The inflationary
consequences of real shocks
- speech by Ben Broadbent
Given at Imperial College, London
20 October 2022
Speech
Introduction and summary
pandemic and Russia's invasion of Ukraine have inflicted
Between them, the Covid-19
significant damage on the UK's national income. Today I want to look at the link between
these extraordinary shocks, the very high rates of inflation that have followed and the
response of monetary policy. I will also draw one particular contrast with the potential
response to easier fiscal policy.
I'll kick off with the slightly less dramatic topic of national
accounting identities. One of the
first things you get taught in macro-economics is that national income is equal to national
output: in principle GDP measures both these things, as well as aggregate demand.
Accounting identities of this sort don't tell you anything about what causes what as they're
true by definition (though it's useful to understand that we earn only what we produce and
sell). But you might at least think, given the recovery in whole-economy output in the
eighteen months since (Chart 1), that the worst of the drops in national income during the
pandemic are well behind us.
Chart 1: GDP just about back to pre-pandemic levels
Level of GDP, 2019 Q4 = 100
104 104
100 100
96 96
92 92
88 88
84 84
80 80
76 76
Dec 19 Jun 20 Dec 20 Jun 21 Dec 21 Jun 22
Source: ONS and Bank calculations.
However, while the accounting equality of output and income is valid in nominal (i.e. cash)
terms, and more generally in closed economies, it's not always the case in real terms and
for open economies. When we're able to trade with other countries we no longer have to
consume and produce the same things. This means output and consumer prices can
diverge. And movements in that relative price will affect the real consumption value of what
quantity (GDP) doesn't change. If you produce apples
we collectively produce even if its
but consume oranges you'll be better off when the price of
oranges falls (relative to that of
apples), worse off if the opposite happens. It's not that domestic output and productivity
don't matter for income: obviously they do. But movements in relative prices matter too,
and there are times when they matter a lot.
In the real-world UK economy, one of the big differences in this respect involves energy
and other physical goods. Collectively we consume a lot more of these things than we
produce. The UK is a big net importer of (non-energy) goods. And although the North Sea
is still providing quite a bit of oil and gas, here too the UK runs a significant deficit.
Besides, only a very small minority of UK residents actually receive any disposable income
from that source. Notionally "British" companies operating in
the North Sea have significant
foreign ownership. What domestic shareholdings do exist are likely to be held mostly in
pension funds and other long-term (i.e. inaccessible) investment vehicles.
This means that, for given GDP, rises in the relative prices of goods and energy make us
collectively worse off. And that's exactly what's happened
over the past couple of years,
thanks first to the pandemic and then Russia's
cut in gas exports. Over that period the
the UK's imports has risen by
price of 20% more than the average price of its output. You
can see this in the last bar in Chart 2.
Chart 2: Bucking the long-term trend, import prices have risen much faster than
output prices over the past couple of years
Change in import prices relative to GDP deflator, annual average, % points
12 12
10 10
8
6420
-2 86420-2
-4 -4
60s 70s 80s 90s 00s 10s Last two
years
-
As a result, real income for the non-North Sea economy as a whole how much our
-
collective output is actually worth, in consumption terms has fallen by over 5% since the
end of 2019 (Chart 3).
Chart 3: Real income has therefore fallen steeply relative to output
Real national income excluding North Sea relative to GVA; 2019 = 100
102 102
101
101
100
100
99
99
98
98
97
97
96
96
95
95 94
1997 2000 2003 2006 2009 2013 2016 2019 2022
-
Real national income excluding North Sea calculated as (Nominal GVA North Sea profits) / Consumption
deflator. Sources: ONS and Bank calculations.
This may not be completely unprecedented but it's pretty unusual. As you can see from
the earlier bars in Chart 2, the post-war trend has been the opposite: compared with that of
- -
aggregate output, the average price of goods and therefore of UK imports in aggregate
has tended to decline1.
During the "noughties", for
At times this has added significantly to real income growth.
example, the integration of China into the global trading system depressed global goods
prices markedly. This wasn't such a great thing if you were a manufacturer in the west,
competing with this new source of production. Net buyers of goods, on the other hand,
were made better off. Real household income outgrew GDP by a cumulative 7 % points
during that decade.
- -
Clearly and with a vengeance the early part of this decade has seen a sharp reversal
of these trends. In the third quarter of this year, UK GDP will probably be only slightly
below where it was in the last quarter of 2019, immediately before the pandemic. Yet real
household income is likely to be over 3% lower, with real corporate profits down by more
than 5% (around 10% if you exclude the North Sea).
It's understandable, faced with this extraordinary squeeze, that people and firms in the UK
- -
economy have sought to protect their real incomes whether pay or profits through
compensating rises in wages and domestic prices. Unfortunately, and at least collectively,
It's not as if one group or sector is worse off only
those efforts will not make us better off.
because another, within the (non-North Sea) UK, is better off. The rise in import costs has
depressed the purchasing power of the country as a whole. So all that can be done is to
shift the losses from one place to another. And in the process, without any lasting impact
on real incomes, the result is simply higher growth of nominal pay and prices. These are
the effects" (of higher import prices on domestic inflation) to which
"second-round
monetary policy is having to respond.
Today, I want to make three points about this process.
First, monetary policy cannot undo the hit to real income. Nor could it ever have done. One
often hears that people are worse off "because of inflation". This is
not quite right.
Implicitly, it presumes that monetary policy could have prevented prices from rising so fast
to nominal incomes. Unfortunately, that's not the case. Even
without doing anything
assuming policy had been tightened sufficiently aggressively, and sufficiently early, to
have knocked eight percentage points off the current rate of inflation, it would also have
depressed nominal income growth by at least as much and almost certainly quite a bit
more. Unemployment would be materially higher and nominal wage growth materially
lower. Ultimately, this reflects what is known as the "neutrality" of monetary policy: in the
long run it has no impact on real economic variables (things like real output or relative
prices). It can't boost structural productivity, for example. Nor can it offset the
consequences for real incomes of (say) disruptions to supply chains in Asia or Russia's
curtailment of the supply of gas to Europe. Indeed, in the first instance, at least for a period
of time, tighter monetary policy lowers GDP and real incomes. I will say more about this
shortly. For the time being, a better short-hand description is this: the pandemic and the
war have led jointly to higher inflation and lower real incomes; the MPC will ensure the
inflationary effects do not persist into the medium term; but the real-income hit exists either
way, and will be reversed only to the extent the underlying shocks themselves go away.
The second point I want to make is that we are inevitably having to learn, to some degree,
about the scale of these effects. The MPC has raised interest rates faster
"second-round"
than at any time in its history but obviously more gradually than inflation itself. In the main,
this is because the direct effects of the jumps in traded goods and energy prices, as violent
as they are, are likely to fade before policy could really do much about them. The exact
timing and scale of the peak rate of retail energy price inflation will obviously depend
(amongst others) on the nature and duration of government support. But in the absence of
further (and equally steep) rises in wholesale gas prices, and even without any such
support, inflation in retail energy bills is likely to be materially lower a couple of years from
now than it is today. Inflation in the areas most affected by the pandemic seems already to
have peaked.
also because we are relatively unfamiliar
However, it's with the second-round effects of
these things. They very clearly existed in the past, before inflation targeting was put in
place in 1992. Economists long recognised that, in the presence of "real income
resistance", negative shocks - -
from, say, higher import prices or higher taxes could
generate inflation in wages and domestic prices. Estimates of these effects using the
historical data, from before the 1990s, were reasonably sizeable. But they then began to
decline, a phenomenon many attributed to greater flexibility in the labour market. So
-
although there were occasions after 1992 when real incomes were squeezed the big rise
in import prices immediately after the financial crisis was one obvious case, so too perhaps
-
the period of weak productivity growth that followed there was very little sign of any
second-round response of domestic inflation.
Absence of evidence is not the same as evidence of absence. Given the enormous scale
of the rise in import prices it would have been surprising to see no impact whatever on
domestic inflation, particularly against the backdrop of a very tight labour market. But it's
unavoidable that we are having to learn about these effects, and to respond to them, as
they emerge. Unlike the more volatile movements in tradable goods prices, shifts in
domestic inflation tend to persist for longer and it will require a period of below-trend
rates. Because they've
growth in demand to bring inflation back towards target-consistent
depressed real incomes, that slowing in demand will to some degree follow from the very
same rises in import costs that have pushed up headline inflation. But monetary policy
needs to be tightened as well.
-
My third point is that the response to a pure demand shock say from easier fiscal policy
- different in this respect. We can be less uncertain about its effects, there's less
is rather
reason to wait till they actually come through and one would therefore expect a more
immediate reaction.
For as long as it's in government's Energy Price
place, the Guarantee has the effect of
limiting headline inflation and, to that extent, any related strengthening of second-round
(and more persistent) effects on domestic inflation. By the same token, however, it
mitigates the severity of the hit to household incomes and thereby supports domestic
- -
demand. As the Committee noted last month, this would all else equal add to inflation
in the medium term. And, compared with the forecast we had in August, the MPC has
judged that the second effect is likely to outweigh the first.
There is uncertainty about the nature and duration of these subsidies. The government
has now said the current scheme will now last only six months, rather than two years, but
that some form of support is likely to be provided thereafter (albeit on a more targeted
basis). The MPC will take account of any fiscal news in the forthcoming Medium-Term
Fiscal Plan, as well as any other news relevant for the medium-term inflation outlook, in its
next set of forecasts.
Anyhow, having laid out already the main points I want to make, the rest of the talk fills in
some of the details. I'll start with a discussion of monetary "neutrality", explaining why
policy cannot in the long run offset the income effects of real economic shocks, including
from the pandemic and the war. I'll then go over briefly the historical evidence about
those
effects", putting the current experience into context. The final section
"second-round
covers the potential response to the recent fiscal announcements. I'll also
touch briefly on
the very marked rise in the expected path of interest rates, beyond the MPC's next
meeting, priced into financial markets.
Monetary neutrality: why we can't escape the hit to real
incomes
first things you'll see is something
If you open an A-level economics textbook one of the
The "AS" (aggregate supply) lines trace out the response of output and prices
like Chart 4.
"AD"
to a change in aggregate demand (represented by a shift in the line), for example
from a change in the stance of monetary policy.
Chart 4: Monetary policy only affects real variables for a while
In the short run the supply curve is upward sloping ("SRAS"), so stronger demand can
raise output as well as prices. This is more or less the relationship that A.W. Phillips had
uncovered, using pre-WWI British data, in his 1958 paper2. But students are also taught
that, over time, once prices adjust in full, there is no effect of monetary expansions on real
- here labelled an aggregate supply ("LRAS")
output. The long-run Phillips curve
-
relationship is vertical.
The idea that money is "neutral" -
that it has no enduring impact on real output or incomes
-
goes all the way back to David Hume, in the mid-18th century. It also makes intuitive
sense, I think. Most people would instinctively understand that one cannot permanently
enrich a country simply by dolling out more banknotes. In the end, all that would do is to
raise all prices and wages equiproportionately and nothing real would be affected. As far
as the theory is concerned, this is pretty much guaranteed in any formal description of the
-
economy as long as (i) people are assumed to care about real not nominal things what
their wages can actually buy, not just what they're worth in pounds or dollars -
and (ii)
prices are ultimately flexible.
But for a while, in the immediate aftermath of Phillips's paper, the point was temporarily
forgotten. His eponymous curve was commonly interpreted as some unchanging,
structural relationship, one that seemed to offer a long-run choice between controlling
inflation and boosting real activity and incomes. If a country was prepared to tolerate a
slightly higher rate of inflation it could (on this view) generate a permanent rise in its real
income.
It was Milton Friedman, in his famous 1968 presidential address to the American
Economic Association3, who brought people back to earth. It was true, he said, that
monetary expansions could boost activity and employment for a while. But this effect relied
on people mistaking nominal for real wage increases and therefore couldn't last. "There is
a temporary trade-off between unemployment and inflation; there is no permanent
tradeoff".
Friedman's main concern was to point out the fruitlessness (not to say danger) of asking
the monetary authority to target or "peg" some arbitrary rate of economic growth or
the
level of unemployment. These are real things that cannot ultimately be affected by
monetary policy: "The monetary authority controls nominal quantities...and can use this
-
control to peg [another] nominal quantity the exchange rate, the rate of inflation, the rate
of growth of nominal national income. It cannot use [monetary policy] to peg a real quantity
- the real rate of interest, the rate of unemployment, the level...or growth rate of real
national income".
For our purposes, the important implication of this conclusion is that if something else
shifts those "real quantities"
monetary policy cannot offset it. The picture in Chart 5 is one
way of representing this "dichotomy" between real and nominal things.
(very high-level)
The left-hand column divides the original, underlying drivers of the economy in two, the
right-hand side does the same for economic outcomes. Solid lines represent long-run,
permanent effects, dotted lines temporary ones. The key point is that the long-run
channels run purely horizontally: over time, monetary shocks (including from monetary
-
policy) can only affect nominal outcomes; enduring changes in real things productivity,
-
real incomes, any relative price can only have been caused by real disturbances4.
Chart 5: In the long run, real things are unaffected by nominal shocks
The fact that the relative price of energy has gone up so steeply in Europe has a real
cause: Russia's curtailment of the supply of gas. The same goes for the steep rises in
prices of non-energy goods that came before, during the course of 2021. Because it
prompted a shift in consumer spending towards goods, while at the same time impairing
their supply, the pandemic pushed up the relative prices of things like computers and cars.
As we saw in the introduction the result of these shocks has been a steep rise in the price
of what the UK consumes relative to what it produces. That inevitably depresses real
incomes, regardless of the path of monetary policy and overall inflation.
This is why I think it's misleading to say that real incomes have fallen "because of
inflation". The phrase "cost of living crisis" is closer to the truth.
Closer still is this: the war
and pandemic have directly and inescapably depressed real incomes; they have also, for a
time, raised domestic inflation; the MPC will ensure the phenomenon is temporary; but the
way (unless and until they're
real-income consequences of these shocks exist either
reversed).
Second-round effects: how hits to real income can result in
domestic inflation and how monetary policy responds
Having discussed the real consequences of these big shocks I'll now say a word about
their nominal effects (the higher of the two dotted lines in Chart 5). How is it that a rise in
import prices can create upward pressure on domestic inflation and what do we know
about the scale of these effects"?
"second-round
This has been a critical judgement for monetary policy. Prices of tradable goods are
-
volatile and their direct contribution to overall inflation tends not to last that long a shorter
time, in particular, than it takes for monetary policy to have a significant effect of its own on
inflation.
The classic example is a change in oil prices. The direct effects on the CPI, most directly
on petrol prices, come through quite quickly. Equally (and unless the price of oil keeps
rising) that also means they drop out of the annual rate of inflation after a year or so.
That's too short a time for monetary policy to have much effect.
traded goods aren't quite as volatile, their direct effects take
Prices of other, non-energy
longer to feed through and therefore affect the overall rate of inflation for longer. But
they're still unlikely to have that much of an impact a couple of years ahead, the sort of
timescales it takes monetary policy to have its peak effects. So although the pandemic
was clearly much less disinflationary than central banks and other forecasters had
-
predicted the demand-shifting and supply-impairing effects on goods prices were very
-
significant it nonetheless seemed likely at the time that these effects would dissipate,
along with the virus itself, within that medium-term horizon.
I think there are some signs this has begun to happen. One of the higher-profile effects of
the pandemic was a dramatic rise in the cost of shipping. Also well reported were the
steep rises in prices and delivery times for computer chips and the cars on which they rely.
In all three cases rates of inflation have fallen back markedly over the past few months
(Charts 6a and 6b).
Chart 6a: Shipping costs have fallen steeply in recent months
May 2020 = 100
Freightos Baltic Container Index
1000 1000
Harpex Charter Rates Index
800 800
Baltic Exchange Dry Index
600 600
400 400
200 200
0 0
May 20 Sep 20 Jan 21 May 21 Sep 21 Jan 22 May 22 Sep 22
Chart 6b: Inflation in prices of cars and computers has also turned out to be
transitory
Annual inflation; per cent
35 35
30 30
25 25
Second-hand cars
20 20
15 15
10 10
5
0
-5 50-5
Computers
-10 -10
-15 -15
2017 2018 2019 2020 2021 2022
code for
'Computers' refers to ONS 'data processing equipment'. Source: ONS and Bank calculations.
However, there was always the risk that big rises in traded goods prices might prompt
faster inflation in its more persistent, domestic components, including nominal wages. This
would have a bigger impact on forecasts of inflation at policy-relevant horizons and clearly
merit a response.
gauging the potential strength of these effects", how much did we have
In "second-round
to go on? Not much, is the answer. As we saw earlier, import (and therefore consumer)
It's this
prices have risen much faster than those of output. widening dislocation that has
One way to measure the strength of effects" is to
depressed real incomes. "second-round
"wedge" between output and consumer prices affect
ask how changes in the near-term
nominal wage growth. Are external hits to real income absorbed relatively quiescently,
without much of an effect on domestic inflation? Or is there sufficient resistance that
what they've lost from
people want to claw back in higher nominal pay higher import
prices?
This was something that received quite a bit of attention from labour market economists
-
during the 1980s and 1990s. It was clear then that external influences on real incomes
-
from changes in import prices or taxes could have significant second-round effects.
Using data from 1956-85, the economists Layard, Nickell and Jackman estimated that a
1% hit to real incomes pushed up near-term nominal wage growth by somewhere between
0.5 and 0.6 percentage points5. The rapid response of pay growth to the big hike in VAT in
1979 was one example.
- -
Over time, however and above all during the inflation targeting period this sensitivity
seemed to decline. Chart 7 plots rolling estimates of this coefficient over the past thirty
years. According to these, nominal pay growth during the inflation targeting era has
become increasingly desensitised to shifts in the wedge between consumer and output
prices. There were periods when it might have responded. After the financial crisis, sterling
fell, pushing up the cost of imports, and productivity growth declined. Yet there was almost
no perceptible response of nominal pay and domestic prices. Economists attributed this
- -
decline either to the change in monetary regime itself, or more often to greater
flexibility in the labour market.
Chart 7: Lower sensitivity of wages to real income shocks during inflation
targeting period
Rolling coefficient on wedge between consumer and output prices using 18-year regressions. Dotted line
shows coefficient estimated by Layard, Nickell and Jackman (LNJ) on 1956-85 sample. Source: Layard,
Nickell and Jackman (1991), ONS and Bank calculations.
But it was hard to be confident about these estimates.
flexibility isn't
Labour-market set in stone. In a speech in 20066, Charlie Bean suggested
that increased ease of migration, in both directions, might have reduced the sensitivity of
real wages to shifts in labour demand. It's possible that, by adding a degree of friction to
the inflow and outflow of migrant workers, the combination of Brexit and the pandemic
have made the labour market less adaptable than it was a few years ago.
There may be other reasons why susceptibility to second-round effects can vary. During
the one period in which higher import prices seriously impinged on real incomes, following
the financial crisis, unemployment was also much higher than it is today. Perhaps this
deterred employees from seeking compensating rises in nominal pay (perhaps, in other
words, the response to a given hit to real incomes depends on the degree of slack in the
labour market and the wider economy).
aside, there simply wasn't much evidence on which to draw from
Those post-crisis years
That's why the estimates in
the inflation-targeting era. Chart 7 are relatively unstable. The
fact is that we've never really seen anything like the hits to real income the economy has
of evidence isn't evidence of
had to endure over the past couple of years. And absence
absence.
This uncertainty about the potential scale of second-round effects has some bearing on
how monetary authorities, including the MPC, have responded to this surge in inflation.
There's long been a debate about how quickly policy should
react to news about the
be adjusted immediately to a level that's likely to be
economy. Should interest rates
appropriate for some time? If so, one wouldn't expect to have to make any further changes
at the following few meetings (in the absence of any incoming news that alters the
outlook). Or should they respond to inflationary news only by degrees, in which case
there's a natural upward slope to the
near-term path of interest rates? Even having
tightened policy at one meeting, there would need to be negative news about the outlook
not to do so again at the following one.
In the data, there does appear to be a degree of "smoothness" in the way official interest
rates behave. Rather than jumping from one level to another, factoring in all the news at
once, the policy rate usually seems to respond to it over time. Two explanations have often
been suggested. One is uncertainty about the impact of changes in official interest rates. If
there's a degree of imprecision in estimates of policy multipliers there's a case for moving
a little more gingerly than otherwise. Another, offered by the economist Michael Woodford,
is that smoothing the spot interest rate gives the central bank better control of
medium-term interest rates, which may matter more in the transmission of policy.
In this case I think a third factor may be at play, namely the need to learn about the extent
of these effects".
"second-round We have inevitably had to learn about them and,
therefore, to respond to signs of more persistent domestic inflation as and when they
emerge.
The response to demand shocks
This is less the case when it comes to plain-vanilla shifts in aggregate demand. These are
more common and the appropriate response is well understood: an inflation-targeting
monetary authority has to lean against them. Indeed, one additional reason for caution, in
the face of these big rises in import prices and their impact on domestic inflation, has been
the likelihood that they will also weigh significantly on domestic demand. Employing again
the simple AD/AS framework, their initial impact may have resembled a leftward shift in
-
supply (Chart 8a) but in time these hits to real income also take their toll on demand,
shifting the AD line to the left as well (Chart 8b).
Charts 8a and 8b: The shocks hitting the UK have pushed up inflation and
started to weigh on demand
That hasn't happened to any appreciable extent so
far. Households emerged from the
pandemic with extremely high rates of saving: having been so suppressed during the
lockdowns, consumer spending had ample room to bounce back when they were lifted
(even without any subsequent growth in income). Those high saving rates had resulted in
"excess deposits": measured relative
the accumulation of significant to household
incomes, they were around 15% higher than before the pandemic (Chart 9). Wider
measures of households' financial wealth had also recovered strongly, along with global
equity markets, and those too were comfortably above average. All this provided the
support for a very steep decline in the rate of saving (i.e. for consumption to grow much
faster than income) once the economy came out of the lockdowns.
but households' overall
Chart 9: "Excess deposits" have fallen only slightly
financial wealth is down sharply
Household financial wealth relative to disposable income
125 410
Household M4 (LHS)
120
390
115
370
110
350
105
330
100
Net financial wealth (RHS)
310
95
90 290
2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022
2022 Q3 data points are estimated. Sources: Bank of England, ONS and Bank calculations.
But to varying degrees these cushions have since been eroded. The saving rate has fallen
sharply and is now around a percentage point below its long-term, pre-Covid average.
why -
Most of the excess deposits remain, it seems. But one might ask they do why, at a
time of significant reported pressure on household finances (when consumer confidence
more of them haven't been spent -
has been setting new record lows), and therefore
it's realistic to think that they will be
whether in the near future. As many have pointed out,
these deposits are probably skewed towards the upper end of the income distribution (and
It's
therefore away from those for whom rises in energy prices are the most burdensome).
also worth recognising that other household assets have been weakening sharply this
Despite higher deposits, households' overall
year. net financial wealth is quite a bit lower
than before the pandemic. It fell sharply during the first half of this year (relative to income)
and is likely to have fallen further since then (the dot at the end of Chart 9 is an estimate of
the position at the end of Q3, based on recent moves in asset prices).
All this suggests that, if household spending has been unusually independent of income
since the pandemic, that is less likely to be the case from now on. The correlation with
MPC's
income is likely to be re-established. And it therefore mattered quite a lot, for the
projections in August, that households were set to experience further steep rises in their
energy bills. Given the path of wholesale gas prices implied by financial markets at the
OFGEM's price cap was set to rise
time, (in the central forecast) by over 3% of household
real disposable income was projected to decline by
income by next spring. Households'
21⁄2%, with consumer spending down by over 1%. This reduced inflationary pressure in the
medium term, helping to pull inflation below target towards the end of the three-year
"helping" because other things mattered too, not least the
forecast period. (I say further
rise in Bank Rate, to a peak of around 3%, then priced into financial markets.)
It therefore mattered too that the new government then launched its Energy Price
For as long as the scheme's in place
Guarantee, forestalling the rise in energy bills. this
will temper any further rise in headline inflation, and with it any related increase in
effects over the medium term. However, by relieving
"second-round" some of the
immediate pressure on household finances, the policy would also add significantly to
domestic spending over the next year (relative to our last forecast). At the margin, the task
of reducing overall demand growth, in order to bring inflation back to target, would
monetary policy. And as I argued earlier, there's less reason
therefore tilt more towards to
a "gradual" or "smoothed"
respond to this news in manner.
Whether or not that response needs to be as large as the shift in market interest rates,
since our last set of forecasts, remains to be seen.
For one thing, there is now some uncertainty about the prospective scale and nature of the
government's energy subsidies. On Monday the Chancellor said the Energy Price
Guarantee would be maintained only for six months, rather than the two-year period
originally planned. He suggested support was likely to continue, beyond six months, albeit
in a more targeted fashion. But we are unlikely to know for a while precisely the form that
will take.
Second, the rise in market interest rates has been very dramatic. At the time of the
Monetary Policy Report in August, prices in financial markets were consistent with Bank
Rate rising to a peak of 3% next spring and then falling back a little over the following year.
Despite a decline in recent days, that expected peak is now around 51⁄4%. This is by some
distance the largest rise in market interest rates between MPC forecasts since the
Committee was founded.
By way of comparison, Chart 10 plots this increase in market interest rates against one
particular, simple representation of how interest rates might have had to respond to a
couple of key developments since August: the decline in sterling's exchange rate and
the
original, two-year version of the Energy Price Cap. Both would tend to raise medium-term
inflation, for any given level of interest rates, and would therefore tend to merit an
additional response from policy (all else equal). This is expressed in Chart 10 as the
called an