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Outlier or laggard:
divergence and
convergence in the UK's
recent inflation performance
- soeech by Dave Ramsden

Given at Peterson Institute of International Economics, Washington DC

19 April 2024

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Speech

Thank you to the Peterson Institute for the invitation to participate in today's event
focussing on the CEPR volume on monetary policy responses to the post-pandemic
inflation'. In line with the title of this panel I want to provide an update on my assessment
of the evidence on what has caused the UK's inflation?. This evidence covers the key
indicators of inflation and in particular persistence as well as associated analysis and what
this implies for the extent to which the risks from persistence are receding.

Economic forecasters have had a challenging time over the last few years in forecasting
the inflation process, given the series of unprecedented and overlapping shocks which
have hit the global economy. These challenges were highlighted in Ben Bernanke's
comprehensive review of the Bank's approach to, and use of forecasting published last
week. A key recommendation of the Bernanke review is that the Bank should make more
systematic use of scenarios in framing the outlook for inflation and the implications for
monetary policy, in a world characterised by greater uncertainty and significant structural
changes. The Bank has committed to implementing all the recommendations of the review.
As someone who has used scenarios throughout my career, I think this is the right
direction for the Bank to go in. But we should travel with a high degree of humility, given
the ongoing uncertainties and complexities we face in forecasting inflation.

Throughout much of 2023 I was worried that the UK was an outlier among advanced
economies, diverging in terms of inflation performance and the degree of persistence. And
this was still a feature at the time of the MPC's last published forecast, in the Monetary
Policy Report (MPR) published in early February. The MPC's forecast showed UK inflation
first falling to the 2% inflation target in 2024Q2, before rising back to close to 3% by
2025Q1, largely due to persistence in domestic inflationary pressures.

But over the last few months I have become more confident in the evidence that risks to
persistence in domestic inflation pressures are receding, helped by improved inflation
dynamics. As we set out in our March 2024 minutes there is a range of views among the
MPC on these risks. For me the balance of domestic risks to the outlook for UK inflation,
relative to the February MPR forecasts, is now tilted to the downside, with a scenario
where inflation stays close to the 2% target over the whole forecast period at least as
likely. This leaves the UK as less of an outlier and more of a laggard in terms of recent
inflation performance, and one that is now catching up quickly.

1 Monetary policy responses to the post-pandemic inflation: Challenges and lessons for the future
CEPR

2 See That was the year that was - speech by Dave Ramsden I Bank of England and Back to the
future - speech by Dave Ramsden (bankofengland.co.uk)

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Per cent Chart 1: Inflation rates in US, Euro area and UK
-UK CPI USPCE -=EAHICP

Sources: ONS for the UK, BEA for the US, Eurostat for the EA and Bank calculations.

Chart 1 shows how UK inflation has evolved relative to the US and Euro area since the
beginning of 2022. As the CEPR study documents, all three experienced the first-round
effects of the shocks associated with the Covid pandemic and Russia's invasion of Ukraine
to varying degrees, which primarily impacted on goods, energy and food prices. As a net
energy exporter, the US was much less affected by the increase in energy prices than the
Euro area and UK, with US inflation peaking at 7.1% in the summer of 2022, two-thirds of
the 11% peak in Euro area and UK inflation, which was seen later, in autumn 2022. The
nature of the support given to UK households and businesses to cushion the impact on
energy bills contributed to UK headline inflation staying higher than Euro area inflation
throughout 2023°.

The Fed, ECB and Bank, along with most other central banks tightened policy to head off
the risk that second round effects in domestically driven inflation took hold, in the context
of tight labour markets. The three central banks made historically large and rapid
increases in policy rates in successive increments of 50bp and through much of 2022, and
into 2023 in the case of the Bank and ECB.

For the UK, the risks from above target inflation becoming entrenched were considered
sufficiently significant that, having reduced the pace of policy rate increases to 25bps last
March and May, the MPC stepped up the pace again, with a 50bp hike in June 2023, as
shown in Chart 2. The MPC's assessment of the risks emphasised three key indicators of
persistence: labour market tightness, private sector wages and services inflation. Trends
in these indicators have also played an important part in the MPC's decision to hold

3 See Monetary Policy Report - February 2023 I Bank of England Box B for further information on the
UK fiscal energy support package.

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Bank Rate at 5.25% since last August, alongside communications which have stressed the
need for monetary policy to remain restrictive for an extended period of time, in order to
slow the economy and bring inflation sustainably back to the 2% target.

Fern Chart 2: Interest rates in US, Euro area and UK

June 2023 50bps Bank Rate increase

EA deposit rate

Jul 22 Oct 22 K) Jan 24

Sources: Bank of England, European Central Bank and Federal Reserve.

Recent inflation developments

US and Euro area inflation fell sharply through 2023, driven primarily by falling energy
prices (electricity and gas), with their contribution to inflation turning negative in the spring
and summer respectively, as Chart 3 illustrates. The unwinding of first round effects is also
increasingly evident in the easing in core goods and food price inflation, which are directly
and indirectly impacted by energy prices.

By last September, headline inflation had fallen sharply to 3.4% in the US and 4.3% in the
Euro area, compared to 6.7% in the UK, leaving the UK clearly standing out. This
divergence was broad based but also in part reflected the timing of UK energy
interventions relative to those across Europe which prolonged the impact of high energy
prices on UK inflation. For example, the first big fall in the Ofgem price cap only came in
October 2023, falling by 27% relative to the previous year.

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Chart 3: Decompositions of headline inflation rates

ey EA(HICP)

Sources: ONS for the UK, BEA for the US, Eurostat for the EA and Bank calculations.

Second round effects are most evident in services inflation, which is relatively labour
intensive - direct labour costs are responsible for around half of services costs in the UK -
and more domestically orientated. In the UK services inflation was 6.9% as recently as
September 2023, contributing to around a half of total CPI inflation at that time.

Based on its assessment of a range of evidence, including the three key indicators of
persistence, the MPC judged that second-round effects in domestic prices and wages
were expected to take longer to unwind than they did to emerge - in other words they
were likely to be asymmetrical. As a result, through last year the MPC judged there would
be significant persistence in wage and price setting, which was built into the projections for
wages and prices.

Furthermore, the risks to inflation both from persistence and from energy prices following
the emerging conflict in the Middle East were judged to be skewed to the upside. In the
November 2023 MPR forecasts shown in Table 1 modal and mean CPI inflation did not
return to the 2% target until around the start of 2026.

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Table 1: February 2024 and November 2023 MPR inflation forecasts

2027 Q1

2026 Q1

I 2024 Q1 I 2024 Q2 2025 Q1

Nov 2023 I Feb 2024 I Nov 2023 I Feb 2024 I Nov 2023 I Feb 2024 I Nov 2023 I Feb 2024
MPR MPR MPR MPR MPR MPR MPR

Feb 2024
MPR

2.0 3.6 28 25 2.3 1.9 1.9

Modal CPI Inflation

Mean CPI Inflation 3.7 44 2272 3.7 3.0 28 2.3 2.2 1.9

In the February 2024 MPR, in view of the more recent improving trends in the key
persistence indicators and in headline inflation, the MPC forecast that on the central case
CPI inflation would fall to 3.6% in 2024Q1 and to 2.0% in 2024Q2. The latest release
published on Wednesday showed CPI inflation fell to 3.5% in Q1 and 3.2% in March.

In its February forecasts the MPC also reduced the size of the persistence judgement and
removed the upwards skew for domestic inflation risks, as these had become more
balanced. In terms of the published forecasts shown in Table 1 this effect was more than
offset by the significant downwards shift in the yield curve between November and
February, itself in part reflecting the better news on UK inflation, which pushed up demand
and inflation further out, leaving the modal forecast at 2.8% in 2025 Q1.

Four steps in the inflation/inflation expectations/wages nexus

The upcoming MPC round will be an opportunity to revisit all of our forecast judgements.
When thinking about current UK inflation dynamics and the interaction between first and
second round effects I find it useful to distinguish four steps in the inflation/inflation
expectations/wages nexus'.

Step one is characterised by the feed through of dissipating external inflationary pressures
on headline inflation. As already outlined first round effects from external inflationary
pressures, primarily stemming from energy prices, were particularly prominent in driving
the increase in UK energy, food and core goods prices. As recently as September 2023
they still contributed 3.5 percentage points, more than half of 6.7% total inflation shown in

41 would like to thank Nick Bate, from the Bank's Monetary Analysis Directorate, for developing the nexus
framing.

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Chart 4. In the latest data for March 2024 the contributions from these pressures combined
has fallen to around zero.

Percentage 9 Chart 4: Step 1 - Feed through of dissipating external inflationary pressures on
porns headline inflation

12

CPI inflation

Energy

Nov 23 MPR

Core goods

Services

Sources: Bloomberg Finance L.P., Department for Energy Security and Net Zero, ONS and Bank calculations.

The assumptions we use to condition the outlook for energy were until the recent rises
broadly unchanged compared to what conditioned the February MPR forecast. Clearly the
risks from events in the Middle East remain to the upside. Food and core goods inflation
have continued to fall, broadly as expected in the February MPR.

As a consequence, headline inflation has fallen broadly in line with the February MPR
forecast, to 3.2% in March. Given we know the level of the Ofgem price cap for April and
also taking account of the freezing of fuel duties in the March Budget, then other things
equal we can be confident headline CPI inflation will fall sharply in April, to close to the 2%
target.

In step two of the nexus, falls in headline inflation have lowered inflation expectations. As
headline inflation has fallen back materially since November 2023 household and business
medium- term measures of inflation expectations have come back in line with historical
averages. Market measures of medium-term inflation expectations continue to remain
more elevated, although off their peaks. More recently, I've started to focus more on
shorter-term expectations given the closer correspondence to headline inflation and
importantly their significance in our understanding of wage dynamics.

In the Bank's most recent Inflation Attitudes Survey, shown in Chart 5, year-ahead
expectations for inflation fell to 3%, their lowest level for just over two years. And the
Citi/YouGov survey for one-year-ahead expectations fell to 3.3% in March 2024 compared

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to 4.2% in October 2023. Similarly in the latest Decision Maker Panel survey business
inflation expectations for a year ahead were 3.2%, falling from 4.6% in October 2023.

Per cent Chart 5: Step 2 - Falls in headline inflation lowering inflation expectations
12

DMP 1 year ahead

Citi/Yougov 1 year ahead

Dashed lines =
2006-2019 averages

Sources: Bank of England, Bloomberg Finance L.P., Citigroup, DMP Survey, YouGov and Bank calculations.

In step three the easing in inflation expectations is a key driver in weakening pay growth,
as illustrated in Chart 6. Annual private sector regular pay growth has fallen from just over
8% in 2023Q3 to 6.0% in February 2024.
Percentage Chart 6: Step 3- Easing inflationary pressures a key driver in weakening pay growth
Latest data

Feb MPR

Productivity

Inflation expectations

2019

Sources: ONS and Bank calculations.

(a) Wage equation based on Yellen (2017). Private sector regular pay growth is Bank staff's estimate of underlying pay growth between January 2020 and March 2022 and ONS private
sector regular pay growth otherwise. Short-term inflation expectations are based on the Barclays Basix Index and the YouGov/Citigroup one year ahead measure of household inflation
expectations and projected forward based on a Bayesian VAR estimation. Slack is based on the MPC's estimate of the vacancies to unemployment ratio. Productivity growth is based on long-
run market sector productivity growth per head. The unexplained component is the residual. Data are to 2023 Q4, projections are for 2024 Q1

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Drawing firm conclusions on the evidence from the labour market is hindered by the issues
with the official LFS data on labour market quantities. And separately, also by the volatility
in the official average weekly earnings series. So the MPC and other forecasters have had
to put more reliance on a wider range of labour market evidence and alternative models of
pay growth®.

Notwithstanding these uncertainties and against the backdrop of a technical recession in
GDP in the second half of 2023, the UK labour market has clearly continued to loosen.
This is apparent from a range of indicators including the official LFS data, the REC survey
and intelligence from the Bank's network of Agents. It is clearly evident in the decline in the
ratio of vacancies to unemployment, the MPC's preferred measure of labour market
tightness, shown in Chart 7, which has now fallen to pre-covid levels. This easing in labour
market tightness has also contributed to the recent slowing in earnings growth shown in
Chart 6.

Contributions to change
since 2019 Q4

Chart 7: UK vacancies to unemployment ratio

Unemployment

Dec 20

Sources: ONS and Bank calculations.

As Andrew Bailey highlighted recently, the UK is experiencing disinflation at close to full
employment; with unemployment remaining at close to historic lows. For me, the most
likely explanation for the ongoing resilience of the UK labour market has been a
combination of labour hoarding, as businesses expect the weakness in activity to be short
lived, consistent with intelligence from the Bank's Agents, in the context of continued weak
participation.

5 See Signal versus noise - speech by Ben Broadbent I Bank of England

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Percent Chart 8: Projections for private sector regular average weekly earnings four-quarter growth (a)
10

Projection

Swathe of wage models

Sources: Bloomberg Finance L.P., Citigroup, ONS, YouGov and Bank calculations.

(a) The shaded range represents a range of projections from three statistical models of nominal private sector regular average weekly earnings growth, including a wage equation based on
Yellen (2017), a wage equation based on Haldane (2018) and a simple error-correction model based on productivity, inflation expectations and slack in the labour market as embodied in the
difference between the actual unemployment rate and the Committee's estimate of the medium-term equilibrium rate. The projections are dynamic, multi-step ahead forecasts beginning at a
point within the models' estimation periods and are sensitive to data revisions, which can lead to changes in the range over the past as well as over the forecast period.

Chart 8 illustrates that from early in 2023, earnings rose by significantly more than could
be explained by our three main models, shown by the swathe®. In response the MPC
made a judgement to build in more persistence in the wage forecast; a judgement that got
progressively larger, peaking in the November MPR projections. As I highlighted in a
speech last November, judgements are a feature of all economic forecasts, but this was a
particularly significant one. Given more recent trends in earnings and labour market
tightness the judgement was reduced in the February 2024 MPR forecasts, but it still
pushed earnings growth on average about 1 percentage point above the swathe of model
estimates in the first half of the forecast.

In terms of short-term trends, our indicator-based models of pay growth suggest that
underlying regular pay growth has already slowed to around 5% from a peak of around
8%. Later in the spring we will see the impact of the increases in the National Living Wage
feed through into the aggregate earnings data. The MPC's forecast is for earnings growth
to slow further from the current level of 6.0% as headline inflation and inflation
expectations continue to fall, against a backdrop of still weak activity and ongoing
loosening in the labour market.

6 This is also illustrated by the size of the positive unexplained component in Chart 6, which is based on one
of the MPC's three main models for earnings.

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In step four of the nexus, weaker pay growth has started to feed into weaker services
inflation, which further broadens out the disinflationary process. In the November 2023
MPR our short term forecast for CPI inflation - which is built bottom-up and relatively
mechanically from the components and is shown in Chart 9 - had services inflation staying
at around 7% until the end of 2023, a similar path as in August. It was then projected to fall
to 6.4% by March 2024.

REFCE Chart 9: Step 4- Weakening pay growth feeds into lower services inflation

Successive short term forecasts for services inflation

Outturns and outturns (a)

Mar 23

Sources: ONS and Bank calculations.

(a) For example, Feb 2024 line shows forecasts through to June 2024, consistent with the February MPR CPI forecasts.
In the latest data services inflation continued to fall in March to 6.0%, slightly above the
short-term forecast underpinning the February MPR forecasts.

Chart 10: Contributions to UK services inflation percentage Bont

mmmConstant mmmPay growth mam Producer prices Residual --Core services ex rents model Projection

Sources: ONS and Bank calculations.

Notes: Indicative projected bars are from Q1

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Chart 10 provides a decomposition of one measure of underlying services inflation that the
MPC looks at. It suggests that the fall from its peak last summer reflected moderating pay
growth but also weaker producer prices for services. The short-term projections are
consistent with the February MPR and illustrate that large base effects from last year will
drop out in 2024Q2.

The rationale for focusing on an assessment of services inflation as an indication of
persistence has been that services prices more reflected domestic inflationary pressures,
in large part from the labour market, and that these pressures are inherently more slow
moving or stickier, particularly when labour markets are tight'. A recent BIS paper supports
similar line of argument based on cross country comparisons®.

But there is also analytical evidence that services inflation has been determined to a
greater extent by the energy prices shock. For example, by estimating the effect using the
most recent data and exploiting the cross-country differences in energy prices my former
MPC colleague Jan Vlieghe finds energy prices to be more important in driving services?.
And the Bank's neural network model for services inflation, one of the recently developed
cross-check modelling approaches the MPC deploys, also finds a significant role for
energy prices"®.

Year-on-year, per cent Chart 11: Services inflation in US, Euro area and UK
12

EA HICP

0
Jan-22 May-22 ep-22 Jan-23 NV 23 Jan-24

Sources: ONS for the UK, BEA for the US, Eurostat for the EA and Bank calculations.

7 See Back to the future - speech by Dave Ramsden I Bank of England

8 See Sectoral price dynamics in the last mile of postCovid-19 disinflation; Amatyakul et al

° See Gertjan Vlieghe, 2024. "Core Strength: International Evidence on the Impact of Energy Prices
on Core Inflation," Discussion Papers 2407, Centre for Macroeconomics (CFM).The decomposition in
Chart 10 is based on a similar exercise but using producer prices.

10 See Buckmann, Potjagailo, and Schnattinger (2023) 'Dissecting UK service inflation via a neural
network Phillips curve' for details.

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This does not mean that the MPC's assessment that services inflation reflects stronger
and more persistent domestic inflationary pressures doesn't apply. As Chart 11 shows the
UK is still clearly an outlier when comparing 12-month services inflation rates with the
equivalent rates in the US and Euro area.

But from my perspective it does imply that while services inflation continues to be more
homegrown, we should place more weight on the likelihood that a greater part of recent
services inflation will dissipate more quickly and so lead to less persistence, as the impact
of the energy price shock unwinds.

Chart 12 shows that the UK's 3-month annualised run-rate for services inflations has
recently converged on the equivalent rates for the US and Euro area. And I expect this to
become increasingly the case for 12-month rates. This in turn will mean that services
inflation contributes less to headline CPI inflation rates.

Per cent Chart 12: Services inflation run-rates in US, Euro area and UK (a)

Sources: Bureau of Economic Analysis, Eurostat, ONS and Bank calculations.

(a) 3-month average, monthly annualized. Seasonally adjusted.

I think it is also notable that the inflation dynamics implied by the nexus are playing out
against a backdrop of continuing weak activity in the UK, reflecting the impact on demand
of restrictive monetary policy, as well as the constraining influence of subdued supply. UK
supply growth has been characterised by weak productivity growth and low levels of
participation.

UK GDP grew by 0.1% in February after 0.3% growth in January, implying an end to the
technical recession in the second half of last year. But GDP is still 0.1 per cent lower than
it was two years ago in 2022Q1, when energy prices surged after Russia's invasion of
Ukraine. Over the same period US GDP has grown by a robust 4.3%.

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Conclusion

To conclude the UK looks like less of an outlier in terms of recent inflation performance
and more of a laggard. And one that is catching up fast. Similar disinflationary effects to
those which started earlier in the US and Euro area are now coming through, leading to a
pronounced reduction in UK inflation. UK CPI inflation in March was below US CPI
inflation and the April data is very likely to show the UK converging in line with Euro area
inflation. There are likely to be bumps in the disinflation process from one month to the
next due to base effects and other one-off factors. But a more material distinction is that
the disinflation process in the US is taking place against the backdrop of a stronger
economy, particularly on the demand side, and is already proving to be less smooth.

At the MPC's last meeting in March I was one of eight members who voted to hold

Bank Rate at 5.25%. Over the last few months, I have become more confident in the
evidence that risks to persistence in domestic inflation pressures are receding, helped by
improved inflation dynamics.

As we set out in the March minutes there is a range of views among the MPC on these
risks. As I've explained today, developments in the nexus of inflation, inflation expectations
and wages, including at higher frequencies, suggest that the restrictive stance of policy
and the more symmetric unwinding of second round effects are also reducing the more
persistent components of inflation such as services inflation.

My assessment is that the balance of domestic risks to the outlook for UK inflation is now
tilted to the downside compared to the MPC's February 2024 forecast, with a scenario
where inflation stays close to the 2% target over the whole forecast period at least as likely
as the February 2024 forecast, which showed inflation rising back above target to close to
3% by 2025Q1.

The MPC will have to consider collectively the degree of restrictiveness of policy at each
upcoming meeting to ensure inflation returns sustainably to the 2% target. I will continue to
take a watchful and responsive approach to my policy decisions as I have tried to do
throughout this period of unprecedented structural shocks. Watchful, in terms of assessing
the evidence as it accumulates and responsive in terms of the stance of monetary policy
warranted by the evidence.

I would like to thank Rupal Patel for her assistance in drafting these remarks. I would also
like to thank my fellow MPC members and numerous Bank colleagues, including Andrew
Bailey, Nick Bate, Stuart Berry, Fabrizio Cadamagnani, Alan Castle, Jonathan Haskel,
Josh Martin, Waris Panjwani, Galina Potjagailo, Adrian Paul, Alister Ratcliffe, Andrea
Rosen, Victoria Sapota, Fergal Shortall, Kenny Turnbull and Danny Walker for their many
helpful contributions.