some sense, it has less flexibility than the flexible inflation targeting that we have.
The other difficulty is more practical. With GDP, it is subject to big revisions. The timeliness is less than with inflation figures, so it is harder to chase and target. Finally, for households at least, it is easier to understand inflation than GDP and nominal GDP.
Q593 Anthony Browne: That is true, but what really matters is the economic impact.
Professor Tenreyro: If you try to simulate the outcomes that you would obtain—
Q594 Anthony Browne: It is very similar. I have seen the comparison charts.
Andrew Bailey: But the GDP deflator is not a very intuitive measure of pricing.
Q595 Anthony Browne: Are there other changes that you think might have an impact? One of the other suggestions I saw from an LSE academic was changing the reporting mechanism, so that, instead of being plus or minus 1%, you can make it plus or minus 0.5% before you have to write a letter, and maybe write a letter every two months rather than every three months, so it tightens up the thing a bit. Their argument was that it would be less of a surprise when things diverged.
Andrew Bailey: As a product of Covid and the war, I have written a letter every time I have had to, except for one occasion, when it was passing through. To be honest with you, I do not think these are first-order issues, but all of these things obviously could be looked at.
Q596 Anthony Browne: Finally, the political background to this is that there is a sense of surprise that inflation is going up so high, and there is the accusation that you started raising interest too late. We have been through this, and I know all the arguments. I am not saying I agree with them, but do you think there is any change to the remit that could have meant we were not in this situation?
Andrew Bailey: I will try to avoid re-running the earlier discussion. Obviously, as Huw was saying, by far the largest contribution to this is the war, and that is not, I am afraid, within the remit of monetary policy.
Professor Tenreyro: You can do simulations of what would happen with, for example, a strict inflation targeting regime as opposed to a flexible inflation targeting regime. If you had a strict inflation targeting regime, you would want inflation at 2% exactly. That would have required, again, having the information about the war back in the midst of pandemic, raising rates and unemployment to double digits, and then being ready for a big undershoot on inflation in the medium term. You would have had a very difficult time trying to comply with a strict inflation target that would apply to today, because then you would miss the target going forward and enter into a deflationary economy.
Q597 Alison Thewliss: I have some questions around the prospect of a recession. You have been very clear, and I agree with you, that the inflation that we are seeing is a consequence of the war in Russia and of Putin’s actions. You have been very clear that you want to avoid a recession, but that it is very much what you are predicting. I do not want to go into the predictions much further, but in a very technical sense, given what Catherine and others have said about entrenching inflation, do you believe, as policy-makers, that a recession is necessary?
Andrew Bailey: You can take from the August report that we think, unfortunately, the most likely outcome is that there will be a recession, but that the main cause of that is the war and the effect on real incomes and demand. In terms of whether it is necessary, I am afraid it is a consequence of that. The necessary question tends to go to, “Are you going to do it through monetary policy because you think it’s necessary?” I would say the main reason it is going to happen is not monetary policy.
Q598 Alison Thewliss: So there is very little you can do to stop it then, in effect.
Andrew Bailey: Insofar as the war is having this huge effect, the answer to that would be no. Maybe I am jumping ahead, but if you ask me the question, “Is it therefore the case that you would not use monetary policy in this way?”, I am afraid the answer is that we have to hit the inflation target. We have to take the actions we need to take to hit the inflation target, hard though those may be in terms of the consequences. Do not take that as a prediction as to what we are going to do next. It is merely my observation that the recession, if it happens, will be driven not by the actions of monetary policy, but I just want to make it very clear that we will have to use monetary policy to hit the inflation target, as we think appropriate at the time.
Q599 Alison Thewliss: Catherine, since you talked about the issue of entrenching inflation, do you believe that a recession may be necessary to avoid that entrenchment?
Dr Mann: I agree with the assessment that the recession is a consequence of the energy price hikes and the war in Ukraine, and that is the vastly dominant driver of the recession that was forecasted in the August monetary policy report. Where I come down in terms of deploying the monetary policy tool is that it is the role of monetary policy to lean against the entrenched medium‑term inflationary expectations that are being driven by the short-term energy price increases.
In the time of a recession that is being driven by oil or energy prices, and other prices, I might add—there are some other external shocks as well—you end up having entrenched expectations above the 2% objective, and then monetary policy has to work even harder to get rid of those entrenched expectations. I look at the entrenchment of the medium-term inflation expectations as something that we do have to deal with, because if we do not, in the medium term, our monetary policy will have to be tighter than if we dealt with it now.
Q600 Alison Thewliss: Moving on slightly to the issue of energy prices, Huw, perhaps you can tell us a wee bit more about what the price cap rises do to demand and to growth within the economy.
Huw Pill: It works through the impact on household incomes. To put a retail spin on the magnitude of the shock, we have talked a lot about it at the wholesale level. As I am sure you all know, median household income in the UK is about £31,000. The price cap from Ofgem, which of course is the average, was about £1,000 a year ago. It is set to rise significantly above that, on the basis of the mechanical exercises we discussed right at the outset of the hearing, to £5,000 or £6,000. If you take the gap there of £5000, that is a sixth of household income, so you can see the profound effect that has on disposable spending power for the average household. That is the mechanism through which it can feed through.
As Andrew has alluded to, we have to make a whole set of judgments around our base case and about how that feeds through into spending, depending on how that is distributed across households. It is the perfect storm of a shock that is affecting the least well-off most. The least well-off are not those who have accumulated savings during the lockdown period. They are not those who have access to financial markets, so can borrow to smooth their way through these things. Effectively, they are more reliant on fiscal policy being an opportunity. That is why the fiscal policy choices, which we are still very uncertain about, can have quite a significant effect on the real developments in the economy, because they will affect how that plays out, but all those issues interact with confidence, how these fiscal measures might be funded, and so forth.
As I said to Gareth earlier, these are exactly the interactions between developments in wholesale energy prices, through all these things into, ultimately, spending power and redevelopments in the economy. In our August forecast, which made some concrete assumptions about this, post-tax labour income fell by about 3.5% given the rise in energy prices and its feed-through, on the assumptions that were embedded there, and household disposable income by about 1.5%. These are, by historical standards, very big negative downturns to the spending power on consumption.
Q601 Alison Thewliss: If the price rises take place as predicted, everyone’s household energy bills will have quintupled in the space of two years. Is there any precedent for this?
Huw Pill: No. As Andrew said earlier, we can compare this with the 1970s, which is not always comfortable, but is certainly the natural comparison that people make. In terms of rising utility bills as a proportion of household income, if you apply the numbers I gave earlier on average, we are talking about somewhere between 5% and 7%. The equivalent number in the 1970s was somewhere between 1% and 2%. That emphasises what I have tried to emphasise on previous interventions, which is that the magnitude of this shock under the assumptions that we have built into the framework for energy pricing and so forth is really without historical precedent.
Q602 Alison Thewliss: We have not really talked so much about the outlook for businesses on this. I have a business in my constituency that came to see me last week, whose electricity prices are going from £160,000 annually to £712,000 annually, just to get a contract. That is not even what it might end up being. They make sausages and pies. You are not going to see the prices of sausages and pies going up by the equivalent of that, so I wondered what analysis you are doing about the impact on businesses. Are these businesses just going to go to the wall because they cannot afford to make these bills? What will be the wider impact of that?
Huw Pill: You are right. The focus of a lot of the public attention over recent months has been on the household side, but the impact potentially on the corporate side is massive. A lot of corporates were into fixed contracts that now expire next month. If they are forced to essentially buy at the spot price that is being offered, this is going to be a massive shock to them. We know what that would imply, for the reasons you are giving, particularly for consumer-facing businesses that are seeing a weakening in demand on account of the household behaviour, but are also finding inputs, not least energy but other inputs, that are pushing that up.
The cashflow squeeze on them will be very profound. Many of those are businesses that borrowed during Covid, some of them for the first time. Of course, interest rates have risen, so this is a complication that could lead to higher business failures. It is why fiscal measures that we make here may apply to the corporate sector as well as to the household sector, and then we have to do the analysis that we have been discussing.
Dr Mann: We get quite a bit of information from our agents about how businesses are faring with regard to changes in a variety of their input costs, so we really do feel like we have a pretty good handle on the situation facing business. That is very much part of our analysis. There are surveys of the businesses as well as ad hoc agent commentary, so it is a very rich fabric of information about what is happening at the micro level.
Q603 Alison Thewliss: Is there anything the Bank is able to do about this in a practical sense, because this is a crisis?
Huw Pill: From a monetary policy point of view, monetary policy is potentially a very powerful instrument, but it is also a very blunt instrument, and a lot of what we are talking about here is to do with distributional effects. The point I was trying to make earlier is that wholesale gas prices are being determined in international markets. The UK is a net importer, so we have to pay that wholesale gas price. The question at hand is not one for monetary policy. This shock is unavoidable, to the extent that we keep using gas in this country, and we are locked in, to a large extent, to using gas, at least in the short to medium term. Who covers that cost? That is the issue, and that really is for people other than us. Our agenda is, given all of that, how we are going to set interest rates in a way that gets us back to target. By getting back to target, for all the reasons that Silvana and others have talked about, we are providing the environment where those policies can be most effective.
Chair: That brings us to the end, nicely in time for Prime Minister’s Questions. Thank you so much for coming to see us today. It is always very informative to have you appear before the Committee in very difficult times. Thank you also for coming so close to your next meeting, given the strictures that come with that, which we obviously respect as a Committee. We wish you well and thank you very much. That concludes this session.