Reflecting on recent times -
speech by Andrew Bailey
Given at The Federal Reserve Bank of Kansas 2024 Economic
Symposium, Jackson Hole, Wyoming
Published on 23 August 2024
From early 2020, the Covid pandemic and then the war in Ukraine caused a surge
in inflation around the globe. These events, and the nature of policymakers'
responses to each, have laid bare the challenges and trade-offs inherent in
addressing both monetary policy and financial stability shocks. In this speech
Andrew Bailey reflects on recent times and discusses what we can learn in terms of
our framework for assessing the extent to which inflation may be persistent, and
how various types of shock might be dealt with in the future.
Speech
I want to use my time to look behind the latest state of monetary policy, at issues that have arisen
from the experience of recent years, but with some reflections on where we are now.
The pandemic caused a sudden, coincident and precipitous fall in global demand and supply -
one of these did not obviously lead the other. Moreover, in March 2020 we faced monetary policy
and financial stability issues arising from the same source, namely the pandemic. Taken
separately, the responses should be different, with a more exceptional temporary, targeted and
typically maximum force intervention better suited to dealing with a financial stability problem. In
contrast, a monetary policy response of the sort used in 2020 is typically undertaken over time.
But when monetary policy and financial stability issues coincide, the judgement becomes more
complicated. By engaging both of the core central bank objectives, the pandemic posed an
unusual but not unprecedented challenge.
As economies started to adjust to the consequences of the pandemic there was a substantial
increase in global demand for goods rather than services, at a time when the supply of goods
remained disrupted and restricted. This was an asymmetric demand shock. Global goods prices
rose as a result, akin to a cost-push shock for open economies like the UK. This was the context
of the so-called transitory assessment of monetary policy, namely that such shocks should be
short-lived in impact because supply chains should recover and inflation expectations should
remain anchored in anticipation of that recovery. That's the theory. The evidence suggests that,
taken on its own, the global supply chain shock had run its course by the end of 2022. But a key
question at that time was whether and to what extent there would also be catch-up effects in
wages and services prices, and over what time period?
In the UK, the labour market did begin to tighten but it was hard to discern at the time by how
much. In mid- to late-2021 the UK Government's furlough scheme - a sensible policy in its own
right - was creating uncertainty around the state of the labour market. We can now use tools such
as the Bernanke-Blanchard approach to assess the timing and scale of this labour market effect.
Using this approach, and based on work done on the UK case by my colleague Jonathan Haskel,
it became evident economy-wide in late 2021 and early 2022, putting further upward pressure on
inflation. We started to tighten monetary policy from late 2021.[1]
Then, starting in February 2022, came the impact of the Ukraine War and Russia's illegal actions.
This created large supply shocks, in particular to energy and food prices. It substantially increased
the risk of de-anchoring of inflation expectations and created the potential for larger second round
effects in the form of more persistent higher inflation. As shock came upon shock, so to speak, the
transitory judgement looked less appropriate.
Our response in terms of both the pace and scale of tightening was progressive but measured.
Why? Four reasons stand out for me.
First, unlike in March 2020, in 2022 there was not a coincident financial stability shock. It could
have happened, for instance in commodity finance markets, but in the event such a shock did not
occur.
Second, the scale of the indirect or second round monetary policy effects was unclear at the time.
There were several sources of such uncertainty. One was the transmission mechanism of
monetary policy. Looking again at the UK case, in terms of the impact of a tightening phase on
economic activity and inflation, the channels of transmission have changed over time. This no
doubt reflects underlying changes in the economy since the previous tightening phase which was
prior to the Global Financial Crisis, most obviously the shift from variable- to fixed-rate mortgages.
But it most likely also reflects specific features of the latest tightening phase. One such feature is
that it followed an extended period when interest rates were near the lower bound, along with the
use of unconventional policy measures, both of which contributed to a relatively fast increase in
longer-term market rates when the tightening came. A second feature of this tightening phase has
been the size of the shocks we have witnessed and the potential non-linearities and asymmetries
that have arisen in the monetary transmission mechanism. When we are dealing with relatively
small shocks which stay within the locality around the inflation target where the linear
approximations we normally make in our models hold, then these issues do not arise. That was
the experience during much of the inflation targeting era.
But when there are big shocks that move outside this locality, such as those of recent years, then
non-linearities and asymmetries can emerge. But, at the time, the impact of this was more
uncertain.
The third reason for a measured response was that a very fast and large response of interest
rates would have risked creating a severe economic shock of its own (a trade-off). I will come
back to this point.
Fourth, while in Europe - and here I refer to Europe in a geographical sense - demand was
recovering faster than supply, levels of activity were well below actual and potential levels pre-
Covid, leaving substantial questions around how much slack there was.
To bring the story up to date. Headline inflation has since fallen sharply as energy and food price
shocks in particular have fallen away. Global goods price inflation has also fallen back sharply,
with supply chains restoring themselves and with signs of strong disinflation emerging in some key
supplier countries most obviously China.
Meanwhile, monetary policy has been leaning heavily against the indirect and second round
inflation effects and the persistence thereof. The job of monetary policy - which it has been doing
- is to squeeze the persistent element of inflation out of the system in a way that is consistent with
returning inflation to its target on a timely and sustained basis.[2] When we think about inflation
persistence, I would distinguish between extrinsic persistence (the duration of external shocks)
and intrinsic persistence in the sense of capturing the impact of the echo effects of those external
shocks owing to domestic responses (second round effects). Extrinsic inflation persistence is a
setting where price and wage setting behaviour remains unchanged, but a succession of external
inflationary shocks cause inflation to be above targe for a sustained period. Since the lags in the
transmission of monetary policy are typically longer than the lags in the transmission of these
shocks to inflation, some volatility of inflation is inevitable, and with the type of big shocks we saw,
all going in the same direction, the impact will be large. Contrast this with intrinsic inflation
persistence where price and wage setting behaviour does change, including in response to the
unusual character of the external shocks. Here, the nature of the response of monetary policy
needs to be different. The reality is that we experienced both types of persistence, though the
scale of the intrinsic persistence has - almost of necessity - been harder to judge and therefore
more subject to revision.
I think we are now seeing a revision down in our assessment of that intrinsic persistence, but this
is not something we can take for granted. Important questions remain which in many ways set the
framework through which we now view monetary policy.
On current evidence, and speaking of the UK, I would say that the persistent element is still with us
but it is smaller in magnitude now than we expected a year ago, and considerably smaller than the
type of persistence that was seen in the 1970s. However, that is not the end of the story. We still
face the question of whether this persistent element is on course to decline to a level consistent
with inflation being at target on a sustained basis and what it will take to make that happen. Is the
decline of persistence now almost baked in as the shocks to headline inflation unwind, or will it
also require a negative output gap to open up, or are we experiencing a more permanent change
to price, wage and margin setting which would require monetary policy to remain tighter for
longer? This framework is now prominent in our thinking on the MPC.
The first of these cases is the more benign - the persistence is essentially self-correcting with the
degree of restriction we have in place today easing off over time. "Self-correcting" is the key
phrase here: it depends on the credibility of monetary policy, which depends on the willingness of
policymakers to act, and the best evidence to support this mechanism is well-anchored longer-
term inflation expectations.
The second case is the intermediate one. Here we would need to maintain restriction for longer
and thus open up more of an output gap.
The last case is least benign and would require more restrictive policy than the first two cases. It
would suggest that there are structural changes in product and labour markets going on which are
causing the supply side of the economy to change as a lasting legacy of the major shocks we
have experienced. To be clear, as policymakers we can have all three of these cases in our
expectations, with different weights attached.
Tentatively, it appears to me that the economic costs of bringing down persistent inflation - costs
in terms of lower output and higher unemployment - could be less than in the past. This is
consistent with a process of disinflation which is steady and more in keeping with a soft landing
than a recession induced process. For the UK, this is consistent with how we have revised our
outlook for growth, and the numbers themselves so far this year.
Inflation expectations appear to be better anchored, which I put down in good part to the presence
of independent central banks with clear mandates and nominal anchors, usually in the form of
inflation targets. But, crucially, policy does have to respond to ensure credibility is maintained.
Moreover, while second round effects may be smaller that does not tell us how much smaller and
less persistent they will eventually end up being than in the past. On this basis, at the moment I put
more weight on the first case - self-correction - but some smaller weight on each of the other two.
These weights can of course change over time.[3]
This is an important issue of the moment for monetary policy. It is directly relevant to the question
of how challenging the last mile of returning to our inflation target level on a sustained basis
actually will be. The well-known argument goes that an independent central bank operating a
transparent low inflation target successfully over time will anchor inflation expectations more
consistently. In this world, in the short-run monetary policy can respond to shocks with suitable
flexibility, acting consistently but not always identically, to return inflation to target. In the UK case,
the evidence suggests this may have worked insofar as we are seeing a lower level of inflation
persistence than we expected a year ago. But, we need to be cautious because the job is not
completed - we are not yet back to target on a sustained basis. Policy setting will need to remain
restrictive for sufficiently long until the risks to inflation remaining sustainably around the 2% target
in the medium term have dissipated further. The course will therefore be a steady one.
Before considering challenges going forward, I want to pull out one further point from recent
experience. In an effective monetary policy regime we should have flexibility in the short term on
how quickly we return inflation to target. Looking back over recent years, I think it is common
ground that the Covid and Ukraine shocks could not have been anticipated, and certainly not in
sufficient time for any consequent monetary policy actions to have had an effect on monetary
conditions. But there are two follow-up questions that I get asked. One starts with the words "with
the benefit of hindsight" what would you have done. The second, asks about actual policy choices
once the shocks took effect.
This is where so-called trade-offs come into the picture. The language of the Bank of England
remit states that "the inflation target holds at all times", which is essential. But it also states that
"the actual inflation rate will on occasion depart from its target as a result of shocks and
disturbances".
It further adds that "attempts to keep inflation at the inflation target in these circumstances may
cause undesirable volatility in output". In 2013 the remit was amended by adding that where
shocks are particularly large or the effects of shocks may persist over an extended period (or
both) then"the Committee is likely to be faced with more significant trade-offs between the speed
with which it aims to bring inflation back to target and the consideration that should be placed on
the variability of output".
This is what we call the trade-off language. We are not alone in having this type of language in our
remit. The language applies when the economy is hit by temporary cost or supply shocks. In these
circumstances we have to judge the appropriate balance of inflation and output volatility, when
judging how quickly to bring inflation back to target. Moreover, such judgement must ensure that,
again using the language of our remit, "inflation expectations are firmly anchored in the medium
term".
Applying this framework over the Covid and Ukraine period has not been easy. As policymakers
dealing with the here and now, balancing the objectives of applying the inflation target at all times
and dealing with trade-off situations requires us to decide whether to look through a transitory
shock or respond because it could have
quasi-permanent features. In doing so of course we must distinguish between these two shocks in
real time. Good luck with that as they say. It has required judgement on whether the shocks were
temporary or not, and whether they were expected to be so or not by participants in the economy.
The further complication is that the configuration of shocks - with no gaps between them -
effectively meant that the judgements had to be reached on the shocks as a collective more than
individually.
The UK was hit by a severe terms of trade shock, raising the rate of inflation in imported goods
and services relative to domestic prices, leading to a sharp fall in household real incomes,
something that could not be offset by monetary policy. But let us say we had seen all of this coming
in sufficient time to act given the lags in the transmission of monetary policy. In that case, the remit
trade-off language would have to be taken into consideration. A negative terms of trade shock
involved a sharp fall in real incomes and wages.
If monetary policy had acted to offset this shock, it would have required a much larger fall in
domestic prices and wages in order to counteract inflation in import prices. It would have required
domestic prices and wages to fall in nominal terms. Achieving this effect would have called for a
substantial rise in interest rates creating a strong probability of a deep recession and a steep rise
in unemployment. Moreover, it would not have led to inflation being at target on a sustained basis
- which is our objective. Rather, as energy and food prices fell back, inflation would fall below
target.
Put simply, responding in this way to short-lived shocks is not consistent with our remit nor is it the
way to ensure the policy framework remains robust. That said, the trade-off element of our remit
leaves us with the judgemental challenge of how to assess and respond to the impact of supply
shocks on inflation, particularly when they are accompanied by demand pressure.[4] What is the
best way to make sure inflation expectations are anchored, and how do we judge in real time
whether they are anchored, accepting that short-run expectations will move with headline inflation
measures? The judgement therefore remains one of to what extent central banks can look through
such shocks, or not, all of which will be state contingent.
So, let me draw out what I see as key challenges for central banks arising from these experiences.
Modern monetary policy with its emphasis on independent responsibilities, clear policy objectives
and nominal anchors typically in the form of an inflation target is the product of tackling the great
inflation of the 1970s. More recent experience defines at least three challenges to that orthodoxy.
First, how to operate monetary policy near to the lower bound of interest rates when the challenge
is to raise not lower inflation. Moreover, if the response has to go beyond moving the official
shortterm interest rate, the policies adopted to counter disinflation will take longer to wind down and
have implications that are more spread out and open to contestation.
Second, in a more uncertain and volatile world, how to set policy in an environment where shocks
may or may not be short-lived - either individually or collectively - and where they may create
conditions where judging trade-offs between inflation and activity play a large part.
Third, how to ensure that we can at all times meet both our monetary policy and financial stability
objectives, including when they may be pointing in opposite directions, and in particular that
central banks have the necessary operational tools and can use them at all times if required.
Recent experiences indicate the larger role of the financial stability objective in modern central
banking in contrast to the orthodoxy of the post-1970s era when monetary policy alone came to
the fore. This rebalancing in some ways takes us back to the earlier classical gold standard era of
central banking. But in modern central banking, the separation principle is much more important
than it was in the classical era. By this I mean distinguishing between, and communicating the
distinction between, monetary policy and financial stability actions.
Looking at recent experience in the UK, the so-called LDI event was clearly a financial stability not
monetary policy one, and the challenge was to structure the intervention and communicate it in a
way that reinforced this point. The March 2020 "dash for cash" was more complicated because it
arose in the context of both financial stability and monetary policy events (the latter in the sense of
the severe and unexpected recession). How to structure and communicate the policy response by
central banks in this - hopefully highly unusual - situation deserves more attention. That said, in the
normal state of affairs we are moving to a world where our standard operations meet the system's
demand for liquidity in normal times, and not more than that. Against this backdrop, monetary
policy can most effectively set the official interest rate. In normal conditions, meeting the demand
for liquidity - most obviously through the level of reserves banks choose to hold - should also
support financial stability. Beyond that, we must then have a set of effective and usable
exceptional tools for financial stability stresses including when they arise in the non-bank part of
the financial sector.
The classical gold standard was an era of prolonged monetary stability punctuated by the need to
respond rapidly and forcefully to financial stability shocks, and in doing so preserve monetary
stability. Walter Bagehot's critique of the Bank of England in the classical gold standard era was
for not responding in a timely and forceful way to financial stability shocks. In the Covid-Ukraine
era central banks did respond rapidly and forcefully. Some would still say we did too much. I
disagree with that assessment. But I do think that going forwards - and as we experienced
positively with the LDI crisis - rediscovering the distinctive roles of monetary and financial stability
actions will help us. Financial stability issues themselves create macroeconomic trade-offs which
can affect monetary policy.
But these will naturally fit within the framework of monetary policy. This is what we did in March
2020. That said, distinguishing the handling of primary monetary policy and financial stability
shocks, and having more targeted tools in our boxes, will I am sure assist with the inevitably hard
job of policy making.
To conclude, the challenge for monetary policy of the Covid-Ukraine era could not have been to
prevent the inflation happening. To attempt to do that would have been to ignore the trade-off
element of our remit. Put more directly, as Ben Bernanke did in his report, it would have led to a
depression and thus a repeat of the errors of the 1920s.[5] Rather, the task for central banks was
to produce an orderly return of inflation to target, with expectations anchored.
Recent experience leads me to be cautiously optimistic that inflation expectations are better
anchored as a result of the regimes we have in place. The second round inflation effects appear to
be smaller than we expected. But it is too early to declare victory. Policy does have to react - the
regime works because we use it.
Economies - and the UK is a good example here - are in a stronger and more resilient position as
a result of the actions taken over recent years. A key point here is not to do with the immediate
situation and prospects. It is that the underlying resilience of economies and financial systems
should be sufficient to enable sizeable market movements and risk asset price corrections to
occur without threatening stability. This is the lesson from Bagehot in the nineteenth century. His
diagnosis was that flaws in the response to financial stability events undermined monetary
stability, at that time in the form of the classical Gold Standard. Similar diagnoses have been
made around the Great Depression and the Global Financial Crisis. This explains why we have
done so much to build stronger financial stability buffers over the last fifteen years since the GFC.
This is the best way to support resilient and competitive financial systems and strong economies.
Market events like those of two weeks ago or so will happen; the test is not whether they happen
but whether they trigger wider instability. As central banks we operate within systems that are
framed by law and institutions to create and preserve stability and prosperity in the public interest.
All that said, communicating policy is harder in uncertain conditions with large shocks.
Communication is complicated where we have to operate to achieve both our monetary policy
and financial stability objectives, with the latter typically being a matter of operating in an
emergency in such conditions. Likewise, communicating when we decide to accommodate
shortrun shocks and/or there is a trade-off between inflation and activity involved is essential but
difficult. These are all areas that will benefit from further assessment.
Thank you.
I am grateful to Nat Benjamin, Fabrizio Cadamagnani, Jonathan Haskel, Karen Jude, Clare
Lombardelli, Katie Martin, Rhys Phillips, Huw Pill, Vicky Saporta, Martin Seneca, Fergal Shortall
and Paolo Valenziano for their assistance in preparing this speech.
1. UK inflation: What's done and what's to come - speech by Jonathan Haskel
2. Transformation and conjuncture - remarks by Huw Pill
3. I am very grateful to my colleague Huw Pill for the insights on this framework.
4. See speeches by my former colleagues Ben Broadbent and Silvana Tenreyro: Lags, trade-offs and the challenges
facing monetary policy - speech by Ben Broadbent | Bank of England and The economy and policy trade-offs -
speech by Silvana Tenreyro.
5. Forecasting for monetary policy making and communication at the Bank of England: a review
Andrew Bailey
Governor, Bank of England
©2024 Bank of England