Treasury Committee
Oral evidence: Bank of England monetary policy reports, HC 143.
Thursday 9 February 2023
Ordered by the House of Commons to be published on 9 February 2023.
Members present: Harriett Baldwin (Chair); Anthony Browne; Danny Kruger.
Questions 726 - 801
Witnesses
I: Andrew Bailey, Governor, Bank of England; Huw Pill, Chief Economist; Bank of England; Professor Silvana Tenreyro, External Member, Monetary Policy Committee; Professor Jonathan Haskel, External Member, Monetary Policy Committee.
Witnesses: Andrew Bailey, Huw Pill, Professor Silvana Tenreyro and Professor Jonathan Haskel.
Q726 Chair: Welcome to the Treasury Committee evidence session. We have resolved that the Thursday before recess is probably not the ideal time to have you in front of the Committee, as various colleagues have succumbed to various things, but we do want to take the important evidence on the latest Bank of England monetary policy report. Can I start by inviting you to introduce yourselves?
Andrew Bailey: I am Andrew Bailey, Governor of the Bank of England.
Huw Pill: I am Huw Pill, chief economist at the bank.
Professor Tenreyro: I am Silvana Tenreyro, professor at the LSE and external member of the MPC.
Professor Haskel: Good morning. I am Jonathan Haskel, professor at Imperial College and an external member of the MPC.
Q727 Chair: Thank you all very much for coming in and talking to us about the current state of play. Inflation is clearly still over 10% in the UK. It is five times your target. Food inflation is over 16%, which shows why inflation harms the poorest and those on fixed incomes the worst. The second-round effects that you have given us evidence on in the past that you were particularly vigilant about seem now to be everywhere that you look in the economy. There are wage pressures, there are strikes, there is services inflation, and there seems to be a change in household inflation expectations. Now, even the Government have said that they just want to see inflation halve over the course of this year, which would take it to 5%, or two and a half times your target.
Governor, do you accept that the Bank has made mistakes in terms of this tightening cycle, that you started raising rates too late and too slowly, that you have really let inflation run away in this country and that it will now be harder and more painful to get inflation back to target?
Andrew Bailey: I know that we have discussed this before, and I would start by saying that we do not make policy with the benefit of hindsight. I have to start with that. I am happy to comment on the history, and it is important, because we learn a lot from that, but I do just want to say that we do not have the benefit of making policy with hindsight.
There have been a number of very big shocks hitting the economy over the last three years, starting with Covid. Going past that, I would pick out now a number of very big shocks that have hit the economy. I will go through them roughly in order of appearing. The first one was the supply chain shock that appeared as the recovery from Covid started. That is a global shock. Speaking for myself now, it was really that shock that caused us to use the term “transient” or “transitory” about the nature of it, because, at that point in time, we really saw that as a single supply-side shock that was part of the recovery from Covid.
I should say that, if we go back to particularly somewhere like the summer of 2021, the UK economy was substantially below the level of activity that it had been pre-Covid. Of course, it is still below the level of activity pre-Covid, but, at that point, it was substantially below.
The reason that we used the term “transitory” or “transient”—we were not the only central bank using it—was because a single supply-side shock like that, on its own, ought to work its way through the system. What I would say now, with the benefit of having seen how things evolved, is that that is what has happened with that shock. It probably peaked around the end of 2021 on most measures, and has now come off quite substantially.
However, two other shocks have hit us. The very big one is Russia-Ukraine. This is the one that is the dominating shock of the last year. We will, no doubt, come on to this, but moving on from it is also why we expect inflation to come down rapidly this year. We have discussed before at these hearings that I do not think that any of us could have predicted what was going to happen in Russia-Ukraine until quite near to it happening, but it is a very big shock.
It has a second effect. I talked about the effect of single supply shocks, but what we have had is a sequence of them, and there are no air gaps between them. That, of course, makes them much more persistent and much more difficult to deal with. The conventional wisdom that you can accommodate the first round effects of a single supply shock starts to go out of the window at that point.
The third shock is the one that we have discussed a lot before, and I take to be highly relevant to your question, which is then the question of the labour supply in the UK. As we have observed and as we have commented on extensively in the monetary policy report, there has been a decline in participation in the UK.
Many countries had a decline in participation in the initial Covid period. What differentiates the UK is that it has not recovered. Coming back to this question about judgments, this is the judgment that we had to make at the time. I remember you saying on a number of occasions in the past—and you are right—that you could observe elements of tightening going on. Our response to that was, “Yes, we do not disagree”. Our agents were telling us this as well.
The challenge that we had to deal with was that the furlough scheme was in place at that time until the end of September 2021. About a million jobs were furloughed right until the end of the scheme, and so the big question was what was going to be the impact of ending the furlough scheme. By the way, I am not criticising it. The furlough scheme did a very good job, but it created this problem of judging what the effect at the end of it would be.
We thought that unemployment would rise at the end of it. If you take our August 2021 monetary policy report—and we always publish later on in the report a comparison of our projections with those of other forecasters—we were at the low end of the assessment of the rise in unemployment that would follow from the end of the furlough scheme, but, of course, it did not happen. That is, in many ways, the important part of your assessment of where we stand now. We have a very tight labour market. We have had a fall in participation and it has not recovered.
The final thing that I will mention, which is the shock that did not happen, is omicron. When we were considering the timing of the initial tightening of monetary policy, we were right on the cusp of omicron and being told that it was going to happen. That is the one where we said its economic effects may be less than the earlier Covid outbreaks, and that was a correct judgment, but again, it was a very big judgment that we had to make at the time.
If you do not mind, my response to this is that we have to make judgments based on imperfect evidence at the time. We learn a lot of things afterwards and I agree with you on that, but I do push back on this question about hindsight judgment.
Chair: I am going to push back on you, Governor, if I may.
Andrew Bailey: That is fine.
Q728 Chair: I have gone back, and you and I have discussed this quite regularly over the last few years. I want to just pick out some of the exchanges that the team has highlighted, and you probably will have gone through them. I am going to start in May 2021, with your evidence there, because, by that time, inflation had risen from below target to your target of 2%. You told us, “There are some very hot spots and hot areas of prices”. I would just remark on the fact that, despite that, the Bank decided to keep interest rates at 0.1% and to carry on with quantitative easing programme of £150 billion.
Andrew Bailey: Can I just put that into the context of what I said? I do not want to repeat it, but that is because we were already observing the global supply chain shock taking place, and there were hotspots. There were hotspots domestically, because pieces of the economy were reopening in sometimes a rather difficult fashion. The question for us was, “Are those going to be permanent effects or temporary, transient effects?” That was the question that we were facing.
Q729 Chair: So the judgment that you took at that point was that it would be temporary.
Andrew Bailey: Yes.
Q730 Chair: We then get to September 2021, and it is that fourth quarter that I find most interesting to look at retrospectively.
Andrew Bailey: I agree.
Q731 Chair: By now, inflation is over your target, at 3.1%. You are still doing the £150 billion of quantitative easing at that point. We then get to November 2021 and inflation is now running at 5.1%. You are saying, “I am now very uneasy about the inflation situation”. Of course, that is the moment when the committee judged that some modest tightening of monetary policy was likely to be necessary, so it did not move until a bit later on in the autumn.
Andrew Bailey: We moved.
Chair: You are still at 0.1% at that point.
Andrew Bailey: That is precisely the point in time that I was just referring to with these two things that we were having to assess. One was the effect of the end of the furlough scheme. By the way, I said it ended at the end of September, but the data does not come through for another a couple of months. The second one is omicron. Those are the two things that were very much uppermost in our mind at that point in time.
Q732 Chair: I understand that, but you accept that monetary policy was kept very loose, despite the evidence that you gave us that there is risk that it transfers into real pressure in terms of wage negotiation. Prolonged inflation leads to higher inflationary expectations—all the things that we are currently seeing.
Andrew Bailey: I perfectly agree with you on that, but the reason that I agree with you is because we were seeking to balance these various conflicting and countervailing pressures at that time and to assess what was going on in the labour market, as these million jobs on furlough unwound, as to how that would wind its way through. Those were very difficult judgments and we concluded by December that the right thing to do was to start to tighten monetary policy, but we were still very uncertain because that was just about to go into the omicron wave at that point.
Q733 Chair: Let us step forward, then, to exactly a year ago today. By now, inflation has risen to 6.2%. Interest rates are still only at 0.5%. Your evidence at that point was that “transitory” was becoming “a slightly overused and, in some circles, over-abused term”. You are clearly now pointing to an upside risk and the risk of real second round effects, and yet the rate is still only 0.5%.
Andrew Bailey: The reason that I made the point about “transitory” goes back to what I said a few moments ago, which is that “transitory” is a term that, in my view, is easier to apply to a single shock. By this stage, of course, we are now seeing that Russia’s invasion of Ukraine was, sadly, starting to happen, though the major impact on energy prices really came over the summer. We were seeking to judge what the impact would now be from more than one shock. I also would just make the point that we were the first major central bank to tighten monetary policy, so this was a problem and a challenge that others were having as well.
Q734 Chair: On that day, the day before Russia invaded Ukraine, inflation was already running at 6% in this country, and interest rates were at 0.5%. I wonder whether it is your opinion now—not with the benefit of hindsight, because these are all contemporaneous observations—that the risk to inflation was always more to the upside than to the downside, given the level of monetary policy that we had at that time, and that the risks of those second-round effects becoming embedded were very high at that moment in time.
Andrew Bailey: At that point, because of the nature of the shocks that we were dealing with and the question of how transitory they would be, that was the question that we were still, frankly, wrestling with at that point. These are judgments that we have to make, I am afraid. We changed our view on that as we went through the summer.
Q735 Chair: How can people feel confident, though, that the Bank of England has made the right judgments at the right time in this period of time? I note that, in terms of public polling, there is now quite a high level of dissatisfaction with the track record of the Bank of England.
Andrew Bailey: I can quite understand the public polling, because our job is to get inflation back down to target. The public would, of course, expect us to do that. We will do it, and I would expect that that will be reflected in public polling. At this point in time, I would, of course, expect the public to say, “It is your job to get inflation down to target”, and my response is, “Yes, it is, and we will do it”.
Q736 Chair: No, it is your job not to have let it get to this kind of level of second-round effect either.
Andrew Bailey: I am sorry to have to disagree on this point, but there is a very large body of first-round effects going on at the moment. One piece of evidence for that is that the fall that we expect to see in inflation this year, which we have set out in the monetary policy report, is the unwind of what we call the base effects from last year. This a very powerful unwind.
There is a second question that, no doubt, we will come on to about whether there will be persistence, but these base effects are unwinding very powerfully this year and will unwind more as the year goes on, because of the nature of what happened last year. That, to my mind, indicates that there is a very big first-round effect here.
Q737 Chair: We will get on to the second-round effects, because 5% now is the Government’s own target. They want to halve inflation this year. A lot of the expectations that you have set in terms of your forecasts are for us getting back down to that level. What worries this Committee is some of those second-round effects persisting at 5%.
Andrew Bailey: As you will see from the report that we published, our projection indicates that inflation will probably come down below 5% by the end of this year.
Q738 Chair: Forgive the Committee for being slightly sceptical of those projections, given how often we have seen those projections turn out to be incorrect.
Andrew Bailey: It is right for you to question us on those and I accept that, but what I would say is that there are really two countervailing forces going on at the moment. There are very powerful base effects that are going to come out this year, and that puts a very powerful negative trajectory on inflation, unless we have some event in the world that we do not know about at the moment. A lot of that is down to energy prices.
We are concerned about the persistence. That is, frankly, why we raised interest rates this time. Of course, we do take different views on this, as you will know, and those of us at the table take different views on this. You could justifiably say to us, “If you have this view of inflation going forwards and you have those powerful downside forces, why are you raising interest rates again?” The answer to that question is that I am very uncertain particularly about price setting and wage setting in this country. We have the largest upside skew in our forecasts that we have ever had on inflation, which still leaves it coming down to target, by the way. Otherwise, the central case would come below target. We do put weight on the persistence risk, but there are very powerful downward forces this year, other things being equal.
Q739 Chair: Thank you, Governor. I am going to turn to Huw now. I know that Silvana and Jonathan have points that they want to raise. Huw, you have very kindly sent the Committee a sort of self-assessment of your time on the committee since September 2021, and we are publishing that today. What was very interesting in your self-assessment is that it slightly differed from the speech and the evidence that you have given here in Parliament before, where you did stress this phrase about “with the benefit of hindsight” that we heard from the Governor just now.
In your self-assessment questionnaire, I was intrigued by your paragraph 7, because you admit that, in that pivotal time that we have been talking about—the autumn 2021 decision—the Bank waited for the end of furlough to tighten, and yet you point in that paragraph 7 to the fact that your network of agents at that time, before the end of furlough, was pointing to tightness in the labour market and strength of the ability of people to negotiate increases in wages. Can you tell us a bit more about this assessment that you have made of how you should have paid more attention to that network of agents contemporaneously?
Huw Pill: First of all, let me say that the assessment that I wrote is one that is made with the benefit of hindsight, so I am assessing myself and looking back over the experience that I personally have had since I joined the committee in September 2021. What I am trying to write is very consistent with what the Governor just said, which is namely that we were given this information from the agents at that time. That information was published in the MPR and was part of what was reported in the minutes and all the usual vehicles of communication, including the discussion that took place in this Committee.
Speaking from a personal self-reflection, looking back, and consistent with what the Governor said, we faced at that time a very specific and a very uncertain environment in the labour market associated with the coming to the end of the furlough scheme. If you remember, as the Government’s furlough scheme was coming to an end, there had been some uncertainty earlier in the year, before I joined the committee, about when it would come to an end.
That was largely resolved by this point, but, in September and through that period, we still had roughly 750,000 jobs on furlough. The question was whether the tightness that was being reported from our agency network in the labour market associated with suggestions around recruiting difficulties and rising pressures in pay would be eased at the moment that the furlough scheme came to an end.
Prima facie, at least potentially, you would release quite a lot of people who are supposedly in the jobs that were under the furlough scheme into the labour market. That would have been a corrective mechanism to this tightness. With the benefit of hindsight, of course, I look back and think, “How much weight should I place on the reports we were getting from the agencies?” versus, “How much weight did I place on the official data, which was reporting that there were a lot of jobs still on furlough and, therefore, the potential for this easing?”
What I did at the time was to think that we probably need to see, post the end of the furlough, how those close to 750,000 jobs that were furloughed play out in terms of the survey data that we see, the reports that we get from the agents and the official data on unemployment and on wage settlements and so on and so forth. I particularly put weight on the official data, which did not come out, as the Governor just said, towards the end of November and early December.
That led to a personal view that it was worth waiting until we saw that data in order to avoid making a mistake about how tight the labour market would prove to be once the furlough scheme ended.
Q740 Chair: Official labour market data is always seen as a lagging indicator. You have this marvellous network of agents that were telling you that the labour market was tight. I wonder whether the fact that you were new to the committee meant that you did not speak up with your concerns loudly enough, and whether those were contemporaneous concerns that you had.
Huw Pill: I was new to the committee. I do not think that precluded me from speaking up, but others are probably in a better position to judge than I am. I want to make clear that the purpose of this exercise, if I have not misjudged it, was for me to give a personal reflection, as an individual, independently accountable member of the MPC, in the report I gave you, which you are referring to. Just to emphasise, that was a personal view.
I would like to think, looking back, that I contributed to the discussion of the committee from the perspective I gave, but certainly the discussion in the committee—this is what is recorded in the minutes and was reported in the equivalent meeting back in November and again in February 2021—was a discussion where this was at the core.
The point that I would emphasise is that, looking back, the reports we were getting from the agents were, “The labour market is tight”. The reports that we were also getting from the agent market were, “There is uncertainty as to how the end of the furlough scheme will play out in terms of easing”. In other words, it was not just those of us on the committee who were uncertain; it was the agents and, perhaps more fundamentally, the corporate contacts that we were gathering information from via the agents. There was a genuine uncertainty at that point as to what would be the impact to the UK labour market of the end of the furlough scheme.
Q741 Chair: Again, I would submit that, while just characterising this whole episode as one of “with the benefit of hindsight”, there was contemporaneous evidence that, on balance, you chose to wait and see whether that followed through into genuine wage pressures. That is where the hindsight comes in. You did have contemporaneous evidence.
Andrew Bailey: I know that Silvana wants to come in, but can I just add one point? I just want to add a reflection of conversations. I do a lot of trips around the country with the agents. I was in Wales three weeks ago and a conversation came up with a number of businesses going back just to that point in time that you rightly referred to. They said to me that what they did not expect—and this goes to the inactivity story—was the labour force saying, “I have re-evaluated my life and I am not going to come back to work”. They were open in saying, “We did not expect that to happen”. That is part of the inactivity story, of course.
Chair: I will bring in Silvana and Jonathan, and we can talk about what this informs us about your future outlook in a minute.
Professor Tenreyro: Just to put the factors into perspective, the labour market contribution is very small. The dominant shock in 2022 was the war in Ukraine, and increasing prices for energy and other commodities, including food. That is important to keep in mind.
In terms of the 11% peak in inflation last year, eight percentage points of that was contributed by energy and other goods prices, which are largely determined in global markets. These are mostly tradeable components. The remaining three percentage points came from services, which are more affected by domestic input costs like wages and more influenced by monetary policy.
If we just follow those numbers and take that eight percentage point contribution from abroad, then to have inflation at the 2% target last year, given that services represent two-fifths of the CPI basket, it would have necessitated inflation in the services sectors to be -15%. That is, in order to meet the 2% target in 2022, we would have needed a services deflation of 15%.
In practice, of course, the split that I gave you is not precise. You can refine it. Some goods sectors include some non-tradeable components, and monetary policy can affect goods sector inflation through other channels. Conversely, services inflation contains some energy and food components.
Even if you refine my calculation, the conclusion is that you still need services inflation running in deeply negative territory in order to meet the 2% target. As you can imagine, having deflation of 15% in services requires a massive recession, much bigger than the great financial crisis, with unemployment at double-digit levels.
This is at a time when the economy was trying to recover from the Covid shock. Let us not forget that consumption and investment at the time and even now were and are still well below 2019 levels. In my view, it would have been incompatible with our remit to have inflation at target last year.
I mentioned this eight-percentage-point contribution. As we go forward into the next two or three years, as those prices stabilise or even turn negative, as we have been seeing, those eight percentage points will become zero or negative. That means that the level of services inflation that you will need to meet the target, again with a contribution from services of roughly two-fifths, would be 5%. That is the level of services inflation that we will need in the coming years to meet the inflation target.
If you really want to hit the target at all times, you need to go from -15% to 5%, which is an impossible task for any central bank. You cannot switch unemployment from two digits.
Q742 Chair: We appreciate that, if you are going to get a massive spike in something like energy, that will make it difficult to achieve 2% on a day-by-day basis. We accept that, but it is notable that, the day before the invasion, inflation was already running at 6%, and the base rate was at 0.5%.
Professor Tenreyro: What we learned, Harriett, with hindsight is that those restrictions in gas supply had started earlier, and that was not known to us.
Chair: I think it was.
Professor Tenreyro: Yes, that is what I am saying. We could see the price effect, which was just the beginning of it, but we did not know that this would be a sustained strategy by Putin going forward. At the time, you could have seen it as temporary.
Q743 Chair: You mentioned services inflation and, in your latest report, you say that services inflation is at a new high. What I am trying to press you on today is that the second-order effects in terms of inflation have now become much more deeply embedded in our economy and will be that much harder to remove.
Professor Tenreyro: Let me talk about that. As I said, in order to meet the inflation target, we would need services inflation to come down from the current 6.8% to 5%. Is that feasible? It is, and this is what is in our forecast. There are three elements to that. First, services inflation does incorporate some energy and food components. Some services are very intensive in the use of those. In fact, if you look just at services that are not energy-intensive, inflation there has been less than 5%. Naturally, as energy prices come down, there will be a direct slowdown in services inflation.
The second component is wage inflation, and we have already seen a slowdown in pay growth in the high-frequency measures. If you look at one month on one month or three month on three months, this has been falling since July.
The last one—and this is, of course, the big one—is monetary policy. We have tightened policy significantly over the past year, and that is going to have a large impact on demand, hence the labour market, and this is going to be the transmission mechanism that will ultimately bring inflation below target. In fact, it is going well below target in our forecast. Those elements should give you the reassurance that we are more than on track.
Chair: I accept that there are some year-on-year effects that are going to roll out. Where I am somewhat probing you here is whether a 5% level of inflation has not become quite ingrained and embedded as a second-order effect in the UK economy.
Professor Haskel: I do not want to move the conversation backwards, but I just want to say two things. One is that, if we go back to the discussion that we were just having around furlough in late 2021, it is important to understand, as Silvana just said, the context in which that was the case.
You will have seen that chart 3.7 on page 87 of our report gives the level of investment over that period. The level of investment was around 10 percentage points below the pre-omicron level in that late 2021 period. In other words, the economy was extremely subdued. If you were to say, “I want you to tighten monetary policy with an incredibly low level of investment”, that would not normally be a very good thing to do. That was one thing to do.
The second thing, which also goes back to the issue, is that there was a lot of uncertainty around the furlough, but, as Andrew just mentioned, we must not forget that omicron was a major threat at that time as well. Could I just say a quick word about that? That is a case study in what we know now as opposed to what we knew then. We now know that the vaccine was robust against omicron, but we did not know that then. We took advice from Chris Whitty—the best advice in the land—about the situation with omicron.
As you will remember, when omicron first came out in South Africa, there was significant concern that it would, indeed, get past the vaccine and that the vaccine would be ineffective against it. I remember asking Chris Whitty, “What happens then?” and he told us the facts. The facts are that the vaccine would have to be reengineered—that would take three to six months—and we would have to start vaccinating everybody all over again.
Again, we know now that that did not come to pass, but, if you will forgive my dwelling on it, it is a little study about how we did not know back then and we had to make policy with the benefit of what we knew at the time. Sorry for that long intervention.
Q744 Chair: Are you not concerned now that the second-order inflationary effects have become much more embedded in the UK economy?
Professor Haskel: I am concerned that they are, and that is why I am voting to raise, but the point that I am trying to make is a slightly separate point, which is that, with the information that we had then, we did not know that at the time, so we did the right policy decision at the time.
Professor Tenreyro: Could I just make one clarification? When I mention 5% services inflation, that is enough to meet the target, because services are two-fifths of the basket, and the other side of the basket is going to be—
Chair: Going negative.
Professor Tenreyro: Exactly.
Chair: I understand that, yes.
Q745 Anthony Browne: I am looking at the prospects of inflation over the coming year. The Bank declared that we have now turned the corner, and your projections are pretty much downhill all the way. I am going to take a range of views of what the risk is to that. Is there a real risk that it will not end up going downhill the whole way?
As you touched on earlier, the Government have given themselves their own target to halve inflation by the end of the year. Do you think that there is any risk to not meeting that? Your expectation is that it will meet that. I am going to take a range of views; we will start with Jonathan. Is there any risk to not going downhill the whole way this year?
Professor Haskel: Again, why do we not just refer to the report, since the hearing is about the report? On page 27, we lay out this rather complicated table. Apologies that it is a complicated table, but there is tons of information in it, which speaks to your issue.
As you say, our projection is that CPI inflation will go down from roughly 10% at the moment to around 4% at the end of the year. Of that, the energy price contribution is going to take about 3.75 percentage points. That is a fall of 6.75 percentage points. The energy price, which we publish in black and white in the report, is going to take 3.75 percentage points off that. We can have a reasonable amount of confidence about that because of the way that the Ofgem price cap works and our current knowledge of what the futures curve is.
Of course, as Andrew was just saying, were there to be another significant shock, that would imperil that, but we have to do the best that we can, again given the information that we know.
Of that fall of 6.75 percentage points, as I say, about 3.75 percentage points is because of energy. There are indirect energy effects, as Silvana was just mentioning. Of course, energy has a direct effect because we buy gas and electricity, but then there are indirect effects because restaurants have to consume energy and all that sort of stuff. That will add maybe 0.25 percentage points to that. That is about four percentage points on that.
That takes you from 10% to roughly 6%, and so the question is where the other two are going to come from. We are being ever vigilant on that issue. That then gets one to the issue about what is going to happen in the labour market and what is going to happen to our export prices and so on.
Again, without going through all the various details in the report, all the numbers are there. I will stop quoting the numbers. I would say that a lot of that energy effect is locked in, again based on our modelling of the futures curve, and we are incredibly vigilant about making sure that the rest of it comes through. Does that help?
Q746 Anthony Browne: Yes, absolutely. Silvana, what do you see as the main risks to inflation coming down to 4% next year, apart from energy?
Professor Tenreyro: As the Governor and Jonathan said, unless there is another big development that we do not know about and we have a massive energy shock or something that is not on the cards, the fall in inflation is pretty much guaranteed. This is, again, that mechanical effect that we were talking about. Those prices that went up incredibly high last year are coming down or stabilising, and that turns that eight percentage point contribution to zero or negative, and then you can do the arithmetic on the rest.
Q747 Anthony Browne: There are not other things that you are particularly worried about, such as an unknown energy price shock.
Professor Tenreyro: Given the amount of tightening that we have put in place—
Q748 Anthony Browne: Nothing else can knock it off course, basically, apart from a big external shock.
Professor Tenreyro: Nothing that we know at the moment and that we possibly can know at the moment.
Q749 Anthony Browne: In the latest meeting, you wanted interest rates to remain at 3.5%. Do you think that the rates are at the wrong level now, or have you changed your view?
Professor Tenreyro: As for all of us, my decision is about how best we can meet the 2% target in the medium term, in line with our remit. Of course, the reason why our remit focuses on the medium term and why we build forecasts is because there are lags in the transmission of monetary policy to the economy. It takes time for changes in bank rate to feed through.
Q750 Anthony Browne: Previous rate rises have not fed through yet.
Professor Tenreyro: We have seen very little of that feeding through. About one-fifth of that has come through. The rest is still to come, and so the impact of monetary policy, combined with these energy and other commodity prices unwinding, should be more than enough to get us not at target but below target in the medium term. This is why, in my view, rates are too high right now, and that is why I did not support the vote.
Q751 Anthony Browne: Andrew, apart from another new energy price shock that we do not know about, what do you see as the other risks to inflation getting down to 4% next year?
Andrew Bailey: I would just like to be clear, because our target is 2%.
Anthony Browne: Yes. Not your target, but the predicted 4%.
Andrew Bailey: As Silvana and Jonathan were saying, unless something happens that we just do not know about—something like some development in Ukraine that we just do not know about at the moment, which would be tragic—those base effects are solidly built in, because they are arithmetic in many ways.
In terms of the big decision that we had this time, you can reasonably, as Silvana has described, ask the question, “If you have that forecast, why are you raising interest rates at this point?” We spent a lot of time discussing this very question. For me, there is still substantial remaining uncertainty, particularly about the domestic side of things, because we have had this other shock, which is the tightening of the domestic labour market and particularly the rise in inactivity.
I will just give a quick summary. What we are hearing and seeing at the moment on that front is that the numbers remain tight and are tighter than we thought they would be at this point in time, particularly on the inactivity side. The agents are telling us at the moment that there are early signs—and I certainly pick this up when I see firms as well—of some signs of loosening. That will come through more in a decline in vacancies and potentially in a decline in hours worked. It will not necessarily come through so much in a rise in unemployment.
The reason for that—and firms say this to me quite consistently—is that it is so hard to recruit people in the current environment, and has been, that they will be reluctant to shed people. They are thinking more in terms of reducing hours rather than heads. That is, by the way, important for our forecast, because reducing hours has a different effect on people than losing jobs. It is a milder effect, and that does feed through into people’s views on savings and on demand.
The final thing that I would say is on the survey evidence, which Huw was referring to this earlier. One of the more prominent ones came out yesterday or the day before—the so-called REC survey. That is a leading indicator, so there is a lag before those sorts of surveys come to pass. That is pointing, and has been pointing for some months now, to a loosening in the labour market and to a loosening in pay.
For my part, though, why did I vote to raise rates? We need to see more evidence that this has happened. We have not yet seen evidence of this, and I am very cautious on that front. As I said, I do think we have turned a corner in terms of headline inflation. It has not only fallen but is now under what we thought it would be in the November report, but we need to see more evidence that this process will take effect.
Q752 Anthony Browne: You mentioned there the risk of a tight labour market. What are the risks of inflationary pay rises in one sector? I am thinking particularly of the public sector, because we are in the middle of the toughest public sector pay round for a generation at least. What are the risks that, if you had inflationary pay rises in the public sector, that would help fuel wider inflation?
Andrew Bailey: Most of what we have talked about on the labour market is about the private sector, not the public sector. That is where the pay evidence is coming from. There is quite a big wedge now between private sector pay settlements and public sector pay settlements.
In terms of the debate on public sector pay and its impact on the economy, I will be careful what I say here and just say one thing. If you think through to the demand effects, it depends on how it is funded.
Q753 Anthony Browne: Do you mean whether the Government borrow more?
Andrew Bailey: Yes, in terms of what its overall effect is. I know that there is quite a debate about what the impact is of public sector pay on overall demand and the economy. Is it like private sector pay or is it not?
Q754 Anthony Browne: What is your view on that?
Andrew Bailey: I will be careful what I say here. I do not think that you can say that there is no effect, but it does depend.
Q755 Anthony Browne: What is the effect?
Andrew Bailey: It depends on how it is funded, frankly.
Q756 Anthony Browne: Do you mean if the Government end up having to borrow more?
Andrew Bailey: I am going to be careful here, because I am not advocating anything at this point. This is not territory that the Bank of England would want to be in. In terms of the economics of it, it depends on whether you raise taxes or whether you borrow, frankly.
Q757 Anthony Browne: In terms of public sector pay rises, if it is inflation across the board in the public sector, are there concerns that it will raise expectations of inflation across the board and second-order effects, or is it just that funding issue?
Andrew Bailey: It very much depends on what form it would take. When we talk about the inflation rate, let us also remember that, at the moment, all of these pay settlements are under the level of inflation, but we have to be forward-looking here.
Anthony Browne: A lot of the demands are above inflation.
Andrew Bailey: What I would urge is that, particularly going forward, because we think inflation is going to fall very rapidly, that is taken into account.
Q758 Anthony Browne: You are right that a lot of the pay offers at the moment are below inflation, but a lot of the pay demands are at or above inflation. If those pay demands are met, is it purely how it is funded? What could be the impact on inflation?
Andrew Bailey: The point that I have made before and will make again on this point is that, because of the nature of the shocks that we have been having, and because they are predominantly external shocks, as colleagues have said—and this is coming through the terms of trade—I will make it very clear that this applies to price setting as well as wage setting. It is very important to say that. If there is a continual attempt to beat those shocks, then the Chair is absolutely right. That is where the second-round effects come from.
We have seen that pay settlements, particularly in the private sector, are higher and consistent with the target, but not at the level of inflation. The question for us, as I said before, is, “Are we now beginning to see evidence of loosening in the labour market that will affect those pay settlements?” There is evidence to suggest that, but it is, in my view, too soon to conclude.
Q759 Anthony Browne: As a last question on this before I move on, if the Government met the inflation wage claims across the public sector and borrowed for them, because taxes are already at a 70-year high, you said that there would be an impact. What would be the scale?
Andrew Bailey: There would be a fiscal impact in that case, and that would then have to feed through.
Q760 Anthony Browne: What would be the impact on inflation and interest rates?
Andrew Bailey: It would, effectively, cause a stimulation for fiscal effects, and we would have to take that into account, so, yes, it would have an effect if you did that.
Q761 Anthony Browne: In terms of potentially higher interest rates than would otherwise be the case.
Andrew Bailey: I want to be clear, because this is a sensitive subject. I want to do no more than lay out the channels.
Anthony Browne: I am just asking about the economics, not the politics.
Andrew Bailey: I know you are. It is a fair question.
Anthony Browne: It is one of the things that Government have to think about.
Andrew Bailey: It is a perfectly fair question, but this is a very sensitive subject, so I will merely lay out the channels. I am not going to advocate any particular policy here or there.
Q762 Anthony Browne: No, I get that, but that is one of the factors that the Government have to think about when they are in the middle of these negotiations.
Huw, what do you see as the main risks? You have this forecast of going down to 4% by the end of the year. Apart from some new developments in the energy markets and Ukraine, what do you see as the main risks to that? Do you think the Government are pretty much guaranteed to meet their own target of halving inflation by the end of the year?
Huw Pill: I am on the end, so a lot has been said and I will try not to totally echo. I will try to pick out my key points. I just wanted to echo something that the Chair said right at the beginning and Andrew picked up on. It is important to see that inflation is too high, and that has consequences for households and so forth, which is exactly why we are committed to getting inflation back to target. Having inflation go to 5% or stop rising, etc, is not the same as getting it back to target. Our target is 2%, and we need to get it to there not just at one moment in time but on a sustainable basis through time. That is the focus of our ambition and our actions and, hopefully, what we achieve.
In terms of the forecast, as has been said by others, inflation is forecast to fall, and is forecast to fall quite rapidly. The reason that it is forecast to fall is the mirror image of why it rose last year. We had the big rises in energy prices driven by external developments, which entered into CPI inflation, and those big rises will now fall out of the annual calculation. In some cases, they will be replaced still by rises, but just smaller rises, which nonetheless will result in a fall in annual inflation. That is what we are looking at.
What are the threats to that? It is important to recognise that, if we get big shocks—and those big shocks might be energy price shocks, but could be other shocks too—those could have an impact on inflation. The character of shocks is that they are uncertain.
Just to hark back briefly to what we discussed, when I joined the Bank halfway through the process that we were discussing in response to the previous set of questions, I had a briefing on where we stand. I had a briefing on geopolitical developments, and the Russia-Ukraine situation was mentioned, but it was not in the top five. What happened really was a shock. Silvana emphasised that addressing that shock would have required big developments in the UK economy.
It is also important to keep in mind that, given the lags in transmission, in order to have that impact, you would have to have known before the shock happened to avoid the volatility in price developments. Because it was a genuine shock in the sense that we did not have the one year to 18 months pre-warning, monetary policy was not really in a position to prevent the volatility that we have seen. That is why inflation went up a lot, but it is also why inflation will come down a lot, owing to these base effects.
At a very high level, in order to address inflationary dynamics in the economy, I would agree that, because of other developments, including those in the labour market that we have just been discussing, we have some domestic dynamic and inflation. We have done quite a lot to address that. We have raised bank rate by almost 400 basis points. We have gone from a situation where we were doing QE to now doing QT. The communication around monetary policy has changed very much since I joined the Bank in September 2021.
All of those things have had their influence on market rates, including market rates at the two-to-three-year horizon that have a big impact on mortgage rates. That is a big channel of transmission of monetary policy into the economy. That is something that we will return to, I would imagine, this morning.
I very much agree with what Silvana said about this policy in the pipeline. Because of what we have done and because of the lags that I have emphasised, there is still more effect of this policy to come through into the UK economy. It is important to see that those transmission lags are famously long and variable. Crucially, they are also not entirely predictable, and so I would caution against the idea that we can fine-tune developments in the UK economy.
When we talk about inflation going to 4%, we have the famous “rivers of blood” chart of inflation, and that reveals the uncertainty. Some of that uncertainty is associated with the possibility of further shocks, but some are uncertainties about how what we do transmits into the economy. There is an irreducible uncertainty of how that works.
Just to hark back briefly, that does also caution about too much focus on whether it is September, November or December. The reality is that we do not have that close control of the economy. To me, the message of the autumn of 2021, when I joined the Bank—and this was not because I joined the Bank—was that there was an inflection point in the conduction of monetary policy. We went from a mode of being supportive in the face of the pandemic to a mode of tightening in the face of inflationary pressures. That is the big story, and the big story was right. That will contain inflation on a sustainable basis over the medium term, and that is the important thing.
Trying to expect perfection on a month-to-month basis is just to expect too much of monetary policymakers. I understand, from where you sit, that you should hold us to a high degree. We are accountable to you, and looking to perfection from us is not an unreasonable thing to do. I can only speak for myself, but I think I can speak, to some extent, for others. Of course, we strive for perfection, but we will fall short.
At the same time, it is about getting the big questions right, and I feel very confident, in line with things that Jonathan has said, that we did get the big questions right at the end of 2021 and into 2022 by tightening monetary policy, and then, in the face of the energy price shock, accelerating the degree of tightening.
Having said all that, the challenge to me now is that we have done a lot, there is still more to come through from what we have done, and we have to be prepared to see it through. In terms of impact on the economy, we will have challenges. We will have political challenges and we will have economic challenges, but seeing it through is the key element of where we are. It is crucial to see it through and that we do enough to address potential upside risks to inflation.
I would agree with various things that have been said, but, if you asked me, “What is the danger to the 4% or the danger to going to 2%?” it is seeing greater persistence inflationary dynamics associated with stronger pricing power on the corporate side in the UK economy—supply chain disruptions and so on and so forth—and/or stronger wage and cost developments in the labour market owing to the unexpected and continued tightness of the labour market, which we have done a lot of work on. In line with what Andrew has said, it is beginning to change, but there are deep structural issues around what is going on in the labour market that are not fully understood and we need to understand better. That is where the issue is.
We need to guard against doing too much with policy, because there is a danger of oversteering if there are lags in transmission. At least from where I stand now, the right stance, which is more similar to what Andrew and Jonathan have said, is that we should be watchful of these risks of greater persistence. That points to looking at developments in price-setting behaviour in the corporate sector, and wage and cost-setting behaviour and tightness in the labour market, and how that feeds through into services price inflation as well.
We have been pretty clear in our communications that that is where our focus is. Should we see things there that cause us to worry, in particular what you can miss in these discussions is that, very understandably, we tend to address these questions shock by shock—what is the impact of the labour market tightness? What is the impact of higher energy prices? What is the impact of the supply chain disruptions? What we have to do, and where the forecast helps us in our discussions, is take notice of how these things interact with each other. It is the combination, back at the turn of 2021, of that period of supply chain disruption with unexpected tightness in the labour market that led to greater persistence than we would have liked to see. Again, in the course of last year, it is the combination of that tightness in the labour market with the impact of the energy price shock.
Looking forward, if you asked me to say, “What is the biggest risk?” it would be that interaction with a continued unexpected tightness in the UK labour market, with some external inflationary shock, rather than one or the other in isolation, that I would be most concerned with.
Q763 Anthony Browne: Can I just ask you the question that I asked Andrew about? You talked about wage setting there. As chief economist at the Bank of England, if the Government did give pay rises across the public sector that were close to or met inflation, what would be the impact on future inflation and interest rates?
Huw Pill: I think that you are asking me to give a different answer to the Governor. I am just teasing.
Anthony Browne: I am sure that you will agree with him, but you might expound a bit more.
Huw Pill: To give the answer that I want to give to that, I am going to have to give you a slightly broader context, so you are going to have to be patient with me. I promise not to run time down. Again, if we look at what happened last year, what is the big shock to the UK economy? As others have said, the big shock, which was unexpected, as I have said, is the rise in gas prices. It was not just unexpected. It was a massive shock. When I joined the Bank, the gas price was 75 pence per therm. If you look in table 1.B, the average price pre-Covid is running at about 50 pence per therm. At its peak on the August bank holiday last year, it is 880 pence per therm, so it went up by more than 11 times.
Q764 Anthony Browne: Are you going to answer my question?
Huw Pill: I am, but it is very important to set the context. There is this unexpected, massive shock, and because the UK is a net importer of natural gas, and we are quite reliant on natural gas for heating and electricity generation, this represents a very significant adverse terms of trade shock.
I have said this in this room before, but, simply put, the price of what we are buying from the rest of the world has gone up a lot relative to the price of what we are selling to the rest of the world. For UK residents, that implies a big squeeze on income, so the question at hand is, “Whose real spending power?” It is income in real terms, real spending power. Who is going to take that cost? How is that distributed across public sector workers and across private sector workers, via Government, to future taxpayers rather than current taxpayers, or to people who rely on profits for their income rather than people who rely on wages for their income? I do not think that it is for the Bank of England to have a judgment about these distributional questions. We do not have a mandate for that.
Anthony Browne: I was not asking you that.
Huw Pill: That was all preamble to get to the punchline, which is the answer to your question, so I apologise. I did warn you that it was going to take a while, but now we are getting to the punchline. The way that I see it is in terms of the intensity of that distributional battle. There is a certain size of the pie. It is a smaller pie than people have liked. Everybody tries to retain their real spending power by asking for a bigger share of a smaller pie. It is the irreconcilability of everybody asking for that bigger share that is what drives inflation.
Anthony Browne: The poorer the country.
Huw Pill: The implication of what you are saying is that, whether it is wage bargaining behaviour or price-setting behaviour or the actions of public sector workers versus private sector workers, these are all parts of the intensity of that. All we can do—and what we should do and will do—is ensure that we respond with monetary policy to make sure that the intensity of that distributional question does not spill over into inflation.
If your point is if things we see lead to greater intensity in that distributional battle, as Andrew said, that implies that monetary policy will be tighter in order to keep aggregate behaviour in the economy in line with price stability.
Q765 Anthony Browne: Just to be explicit on that, if the public sector wage agreements are at or around inflation—and I am just trying to unpack what you are saying—that would have some impact on future inflation and interest rates.
Huw Pill: There is certainly the potential for that to happen and, if that happens, our job is to ensure that it does not lead to inflation by responding to it with tighter monetary policy.
Q766 Chair: Huw, you were forecasting 13.1% inflation peak at one point, and the peak was 10.7%. Is that difference the energy price cap on households and businesses, or is it something else?
Huw Pill: It largely is. I think you are referring to the August report. In the August report, if you remember, at that time, partly because of the political situation in the UK, we did not have a fiscal response to the very dramatic rise in European wholesale gas.
Chair: It was announced in September.
Huw Pill: We make an assumption about what wholesale gas prices will be, based on market pricing, so the window we were looking at for the August report was basically a two-week period towards the end of July. It was, at that point, quite a mechanical calculation, because it is about futures prices feeding into the Ofgem price cap and so forth. How that Ofgem price cap applies to the average household and how much energy they spend in their utility bill is what enters the CPI inflation calculation, so there is a fairly mechanical dynamic that led to that.
Unfortunately, as we discussed in this room in September, it is mechanical and obvious to everybody. During August, wholesale gas prices doubled again, and lots of investment banks made the same calculation. If you remember, there was this discussion of whether their forecasts for inflation, which were substantially higher than 13%, were legitimate. Once we had the new Prime Minister, we had the energy price guarantee and so forth, and that shifted from what could have been, on the Ofgem measure of average household energy bill, potentially approaching £6,000 a year, down to £2,500 a year.
Q767 Chair: So you think the difference between the 13.1% and the 10.7% is by and large explained by the energy price cap.
Huw Pill: A big part of it, yes.
Q768 Danny Kruger: We have a bunch of questions and would appreciate fairly snappy answers—at your discretion, but we do not need too much context. On this one, I would really appreciate some clarity, Governor, if I may start with you with a really straightforward question. The report is now saying that we think that we have turned the corner on inflation. That is the headline message from the report. At the same time, you are raising rates, and you are doing so before the full effect of the last rate rises has been properly felt. Can you just explain for the public what message you are hoping they should take about your assessment of inflation at this time?
Andrew Bailey: I am happy to do that, because, as I said earlier, this was a very big subject of conversation in the round we have just had. I believe that inflation has just turned a corner, and the reason for that is that, in the last two months, we have seen a lower number. It is also, as I said a few moments ago, a bit below where we thought it would be in the November report.
Secondly, and probably much more significant, these very strong negative base effects, all other things equal, bring it down quite substantially—more so in the second half of the year than the first half of the year, by the way, in terms of the slope, but they will bring it down.
However, as we have discussed quite a bit already this morning, there is substantial uncertainty, not around the base effects—we have covered that off by saying that it would take something that we do not know about to counteract those—but just where the labour market is going and just where price setting is going in the economy.
The agencies are telling us that they do see signs now that it is turning, but my view is that we are at a point where the uncertainty is such and the risks are therefore such—bear in mind the chart that Huw was referring to, which is the so-called fan chart—that we have the largest upside risk on inflation that we have ever had in the life of the MPC, which is over 25 years now.
The reason for that is that there are a number of stories that you can tell that create that risk. One is labour market pressures. Another would be if energy prices do not keep coming down as the futures curve of market suggests that they will. We did put a number in there, because we used to use a different approach, which was to take the first six months of the futures curve and then just pin it, basically, at a constant level.
If you impose that on to the forecast that we have now, you add about 0.8% to inflation, so you can see that there are upside risks. Particularly with the labour market, and speaking for myself in terms of my own vote in this last round, I want to see more evidence that, although we have turned a corner, we really are going to go on now. Particularly, it is not primarily what happens this year but that we sustain it thereafter.
Q769 Danny Kruger: To summarise, your assumption is that inflation is now falling, but, in order to make sure, you need to keep the lid on demand a little longer.
Andrew Bailey: Yes, and we need to see where the labour market and price setting is going too.
Q770 Danny Kruger: It is very difficult communication. I do appreciate that you are trying to, basically, put the foot on the accelerator and on the brake almost at the same time. You want to encourage confidence, but also not too much exuberance in the system, so it is difficult communication. It reminds me slightly of the Archbishop of Canterbury trying to have it both ways.
Andrew Bailey: He has divine intervention on his side. I would not claim that.
Danny Kruger: So do you.
Andrew Bailey: I wish.
Q771 Danny Kruger: Given the challenge of the communication, I am going to slightly attack you all from both sides, if I may. In the inflation predictions—we have discussed this a bit already—the prediction for services inflation is higher than you thought it was going to be last time round, and that is largely driven by wages. I know that you have discussed this with Anthony. Governor, you famously said some time ago that you would discourage people from seeking pay rises. Do you feel vindicated by that warning, and do you want to repeat it?
Andrew Bailey: I want to be clear. That was in the context of excessive pay rises that seemed to beat inflation. It is Huw’s point about the pie. We know why it would be natural to do that, but, as Anthony interjected a few minutes ago, the nature of these terms of trade shocks, unfortunately, is that the country is worse off as a whole, and it is that process. I am not going to say that I am vindicated. It is a very difficult situation for people in this country, and particularly for those on low incomes.
Q772 Danny Kruger: Let me come at it from the other side and talk about people who are working hard on low incomes, such as people in the construction sector. This is a leading indicator, as I understand it. Often, you can see what is happening in the economy a little further ahead if you look at what is going on in construction. Jobs in that sector are falling and we know that there are increasing vacancies in construction. Mortgage demand is very low. We are putting up rates again. How many interest rate increases do you think the housing market can bear? At what point would you start to worry about the effect on the housing market from these rate rises?
Andrew Bailey: We do follow it very carefully. What I would say is that, particularly in terms of new fixed rate mortgages—of course, fixed rates are now the predominant mortgage type in this country—rates have gone up, as Silvana was saying earlier, because we have put rates up. Since we had the hearing in November, when I said I hoped that mortgage rates would come down, they have, not untypically by about 1%. The reason for that is that these fixed rate mortgages are priced off the swap curve.
We have seen that, since the period of difficulty in September and October, the curve as a whole has come down, and that has been reflected through into mortgage pricing, so that is helpful.
Q773 Danny Kruger: Demand is coming down too.
Andrew Bailey: Yes, but those are slightly backward-looking indicators. The effects of last autumn also affected activity in the housing market, because, as you may remember, a lot of mortgage products were withdrawn from the market. They are coming back on to the market now, so we will see.
Q774 Danny Kruger: Huw, could I ask you about the future and the sort of scenario we might find ourselves in? I appreciate that we are not totally clear whether we are going to be in a recession. We very much hope not, but there is some significant risk of it. Recessions usually involve very low inflation. Even if we hit the targets that we are hoping for here, we are still going to be at 5% inflation and potentially in a recession. The combination of that is terrible and it does take us back to the 1970s. If wages are falling as well, and if prices are rising, that is absolutely catastrophic for living standards. I am sure that you worry a lot, but to what extent do you foresee a stagflationary or inflationary recession?
Huw Pill: We are, of course, very concerned about that. I hesitate, because I know you have asked for short answers, but I just want to put it in context. What we can do with monetary policy is, essentially, steer spending in the economy and demand in the economy, including through the channel you mentioned, through the housing market, but also other channels.
We want to steer demand and spending in the economy such that we do not generate too much demand relative to the productive potential of the economy to generate either more inflation or more persistence in inflation. Equally, there are risks on the other side. If we slow spending down too much by over-raising interest rates and so forth, then too-weak demand relative to the production potential of the economy will lead to downward pressures on prices and, ultimately, disinflationary forces that push us below target.
To meet the inflation target sustainably, what we are trying to do is map, given the inflation rate, our steering of demand, given the production potential of the economy. This edition of the monetary policy report contains a big section looking at the supply side of the UK economy. It is important to see that the supply side of the UK economy, in our forecast, is weak, and that is a constraint on our ability to let demand run.
To say this is black and white would be taking it too far, but, to a first approximation, monetary policy does not have that much effect on the supply side of the economy. We can talk—and maybe you want to talk—about why we take the view that the supply side of the economy remains very weak. It is important to put this notion of recession and so forth in context.
We have a very shallow recession by the historical standards of recessions. It is still a recession in our forecast, meaning, on the definition that is typically used, a technical recession of at least two quarters of negative growth, but we are bobbling around zero. In fact, the fourth quarter, which we thought would be a negative number, may turn out to be a zero or positive number, and then the second half of last year may not be a technical recession.
Once we are bobbling around the zero level, for exactly the reasons we talked about earlier, given the uncertainties we face, including the uncertainties about how our policy transmits, we may see weak positive growth, we may see recessions or we may see negative growth. The point is that I would get away a little bit from focusing on recessions, but we will see a relatively long period of weak growth, and the fundamental driver of that is weakness on the supply side.
Q775 Danny Kruger: We do want to come on to the supply side in a bit, if you do not mind. It might be true that the recession will be weaker overall, seen from a bird’s eye perspective, but, for particular sectors of the population, it is going to be very acute. Perhaps that is a difference from recessions historically: that it will be far worse for some people than it would have formerly. I would mention in particular people working in construction.
If we are talking about wage deflation in some areas and these price rises, it is going to be absolutely catastrophic. The NIESR was saying this week that they are expecting a quarter of households to be unable to cover food and energy.
Huw Pill: I certainly do not want to push back against the cost of this environment. It goes very much to what the Chair said in her first sentence. Inflation has been too high. It may have been driven by external sources and we are trying to correct it, but this terms of trade shock has very big implications and very challenging implications for a set of businesses in some sectors rather than others, in some parts of the country rather than others, and for sets of households, particularly those towards the bottom end of the income distribution, who spend more on energy and food. We are very aware of that.
It is also important, though, to recognise that monetary policy, as we have been discussing, is potentially a very powerful tool to steer aggregate behaviour in the economy. It is also a very blunt tool and is just not well designed to try to have impacts on one sector or the other. We do not have a mandate to do that as the MPC. Of course, we need to monitor that, because how our policy transmits into the aggregate is, importantly, affected by these distributional effects. We look at cross-sectional, cross-regional and cross-income distribution impacts of our policies very closely, and that is something we monitor, but we have to be cautious about taking responsibility for something that, frankly, we do not have the instruments to address.
Q776 Danny Kruger: I appreciate that you have very powerful but very blunt levers at your disposal. Professor Tenreyro, you are the leading dove on the committee, as I understand it, on interest rates. It is impossible to ask you to tell us now what your advice will be in three months’ time, but, at the moment, do you expect to be calling for a cut in rates, seeing as you did not support the raise that we have just seen, when it comes to the next meeting? A fairer way of asking that is, if we were to see you calling for a cut, what would you be looking for in advance of that and what would you expect your colleagues to be convinced by that would make them support you in a rate cut?
Professor Tenreyro: I made my point clear that I think the policy is already too tight to meet the target. In our forecast, our model projections for inflation fall well below the target. Mean inflation also falls below the target, so that means that the risk to the downside of that 2% is higher in those projections than the risk to the upside.
Again, as I said before, how can we loosen policy? One is directly through cutting rates or through an inversion in the curve, and that can happen on its own, even without our actions. Where things stand right now, I would see myself considering a cut. I do not want to talk about a particular meeting, because meeting to meeting does not make much of a difference, but the overall stance of policy right now is loose, in my view.
There are, of course, as the Governor said, upside risks. Energy prices can go up, but also, as we saw, they can go down. They are still much higher than they were pre-Covid, so there is always that possibility too. In this round, we made a judgment to push up demand, and hence inflation, and there are also risks to that on the downside.
I have a more balanced view of the risks at this stage, certainly around hitting the 2% target in the medium term.
Q777 Danny Kruger: I am going to come on in a moment to energy costs, if that is okay. Professor Haskel, can I put Professor Tenreyro’s point to you? If inflation falls very quickly, you will end up below target and then you will be having to unwind these rate rises very quickly. What danger do you foresee if that were to happen? Are you worried about having to cut rates very quickly and what the effect of that might be?
Professor Haskel: Could I just step back for a moment, if you will forgive me? I know that you wanted crisp answers. We have talked a lot about uncertainty, and so you might say, “What do we do in the face of uncertainty? Do we just throw up our hands and just say that it is all too difficult?” In my opinion, we should not do that. We should do two things, at least. One is we should guard very vigilantly against really bad outcomes, and one really bad outcome would be a lot of inflationary momentum in the economy, as we have just discussed. The other bad outcome, to your question, would be if we undershot the target very severely. That is rule number one.
Rule number two, which follows from that, is, because of these risks and these uncertainties, we should be super-vigilant on the signals that we are getting as they come along, so we can learn something about the risks and, therefore, better inform our judgment.
The reason I say all of that is about what I am then doing. Number one, I am very worried about excessive momentum building up for inflation and, therefore, I want to guard against that. Number two is I am putting a bit less weight than I would otherwise do on the medium-term forecast, and I am looking much more at the shorter-term indicators, to which you might say, “What shorter-term indicators?”
In speeches, I have tried to go through a number of those. The ratio of vacancies to unemployment, for example, is an important, somewhat leading indicator. Putting out a vacancy means a firm is indicating their future expectations of high demand, so I will be looking at that. In terms of redundancy numbers, because many companies have to notify the Government if they intend to make big numbers of redundancies under certain circumstances, those are an interesting, almost accidental leading indicator, and they are very low at the moment. The V-U ratio is very high. There are, more broadly, the indices of inactivity that the Governor talked about before.
All of that is to say that I am super-worried about going under the target, but, as I say, given the uncertainties at the moment, I would rather put a little bit less weight on that medium-term forecast and look for those shorter-run indicators. I hope that is helpful.
Andrew Bailey: Can I very briefly make one other point? If we get this outcome of inflation falling rapidly, we do have to stabilise inflation at the target. I want to emphasise that point. We could see it go under target, just as we have seen it go over target, because base effects, by definition, do not recur in the same way. That will have to be, of course, a critical focus for us.
Q778 Danny Kruger: I will move on to energy costs now. It is all very related. When you came before us in November, Governor, I asked you the impossible question about how you could have such confidence that inflation was going to fall when it was all in Mr Putin’s hands. It remains in Putin’s hands, to a significant degree. You said in the media last week that “as long as Russia continues this barbaric war, there’s always the possibility that energy prices could go up again”. Can you just tell us precisely how you have factored that risk into your work? It is an impossible question to answer, but it does not appear that this war is going to end imminently, and there is always the chance of further decisions or events choking off supply even further. How have you factored that into your work?
Andrew Bailey: This comes back to what a number of us have said in the course of this discussion, which is that we cannot deal with something that is totally unpredictable. I will just make two points.
First, I would go back to something that I said a few minutes ago and is in the report, which is that we have conditioned the forecast on what we call the full futures curve—i.e. the full duration of the futures curve. That is a change of methodology from what we were doing in the past, partly because the old method was, as I said, that we used the first six months of the futures curve and then took a constant price thereafter. The problem that we ran into last year, particularly going back to the summer, was that we would have had a very strange pattern to energy price inflation if we had done that, not least because of the way the support scheme worked, and that is not a criticism of it.
As I said, we have done the “what if”. The staff did the “what if”. We had not the full futures curve, i.e. they do not keep coming down but they stick in the way we used to do it. As I said earlier, staff estimated that that would add about 0.8% to inflation. That is part of our consideration in the upside risk. We do not build the upside risk bottom up. We do it rather top down, but then we have storeys that sit underneath it, and that is part of it.
Can I just make one other point? I just wanted to make a point that came out of something that Huw was saying and is relevant to the energy point. It is relevant to this point about low-income households. It is important to know, because Huw gave the price of 50p a therm as the pretty stable price pre the Ukrainian thing starting. This big downshift in energy price inflation does not take the level of household energy prices back to that level. Of course, for the cost of living, that is relevant.
Danny Kruger: Point taken.
Professor Haskel: Just to add a little bit to what Andrew said, being an economics professor, of course I have to talk about supply and demand. You will have seen in the report that we look at the demand for energy and see whether that has changed and whether that would affect the outlook. In chart 2.14, there is somewhat of an indication that people’s demand for energy might have gone down. That is one thing.
The second thing is that, as you will know, what is crucial in the energy market is that we build up very high inventories of gas, which we then run down later to come into the winter. We monitor those inventories very closely as well to help us give a forward-looking picture about what prices might be.
Professor Tenreyro: Just to complement that, storage levels are up at 80% or so in the middle of the winter, so this is a very high level to start with.
Professor Haskel: Yes, they are right at the top of the 2017-22 range.
Professor Tenreyro: More generally, there is a substitution to alternative suppliers and sources of energy, which has also eased the pressure and could be a source of downside risk as well.
Danny Kruger: We applaud demand reduction in energy.
Professor Tenreyro: That has been huge in continental Europe. In this country, there is more to be done.
Q779 Danny Kruger: We should think about policies on that. Wearing three-piece suits is a very helpful way to reduce demand for energy, and I encourage it for all members of the Committee.
Governor, you talked about the futures market, which, in a sense, seems to be the god of this bit of policymaking. When we asked the Chancellor what he was basing his predictions on, he said, “The OBR says that inflation is coming down”. We said to the OBR, “Why is inflation coming down?” and they said, “Because the energy futures market says it is”.
If they were very bullish about reductions in energy costs, why do you think that is? The war is not ending anytime soon. Is more LNG going to come out of nowhere? Why do you think the futures market is so confident?
Andrew Bailey: First of all, since we had the hearing in November, wholesale gas prices have come down a lot. I think it is 50%. Again, we have to be clear on the limits of our knowledge. That is not something that we predicted when we were here in November.
Looking forwards, I would say that there is a balance of factors in the market, and some of them point one way and some the other way, frankly. Europe has built up its capacity to receive particularly liquified natural gas from other parts of the world, and that has helped a lot, particularly with what Silvana and Jonathan talked about—the storage position.
My assessment would be that there is currently not a large increase in global investment in more gas extraction and oil extraction, so that will have an effect in terms of available supply. There is a very interesting question about how the Chinese economy is going to recover and come out of the Covid restrictions, and what that will do to China’s demand for energy, because China is a major importer.
The third factor is Russia. Parts of the world that are implementing sanctions have reduced their dependence on Russian supplies. There are other parts of the world—put it that way.
Q780 Danny Kruger: Professor, I want to come to you, but can I just ask you to answer this question as well? If we are going to have persistently high energy costs—they might not be as high as now, but it is fair to say that we are going to have high energy prices for some time—does that automatically mean persistently high interest rates, in your view?
Professor Haskel: I wanted to come in on the bullish point, if I may. In chart 2.3, we do indeed show what you might imagine would be a very bullish diagram. Futures energy prices, which I think you are referring to, dive right down, but they dive right down to a level. The axis of the chart starts in January 2022 and, as Huw said earlier on, there was, of course, a big run-up in gas prices in advance to the war. Although that chart looks like energy prices are going to drop back down to where they were, they are still well above—
Andrew Bailey: It is the point I made about levels.
Professor Haskel: Indeed, Andrew, yes. They are still very well above what they were before that, and so I would not be too bullish on the basis of that chart.
Q781 Danny Kruger: Overall, we keep being optimistic about a fall from a very high rate on all these things back down to a rate that is still not comfortable. Professor, do you think those high prices are just going to lead automatically to high rates as a persistent feature?
Professor Haskel: No, not necessarily. It depends on how the economy adjusts. This is a high level of prices, which, as we have discussed, is very painful for people. I do not want to minimise that, but, as far as inflation is concerned, it is perfectly consistent to have a high level of prices and it be consistent with falling inflation or with constant inflation, so not necessarily, no.
Professor Tenreyro: That is precisely the point that I was going to make. There is a distinction between the levels and the change. Even if we remain with very high levels of energy prices, the contribution that they make to inflation is zero, as long as they do not keep increasing. That is the distinction.
We are still poorer. The country is poorer. That is an important consideration too when we look at other countries that are net exporters of energy. This has been a big boost to their terms of trade, and we see that reflected in the differences across countries in real incomes and real consumption.
In our case, consumption is still way below 2019 levels. If you look at the US, for example, which is a net exporter of energy, consumption has been running above their pre-Covid trend. It is a divergent picture and much more different.
Anthony Browne: I was going to ask about the bonus cap, so this is not the Monetary Policy Committee, but Andrew Bailey, as the Governor—
Andrew Bailey: I can pass it to the others, but it will probably come my way.
Anthony Browne: It is to you, as the—
Andrew Bailey: The all-rounder.
Q782 Anthony Browne: It is to you, as the top banking supervisor. One of the survivals of the Liz Truss premiership is the commitment by the Government to scrap the so-called bonus cap. The UK Government at the time did not support it, but that was supposedly introduced to stop excessive risk-taking in the banking industry. Do you have any concerns about getting rid of it in terms of it leading to more risky behaviour?
Andrew Bailey: I am ancient enough to have appeared before this Committee about a decade ago on this subject.
Anthony Browne: You were chief executive of the PRA.
Andrew Bailey: I was briefly at the FSA and said that I did not agree with the bonus cap when it was being introduced as part of EU legislation. One of the things that I remember saying at the time—this sounds terribly prescient of me; I do not want to sound like that—was that I was concerned that it would lead to two things. One is that it would lead to an increase in permanent pay—a substitution from bonus to permanent pay—and, secondly, it did not have the right incentives in terms of risk-taking. We have published evidence to suggest that the first of those has happened.
On the question of why we support getting rid of it, first of all, it does not have the right incentives. It has led to that. Secondly, as you know, we have always had a UK policy framework in place. That remains in place and has a different thrust to it and is consistent with the right incentives. It involves several things, one of which is deferral of the payment out of quite a good proportion of the variable remuneration, and the potential then for what is called malus. I often get transcripts back saying it is “malice”, and we do not have a policy of malice. Malus is taking it back before it is given out, as it were. There is also the potential for clawback, which goes beyond that point.
The other thing is that we have a policy of saying that we want a large part of the variable remuneration paid in instruments that then subsequently reflect risk—not cash, in other words. Our view is that we have a better policy framework in place, and the bonus cap has the wrong incentives attached to it.
Q783 Anthony Browne: So getting rid of it will not lead to more risky behaviour.
Andrew Bailey: No, we do not think so. When it was advocated by the Government, my view was that we have taken a very consistent line on this, so our view is very clear on it.
Q784 Anthony Browne: Another change that is happening is the ringfencing regime. The Skeoch review has recommended various reforms to it. We had some questions here with bank CEOs earlier this week, just a couple of days ago. Do you have any concerns about the changes to the ringfencing regime?
Andrew Bailey: The proposals from Keith Skeoch and his group are sensible. My whole approach on these areas of policy is that they should not remain fixed for all time. They will become dangerously not consistent if they do. The things that Keith has proposed are sensible. I also know that there has been some debate about the relationship between the ringfencing regime and the resolution regime.
Anthony Browne: I was going to ask that.
Andrew Bailey: I see them as complements. They are not substitutes.
Q785 Anthony Browne: So the fact that we now have a better recovery regime, although we do not totally know how it would work in a real crisis, is not an argument for getting rid of ringfencing.
Andrew Bailey: No. Ringfencing would make the execution of a resolution and recovery more straightforward in that sense.
Q786 Anthony Browne: My final question as the prudential regulator is on the Basel 3.1 measures, which are being consulted on at the moment. They will increase the capital requirements for lending to SMEs, UK companies with no formal credit rating, and infrastructure projects. When the EU came through with this originally, it effectively reduced the risk weighting for SMEs. This will inevitably push up the costs of lending to SMEs and to infrastructure projects. Is that desirable?
Andrew Bailey: We are in a consultation, so we want evidence. We have asked the banks to provide us with their evidence of what the measures will do versus the current thing. I can speak for Sam Woods now, I am sure. We will be very happy to come to the Committee and lay out that evidence. We can write to you and put it before you, because it is important.
Just as a bit of history, in the Basel 3.0 implementation, the EU did not implement Basel properly and has been judged by the Basel Committee to be non-compliant. The UK was a member of the EU at that point, so we had to implement the EU rules.
Basel 3.1 amends the SME and infrastructure regimes to reduce the capital requirements. By the way, that mostly applies to the standardised approach. If you are an IRB, that is a different matter. For the big banks, it is a different story.
Basel 3.1 reduces it, so our proposal in the consultation is to implement those reduced Basel numbers. The EU, as I say, did a special thing on Basel 3.0, and we think that they intend to continue those and not implement Basel. You have probably read that there is quite a dispute now between the regulators and the authorities within the EU on this question.
The key thing in the consultation is that we want the evidence of how these regimes compare, and then we will be able to assess that and we will be completely transparent about that to you. We are happy to do that.
Q787 Danny Kruger: We discussed earlier the supply side and the inability of interest rate changes to significantly effect precise changes there, but I would be very interested in your general view on the challenge that the UK faces. We have this chronic productivity problem in this country. We have never recovered from 2008. In the absence of any Labour colleagues here, I thought I might ask you a slightly political question.
It was interesting in reports of this reshuffle that we have just had and the moving around of ministerial Departments that the Prime Minister initially offered the science Department to Michael Gove. I am not asking you to comment on that. I do not even know if it is true. What I was struck by was the suggestion that the science Department was a senior new Department of state to the levelling-up Department, and the implication that what the UK needs most is a revolution in science and tech rather than the levelling-up agenda.
I would just be interested in your views, without getting into the policies of that; please do not feel drawn. In terms of tackling the UK’s productivity challenge, would you prioritise investment, policy, political support into R&D, technology and science, or into the rebalancing of the UK economy to make sure all the regions of the country are growing well? How would you distinguish between those priorities?
Andrew Bailey: We are lucky enough to have a real expert on the subject here. It is not me; it is Jonathan, so I will let Jonathan come in first.
Professor Haskel: It is very kind and very flattering of you, Andrew. I will say a couple of things on this. Thanks for the question. I have always thought that one of the good features of the UK is that science policy has been remarkably stable. I can be very non-political about this, because credit should be given to David Sainsbury, who was on the Labour side, and David Willetts, on the Conservative side. The two of them ensured that a lot of science policy was taken away from the politics of all of this, so that is a good part of that.
We certainly have lots of academic evidence and practical evidence that the benefits of having a strong university sector and a strong research base flow, although maybe not quickly, over to the private sector as well in terms of boosting productivity. That is one set of remarks.
As a second set of remarks, the priority would be around investment. If I could take us back to the report, in chart 3.7 on page 87, you will have seen that we have a diagram there about investment in the UK. This is business investment, I should say. There are lots of different measures of all of that. Essentially, business investment was steaming along up until 2016 and, unfortunately, it has more or less flatlined since then.
If I had to boil a complicated issue down to one thing, it would be encouraging those types of investments.
Q788 Danny Kruger: But you are not particularly interested in where they go. You have a spatially blind attitude to business investment, do you, wherever the greater risk returns can be realised, rather than thinking about investment in places other than Cambridge?
Anthony Browne: There is nothing wrong with Cambridge.
Professor Haskel: The issue with investment is that the investment that is going to give us the biggest bang for our buck in terms of productivity is probably intangible investment—R&D, design and software, and all of those kinds of issues. Intangible investment does the best job when it is in a cluster with other like corporations that are also making intangible investment, because the R&D scientists can get together with other scientists; the software writers can get together with the movie-makers to make the CGI stuff and all those kinds of things.
Inevitably, given the cluster benefits from that type of investment, the benefits of that in terms of the immediate overall will be concentrated in towns and cities, which takes us then to issues around planning when we worry about policy.
Of course, once we have this investment and the cake gets bigger—back to the earlier discussion—then society can choose as it wishes to distribute the cake to whichever parties it wants to distribute it. As Huw was saying earlier on, that is not a question for us. That is a question for you.
Q789 Danny Kruger: When you say deliberation, do you mean through welfare spending and public services?
Professor Haskel: Yes, through the tax system, or through welfare or public services.
Q790 Danny Kruger: That feels like the old model, which is that the south-east generates income for the Treasury, which it then hands out as compensation to the places that were not involved in the production of value in the first place.
Professor Haskel: I am not saying that is right or wrong. I am just saying that, because of the characteristics of this rather powerful form of investment, because they get the most bang for their buck when they are clustered together, inevitably those benefits are going to be generated at a quite geographically concentrated level.
Q791 Danny Kruger: Do you think that there is a role for Government in creating or encouraging clusters in new places and not the traditional centres of development and growth? How effective do you think it would be for Government to say, “We are going to create a new sector cluster in a place that has not had one traditionally”? Do you think that is doable?
Professor Haskel: Andrew is looking at me, because this is not really monetary policy.
Andrew Bailey: He is an expert on the subject.
Professor Haskel: I am off our narrow brief but I can just offer a view. There is some benefit in that, but what we know about cluster policy is that it takes a very long time. Stanford University, for example, is an amazing cluster out in Silicon Valley, but, 100 years ago, Stanford University was referred to as “the farm”. Nobody went there and it was almost an unknown university. These things take a long time to bear fruit.
Q792 Danny Kruger: My final question may be one for the Governor. This does range rather broadly beyond monetary policy, but it is related. You might want to comment on Brexit in this context. I noticed hearteningly that you think that, although there have been undoubted impacts from Brexit in terms of political distraction and significant uncertainty for business, there is reduced divergence in terms of trade with the EU versus trade with non-EU countries, so maybe things are looking up. If you would like to comment, I would be delighted. Maybe you can conclude that the effects of Brexit are, as you might put it, transitory. Are there any thoughts on that?
I really want to hear from you on the overall model that, in my view, was rejected by the Brexit vote and by the majority of the country. It refers to our conversation just now. For 20 years, we have had an economic model dependent on cheap credit, printing money from the Bank, cheap labour from immigration, a high immigration policy, and cheap imports due to our strong pound. All of that, in a sense, has had some benefits to some people, but, for the majority of working people in this country, it has not been helpful. As a result, they voted to change that model, not just to leave the EU. It was a more wholesale rejection of the economic model that we have had for so long.
Do you accept that your mission as part of economic policymakers in this country is to help make that decision successful and, therefore, to make Brexit work, and how are you doing that?
Andrew Bailey: Let me say two things to start with. I have said this many times before. As a public official and servant, I am neutral per se on the issue. The second thing to say is that, as you rightly say, it was decided by the people in a referendum. It is our job to implement, where it affects us, the policies that follow from it. That goes back to the discussion we were just having on financial regulation, so we are clear on that. That is very important.
On this question that you raised about trade, our staff have done a lot of work with ONS and HMRC on the trade data. It has been very hard to interpret some of the trade data, because there has been a shift in the method of collection. The conclusion of that work is that the effect of Brexit on trade, which we have said for some time would be initially negative, has come through possibly more quickly than I thought it would. It does not mean to say that it will be bigger, but just that it seems to have come through more quickly.
As you rightly said there, and as we have said for a long time, there will, of course, be an adjustment of the real economy to that over the longer term. The economy will adjust. That is natural and will be supported, no doubt, by public policy to do so.
In the initial phase, it has probably come through rather more quickly, based on the work that our staff have done on trade data so far. That is the only conclusion that we have. We have factored that into the monetary policy assessment, because we believe that there is a relationship between openness and productivity. That shock to productivity that we have had in our assumptions for some time now has not increased, but it has come through probably more quickly.
Professor Tenreyro: Our role in the economy is framed by the remit, so we need to get inflation to 2%. That is our contribution to the economy. The MPC has a track record of having achieved that 2% inflation over its 25 years. As we said before, we have been shocked by unprecedented shocks—Covid, the war in Ukraine and so on—and the role of the MPC in that setting is to return inflation to target sustainably. That is our part. We cannot affect the supply side of the economy. That is for Government to do. Our role is to stick to the 2% target in the medium term.
Q793 Chair: I just want to conclude with the subject of quantitative tightening and quantitative easing, because, as you know, we launched an inquiry into that last week. It was striking that, in this monetary policy report, you mentioned simply that they exist as tools. You did not really say anything more about them. I just wondered if you did at all discuss them in the meeting itself.
Andrew Bailey: Our normal practice is to comment on that in the minutes of the meetings, where we do get reports from the staff on the operations that have been done and where it has got to. We set a target for quantitative tightening over a year, so we are not going to vary that target. The committee will have to reconsider that when we get to that point, but we are not at that point at the moment. To the extent that we cover the operations, it is in the minutes. We have been conducting those operations now since November and, so far, I would say that they have been very smooth in that sense.
Q794 Chair: You are at £827 billion at the moment in terms of your ownership of gilts. Is that right?
Andrew Bailey: Yes, around that. It is somewhere between £825 billion and £827 billion.
Q795 Chair: The £19.3 billion that you bought to stabilise the markets because of the liability-driven investment crisis is separate. Those have now all been sold.
Andrew Bailey: Yes, they have all been sold.
Q796 Chair: As a result of being able to sell those relatively easily, has that informed what the operational team is doing in terms of the quantitative tightening at the moment?
Andrew Bailey: It has. We sold just over £19 billion using a different approach. In the quantitative tightening gilt operations, we do auctions and we name the amount. We did the £19-billion-plus on the basis of what we call an open book approach, where we set the price and say, “What do you want?” We sold it very quickly. We started towards the end of November and were done by mid-January--12 January was the last one.
What I would say is that it has not changed our view on how we do the gilt auctions process. We have set the objective of £80 billion of reduction. That is both through the active sales and the runoff for the first year, and we will stick to that because it is operating smoothly; it is not disrupting markets. Indeed, I would say that markets are more stable than they were a few months ago. We will then review it.
We have a second set of sales going on. We are gradually selling off the corporate bond portfolio. That is £20 billion. We have taken over some of the lessons from the £19 billion sale process into that sale process as well.
Q797 Chair: Did you say you have sold all the corporates?
Andrew Bailey: No, it is not all gone yet. We are about 40% to 45% of the way through at the moment.
Q798 Chair: There is the £80 billion on top of that, and then there is the £19.3 billion that you have already done. In terms of that experience now of some quantitative tightening, one of the great unknowns is what it equates to in terms of monetary policy tightening. Are we any more informed on that at this point?
Andrew Bailey: Huw might want to come in on this. We do not have enough systematic evidence yet. It is a bit early for that, frankly. What we can observe—and I will just finish off—is market reactions to it. We are not seeing any what I would call market disturbance. We look at the conditions in markets around the auctions. We look at measures of liquidity. Bid/ask spreads have come down, for instance, during this period quite a bit.
Huw Pill: I do not have much to add on that. There has been an emphasis on what Andrew has described, and maybe in the way you phrase the questions, on the operational aspects of this. From a monetary policy point of view, it is a more slow-moving business. We anticipated that, reflecting the fact that this is not at the front and centre of the discussion in the monetary policy report, quantitative tightening would run a little in the background on this lower-frequency, year-to-year basis, and not be so much on a month-to-month or meeting-to-meeting basis, where we would focus on using bank rate as the active instrument. Bank rate has now moved to a level where we have scope to move it in either direction, which has been part of the discussion this morning, so that validates this “in the background” approach.
There are different views on the committee, so I should recognise that. My personal view is that I would expect the sale of these bonds to have some effect on market pricing along the yield curve. That is very difficult to quantify and, of course, there are lots of other things influencing the market yield curve. That should not be a concern for the conduct of monetary policy focusing on the use of bank rate as the active instrument, because, as is the case with all our decisions, we condition our monetary policy stance on developments in all aspects of the economy, including asset prices and the stage of the yield curve.
Although it is an interesting academic question, how has quantitative tightening affected the yield curve? From our point of view, because we observe the yield curve, we can still set monetary policy using bank rate.
Q799 Chair: Huw, you mentioned that transmission mechanism. There is also the fact that quantitative easing used to be a profitable exercise for the Treasury. You used to hand back the profits and now you are projecting that there are going to be losses and that the Treasury is going to have to absorb those. That is another way in which, presumably, there could be some tightening experience through this change in direction.
Huw Pill: What has happened in terms of the cash flows is not a surprise. It was always envisaged that there would be a point at which those cashflows would turn negative. It is really a fiscal decision, which is a decision more for the Treasury than for us, to work out how to incorporate that in their own fiscal planning, of which this is one part. I would say that this probably is not a monetary policy implication of all these things, but it would be on the fiscal side.
Q800 Chair: But it does tighten fiscal policy, which might have a monetary implication.
Huw Pill: I would be cautious about saying that because, through time, we have transferred a lot of money to the Treasury. All the coupons that we received on the bonds that were held have already been given to the Treasury. In terms of what the Treasury did with them, maybe they paid down debt or maybe they spent them. These are things that are not for me to comment on. That was a fiscal decision. Just as it was not for me to comment on that side of the operation—and I was not at the Bank at the time, but I would not have commented on them anyway—it is not really for us to comment on the other side. That is a fiscal question.
Andrew Bailey: It is £123.8 billion that we transferred over in cash flow.
Q801 Chair: Yes, it is. How does your approach differ, Governor, to the approach taken by the Fed, now that it has reached the same inflation point, and the European Central Bank?
Andrew Bailey: The difference with the Fed is that it has a much shorter-duration book of assets. The main reason for that is because the US Government debt has a much shorter average duration. UK Government debt has a longer average duration than many other countries, which, in many ways, is a good thing. The Bank’s decision right at the outset of quantitative easing, going back to 2009, was that we would be neutral in terms of market impact. Essentially, they bought in three buckets—short, medium and long—to replicate the stock of gilts in issue.
What that means is that, because we have a longer average duration on the book, if we were to rely on the approach that the Fed can take, which is passive runoff—and it happens very quickly—the process would take a much longer time. That is really what has led us, therefore, to conduct active sales, which is different from the Fed’s approach.
I have one more point that might be useful. I am happy to come back in the inquiry. By the way, I very much welcome the fact that you are doing this. It is important to keep this under review. In terms of the total stock of assistance that we provide—and £825 billion, as you said earlier, is not a bad way of looking at it—we will not take it down to zero. We cannot, because there is an equilibrium demand for reserves in the banking system. Reserves are the other side of the balance sheet.
We do not know what that equilibrium level is. I can tell you two things. One is that the number that we have at the moment is higher than it is, and the number that we had before the financial crisis was way too low. It will settle at some point. We will then have to decide what the right mix of short-term repos and outright holdings is to match that. We will have a decision to take, and the Treasury will have to be part of that decision, but I just wanted to caution on the idea that we will sell from £825 billion to zero. There will have to be an adjustment done at that point, but just bear that in mind.
Chair: We will take more evidence on this, because this is going to be a topic of interest to the wider Committee. At this point, I am just going to thank you for your time. It has been extremely interesting to explore the thinking behind where we are and the role of hindsight versus contemporary evidence that there were of the risks to the upside on inflation.
Just speaking personally at the end of the session, I still think that the factors that led to an upside surprise on inflation are potentially still with us in terms of the secondary effects in the economy. I know that you note that in your monetary policy report. Inflation is the worst tax that we can inflict on the economy, and it hurts the poorest the most, and so I just would conclude by urging you to remain extremely vigilant about those becoming more embedded in the UK economy. Thank you very much for your time.