Mark Carney: The turn of the year
Text of the Peston Lecture by Mr Mark Carney, Governor of the Bank of England and
Chairman of the Financial Stability Board, at the Queen Mary University of London, London,
19 January 2016.
* * *
I am grateful to Ben Nelson and Iain de Weymarn for assistance in preparing these remarks, and to James
Cloyne, James Talbot and Matthew Waldron for background research.
It is a pleasure to be at Queen Mary University of London to give the 2016 Peston Lecture.
Fifty years ago Lord Peston was invited to take up a Chair in Economics at Queen Mary and
to found the forerunner of today's School of Economics and Finance.
Anniversaries provide the opportunity to look back and plan ahead. When doing so, it is
sometimes helpful to recall Shimon Peres' definition of a young person as someone whose
future ambitions exceed their past accomplishments. So while Queen Mary can take justified
pride in its long-standing commitment to community engagement and widening local
participation, what is most striking are your plans for the future, including to push forward
translational research in population-scale genomics, with the potential to bring health benefits
to people across the UK and beyond.
Queen Mary is clearly a young institution.
The turn of the year is also a time for reflection and planning. The beginning of 2016 in the
UK is significant in that it marks a turning of a page in banking regulation and a turn in
financial conditions. At the same time, in the MPC's judgment, it did not yet herald a turn in
the stance of monetary policy.
I would like to expand on these developments today, including what they mean for the UK's
economic prospects.
Since the Bank's full powers came into force a few years ago, we have pursued a strategy:
1. To rebuild the resilience of the banking system;
2. To maintain an accommodative stance of monetary policy to achieve the inflation
target and support the recovery; and
3. To develop and deploy a macroprudential toolkit to prevent the emergence of new
vulnerabilities that could derail that recovery over the medium term.
We've made determined progress in all respects. In particular, we've reached inflection
points in micro and macroprudential policies, and are able to set out the requirements for one
in monetary policy. In doing so, we have increased the prospects of a durable expansion.
But the path of policy is not preordained, and continued progress will require both vigilance
and dexterity. That's because private and public balance sheets remain stretched. The global
environment is unforgiving. And the supply side of our economy is still healing.
Let me expand.
1. A resilient banking system
I will begin with the foundation upon which strong, sustainable balanced growth is built: a
resilient financial system. The combination of a radical overhaul of the regulatory framework
and years of determined effort has significantly strengthened the UK banking system.
Consequently, last month the Financial Policy Committee (FPC) was able to send two
signals that the system had turned the corner.
First, it has clarified the overall capital framework for banks, providing much needed certainty
to the sector. While there are details still to be finalised and complexities to be reduced, there
is no new wave of capital regulation coming. There is no Basel IV. Indeed, last week, central
bank Governors and Heads of Supervision agreed that work to address the problem of
excessive variability in risk-weighted assets - one of the final parts of the post crisis capital
framework - would be completed by the end of 2016 without significantly increasing overall
capital requirements.
Second, the FPC now judges that the system is already within sight of the amount of capital
it needs to have by the end of the decade and has the capacity to continue lending to the real
economy even under severe stress.
The Bank's most recent stress test underscores these improvements. It focused on an
emerging market stress, centred on a sharp slowing of Chinese growth, which prompts
reassessments of global economic prospects, falls in asset and commodity prices and
increased global deflationary pressures.1
Sound familiar?
Despite challenging conditions abroad, the UK financial system can continue to take the
types of prudent risks needed to grow jobs and incomes here at home.
In short, the efforts of banks over the past seven years to rebuild their balance sheets and
improve risk management are paying off. Mortgage rates are at all-time lows. Corporate
credit availability has recovered solidly. Lending to small firms is growing again having fallen
sharply in the wake of the crisis (Chart 1).
Chart 1: Corporate credit growth as a whole recovering and SME credit growth
positive(a)
2.0
1.0
0.0
-1.0
SMEs(b) Large(c)
-2.0
Total
cent
-3.0
Per
-4.0
-5.0
-6.0
-7.0
Apr Jun Aug Oct Dec Feb Apr Jun Aug Oct Dec Feb Apr Jun Aug Oct Dec Feb Apr Jun Aug Oct
12 12 12 12 12 13 13 13 13 13 13 14 14 14 14 14 14 15 15 15 15 15
Notes: (a) Rate of growth in the stock of lending on previous year. Lending by UK MFIs. Data cover lending in
both sterling and foreign currency, expressed in sterling. Not seasonally adjusted. (b) SMEs are those businesses
with annual debit account turnover on the main business account less than £25 million. (c) Large businesses are
those with annual debit account turnover on the main business account over £25 million.
2. Financial conditions and macroprudential policy
The improvement in the price and availability of credit is one sign of the normalisation of the
UK financial environment. Another is that, after seven years of deleveraging, aggregate
credit to the UK private
non-financial sector has begun to grow again (Chart 2).
This has not been a debt-fuelled recovery. Aggregate private credit growth is modest
compared to pre-crisis conditions, and is just now coming into line with nominal GDP growth
(Chart 3).
Chart 2: Credit growth in the private sector is recovering
25
Private non-financial sector credit growth (oya) Sample average
20
15
cent
10
Per
5
0
-5
1967 1968 1970 1972 1973 1975 1977 1978 1980 1982 1983 1985 1987 1988 1990 1992 1993 1995 1997 1998 2000 2002 2003 2005 2007 2008 2010 2012 2013
Source: Bank of England.
Chart 3: Credit growth coming back into line with GDP growth in the latest data
15
Credit growth relative to GDP growth
Credit growth relative to GDP growth (3-year trailling average)
10
5
points
0
1969 1971 1973 1974 1976 1977 1979 1981 1982 1984 1985 1987 1988 1990 1992 1993 1995 1996 1998 2000 2001 2003 2004 2006 2007 2009 2011 2012 2014
-5
Percentage
-10
-15
-20
That said, increased vigilance is merited given the softness in nominal GDP growth, the
stillelevated levels of household debt relative to income, the large current account deficit and
pockets of more buoyant activity in areas such as Buy-to-Let mortgages, unsecured
consumer credit and commercial real estate.
More fundamentally, it doesn't take a genius to recognise that a prolonged period of low and
relatively predictable interest rates could encourage the build-up of excessive risks. That's
why the Bank is monitoring risks closely and has taken action where appropriate. Targeted
measures include:
- limits on high Loan-to-Income mortgages introduced last year, which contributed to
the share of households with very high mortgage debt to income ratios falling back
to levels last seen in the 1990s (Chart 4);2
- requirements for banks to assess whether borrowers could still afford their
mortgages at much higher levels of Bank Rate; and
- the current review of underwriting standards for Buy-to-Let being conducted by the
Bank's prudential supervisors.3
Chart 4: FPC action capped share of new mortgages that can be originated at above
4 1⁄2 times income
Risk scenario
After FPC action
loans
new
of
cent
Per
0 1 2 3 4 5
Loan to income (LTI)
Sources: FCA Product Sales Data and Bank calculations. The risk scenario considered how the distribution of
LTIs of new loans might have might evolved if momentum in the housing market had continued to build from
mid2014 in a way that was similar to the patterns seen in the UK housing market in the early 2000s.After FPC action
line pertains to 2014Q4 - 2015Q3.
In addition, given the financial system has moved out of the post-crisis period of heightened
risk aversion, the FPC has made clear its intention to set the Countercyclical Capital Buffer
above zero before the level of risk becomes elevated.
With active macroprudential policy, monetary policy can focus on its primary job of inflation
control. It is that to which I will now turn.
3. Objectives, strategy and outlook for monetary policy
The obvious question is, if the turn of the year heralded the normalisation of bank regulation
and macroprudential policy, why not the start of normalisation of monetary policy? After all,
the Federal Reserve raised rates in December. Might the 'special relationship' extend to
monetary matters?
Of course there is nothing particularly special about foreign central banks' policy rates. What
is most important is whether the shocks to which others are responding are similar to those
with which the MPC must contend. To my mind, there are some important differences in this
regard:
 First, cost pressures are stronger in the US. American unit costs have increased by
3% in the past year and are growing above historical averages, while unit costs in
the UK are currently rising by around half that rate or at a speed notably below that
consistent with the inflation target.4
 Second, the UK economy is twice as open as the US and is therefore more exposed
to global weakness, dragging on exports.5
Third, this also means that pass-through of weak global inflation, compounded by

exchange rate appreciation, is likely to exert a greater and more persistent drag on
UK inflation. Partly as a result, after adjusting for one-off factors, core inflation is
firmer in the US than the UK.
 Fourth, the stance of fiscal policy differs markedly. The UK is undergoing the largest
fiscal consolidation in the OECD, with the structural deficit projected to decline by
around 1 percentage point a year on average over the next four years, having fallen
only 1/3 percentage point on average over the past three. In contrast, US fiscal
policy is expected to loosen notably over next three years.
 Finally, the Bank of England's control over macroprudential policy reduces the need
to use monetary policy to address financial stability considerations.
Recall that, despite an expansion that started two years before our own, the Fed has only
raised rates to our lofty level of 1⁄2 %. This last point is not facetious. As my MPC colleague
Jan Vlieghe argued in a speech yesterday, a variety of structural factors have likely
depressed the so called equilibrium interest rate, or the rate consistent with the economy
operating at full employment and inflation at target.6 Bank staff have estimated many of these
drivers. In my long-held view, rate rises, when they come, are likely to proceed at a gradual
pace and to a limited degree for some time.
Most economics is at the margin, and the tightening of monetary policy - once warranted - is
likely to be marginal for some time.
Given all of that, what are the prospects for a rate rise in the UK?
Last summer I said that the decision as to when to start raising Bank Rate would likely come
into sharper relief around the turn of this year.
Well the year has turned, and, in my view, the decision proved straightforward: now is not yet
the time to raise interest rates. This wasn't a surprise to market participants or the wider
public. They observed the renewed collapse in oil prices, the volatility in China, and the
moderation in growth and wages here at home since the summer and rightly concluded that
not enough cumulative progress had been made to warrant tightening monetary policy.
The outlook for monetary policy depends on three things: the MPC's objectives, its strategy,
and the UK's economic prospects.
Our objective is clear: to return inflation to the target in a way that avoids undue volatility in
output and employment.
The MPC's strategy for achieving the inflation target varies over time, and it depends on the
nature of shocks hitting the economy and the risks facing the economy.
For conventional demand disturbances, including modest changes to households'
consumption plans, or for one-off shocks to the price level, such as a one-time fall in oil
prices, a relatively rapid return of inflation to the target, such as in twelve to eighteen months,
would usually be appropriate.
When there are large trade-offs between returning inflation to target and avoiding undue
volatility in output and employment, this horizon can be extended. In February 2011, in
response to a series of shocks to VAT, the past fall in sterling, and increases in commodity
prices, the MPC decided to seek to return inflation to target in around two to three years.
Extending the policy horizon made sense given the substantial slack in the economy, which a
faster return to target would only have increased.7
At present, the MPC is seeking to return inflation to the target in around two years and to
keep it there in the absence of further shocks. We don't want an overshoot of inflation.
This two-year time horizon reflects the need to balance the strength of private domestic
demand growth against the sustained headwinds from a weak world economy and ongoing
fiscal consolidation. External factors - including a strong exchange rate and subdued global
price pressures - can be expected to exert a persistent drag on UK inflation.
To offset this drag from abroad, domestically-generated inflationary pressures must rise. But
this process must be sustainable; that is, it should not come at the expense of future,
excessive volatility in employment and output.
The MPC's current policy horizon of around two years reflects our judgment of how best to
balance these persistent forces while implying a slightly tighter stance of monetary policy, all
else equal.
Since monetary policy operates with a lag, it must be forward looking.8 As a result, monetary
policy will continue to depend on economic prospects not the calendar.
The UK's prospects must be assessed in the light of an unusually uncertain supply side of
the economy.9 The financial crisis upended the certainties of the pre-crisis years when
productivity progressed predictably and labour supply expanded at a steady pace.
Productivity growth fell markedly after the crash and, though recently picking up, now seems
7
Indeed, Lord King's letter to the Chancellor noted that this would also have entailed risking an undershoot of
inflation in the medium term once temporary factors had abated.
8
Estimates of the effects of monetary policy rely on plausible ways of identifying monetary policy shocks. There
is a large literature on this, which seeks to quantify the "long and variable lags" suggested by Friedman.
Examples include Christiano, Eichenbaum and Evans (2005), Uhlig (2005), and Smets and Wouters (2007).
Estimates for the UK include those in Burgess et al (2013) and Cloyne and Hurtgen (2014). Such estimates
typically refer to unanticipated changes in interest rates. A challenge for this literature is that, as noted by
Leeper, Sims and Zha (1996) and Bernanke, Gertler and Watson (1997), most of monetary policy is
endogenous, meaning policy authorities move interest rates in response to economic developments, not in
spite of them, as I emphasise later. The systematic effects of monetary policy are more complex to
characterise.
9
For the monetary policy implications, see for example Broadbent (2013).
to be oscillating around a rate below its historical average. And there have been sharp
increases in labour supply caused by peoples' need to work to help pay down debts and
rebuild retirement savings. More recently, net migration has been higher. Most of these shifts
are still playing out and haven't settled into more predictable trends.
To make forward-looking policy today in light of such uncertainties about tomorrow, tracking
a broad range of indicators helps not just to give a picture of how the economy is evolving in
real time but also to update, in a 'Bayesian' fashion, an assessment of prospects ahead. In
this manner, being data driven isn't akin to driving by looking in the rear-view mirror but more
like adjusting your speed to the terrain ahead.
Although different indicators will merit focus at different times, as I highlighted last summer,
three types warrant particular attention at present:10
1. The prospects for growth momentum in excess of trend consistent with eliminating
spare capacity in the economy;
2. Evidence of and expectations for a sustainable firming in domestic cost pressures;
and
3. Developments in core inflation consistent with a reasonable expectation that total
CPI inflation will return to the target in around two years' time.
Progress in all three, both realised and prospective, will increase confidence that the initiation
of limited and gradual rate increases will be consistent with returning inflation sustainably to
the target.
In this light, let me turn to recent developments.
Momentum and slack
After gaining momentum in 2013 and peaking around 3% in 2014, output growth has been
steady during 2015, at rates close to 2%, a little below pre-crisis norms (Chart 5).11
The average quarterly growth rate for 2015 of around 0.5% has disappointed compared to
the MPC's summer expectations of 0.7%. This shortfall reflects much weaker net trade, the
absence of a rebound in housing activity, and less robust consumption growth.
Nonetheless, private domestic demand is still solid, and household consumption has been
resilient. Consumption growth accelerated to 3% in the third quarter of 2015 (Chart 6),
underpinned by the strongest real income growth since the crisis and highest consumer
confidence in a decade. Excluding the understandable weakness in North Sea oil, business
investment grew strongly throughout 2015. Surveys suggest investment intentions remain
robust and, consistent with a stronger banking system, accommodative monetary policy, and
very supportive credit conditions. Such solid private domestic demand growth can be
expected to continue.
Chart 5: Headline growth rate has moderated
3.5
3.0
2.5
2.0
cent
Per
1.5
1.0
0.5
GDP growth (oya)
Average within each calendar year
0.0
10 10 10 10 11 11 11 11 12 12 12 12 13 13 13 13 14 14 14 14 15 15 15
Jun Jun Jun Jun Jun Jun
Sep Dec Sep Dec Sep Dec Sep Dec Sep Dec Sep
Mar Mar Mar Mar Mar Mar
Source: ONS and Bank calculations.
Chart 6: Household consumption has accelerated despite slowing headline growth
3.5
GDP growth (oya)
3.0
Household consumption growth (oya)
2.5
2.0
1.5
1.0
cent
0.5
Per
0.0
-0.5
-1.0
-1.5
-2.0
10 10 10 10 11 11 11 11 12 12 12 12 13 13 13 13 14 14 14 14 15 15 15
Jun Jun Jun Jun Jun Jun
Sep Dec Sep Dec Sep Dec Sep Dec Sep Dec Sep
Mar Mar Mar Mar Mar Mar
Source: ONS and Bank calculations.
Chart 7: Euro-area GDP growth picking up a little; US growth moderating
6
US Euro area
4
2
0
cent
Per
-2
-4
-6
-8
06 07 07 07 08 08 09 09 10 10 10 11 11 12 12 12 13 13 14 14 15 15
Jul Jul
Jan Jan
Oct Jun Oct Jun
Sep Feb Apr Sep Feb
Dec Aug Nov Dec Aug
Mar Mar
May May
Source: Bank calculations.
The same cannot be said of the global economy, which has slowed even relative to the
MPC's modest expectations in the summer. There are some positives. The broadening of
euro-area growth has offset the effects of a moderation in US growth on UK-weighted
demand (Chart 7). In addition, to the extent that renewed sharp declines in oil prices are
predominantly supply driven, they should support growth, though sustained spillovers to
tightening financial conditions would mean to a lesser degree than usual.
Since August, downside risks to growth in emerging market economies have begun to
crystallise. This has triggered sharp drops in risky asset prices, rises in risk premia, and falls
in the expected path for policy rates across advanced economies, including the UK.
Further downside risks to the global outlook remain, reflecting the ongoing challenges in
China, fragilities in other major emerging market economies, and the potential for financial
contagion. Chinese trade has been strikingly weak recently, possibly reflecting rebalancing
there, as softer investment reduces demand for imported capital goods. This process has hit
advanced economy exports to China, particularly those from the UK which dropped by one
third in the year to November. Global difficulties are likely to continue to suppress world
demand relative to our expectations in August. In addition, possible spillovers to domestic
demand via wealth and cost of capital channels bear close monitoring.
As one consideration in setting monetary policy, the MPC must evaluate how much of the
moderation in output growth reflects slower supply growth. Slack ultimately matters for
inflationary pressures, though sizing it requires careful judgement, particularly after a supply
shock.12
A simple read can be taken from the unemployment rate, which has continued its solid
downward trend since the autumn of 2013, falling more rapidly than we had expected in
August and its historical relationship with GDP growth would have suggested (Chart 8).
Short-term unemployment is now below its pre-crisis average rate, though longer-term
unemployment has further to go (Chart 9).13 In addition, the vacancy to unemployment
ratio - a simple measure of labour market tightness - is at its highest observed level since
August 2005.
Chart 8: Unemployment fell faster than expected given GDP growth during 2014-5
4
Whole sample 2014-15
3
(pp)
2
1
unemployment
in
0
change
-1
2015Q3
-2
4-quarter
2014Q3
-3
-10 -5 0 5 10 15
GDP growth (oya, per cent)
Source: ONS and Bank calculations. Sample is 1972Q3 to 2015Q3.
12
Sceptics have questioned the importance of slack for overall price pressures, not least given the "missing
disinflation" experienced in many advanced economies, including the UK, over the crisis. Various explanations
have been put forward for this, including recently by Simon Gilchrist and co-authors (2015), who study the
implications of financially fragile corporate balance sheets for pricing dynamics. The UK's openness,
moreover, complicates the identification of the price Phillips Curve because of the role played by imported
costs. Nonetheless, when these are accounted for, and with careful shock identification, a price Phillips Curve
can be found. See e.g. Burgess et al (2013), Greenslade, Millard and Peacock (2008), and Groen and
Mumtaz (2008). For further discussion see Carney (2015b).
13
Recent Bank research has found a significant role for the long-term unemployment rate in wage determination
in the United Kingdom, in contrast to the view that the long-term unemployed put little downward pressure on
wage growth. See Speigner (2014).
Chart 9: Unemployment on a solid downward trend, and short-term unemployment
now below pre-crisis average
5
6 months or less
4.5
between 6 and 12 months
over 12 months 4
3.5
3
cent
2.5
Per
2
1.5
1
0.5
0
1992 1993 1994 1995 1996 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2007 2008 2009 2010 2011 2012 2013 2014 2015
Notes: Dotted lines show averages computed over 2000-5. Source: ONS and Bank calculations.
In the wake of the crisis, one reason that headline unemployment has not been a sufficient
summary statistic for slack in the labour market is because of underemployment of those in
work. Employees wanted to work more - perhaps to make up for lost income. This gap
between actual and desired hours widened significantly (Chart 10). Since the start of 2013, it
has been closing and most recently, rather sharply so. As overall employment growth
remains strong (Chart 11), this may reflect a normalisation of working patterns, with desired
average hours returning to their pre-crisis level, rather than an unwelcome decline in labour
demand.
An additional source of labour supply is net migration, which has recently been running
above past averages. This is likely the product of both 'pull' and 'push' factors: many UK
firms report skills shortages which foreign workers can help to fill; while weak wage and
employment prospects abroad raises foreign workers' willingness to migrate to the UK.
The implications for inflation are likely to be relatively small as migrants not only supply
labour - raising supply - but also spend their incomes - raising demand.14
Chart 10: Average hours have fallen since the start of 2015, but additional reported
desired hours have also fallen in tandem
33 0.7
Average hours per head (LHS)
0.6
Reported average desired hours per head (LHS)
Net additional reported desired hours per head (RHS)
0.5
32.5
0.4
0.3
32
0.2
Hours Hours
0.1
31.5
0
-0.1
31
-0.2
-0.3
30.5 -0.4
01 02 02 03 04 04 05 06 06 07 08 08 09 10 10 11 12 12 13 14 14 15
Jun Oct Jun Oct Jun Oct Jun Oct Jun Oct Jun Oct Jun Oct Jun
Feb Feb Feb Feb Feb Feb Feb
Source: ONS and Bank calculations.
Chart 11: Employment growth still solid
5
Employment growth (oya)
Employment growth (3m annl.) 4
3
2
cent
Per
1
0
-1
-2
13 13 13 13 13 13 14 14 14 14 14 14 15 15 15 15 15
Jul Jul Jul
Jan Jan Jan
Sep Sep Sep
Mar Nov Mar Nov Mar
May May May
Notes: LFS heads. Source: ONS.
On balance I read these labour market indicators as pointing to a further normalisation of the
labour market and broadly consistent with our expectations last summer for a modest decline
in slack.
What could these developments mean for domestic cost pressures?
Domestic cost pressures
As the economy continues to expand and slack diminishes, the resulting pressure on
resources would be expected to bid up wages.15
Recently, despite falling unemployment and the MPC's expectations in the summer, wage
growth has moderated from rates around 31⁄4 % to around 2 1⁄2 % (Chart 12). This could
reflect a range of influences, some of which are more relevant to the overall inflation outlook
than others. For example, in the past year, there is likely to have been some dampening
effect on measured wage growth owing to changes in the composition of the workforce with
more younger, less experienced workers entering employment.16 In addition, when measured
on an hourly basis, the moderation in wage growth has been less marked, consistent with the
fall back in average hours being a normalisation of working patterns.
Nonetheless, the slowdown in wage growth gives pause to the inference that the labour
market is as tight as would be suggested by the drop in unemployment alone.
Chart 12: Pay growth has tended to track unemployment, but with notable exceptions,
including during 2014, and moderation recently
6 -2
Private sector regular pay (LHS, oya)
Unemployment rate (RHS, inverted scale) -3
5
-4
4
-5
cent cent
3
Per -6 Per
2
-7
1
-8
0 -9
01 01 02 02 03 04 04 05 05 06 07 07 08 08 09 09 10 11 11 12 12 13 14 14 15 15
Jul Jul
Jan Jan
Oct Apr Jun Oct Apr Jun Oct
Dec Feb Sep Dec Feb Sep
Nov Aug Nov Aug
Mar Mar Mar
May May
Source: ONS and Bank calculations
It is possible that the rate of unemployment at which the economy can operate without
generating accelerating inflation is lower than previously thought, meaning less pressure on
wage growth at any given jobless rate. This could be, for example, because job matching has
become easier with new technologies or with greater labour mobility afforded by a recovery
in housing market liquidity. Equally, changes to unemployment insurance could have
encouraged more intensive job search by those out of work. Set against that, analysis by
Bank staff suggests a decline in matching efficiency in the past two decades, suggesting
balanced risks to our assessment that merit continued monitoring.
A final possibility is that the moderation in wage growth reflects the low headline inflation
rate. With widespread recognition that there is literally no inflation at present, bargaining over
real pay is more straightforward. Indeed, there is some anecdotal evidence from the Bank's
Agents that slower increases in households' living costs have been a significant driver of
lower pay awards. A simple estimated Wage Phillips Curve suggests a similar conclusion.17
If this is occurring, this will slow the build-up of cost pressures. The MPC must remain vigilant
for signs that low inflation is having second-round effects in the wage bargain, possibly via
inflation expectations. The mechanical return to higher rates of inflation as past falls in
energy prices begin to drop from the annual comparison should in time reverse this effect
and support wage gains. More fundamentally, falling joblessness and a high ratio of
vacancies to unemployment should support wage growth. At a minimum, such dynamics
suggest the need to continue to eliminate slack smartly.
Of course, what matters for inflation is not wage growth in isolation, but pay relative to
productivity. Growth in output per worker has been around 1% recently and is likely to have
fallen a little further towards the end of 2015.18 The result is that the levelling off in pay growth
has had smaller implications for unit cost growth. In the third quarter of 2015, these grew at
around 11⁄2 to 2% on a range of measures, and seem likely to grow at rates a touch below
what we expected in August.19 Stepping back, there is little indication of accelerating unit
costs we had expected. And certainly, given the scale of foreign disinflationary pressures,
current domestic cost growth is not yet consistent with a firming in underlying inflation.
This brings me to the final set of factors, core inflation measures.
Core inflation measures
Around one third of the inflation basket is accounted for by non-energy imported goods
whose prices depend on their world prices and the sterling exchange rate. Measures of core
inflation, which strip out the direct impact of volatile CPI items like energy and food prices,
help to give a read on how developments in these variables combine with domestic cost
pressures to drive underlying inflation trends. They also tend to give a sense of headline
inflation once the effects from volatile items drop out of the annual comparison.20 Put
differently, total CPI is more likely to move towards core than the reverse, suggesting, as a
rule of thumb, that inflation is likely to pick up but not to overshoot core CPI a year ahead.
17
See Annex.
18
Productivity measured in heads (i.e. output per worker) is relevant in computing unit cost growth using wage
or labour compensation measures also expressed in per head terms.
19
The Minutes of the MPC meeting held on 13th January 2016 noted that "In the year to 2015 Q3, a measure of
total unit labour costs based on the MPC's backcast estimate of GDP had grown by 1.6%. Growth of unit
wage costs had been somewhat stronger over the same period, at 2.3%, though both rates were likely to have
eased back slightly in the fourth quarter of last year."
20
Analysis by Bank staff suggests that a simple principal component (PC) measure of core inflation - which
summarises the broad trends contained in a large set of measures - is a better predictor of subsequent
headline inflation than is current headline inflation. In other words, gaps between core inflation and headline
inflation tend, on average, to be resolved by total inflation moving back towards core inflation (rather than vice
versa). However, although smaller, the root mean square error from core inflation-based forecasts for future
inflation does not seem statistically significantly smaller than forecasts using current headline inflation.
Additionally, the summary PC measure of core inflation forecasts headline inflation 1-year ahead more
accurately than a simple assumption of 2%, such that core inflation provides useful information for near-term
inflation trends.
14
BIS central bankers' speeches
Chart 13: Core inflation has picked up but remains notably below 2%
7
12 month CPI inflation
6
12 month Core CPI inflation (a)
Goods price inflation 5
Services price inflation
4
3
cent
2
Per
1
0
-1
-2
-3
Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct
10 10 10 10 11 11 11 11 12 12 12 12 13 13 13 13 14 14 14 14 15 15 15 15
Notes: (a) CPI inflation excluding energy, food, alcoholic beverages and tobacco. Source: ONS.
Measures of core inflation have been below 2% since the middle of 2014 (Chart 13), and
weaker than projected in August. This mainly reflects weaker goods price inflation, which, in
turn, is likely the product of sterling's past appreciation (Chart 14).21 Those dynamics will
continue to weigh on core inflation for a while, since around two-thirds of the effects of a
currency move are estim