A Framework for All Seasons?
Speech given by
Mark Carney
Governor of the Bank of England
Bank of England Research Workshop on The Future of Inflation Targeting
9 January 2020
I am grateful to Clare Macallan for her assistance in drafting these remarks and to Nishat Anjum and
Alexis Tessier for background research and analysis.
Introduction
Following a chequered history of high and volatile inflation in the post-war era, the UK finally found monetary
success as an early adopter of inflation targeting in 1992. The UK's current regime, launched in 1997,
delegated operational independence for setting monetary policy to the Bank of England and included many
-
institutional innovations that have stood the test of time most notably a Monetary Policy Committee with a
mix of internal and external members; transparent, independent voting; and a clear accountability framework.
Since operational independence for inflation targeting was delegated to the MPC, there have been a raft of
improvements, both large and small. Transparency has steadily increased with initiatives ranging from
publishing detailed assumptions underlying forecasts ex ante to assessing forecast accuracy ex post as well
Inflation
as the simultaneous release of Monetary Policy Summaries, Minutes, and Reports. More recently,
the MPC has introduced layered communications, with simpler, more accessible language and graphics to
reach the broadest possible audience, and we have launched the Monetary Policy Report in order to give
greater prominence to the most pressing issues shaping each monetary policy decision.
A major improvement to the inflation targeting framework itself was to confirm explicitly beginning with the
2013 remit that the MPC is required to have regard to trade-offs between keeping inflation at the target and
avoiding undesirably volatility in output. In other words, the MPC can use the full flexibility of inflation
targeting in the face of exceptionally large shocks to return inflation to target in a manner that provides as
much support as possible to employment and growth or, if necessary, promotes financial stability.
a radical overhaul of the Bank's
Even more fundamentally, the lessons of the global financial crisis prompted
broader policy framework. The crisis exposed the limits of inflation targeting itself, notably how a healthy
focus on price stability could become a dangerous distraction. Central banks had won the war against
inflation only to lose the peace as financial vulnerabilities built remorselessly during the Great Moderation.
Price stability clearly is not a guarantee of financial stability.
With the deficiencies of the Tripartite regime1 on full and painful display, the decision was taken in 2012 to
give the Bank of England responsibility for macroprudential and microprudential supervision. Two new
independent committees, the FPC and the PRC, were created and charged with maintaining financial
stability and safety and soundness of banks and insurers, respectively. In 2016, these committees were
placed on equal footing with the MPC, underscoring the symbiotic roles that all three play in underpinning
confidence in money and in promoting the best possible macro-economic outcomes.2 Any consideration of
1
In 1997, then Chancellor Gordon Brown put in place a new system for financial regulation, with responsibility shared by three
institutions. The Bank of England was given responsibility for financial stability; the FSA was responsible for regulating individual
This arrangement became known as the "Tripartite".
banks; and the Treasury dealt with legislation.
2
In addition to the Monetary Policy, Financial Policy and Prudential Regulation Committees, the Bank is responsible for the issuance of
bank notes, provides the foundations of the payments system through RTGS, regulates systemic financial market infrastructure, and
has powers and facilities to provide wide range of liquidity to banks and other financial institutions in order to promote the continuous
functioning of the financial system during shocks. Other institutions that support confidence in the currency include legal tender status
(meaning that you cannot be sued for non-payment of debts if you offer sterling to meet them) and the insurance of deposits of up to
£85,000 at banks and building societies backed by the Government.
the UK's monetary policy framework must take into account this unique and highly effective institutional
structure.
To set the stage for today's discussions, I would like to do two things.
First, I will review the conduct and
performance of inflation targeting during my time as Governor. This period, which roughly coincides with the
post-crisis recovery and which has seen more than its share of shocks and structural developments,
provides some insights to the ability of inflation targeting to deliver price stability and support macroeconomic
outcomes. I will suggest that, so far at least, inflation targeting has proven to be a framework for all seasons,
an essential part of a robust foundation for economic prosperity.
It is important not to lose sight of the fundamental success in achieving price stability that has resulted from
delegation of inflation targeting to an independent central bank. In the two decades prior to independence,
inflation averaged over 6%. Since independence, it has been close to 2% and one-fifth as volatile (Table 1).
Inflation expectations have remained well anchored throughout some of the largest economic shocks in post-
war history.
Table 1: Inflation lower and less volatile since MPC independence
Four-
Annual Fourquarter quarter GDP Real
CPI Inflation GDP growth Unemployment wage
Inflation volatility growth volatility rate growth
Pre-inflation 9.0 5.4 2.2 2.9 7.8 0.8
targeting
(1972-1992)
Start of inflation 2.3 0.4 2.9 0.7 9.0 0.3
targeting to MPC
independence (1993
-
1997 Q2)
MPC independence 1.6 0.5 3.0 0.9 5.4 0.7
to crisis
(1997Q3 -2007)
-
2008 end 2012 3.3 1.0 0.0 2.7 7.4 -0.3
-
2013 present 1.7 1.0 2.0 0.5 5.1 0.2
The bar for change to the regime is very high. But while the inflation targeting regime has generally served
the end of monetary history.
the UK well since its adoption, it would be Fukuyama-esque to declare it In the
second part of my remarks therefore I would like to raise some structural challenges to monetary policy that
favour careful consideration.
Inflation targeting may have proven to be the framework for all seasons, but what if the climate is changing?
Could deep structural changes in our economies reduce the effectiveness of the regime? Is it possible that
political economy considerations could complicate the management of monetary policy? And could these
developments merit either a substantial adjustment to inflation targeting or even the adoption of a different
monetary policy framework in the years ahead?
In what follows, I will not presume to give the answers but would suggest that a careful and deliberate
research review of the UK's monetary policy framework is warranted. That's why my colleagues and I look
to the contributions of the distinguished group assembled here today. And it's why the Bank will
forward
conduct a dedicated research programme over the next year, joining many of our peers around the world in
similar exercises.3 At a minimum, as I advocated in my parliamentary testimony prior to joining the Bank,4
open, periodic reviews reinforce the legitimacy and acceptance of this vital component of the UK's
macroeconomic landscape.
Let me begin by reviewing how inflation targeting has performed in recent years.
Monetary "Spring" -
I. Securing the recovery
When I joined the Bank, a long economic winter of discontent was finally beginning to thaw. Throughout
most of 2011 and 2012, UK GDP growth (at around 11⁄2%) had languished well below its pre-crisis trend (of
close to 3%), and unemployment was about 8%. But by mid-2013, there were signs of a nascent recovery:
four-quarter growth had picked up above 2%, and the unemployment rate fell to 7.7%, its joint lowest level
since early 2009 (Charts 1a and 1b). The timing and pace of the recovery had caught most unawares.
Chart 1: Signs of a nascent recovery by mid-2013
a) Swathe of survey indicators of quarterly UK GDP growth
Percentage change on previous quarter
1.0
0.5
0.0
-0.5
-1.0
-1.5
-2.0
2009 2010 2011 2012 2013
Sources: IHS Markit/CIPS, BCC and CBI, Bank calculations.
3
In the US, the Federal Reserve is conducting a broad review of the strategy, tools, and communication practices it uses to pursue its
monetary policy goals; the Bank of Canada is assessing a broad range of monetary policy frameworks ahead of its renewal in 2021 of
the inflation-control agreement; and President Lagarde announced that the ECB will undertake a strategic review, which will include an
assessment of monetary policy strategy and the operational framework.
4
Available at https://www.parliament.uk/documents/commons-committees/treasury/carney-pdf-TC-07-02-13.pdf.
b) Unemployment rate
Percent
9.0
8.5
8.0
7.5
7.0
6.5
6.0
5.5
5.0
2008 2009 2010 2011 2012 2013
With the wisdom of hindsight, there were three main drivers of the recovery: a marked reduction in extreme
uncertainty (particularly as the euro area stabilised) and an associated modest pick-up in global activity;
significant progress on repairing the core of the UK financial system; and a material improvement in
household balance sheets as UK households worked hard to pay down their debts. In addition, the Bank's
Funding for Lending Scheme provided support to activity, by improving financial conditions.
On the nominal side, UK inflation had fallen from a peak of 5.2% in September 2011 to 2.9% in June 2013
(Chart 2a), as upward pressures from the past exchange rate depreciation (and higher energy prices) eased.
-
Domestic inflationary pressures were subdued, with annual pay growth running around 1% (Chart 2b) far
below its pre-crisis average rate of 4%.
Chart 2: Headline CPI inflation elevated but domestic inflationary pressures subdued
a) CPI inflation
Percentage changes on a year earlier
6
5
Headline CPI
4
3
2
2% target
1
Core CPI
0
b) Whole economy regular pay growth
Percent
5.0
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
2006 2007 2008 2009 2010 2011 2012 2013
With output only having just returned to its pre-crisis peak and unemployment still several percentage points
above any reasonable estimates of its equilibrium rate, the MPC judged that there was a large amount of
spare capacity in the UK economy, and significant scope for aggregate demand to increase consistent with
inflation returning sustainably to the 2% target.
But the exact extent of slack was more uncertain than usual. Productivity had fallen alongside activity during
the recession, and its reported growth had been anaemic since, averaging around half its pre-crisis rate
(Chart 3). The MPC judged that slow productivity growth was partly a result of the post-crisis weakness in
the banking system, which had been restricting the reallocation of capital and labour.5 It was not clear how
quickly productivity growth might return to pre-crisis rates as demand recovered and financial intermediation
returned to normal. But old habits die hard, there was an (ultimately misplaced) optimism that productivity
growth would pick up sharply.
Chart 3: Productivity growth anaemic post-crisis
Index: 2001 Q1 = 100
118
116
114
112
110
108
106
104
102
100
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
5
Whereas half of all productivity growth at the economy-wide level in the years prior to 2008 occurred through this channel, reallocation
F (2014), "The
appeared to make no contribution to productivity growth around this time. See Barnett, A, Barriel, M, Chiu, A Franklin,
Perspectives," Bank of England Working Paper.
Productivity Puzzle: Firm-Level
In parallel, evidence of increased labour supply was emerging. In the wake of the crisis, several forces
encouraged more people to seek work and others to delay retirement, including the accumulated debt
burdens of UK households in the run-up to the crisis; increased uncertainty about future incomes in its
aftermath; changes to pension arrangements; and reforms to the UK's welfare system. These forces meant
that labour supply was increasing, despite the persistent drag from an ageing population. Changes to the
nature of work, including the rise of the gig economy and self-employment, that gave rise to more flexible
employment opportunities, reinforced this view.
Such enormous uncertainties about supply meant knowing what was happening to demand was no longer
sufficient to gauge changes in spare capacity and therefore to set the appropriate monetary policy response.
revealed
This was a unique situation in the history of UK inflation targeting. The historic reduced-form
-
reaction function of the Committee turned out to be based on changes to demand alone the MPC had
always tightened policy significantly during previous periods of accelerating growth and firming business
confidence (Chart 4).
Chart 4: Close correlation pre-crisis between output growth and policy
3 month moving average,
3 month moving average,
60 25
55 0
50 -25
45 -50
Combined CIPS output survey
(left-hand scale)
40 -75
Average MPC vote, including QE
35 -100
(right-hand scale)
30 -125
1998 2000 2002 2004 2006 2008 2010 2012
Sources: IHS Markit, ONS and Bank calculations.
Notes: Combined CIPS output survey is a weighted average of the Markit/CIPS PMIs for services, manufacturing and construction.
Average MPC vote includes both decisions on Bank Rate and QE, with every extra £25bn of asset purchases (gilts and corporate
bonds) treated as equivalent to a 25bp cut in Bank Rate (see Joyce, Tong and Woods, 2011).
With uncertainty about supply now overwhelming uncertainty about demand, and with the strong desire to
- -
secure a recovery in an economy that had reportedly at least only narrowly missed a triple dip recession,
the MPC provided forward guidance in August 2013 that explicitly linked any potential change in interest
rates to the unemployment rate. By using a clear and widely understood indicator of the degree of spare
capacity,6 the Committee sought to secure the nascent recovery while learning more about the supply
capacity of the economy. Recall that at the time fiscal consolidation continued to weigh on domestic demand,
making monetary policy the "only game in town."
6
For the full text of the guidance, see the minutes of the August 2013 MPC meeting, available at
https://www.bankofengland.co.uk/minutes/2013/monetary-policy-committee-august-2013.
The message the Committee gave UK households and businesses was simple: the MPC would not even
think about tightening policy at least until the unemployment rate had fallen below 7%, consistent with the
creation of around three quarter of a million jobs. We reassured households and businesses that, after five
difficult years, the recovery would not be choked off prematurely.
On the basis of this past behaviour, the MPC would have raised interest rates by 2 to 3 percentage points
between August 2013 and the end of 2014 (Chart 5). For anyone who might suggest the MPC should have
followed its historic reaction function (and several external commentators did at the time7), note that, even on
unchanged policy, CPI inflation in the summer of 2016 was running at only about 1⁄2% and core CPI inflation
around 11⁄4%.
Chart 5: Forward market interest rates rose only modestly as unemployment fell quickly towards 7%
August 2013
Data published showing Percent
guidance issued
unemployment fell to 6.9%
4.0
February 2014
3.5
guidance issued
3.0
Counterfactual path for Bank Rate
2.5
based on historic correlation with
survey indicators of output growth
2.0
1.5
UK 1 year instantenous forward
1.0
0.5
0.0
Jan. 12 Jul. 12 Jan. 13 Jul. 13 Jan. 14 Jul. 14
Sources: Bloomberg Finance L.P., IHS Markit, ONS and Bank calculations.
In an environment of strengthening domestic activity and some external exhortations to raise interest rates,
forward guidance was effective in managing expectations. Surveys conducted in the months that followed its
introduction indicated high awareness among companies, with almost half reporting that they expected Bank
Rate to remain at low levels for longer than they would have done had guidance not been in place. And the
said that the Bank's policy
majority of businesses guidance had made them more confident about UK
economic prospects. Household expectations also shifted markedly in favour of fewer and later rate
increases (Chart 6).8 In parallel, household and business confidence continued to strengthen, reinforcing
the economic momentum.
7
For example, the IEA's Shadow Monetary Policy Committee voted for higher rates at all of its fourteen meetings between
November
2013 and December 2014.
8
For more information, see the box on page 12 of the February 2014 Inflation Report.
Chart 6: Households consistently expected increases in interest rates to be gradual and limited
Median household Bank Rate expectations
Per cent
2014 Q1
6
2015 Q1
Pre-crisis average level of
5
2016 Q1
4
2017 Q1
2018 Q1
3
2
1
0
0 1 2 3 4 5 6
Years ahead
Notes: Household expectations are from the Bank/TNS Inflation Attitudes survey and show how Bank Rate is expected to increase
relative to the rate prevailing at the time. Pre-crisis average Bank Rate is calculated from 1997 to 2007 inclusive.
In the event, the unemployment rate fell far faster than the MPC had expected, falling below 7% in February
2014. But even as the recovery strengthened and survey indicators of output growth reached levels
previously associated with sharp policy tightenings, household, company and market expectations about the
future path of policy remained subdued and interest rate volatility remained low (Chart 7). People
understood the conditionality of guidance, as they and the MPC had learnt that there was still considerable
spare capacity in the economy.
Chart 7: Interest rate volatility has remained low since guidance was provided
Standard deviation of option-implied distributions for 3m LIBOR in 12-months' time
Basis points
180
August 2013
guidance issued
160
February 2014 140
guidance issued
120
100
EU referendum
80
60
40
20
0
2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020
Sources: Bloomberg Finance L.P., Chicago Mercantile Exchange (CME), Intercontinental Exchange (ICE) and Bank calculations.
The improved transparency of the inflation targeting framework also promoted this smooth learning process
about the supply side that helped maximise economic outcomes. Starting in 2014, the MPC began carrying
out a stocktake of the supply side of the economy each year, publishing its best collective judgments on the
natural rate of unemployment, the output gap, as well as the expected growth in productivity, labour supply
and potential output.9 As part of these exercises, the MPC revised down its (hitherto private) estimate of
equilibrium unemployment rate from 61⁄2% in August 2013 to 51⁄2% in August 2014,10 though it also judged
that spare capacity in the UK economy was gradually being used up as demand was growing rapidly while
supply growth was still subdued.
In short, spring was gradually turning to summer.
-
II. Summer Supporting the expansion
By the end of 2014, the challenge for the MPC had become to keep the economy on this path to a long
economic summer by setting policy to return the level of output to potential and total CPI inflation sustainably
to the 2% target.
The MPC recognised that achieving this trajectory as the headwinds to demand following the crisis continued
to fade would likely require some tightening in monetary policy.
But how much? During the pre-crisis inflation targeting era, Bank Rate had averaged 53⁄4%, and the
equilibrium real interest rate was generally thought to be around 33⁄4%. Early in 2014, the Committee
-
concluded that the equilibrium interest rate the level of the real policy rate that, if allowed to prevail for
-
several years, would place economic activity at its potential and keep inflation low and stable had fallen
significantly.11 This equilibrium rate, r*, is determined not by central banks, but by the real, fundamental
factors driving desired savings and investment. For an open economy like the UK, those factors will reflect
global influences as well as domestic ones.12
Both long and shorter-term factors have contributed to the fall in equilibrium interest rates. In recent
-
decades, a set of powerful structural forces has been pushing down global r* including demographic
change, slower potential growth, a larger left-hand tail in the distribution of economic outcomes, and the
increased cost of financial intermediation. The financial crisis added to this downward pressure. Uncertainty
rose, growth in other advanced economies slowed, financial conditions tightened, and both the public and
9
These annual stocktakes serve two purposes. First, they provide the MPC with a regular opportunity to step back from the
month-tomonth flow of economic data and consider supply-side developments as a whole and over an appropriately lengthy time period.
Second, by undertaking routine systematic annual assessments of the supply-side, rather than addressing the issues ad hoc from
quarter to quarter, we hoped to provide clarity on our analytical processes to observers outside the Bank.
10
See the August 2014 Inflation Report. The equilibrium unemployment rate depends on the horizon being considered, as wage
will be more persistent than others. These figures are the MPC's estimates of
pressures can arise for many reasons and some factors
equilibrium unemployment rate, the measure most relevant for gauging wage pressures over the MPC's
the medium-term three-year
forecast period. This is distinct from the MPC's -
estimate of the long-term equilibrium unemployment rate which depends on structural
factors such as the extent to which potential employees are aligned with vacancies in terms of skills, location and occupation; the
benefits regime; and the influence of trade unions on wage bargaining - and which remained at 5% during this period.
11
See speech by Mark Carney at the
'The spirit of the season', Economic Club of New York, 9 December 2013 and the box on page 40
of the February 2014 Inflation Report.
12
See speech by Mark Carney given at the 2017 IMF Michel Camdessus Central Banking Lecture, 18
'[De]Globalisation and Inflation',
September 2017.
private sectors sought to reduce their pace of borrowing. These shorter-term factors pushed the equilibrium
interest rate in the UK (and other advanced economies) into negative territory, prompting the adoption of
unconventional policies following the crisis.
The fading of the headwinds from the crisis implied that some of the fall in the equilibrium rate would
gradually unwind, though the structural forces were thought likely to persist for many years to come. As a
result, the MPC judged that the pace of Bank Rate increases consistent with eliminating slack and keeping
inflation close to the target would be gradual and that, even once spare capacity had been absorbed, the
appropriate level of Bank Rate was expected to be materially below the pre-crisis average of 5%.
guidance that future rises in Bank Rate were expected to be "limited and
Out of that assessment came the
gradual" -
a phrase so often repeated it became part of the monetary policy furniture.
the MPC's "limited and gradual"
As intended, guidance dampened interest rate volatility and reduced the
correlation between interest rate volatility and economic uncertainty. Both developments increased the
degree of monetary policy stimulus at a given policy rate, thereby reinforcing the recovery during turbulent
times.
GDP grew robustly over this period, supported by strong consumer and business spending against a
backdrop of continued fiscal consolidation. Unemployment continued to fall and the amount of excess
supply was gradually, but meaningfully, reduced. These factors looked set to provide the momentum
needed to bring domestic inflationary pressures back to up to a rate consistent with the inflation target. It
was notable that wage growth was already showing signs of picking up.
At this time, however, total CPI inflation had fallen to around zero. While below-target inflation partly
reflected the drag from past spare capacity, the majority was due to falls in energy prices, muted growth in
world prices and a recent appreciation of sterling.13 Measures of core inflation that attempt to strip out these
external factors had fallen much less sharply, though were still below target-consistent rates.
The MPC expected the effects of the external factors on inflation to be protracted, particularly the dampening
influence of sterling, which was likely to still be affecting inflation in two years' time or what is viewed as the
conventional policy horizon. The Committee had learnt from the experience of the post-crisis depreciation in
sterling that the pass-through of changes in the exchange rate through supply chains into UK CPI inflation is
slow, not swift, taking several years to complete.
The Committee therefore continued to maintain Bank Rate at 0.5%, judging this was appropriate to ensure
that waning drag on inflation from external price pressures would be balanced by further increases in
domestic inflationary pressures brought about by eliminating the remaining margin of spare capacity in the
economy. The performance of total and core CPI inflation in the run-up to the referendum was consistent
13
The MPC judged that these factors could explain around three-quarters to four-fifths of the deviation of inflation from target, with the
remainder reflecting the impact of past spare capacity weighing on domestic cost growth.
-
with this judgment one that helped ensure that the UK economy continued to expand jobs and growth at
some of the strongest paces in the advanced world.
the strength of the Bank's expanded powers. Aware that the
In my view, this period demonstrated
combination of strong growth and historically low interest rates could lead to excessive risk taking, this was a
UK banks' CET1 capital
period of macroprudential activism by the Bank. In the five years to 2016, the major
ratios in aggregate nearly doubled, rising from 7.2% to 13.4%. The FPC introduced a new leverage ratio and
counter-cyclical capital buffer. With the PRC, it regularly stressed tested the major banks against a wide
range of extreme economic and financial shocks. In a major innovation, the FPC brought in two measures to
help ensure that mortgage underwriting standards did not deteriorate as they had in previous cycles and to
limit the rise of heavily indebted households.
The active management by the PRC and FPC of potential risks to financial stability ensured that monetary
policy could concentrate on its core responsibilities. Achieving those was about to get much more
complicated as summer came to an abrupt end.
-
III. Autumn Managing the trade-off in the exceptional circumstances of Brexit
The main challenge facing the MPC most recently has been to support the UK economy through Brexit. To
maintain the seasonal metaphor, recent years could be described as autumnal, consistent with the start of
that season being associated with big changes like beginning a new school year or a new job.
Prior to the referendum, the MPC expected that a vote to leave would prompt the exchange rate to fall
sharply, inflation to rise above the 2% target, and growth to slow materially.14 That is exactly what happened
(Charts 8a, b and c).
Chart 8: Following vote to leave EU, sterling depreciated, inflation rose and growth slowed materially
a) Sterling ERI
Index, Jan 2005 = 100
95
EU referendum
90
85
80
EU summit
75
70
Jan. 15 Jul. 15 Jan. 16 Jul. 16 Jan. 17 Jul. 17 Jan. 18
14
See the May 2016 Inflation Report.
b) CPI inflation
Per cent
3.5
EU referendum
3.0
2.5
2.0
1.5
1.0
0.5
0.0
-0.5
Jan 14 Jul 14 Jan 15 Jul 15 Jan 16 Jul 16 Jan 17 Jul 17 Jan 18
c) UK and G7 growth
Percentage changes on a year earlier
4.0
EU referendum
3.5
3.0
Swathe of other G7
countries
2.5
2.0
1.5
1.0
UK GDP growth
0.5
0.0
-0.5
2015 2016 2017 2018
Sources: Eikon from Refinitiv and Bank calculations.
Sterling dropped immediately following the referendum, the biggest recorded single day move, and it
subsequently traded around 15 to 20% below its late-2015 peak ahead of the referendum being called.
Inflation rose well above the 2% target, eventually peaking at 3.1% in late 2017, an overshoot entirely due to
the referendum-induced fall in sterling.
UK growth dropped from the fastest to the slowest in the G7. Households trimmed spending, as the effects
of sterling's fall showed up in higher prices in the shops and squeezed their real incomes. Business
investment was cut back more markedly, despite supportive financial conditions and (at the time) strong
global growth, as companies understandably put projects on hold whilst they waited for greater clarity over
the UK's future trading relationships.
The weakness in investment has weighed on growth in the potential supply capacity of the UK economy,
through lower growth in the capital stock and reduced process innovation. Brexit-related uncertainties may
have dissuaded companies from expanding supply capacity or entering new markets. And companies have
spent considerable time and resources planning and preparing for various contingencies, limiting their ability
to produce output and take strategic decisions that would boost innovation and productivity.15
The MPC has repeatedly emphasised that monetary policy cannot prevent either the necessary real
adjustment as the UK moves to its new trading arrangements or the weaker real income growth likely to
accompany that adjustment. Monetary policy does, however, have a role to play in supporting the economy
during the adjustment process.
The balance of Brexit's effects on demand,
supply and the exchange rate meant the MPC faced a trade-off
between the degree of support it provided to jobs and activity on the one hand and how fast it would return
inflation sustainably to the target on the other. Once again it was in a unique position relative to other major
central banks, which were in positions of "divine coincidence" in which both output gap and inflation rate
pointed the policy stance in the same direction (Charts 9a and 9b).
Chart 9: Divine coincidence continued in the euro area post-crisis but not the UK
a) UK
Great moderation
6
Inflation (%)
Financial crisis and after
Inflationary, 4
Inflationary, no
with trade-off trade-off
2
-6 -5 -4 -3 -2 -1 0 1 2 3 4
Excess demand (%)
0
Disinflationary, no Disinflationary, with
trade-off trade-off
-2
Sources: ONS and Bank calculations.
15
See, for example, evidence from the Bank's Decision Maker Panel, a survey of over 8,000
companies.
b) Euro area
Great moderation
Inflation (%)
4.5
Financial crisis and after
4
3.5
3
2.5
8
2
-4 -3 -2 -1 0 1 2 3 4
1.5
Excess demand (%)
1
0.5
0
-0.5
-1
Sources: Eurostat, IMF and Bank calculations.
Notes: The measure of inflation is the four-quarter change in the harmonised index of consumer prices (HICP). The output gap is the
IMF's estimate from the October 2016 WEO at an annual frequency, interpolated to create a quarterly series.
During exceptional circumstances such as Brexit, the MPC has been required by its remit since 2013 to
balance such trade-offs.16 Consistent with that requirement, in August 2016, the MPC judged that it was
appropriate to set policy after the referendum so that inflation returned to its target over a longer period than
the conventional horizon of 18-24 months in order to support jobs and activity at a time when uncertainty was
elevated and the economy was slowing.
the MPC's framework for setting policy to manage this
Chart 10 illustrates trade-off. The red lines represent
the potential trade-offs that the Committee could strike: mapping the size of the inflation overshoot that it
could be prepared to tolerate for a given amount of spare capacity, and vice versa. The flatter the line, the
less weight the Committee places on output stabilisation and the more it is willing to tolerate large output
gaps in order to eliminate small overshoots in inflation.
To be clear, the precise trade-off that the MPC pursues is not determined by the preferences of its members.
Rather, it is grounded in society's choice of the desired end, as captured by the statutory objectives and the
remit the Committee is given by government. However, the actual trade-off that is struck will be importantly
influenced by MPC members'
views of both the nature of the shocks hitting the economy and the
transmission mechanism of monetary policy.17
16
As the remi