Guidance, Contingencies and Brexit
Speech given by
Mark Carney, Governor of the Bank of England
Society of Professional Economists
24 May 2018
I am grateful to James Benford and Clare Macallan for their assistance in preparing these remarks.
Introduction
This evening I would like to discuss potential paths for monetary policy during the next, critical phase of the
Brexit process. Note the conditionality of the phrase "potential paths." The actual path for policy will depend
on the outlook for the economy which in turn will depend very much on how the Brexit negotiations evolve.
Monetary policy is always contingent on the economic outlook. This is broader than it being data dependent.
In order to achieve the inflation target, monetary policy needs to adjust not only to news about current
conditions but also to any changes in likely future circumstances.1 While it may be the MPC that sets
interest rates, it is ultimately the economy that determines them.
Monetary policy will be most effective if agents can anticipate how policymakers will react to changing
conditions. But the predictability of monetary policy can break down when there are large structural changes
in:
- Supply capacity;
- Equilibrium interest rates; or
- Trading relationships.
In such circumstances, forward guidance can help anchor expectations and improve the effectiveness of
monetary policy.
This generally wasn't necessary during the Great Moderation, when the economy was largely subject to a
series of demand shocks. The inflation target could be achieved without causing undesirable volatility in
"divine
output and employment (so-called coincidence"2).
Despite the crisis, divine coincidence has continued to reign in the euro area and the US (see charts in the
Appendix). Large output gaps and below-target inflation have pointed monetary policy in the same direction.
That, unfortunately, has not been the case in the UK economy, which has been subject to a series of major
supply shocks over the past five years, creating tensions between short-term output and inflation
stabilisation. Brexit is the latest and potentially largest example.
Brexit is a regime shift that has markedly increased the range of possible outcomes for the UK economy and
therefore the potential paths of monetary policy.
1
Another dimension to uncertainty is 'model' uncertainty around the structure of the economy. That is distinct from uncertainty about
possible future events, or 'shocks', affecting economy. Model uncertainty captures uncertainty around how the economy
responds to
those events, including to changes in monetary policy itself.
2
See Blanchard, O., and J. Galí (2007). "Real Wage Rigidities and the New Keynesian Model". Journal of Money, Credit, and Banking,
39(1), pp. 35-65.
The major Brexit contingencies include:
- The form of the new economic partnership between the EU and UK;
- Whether the transition to that end state will be smooth or cliff-edged; and
- How agents in the economy (households, businesses and financial markets) react to these
prospects, particularly the extent to which they are affected by the uncertainty during the
negotiations and the degree to which they anticipate the outcome and pull forward adjustment.
As the Brexit process continues and the answers to these questions become clearer, the MPC will adapt its
specific guidance and monetary policy more broadly in order to meet the inflation target.
My message this evening is straightforward. From a monetary policy perspective, the Bank of England is
ready for Brexit whatever form it takes.
The role of guidance and the UK experience
the MPC's experience with forward guidance.
Before turning to Brexit, I would like to review briefly
The objective of forward guidance is to give insights into the MPC's -
reaction function in other words, how
the Committee will adjust policy when the outlook for growth and inflation changes.
In a perfect world, guidance would be redundant. People would know how the MPC intends to set rates over
-
the future and how those intentions would adjust to economic developments in all eventualities the
and people don't have endless time to devote to
so-called reaction function. But the world is complex
understanding monetary policy. In practice, therefore, guidance can be useful in providing people with
information about how the MPC sets policy and, over time, in improving understanding of how monetary
policy will adjust to news.
Guidance thus helps people to think along with the Committee so that their expectations about the path of
policy adapt with ours as economic circumstances change. This can make monetary policy more effective
by reducing unwarranted volatility in interest rate expectations and the extent to which the MPC has to move
Bank Rate to meet the inflation target. The more those expectations are aligned with the policy path
necessary to achieve the inflation target, the higher the probability that policy objective will be achieved.
Guidance is not a promise of the future path of policy. And its use will not mean that all observers will agree
on the likely path of policy for the simple reason that not everyone will agree on the likely path for the
economy. However, with guidance, someone who has a different outlook can better anticipate how the MPC
will adjust once the scales fall from the Committee's eyes. Again it is the combination of the economy and
the primacy of the inflation target, not the MPC, that ultimately determines that path of policy.
The MPC's guidance speaks first and foremost to UK households and businesses. This is particularly
important during large structural or regime shifts when uncertainty is high. In the wake of financial crises or
advance of wholesale changes to trading relationships, people's expectations for monetary policy can
understandably diverge from its most likely path to the detriment of the economy's performance. Guidance is
most useful at such turning points.
The views of economists and financial market participants are, of course, central to the transmission
mechanism from Bank Rate, set by the MPC, to the various interest rates facing households and businesses
and to asset prices more generally.
-
Guidance can reinforce the transmission mechanism by reducing unnecessary uncertainty not eliminating
all uncertainty.3 It is not the same as guaranteeing the future stance of monetary policy. Indeed, market
participants can be expected to pay the closest attention to any explicit conditionalities around guidance and
should usually be the first to update their expectations of policy as the outlook for the economy changes.
Finally, guidance should be seen in the context of a series of MPC initiatives to increase transparency. In
recent years, the MPC has made major structural changes to our communications ranging from publishing
statements each time we meet to the simultaneous release of Minutes, Inflation Reports and Monetary Policy
Summaries on Super Thursdays to the provision of the detailed assumptions underlying our projections. And
last year, we introduced layered communications, with simpler, more accessible language and graphics to
reach the broadest possible audience.
Crucially, the Committee has also initiated an annual stock take of the supply side of the economy. It now
publishes 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.
To draw out these points consider three examples of forward guidance by the MPC.
The first occurred five years ago when the economy began to recover from the worst downturn since the
Great Depression. During previous periods of accelerating growth and firming business confidence, the
MPC had always tightened policy significantly (as evidenced in the correlation between survey indicators and
MPC votes seen in Chart 1). 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. For anyone who might suggest the
MPC should have followed that reaction function, 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%.
3
In other words, the amount of volatility in interest rates should match the amount of uncertainty surrounding the economy. There
should ideally be no additional volatility, or risk premium, due to uncertainty about how policy would respond.
Chart 1: Close correlation pre-crisis between output growth and policy
3 month moving average,
3 month moving average,
bps
balance
65 50
Combined CIPS output
60 survey (LHS) 25
55 0
50 -25
45 -50
40 -75
Average MPC vote, including QE
35 -100
(RHS)
30 -125
1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
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).
Five years ago, the MPC recognised that past should not be prologue. The MPC was pretty certain there
was a large amount of slack, although it had questions over how much productive capacity had been
destroyed following the crisis; how quickly productivity growth would recover; and whether labour supply
would change in the wake of reforms and a heavy burden of household debt.
Such uncertainties about supply meant that knowing what was happening to demand was no longer
sufficient for gauging the appropriate policy response. The historic reduced-form reaction function of the
Committee, based on demand alone, would have been a poor guide to the expected path of policy.
That is why the Committee provided forward guidance that explicitly linked any potential change in interest
rates to the unemployment rate - a clear and widely understood indicator of the degree of slack.4 The
Committee's
objective was to secure the nascent recovery while learning more about the supply capacity of
the economy.
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
years of decline and stagnation, the recovery would not be choked off prematurely.
That guidance was effective. Surveys conducted in the months that followed indicated high awareness of it
among companies, with almost half reporting that they expected Bank Rate to remain at low levels for longer
And the majority said that the Bank's policy
than they would have done were guidance not in place.
4
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.
guidance had made them more confident about UK economic prospects. Household expectations also
shifted markedly in favour of fewer and later rate increases.5 Household and business confidence continued
to strengthen, reinforcing the economic momentum.
In the event, the unemployment rate fell far faster than we 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 (Chart 1), market expectations about the future path of policy
remained subdued (Chart 2). Participants understood the conditionality of guidance, as they and the MPC
learned that there was still considerable spare capacity in the economy.
Chart 2: 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
1.0
forward OIS rates
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.
The MPC's second use of guidance responded to another structural development: the sharp fall in the
equilibrium real interest rate, or r*.6
In February 2014, the Committee explained why it expected the equilibrium rate of interest to be much lower
than in the past, and then outlined the possible consequences for policy.7
The Committee signalled that the policy path was likely to be different from the past. It observed that the
appropriate path of interest rate increases to eliminate slack and keep inflation close to the target was
5
For more information, see the box on page 12 of the February 2014 Inflation Report.
6
This is the policy rate that, if allowed to prevail for several years, would keep economic activity at potential and inflation at target.
7
-
Secular drivers that had pushed down the equilibrium rate prior to the crisis including slower potential growth, demographic forces,
-
changes in income distribution and excess saving in emerging markets were likely to persist. Colleagues at the Bank of England
estimate that these factors can explain around 400 of the 450 basis points fall in global long-term equilibrium rates since the 1980s (see
Rachel, L and Smith, T (2015), "Secular drivers of the global real interest rate", Bank of England Working Paper No. 571). In addition,
more cyclical factors, such as the protracted process of balance sheet repair in both public and private sectors, had weighed further on
the equilibrium real rate, causing it to turn sharply negative during the downturn. The MPC expected these forces to fade only gradually
as the economy recovered. See Carney, M (2013), "The spirit of the season" at The Economic Club of New York; and the box on page
42 of the August 2014 Inflation Report.
expected to be gradual and, 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%.
Out of that guidance came the phrase 'limited and gradual', so often repeated it has now become
part of the
monetary policy furniture. Importantly, it is widely recognised by UK households and businesses whose
expectations of rate increases have remained well anchored as the recovery has progressed (Charts 3b and
3c) as well as by financial markets (Chart 3a). Similar guidance was subsequently adopted by the FOMC
and ECB.8
Chart 3: Households and businesses have consistently expected increases in interest rates to be
gradual and limited
a) Historic UK Bank Rate tightening cycles
Cumulative change, percentage points
2.0
1.8
1.6
November
October 2006
1.4
2003
September
1.2
1999
September
1.0
1994
August 2006
0.8
0.6
0.4
May 2018 Inflation Report
market interest rate path
0.2
November 2017
0.0
Months since first increase in Bank Rate
Sources: Bank of England, Bloomberg Finance L.P. and Bank calculations.
Notes: Tightening cycles since the start of inflation targeting in 1992. Tightening cycles are shown up to when interest rates reached
their highest level before they were next reduced. The curve is estimated using instantaneous forward overnight index swap rates in the
15 working days to 2 May 2018.
8
the FOMC has repeatedly stated that "a
For example, in the minutes of its policy meetings since mid-2014, gradual approach to raising
for the federal funds rate" was judged to be appropriate, while the minutes of the ECB's policy meetings have noted that
the target range
"prudence, patience and persistence with regard to monetary policy remained warranted".
b) Median household Bank Rate expectations
Per cent
2014 Q1
6
2015 Q1
Pre-crisis average level
5
of Bank Rate (5.2%)
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.
c) Proportion of households and companies expecting an increase in Bank Rate within the next year
Per cent
EU referendum
100
90
80
70
60
50
Households
40
30
20
Companies
10
0
Jan. July Jan. July Jan.
2016 2017 2018
Sources: Deloitte CFO survey and IHS Markit Household Finance Index (HFI).
As intended, "limited and gradual" guidance has dampened interest rate volatility and reduced the
(Chart 4)
correlation between interest rate volatility and economic uncertainty (Chart 5).9 Both developments have
increased the degree of monetary policy stimulus, thereby reinforcing the recovery during turbulent times.
9
Part of the fall in volatility is likely to be due to rates being close to the lower bound, since this cuts off part of the lower tail of the
distribution.
Chart 4: Interest rate volatility has remained low since guidance was provided
Standard deviation of option-implied distributions for 3m LIBOR in 12-months' time, UK and US
Basis points
200
August 2013
180
guidance issued
3m US LIBOR (12m ahead)
160
standard deviation
February 2014
140
guidance issued
120
100
EU referendum
80
60
40
3m UK LIBOR (12m ahead)
standard deviation
20
0
2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
Sources: Bloomberg Finance L.P., Chicago Mercantile Exchange (CME), Intercontinental Exchange (ICE) and Bank calculations.
Chart 5: Guidance has reduced the correlation between economic uncertainty and interest rate
volatility
Economic uncertainty10 and option-implied volatility of 3 month rates 1 year ahead
3m rate standard deviation
180
160
2000-August 2013
140
120
100
80
60
40
August 2013 -
20
EU referendum - latest
EU referendum
0
-2 -1 0 1 2 3 4 5
Economic uncertainty (deviations from average)
Sources: Bloomberg Finance L.P., ICE, Bank calculations and Haddow et al, ibid.
10
The indicator of economic uncertainty is based on the principal component from seven measures of uncertainty: FTSE and sterling
among forecasters' growth projections,
option-implied volatility, dispersion of company earnings forecasts and proportion of companies
households' unemployment expectations, and number of press articles citing 'economic
reporting that uncertainty is limiting investment,
uncertainty'. See Haddow, A, Hare, C, Hooley, J and Shakir, T (2013) "Macroeconomic uncertainty: what is it, how can we
measure it
and why does it matter?", Bank of England Quarterly Bulletin, 2013 Q2.
The MPC is now in the process of reviewing the possible range for the equilibrium real interest rate in the
medium term. This analysis reflects the importance of global equilibrium rates for the UK, and the
possibilities that the global equilibrium real rate may rise as the global recovery proceeds and that domestic
cyclical factors such as the pace of public and private balance sheet repair may shift. The Committee
intends to provide information about its updated view in its August Inflation Report.
Guidance, Contingency and Brexit
My third example of guidance is associated with another major structural change: Brexit.
To put the upcoming regime shift into context, consider what has already transpired merely in anticipation of
possible future changes to flow of goods, service, capital and people.
On the eve of 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.
That is exactly what has happened.
Sterling fell sharply immediately following the result, and remains some 15% below its late-2015 peak before
the referendum was called. Financial markets are valuing today what they expect tomorrow: a relative fall in
real incomes as the UK moves toward its new trading arrangements.
Inflation rose well above the 2% target, peaking at 3.1% late last year, an overshoot entirely due to the
referendum-induced fall in the exchange rate.
And UK growth has dropped from the fastest to the slowest in the G7. The economy has significantly
underperformed the MPC's projections ahead of the referendum, which were conditioned on a vote to
remain.11 That deceleration has occurred despite support from a much stronger-than-anticipated euro-area
and global growth and much more supportive domestic financial conditions, with the latter importantly
influenced by the timely, comprehensive package of easing measures introduced by the Bank's policy
committees after the vote.
The MPC now views the economy's potential
growth rate to be around 1.5%, about 60% of its pre-crisis
average. That diminished rate of supply growth reflects the climate of the past few years, with the shallowest
investment recovery in over half a century,12 lower growth in labour supply and modest productivity growth.
By the first quarter of this year, UK GDP had increased by 1 percentage point less than the MPC had
projected in May 2016. Factoring in the stronger-than-anticipated growth in the European and global
economies and more supportive fiscal policy, the shortfall increases to around 13⁄4%-2%.
11
This was in line with the MPC's
standard approach to condition its projections on the government policy of the time.
12
By contrast, growth in UK total investment outperformed the rest of the G7 in 2017. That reflected strong growth in spending on
buildings. Dwellings investment (1.7pp) and spending on other buildings and structures (2.1pp) together contributed 3.8pp to total
growth of 4.0%.
Even without taking those additional factors into account, average household incomes are currently 4% lower
than the MPC had expected prior to the referendum, equivalent to over £900 per household.13
Lambda: trade-off management in exceptional circumstances
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 can, however, support the economy during the adjustment
process.
During these exceptional circumstances, the MPC is required by its remit to balance the trade-off between
the speed at which inflation is returned to target and the support that monetary policy provides to jobs and
activity.14
The MPC set out our framework for managing this trade-off including guidance on its tolerance for the
overshoot of inflation of target under exceptional circumstances.
illustrates the MPC's framework for setting policy to manage this
Chart 6 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.
Chart 6 also demonstrates how the expected trade-off has evolved in successive MPC forecasts since the
referendum. It shows the MPC's central projections at Year 2 for CPI inflation on the vertical axis against
those for spare capacity (the opposite of excess demand) on the horizontal axis from successive Inflation
Reports since August 2016. The projections are conditioned on the market yield curves prevailing at the
time the forecasts were made.
Consistent with its remit, the MPC has judged that it has been appropriate to set policy 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. It therefore
implemented a package of easing measures in August 2016 - shifting the trade-off upwards and to the right
13
One third of the 4% shortfall in real wages reflects stronger-than-projected inflation, which is almost entirely accounted for by the
referendum-related fall in sterling. The remainder reflects weaker-than-expected nominal wages, the majority of which can be
accounted for by weaker-than-anticipated productivity growth.
14
Specifically, in exceptional circumstances, "shocks to the economy may be
particularly large or the effects of shocks may persist over
an extended period or both". When this is the case, the challenge facing the MPC can be more significant, and the remits
directs that
"[i]n forming and communicating its judgements, the Committee should
promote understanding of the trade-offs inherent in setting
monetary policy", including, importantly "the horizon over which the Committee judges it is appropriate to return inflation to the target".
(from the mauve dot labelled 'August 2016, no stimulus' to the purple dot labelled 'August 2016' in
Chart 6).15
Chart 6: MPC has managed the trade-off16
3.0
Inflation (%)
November 2016
February 2017
2.5
August 2016
November 2017
May 2017
February 2018
Excess demand (%)
August 2017
May 2018
2.0
-1.5 -1.0 -0.5 0.0 0.5 1.0 1.5
August 2016,
no stimulus
Preferred trade-off
1.5
if λ=0.1
Preferred trade-off if λ=1
1.0
Since then, the Committee has managed policy to diminish steadily the trade-off, increasing employment,
using up the expected degree of spare capacity in the economy, and reducing the expected overshoot of the
inflation target.
Throughout this period, inflation expectations have remained well anchored,17 the volatility of interest rates
very low, and financial conditions highly supportive.
Over the course of 2017, the steady absorption of slack and the prospect of moving into excess demand by
Year 3 - evident in the dots showing the successive Inflation Report projections in - reduced the
Chart 6
degree to which it was appropriate to accommodate an extended period of inflation above the target. As a
consequence, the MPC began to remove some of the stimulus policy had been providing raising Bank Rate
to 1⁄2 percent last November (the pink dot in Chart 7).
15
Calculations at the time suggested that returning inflation to target at a conventional horizon could have cost 1⁄4 million jobs and
widened the output gap to 11⁄2%. See 'Lambda', speech by Mark Carney at the London School of Economics, 16 January 2017.
16
Each observation shows the central projection for spare capacity or excess demand at the end of the second year of the forecast
period (the 'Year 2' point) on the horizontal axis against the central projection for four-quarter CPI inflation at Year 2 on the vertical axis
Inflation
from successive Reports. The left-most observation (labelled "Aug. 2016 no stimulus") is a counterfactual version of the August
2016 Inflation Report forecasts with the effect of the MPC's Bank Rate cut, Term Funding Scheme and Asset Purchases removed. See
'Lambda', speech by Mark
Carney at the London School of Economics, 16h January 2017, for further details and discussion.
17
See Table 4.C in the May 2018 Inflation Report, available at www.bankofengland.co.uk/inflation-report/2018/may-2018.
Chart 7: Trade-off in successive Inflation Report projections at Year 3
3.0
Inflation (%)
August 2016
2.5
November 2016
May 2017
November 2017
February 2017
February 2018
August 2017
Excess demand (%)
May 2018
2.0
-1.0 -0.5 0.0 0.5 1.0
August 2016,
no stimulus
Preferred trade-off
if λ=0.1
1.5
Preferred trade-off if λ=1
1.0
A Guidance Stocktake
As the UK enters the most critical phase of the Brexit negotiations, it is useful to take stock of forward
guidance and its potential role during the upcoming period.
The interest rate expectations of households and businesses have remained in line with the MPC's limited
and gradual guidance (see Charts 3b and 3c).
The MPC's guidance has anchored expectations in financial markets that interest rates will rise at a gradual
pace and to a limited extent (Chart 3a).
Guidance has dampened the volatility of interest rates, consistent with the expected and actual path of policy
rates (Chart 4).
Guidance has reduced the impact of economic uncertainty on short-term interest rates (Chart 5).
The responsiveness of market interest rates to economic data has generally been higher in the UK than in
the US or euro area (Chart 8).
While there have been occasions where financial market expectations diverged somewhat from upcoming
MPC decisions, these should be kept in perspective. Divergences have generally been modest moves
around the exact timing of a few rate increases over the next few years, as opposed to the launch of the
sharp tightening cycles of days gone by (6 to 8 rate increases over 12 to 15 months (Chart 3)). Short-term
interest rate volatility in the UK has been in line with that in other major economies and is very low relative to
history, only in the 5th percentile of its historical distribution since 1997 (Chart 9).
Inflation expectations have remained well anchored despite a series of major real and nominal shocks.
And financial conditions have remained highly supportive, reinforcing the recovery.
Chart 8: UK market interest rates still responsive to economic data news
UK
Rolling 1-year sensitivity
Lehman collapse
US
0.7
Draghi "whatever it US presidential
Euro area
takes" speech election
0.6
0.5
Eurozone debt EU referendum
0.4
crisis
0.3
0.2
0.1
0.0
-0.1
2004 2006 2008 2010 2012 2014 2016 2018
Sources: Bloomberg Finance L.P. and Bank calculations.
-
Notes: Dotted lines show 2004 2017 averages. For details of the methodology, see 'Stirred not shaken: how market interest rates
have been reacting to economic data surprises' , Bank Underground blog.
Chart 9: Interest rate volatility as percentile of historic distribution since 1997
Percentile
0.35
0.30
0.25
0.20
0.15
0.10
0.05
0.00
Jun. 16 Sep. 16 Dec. 16 Mar. 17 Jun. 17 Sep. 17 Dec. 17 Mar. 18
Sources: Bloomberg Finance L.P., ICE and Bank calculations.
Guidance into Brexit
Now, with the excess supply in the economy virtually used up and the Brexit date looming, monetary policy
could travel along two broad paths.
The first path is consistent with the MPC's current central projection which assumes a smooth transition to a
Committee's reaction function will
Brexit that is the average of a range of outcomes. In this case, the
become conventional again, with the path of policy driven primarily by demand.
A sharper Brexit could put monetary policy on a different path. For example, if the transition were disorderly,
or the end state agreement materially worse than the average potential outcome, then the MPC could once
again be confronted by a trade-off between the speed with which it returns inflation to target and the support
policy provides to jobs and activity. On this path, the MPC can be expected to set policy to manage any
trade-off using the framework it applied following the referendum.
The dependence of policy on which Brexit path is taken is one reason why guidance remains valuable during
with the MPC's current policy stance.
this crucial phase. Let me expand, beginning
The Committee's latest guidance
Inflation Report. In the MPC's central
The MPC published its latest assessment of the outlook in our May
forecast, conditioned on the gently rising path of Bank Rate implied by current market yields, GDP is
expected to grow by around 13⁄4% per year on average over the forecast period. While modest by historical
standards, the projected pace of GDP growth over the forecast is nonetheless slightly faster than the
diminished rate of supply growth, which is projected to average around 11⁄2% per year. Recall that the MPC
now publishes all of its key assumptions about supply.
In the MPC's central projection, a small margin of excess demand emerges by early 2020, feeding through
into higher rates of pay growth and domestic cost pressures. Although inflation is projected to fall further
over this year as the impact of sterling's past depreciation continues to wane, building domestic inflationary
pressures mean inflation settles at the 2% target around mid-2020.
As the MPC has stressed, were the economy to develop broadly in line with the May Inflation Report
projections, an ongoing tightening of monetary policy over the forecast period would be appropriate to return
inflation sustainably to its target at a conventional horizon.
One simple way to illustrate the potential need for modest rate rises is to look at the Committee's projection
conditioned on a constant rate. In it, excess demand increases to close to 1% of GDP three years from now
and inflation is well above target at 2.4% at years 2 and 3 (Chart 10).
Chart 10: With no monetary policy tightening, excess demand builds significan