In this extract from his speech delivered to LSE, Bank of England Governor Andrew Bailey discusses the role of monetary policy in attenuating the impact of the shocks faced in recent times, and the economic outlook for the future.
The past few years have been a time of macroeconomic upheaval. A series of significant economic events have deeply affected the UK economy. This includes the change in our trading relationship with the European Union, the Covid-19 pandemic with shutdowns of some sectors of the economy and supply chain bottlenecks in others, and the rise in energy prices caused by Russia’s brutal war on Ukraine and its people. These shocks have affected the UK economy in different ways. But they have all eroded the terms on which we trade with the outside world. This has made us poorer as a country; manifesting itself in a rise in the prices we have to pay for the things we buy as consumers.
Monetary policy cannot make the shocks to our national real income go away. But what it can – and must – do is to make sure that the inflation that has come to us from abroad does not become lasting inflation generated at home.
How monetary policy can temper inflation
Our most important tool to bring inflation down is Bank Rate. This is the interest paid on reserves held by commercial banks at the Bank of England. Because commercial banks are at the centre of a system of intricately linked financial markets, Bank Rate affects interest rates and yields more widely. And because those interest rates and yields determine the returns on savings and the cost of credit – including the rates people pay on their mortgages, and the rates businesses pay on loans to finance their investments – monetary policy exerts a powerful influence on spending by households and businesses.
Monetary policy, in other words, works through the management of aggregate demand in the economy. Simply put, when inflation is too high, we increase Bank Rate to dampen demand; when inflation is too low, we reduce Bank Rate to boost demand.
In reality, things are of course more complicated.
For a start, monetary policy operates with a lag. It takes time for changes in Bank Rate to work through the financial system to loan and mortgages rates, and for those changes to affect consumption and investment decisions by households and businesses. It then takes time for changes in those spending choices to affect prices in the shops. This means that the Monetary Policy Committee needs to look ahead and focus on the outlook for inflation, as much as on its current level, when deciding the appropriate level of Bank Rate today.
When we look at the outlook for inflation today, we have to recognise that the full effect of the higher level of Bank Rate is still to work its way through financial markets and the real economy.
There is another complication. What actually happens in the economy – to economic activity and inflation – will be determined by aggregate demand and supply. Economic life plays out at the intersection between them, in an economic equilibrium. While it is sometimes useful to focus on one of the two, taking the other as given, we always have to bear in mind that market economies work through the forces of both demand and supply.
Why supply matters
For monetary policy, the natural starting point is the demand side. Monetary policy exerts a powerful influence on the components of aggregate demand – on consumption and investment – but it can do little to affect the supply side – the production technologies and know-how used to make goods and services available for use in the economy.
But ultimately, it is the balance between demand and supply that determines inflationary pressures in the economy. And sometimes shifts in supply can be as abrupt and as important for the inflation outlook as shifts in demand.
We have seen this very clearly in the past three years since Covid hit. Throughout this time, the Monetary Policy Committee has had to play close attention to the supply side of the economy – and make a number of critical judgements about it – for instance, as care for the public’s health necessitated a pause in a range of economic activities.
Monetary policy’s inability to influence supply has at times been taken to suggest that monetary policy has no effects on real economic activity at all. In classical economic theory, for example, monetary policy only affects nominal variables such as wages and prices, not real variables such as the level of production and employment. In this tradition, real business cycle theories have been developed in which supply side disturbances are the main drivers of real activity.
But overwhelming empirical evidence, and many years of practical experience, show that monetary policy affects economic activity and inflation through aggregate demand. In the New Keynesian models that have dominated monetary macroeconomics over the past three decades, monetary policy has real effects because market prices are sticky. So when nominal interest rates change, the real interest rates that determine real consumption and investment decisions change with them. And markets may operate with “excess supply” or “excess demand” for as long as it takes wages and prices to adjust to shifts in either demand or supply.
Economic growth – and with it the prospects for our real national income – will be determined by technological progress, investment and innovation, and by skills and trends in the population.
Rather, it is over longer stretches of time that monetary policy is indeed “neutral”, and that we can think of the level of economic activity as being driven entirely by supply. By facilitating low and stable inflation, monetary policy helps create conditions conducive to economic growth. But other forces will ultimately determine the growth path of the economy. Economic growth – and with it the prospects for our real national income – will be determined by technological progress, investment and innovation, and by skills and trends in the population.
Equally, both the structure of the economy and the distribution of real national income are beyond the realm of monetary policy. Yes, monetary policy affects asset prices and unemployment over the near term. And yes, excess demand or supply may give rise to sectoral imbalances. But over the longer term, these features of our national economy will be driven by real factors and by structural policies rather than monetary policy.
Over time, even the level of interest rates is determined by such structural factors. While monetary policy steers market interest rates here and now, we do not set Bank Rate in a vacuum. The level of interest rates is anchored in an underlying equilibrium rate of interest determined by economic fundamentals on both the supply and demand side of the economy. This equilibrium rate of interest is the hypothetical interest rate that would sustain demand in line with supply, and inflation at target.
Monetary policy in the time of Covid-19
The Covid-19 episode is a particularly clear example of how difficult it can be in practice to judge the relative impact of supply and demand.
The pandemic was highly unusual and difficult for many reasons. In terms of the economy, it was unusual for the sudden and extreme fall in economic activity, but also for the almost synchronous and equivalent fall in both aggregate demand and supply. In most recessions, demand falls much more abruptly than supply. An output gap opens up, creating spare capacity in the economy and usually a rise in unemployment. That is not what happened during Covid-19.
The reason this unusually synchronous pattern of movements in aggregate demand and supply took place is not hard to find. Government policy on public health, in the face of the most extreme pandemic for at least a century, led to deliberate lockdowns. Much of economic activity simply ceased.
The important question we faced as monetary policymakers was what would happen when the restrictions were lifted as Covid-19 abated. Would a synchronous and equivalent fall in demand and supply simply be followed by a synchronous and equivalent rise?
At the time, I remember being asked quite often if the pandemic would leave scars on the economy, that is – whether firms would be able to survive the prolonged economic impact of the pandemic, let alone continue to invest in the future – or whether millions would be driven into unemployment as the Government furlough scheme, which remunerated those whose jobs were in effect suspended, was set to end at the end of September 2021. This was by no means clear at the time. The furlough scheme was unprecedented and had been operating for 1½ years, and even firms were unsure of what the effects on recruitment would be, as they reported to the Bank’s Agents at the time.
A key consideration for policy, therefore, was to ensure that supply would come back on stream, and for monetary policy in particular to ensure that there was sufficient demand in the economy to pick it up.
What actually happened was quite different from what we had feared. The situation we found ourselves in over the autumn and winter of 2021-22 was not a looser labour market and an increase in unemployment as the furlough scheme ended. Rather, it was a tighter labour market and a decline in labour market participation. In other words, as demand increased after Covid-19 restrictions ended, supply did not follow to the same extent.
At the same time, a rotation in demand away from services and towards goods, in particular in the United States, continued to put strains on global supply chains. And unfortunately, the contraction in the labour force coincided with the most extreme shock of all during this period, the impact, particularly on energy prices, of Russia’s appalling and unprovoked invasion of Ukraine.
So the supply side has played a more important and unusual role in recent macroeconomic developments.
The outlook for inflation
The economy has been subjected to some very large and overlapping shocks. The largest impact has come from the effect of Russia’s invasion of Ukraine. This appalling act had a massive impact on energy prices last year, and has substantially affected other prices, notably food. For a variety of reasons, particularly in energy markets, those effects are now unwinding.
It is primarily for this reason that we expect to see a sharp fall in inflation during the course of this year, starting probably in a couple of months or so from now.
Growth in the economy has suffered too, as a consequence of the sheer scale of the hit to the terms of trade. There has been a very large impact on national real income. But the economy has been more resilient of late, helped by the sharp fall in energy prices. The same is true for the world economy more broadly.
We must avoid these very large shocks leading to persistent inflation, and that is why we have raised the official interest rate 11 times, to 4.25 per cent.
What does this mean for monetary policy looking forwards? The remit is clear. The adjustment and response to the shocks we have experienced must return CPI inflation to the 2 per cent target sustainably. We must avoid these very large shocks leading to persistent inflation, and that is why we have raised the official interest rate 11 times, to 4.25 per cent.
Recently, the evidence has pointed to more resilient activity in the economy, and likewise employment; signs that nominal wage growth has been rather weaker than expected; and two months in which there was first some downside news on inflation relative to our expectation and then a bit more upside news. This reminds us that the path of inflation will not be entirely smooth and cost and price pressures remain elevated.
Alongside this news, we have seen strains in the global banking system. Assessing this would be for another occasion. Suffice to say we believe the UK banking system is resilient, with robust capital and liquidity positions, and well placed to support the economy. We have a strong macroprudential policy regime in this country. With the Financial Policy Committee on the case of securing financial stability, the Monetary Policy Committee can focus on its own important job of returning inflation to target.
We have to be very alert to any signs of persistent inflationary pressures. If they become evident, further monetary tightening would be required. With this in mind, the MPC’s response will be firmly anchored in the emerging evidence.
This above is a shortened and edited version of the speech delivered by Andrew Bailey at LSE on 27 March 2023. You can read the full transcript here.
All articles posted on this blog give the views of the author(s), and not the position of LSE British Politics and Policy, nor of the London School of Economics and Political Science.
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