That was the year that was -
speech by Dave Ramsden
Given at Bank of England Watchers' Conference organised by the
Money Macro Finance Society and King's Business School at King's
College London
24 November 2022
Speech
Thank you for the invitation to speak today. I am particularly pleased that I have close links
with the two institutions, the Money Macro and Finance Society and Kings College
London, who have organised this first Bank-watchers' conference.
In the spirit of the sixty year old TV programme that inspired my title I want to give my
personal review of why the economy, and in particular inflation, turned out to be very
different over the past year, and suggest some potential consequences for the MPC's
approach to forecasting the economy and setting policy to hit the 2% inflation target. As a
member of the MPC I hope to be able to do justice to how our thinking has evolved but I
should stress at the outset that these are personal observations, which will nevertheless
hopefully help set the scene for discussions at this conference.
monetary policy speeches this year I've focused on the impact of shocks.
In my other
Today I'm going to look more through the lens of the uncertainty generated by those
shocks, which has made the course of the economy in general and inflation in particular
increasingly hard to predict1. Uncertainty has come not just from new shocks hitting the
economy, most notably huge increases in energy prices, but also from unexpected
developments, particularly in the labour market, as well as from other sources, like the
on-going impact of Brexit and the pandemic.
Economic uncertainty can be illustrated in various ways. Chart 1 shows a market-based
measure of volatility two years ahead, the horizon for monetary policy, which has been on
a sustained and steeply rising trend over the last year, and spiked very recently at a much
higher level even than during the global financial crisis.
Without wishing to downplay the audience today, the Bank-watchers who matter most for
whether the MPC meets its target of getting inflation back to 2% are households and
businesses. Uncertainty is impacting directly on them, undermining their confidence to
make decisions and plan ahead, adding to what is already a very challenging economic
situation in the face of the cost of living crisis and tightening financial conditions.
I want to frame my observations by going back twelve months. At that point the economy
was recovering from the worst of the Covid pandemic and CPI inflation had started to rise.
Market expectations showed a 50:50 chance that Bank rate would be increased from
0.1% to 0.25% at the upcoming December 2021 MPC meeting.
Source: Bloomberg L.P., Tradeweb and Bank calculations
Notes: Realised volatility is a 5-day moving average of the difference between the highest and lowest 2-year nominal UK
government bond yield within a day.
The MPC had recently published its November 2021 MPR, summarised in Table 1. The
MPC forecast that GDP would continue to grow, though at a slowing rate, at 2.9% in the
year to 2022Q4. CPI inflation would rise in the short term reaching a peak of 4.3% in
2021Q4, before falling back to 3.4% by 2022Q4 and be close to the 2 per cent target by
2023Q4. Other forecasters were predicting a similar outlook for activity, although their
average CPI inflation forecast for 2022Q4 was somewhat lower at 2.7%2 .
In its November 2021 MPR, the MPC stressed that there was a high level of uncertainty
around the outlook, including for energy prices. The Bank's forecasts at the time were
conditioned on the declining futures curves for energy prices for the first six months of the
assumed flat thereafter. On that basis the MPC concluded that "while the
forecast but were
risks around energy prices are judged to be to the downside those towards wage growth
are judged to be skewed to the upside".
Fast forward a year and the November 2022 MPR forecast shows just how much has
changed for the worse (Table 2). Inflation is now expected to peak at 10.9% in 2022Q4,
over three times higher than was forecast only a year ago, before falling sharply from the
middle of 2023, to well below target by 2024Q4. With the economy already likely to be in a
recession which is forecast to be prolonged, GDP growth is negative in the year to 2023Q4
and 2024Q4, to 7.5 per cent below what was forecast a year ago3. Despite much weaker
growth, unemployment looks likely to be lower in 2022Q4 than was forecast a year ago
and wage growth is forecast to be much higher, 5 3⁄4% compared with 1 1⁄4%. As the
recession is forecast to deepen, unemployment rises sharply throughout the forecast
period, a significant degree of spare capacity opens up and wage growth falls back.
In response to significantly higher and more persistent inflation the MPC has increased
Bank Rate at every meeting in the intervening twelve months, from 0.1% to 3.0%. The
latest forecasts were conditioned on market expectations showing Bank Rate peaking at
5.25%, over 4% higher than the peak expected a year ago.
I want to review four of the main sources of uncertainty over the last year and draw out
their interactions as well as their implications for the persistence of inflation, since this is
feature of the MPC's latest forecasts and the focus of monetary policy.
the key
High and volatile energy prices
First energy prices. While these had started to rise from late 2020, gas prices in particular
build up to Russia's
started to accelerate more quickly a year ago in the invasion of
Ukraine. This shock was unexpected, large and passed through quickly to consumer
prices. As a net importer of energy the sustained terms of trade shock to the UK from
-
persistently high energy prices and from the smaller but still significant increase in food
prices and manufactured imports which also took place - has left the UK economy poorer.
These price shocks have been the single biggest driver of the recession and very high
inflation the UK economy is having to contend with.
The ratcheting up in gas future curves has been a feature for most of this year (Chart 2).
At the time of the August 2022 MPR the futures curve peaked at 450 pence per therm
which would have implied average household energy bills of £3500 from October 2022,
nearly three times higher than a year earlier. Although the futures curve has fallen back
since and remains on a declining trend into the medium term, persistence has become
more evident.
In the November 2022 MPR the MPC moved to adopting the full futures curve for its
conditioning assumption for the forecast of energy prices. In November 2021, energy
prices directly accounted for only 0.8% of the inflation forecast for 2022Q4 compared to a
direct impact of 3.8% in the latest forecast (Chart 3).
Sources: Bloomberg Finance L.P., Department of Business, Energy and Industrial Strategy, ONS and Bank calculations.
Notes: Pink diamond represents October 2021 inflation outturn.
Energy prices are also the biggest driver of the sharp decline in CPI inflation forecast from
the middle of next year, contributing 2.7 percentage points of the forecast fall of 5.7
percentage points in CPI inflation to 5.2% in 2023Q4.
Volatility of gas prices has also been a key feature. Greater security of European supply
through this winter has helped ease pressures but there remains significant concerns
about next winter, and in November the MPC flagged that a persistently higher path for
energy prices remains a possible alternative scenario. And given the uncertainties and
balance of upside risks, we incorporated an historically large upside skew on our inflation
forecast.
Sustained labour market tightness
Back at the time of the November 2021 MPR, most MPC members were concerned that
the end of the furlough scheme could be material for near-term developments in the labour
market, as some of the estimated 1 million workers still on furlough when the scheme
ended in September 2021 moved into unemployment. The November MPR forecast was
for unemployment to rise to 4.5% in 2021Q4. As the economy recovered, employment
remained resilient and unemployment fell to 4.1% after the end of the furlough scheme,
only slightly higher than its level prior to the pandemic in Q4 2019.
Successive MPR forecasts in 2022 have remained too pessimistic about the near-term
path of unemployment; rather than slowing as demand in the economy has slowed,
demand for labour has remained resilient, at least until recently. Unemployment fell further
and at 3.6% in the three months to September remains close to its recent 50-year low.
Although labour demand has eased more recently, the level of vacancies remains high
and recruitment difficulties remain widely reported in surveys of firms. This sustained
tightness has been driven by a much weaker recovery in the participation rate
post-pandemic, in marked contrast to most OECD countries4. Evidence for this
'participation puzzle' for the UK only emerged in the
spring5. Six months on, the causes
remain unclear though the latest survey evidence suggests some of this inactivity reflects
people with long term sickness and those who have decided to retire early. Many more
they don't want a job compared to the period after
people moving into inactivity now say
the global financial crisis6.
This points to the role of labour supply effects rather than cyclical weakness in labour
demand and indicates that this increase may be persistent, as there is a much lower flow
rate into employment compared to those who want a job. As such it is one example of a
pattern for recent shocks to have as much or more impact on the supply side than the
demand side of the economy, which further complicates assessment of the economy and
the appropriate policy response7.
As the MPC has learnt more about the labour market, the trough in unemployment has
been revised down in successive forecasts over the last year (Chart 4). However, such is
the weakness of demand from the recession in activity that unemployment is forecast to
rise from the start of 2023 throughout the three years of the forecast.
The sustained labour market tightness seen to date, together with the influence of much
higher inflation, have led to nominal pay growth increasing materially through 2022, at a
consistently faster rate than expected in successive forecasts (Chart 5). Annual growth of
private sector regular pay reached 6.6% in the three months to September. It is forecast to
rise further in the near term before falling back as unemployment rises, spare capacity
opens up and as inflation falls.
Sources: ONS and Bank calculations
Increasing Inflation expectations
Increasing evidence of second round effects in wage and price setting has been a key
focus of the MPC over the last year. Given the size and duration of the price increases
from energy, food and other price shocks, this is not surprising. It has also been reflected,
again not surprisingly, in the pickup in the various measures of short-term inflation
expectations which the MPC monitors closely. What would be more of a concern is if
increased short term persistence of actual inflation was reflected in an increase in
medium-term inflation expectations, as this would suggest that inflation expectations might
be becoming de-anchored from the 2% inflation target.
Having increased during much of 2022 for households and businesses, medium to
longer-term measures of inflation expectations have shown signs of easing back more
recently. The October Decision Maker Panel survey of businesses showed that three-year
Households' inflation
ahead CPI inflation expectations fell from a peak of 4.8% to 4.0%.
expectations as measured by the YouGov/Citigroup survey eased from August highs.
The most reliable market-based measure of longer term inflation expectations was on a
sustained upwards trend through 2021 and into 2022, peaking at 4.7% in March8. It has
been volatile around a declining trend since, albeit one distorted by the LDI episode. But
while this latest trend is encouraging it remains well above its long run average, and
further above its average than the equivalent measure for the Euro area (Chart 6).
Sources: Bloomberg Finance L.P. and Bank calculations.
Notes: Five-year inflation, five years ahead and two-year inflation, five years ahead, derived from swaps. The
instruments are linked to the UK RPI, US CPI and euro-area HICP measures of inflation respectively. UK RPI is due to
be aligned with CPIH from February 2030, which will affect the pricing of the UK five-year, five-year measure. Since
2000, annual CPIH inflation has averaged 90 basis points lower than RPI inflation.
In a higher inflation environment, some research has found that the distribution of inflation
expectations can also matter. Views differ about the salience of this kind of historical
the UK's current situation but it does suggest
research for that during periods of high
inflation, such as those experienced in the US in the 1970s, the change in the standard
deviation and skew of expectations in survey results might signal risks to a de-anchoring of
inflation expectations, even if the median doesn't
change9. In the UK, we have seen some
Bank's
signs, from the Market Participants survey10 and the Decision Maker Panel survey
of businesses, of expectations becoming more skewed to the right over 2022 relative to
previous years, with a larger share of respondents expecting higher inflation in the medium
term.
There is a range of views among members of the MPC as to whether developments in
inflation expectations and the potential for them to become de-anchored add to the other
risks around the inflation outlook11. My concerns about the emergence and embedding of
an inflationary mentality has been one of the factors contributing to my minority votes for a
faster pace of tightening, first in February and again in September this year.
Global financial markets have been increasingly volatile over the last year, in particular as
markets have responded to increased evidence of persistence in inflation and central
banks' policy actions and communications in reacting to it. The last year has
been
characterised by large moves in exchange rates and falls in risky asset prices but the
repricing of government bonds and of expectations for monetary policy have been
particularly striking.
Significant UK specific factors emerged in September and October, which have been
covered in detail elsewhere12. The UK policy premia which opened up have now
disappeared. The cumulative increase in yields on UK 10 gilts over the last year is now
very closely in line with the change in US and German 10 year bonds (Chart 7). Having
peaked at 4.6% in late September yields on 10 year gilts were back down at 3.2% at close
yesterday, their level at the start of September.
Source: Bloomberg L.P., and Bank calculations
Notes: The path for Bank Rate implied by forward market interest rates are based on overnight index swap rates. Latest
yield curve refers to forward market interest rates at cob 21 November 2021.
UK fiscal policy developments in response to the energy price shock have been a key
contributor to the outlook for inflation. In early September the Government announced an
Energy Price Guarantee (EPG) for households (and a business equivalent) to cap average
energy bills at £2500 up until April 2023. In the Autumn Statement on 17 November, the
Government announced an increase in the cap to £3000 for the year to April 2024. Energy
prices would otherwise have been significantly higher and more volatile given expected
wholesale gas prices, as embodied in the futures curve.
The Autumn Statement extension of the EPG looks broadly consistent with the working
assumption that the MPC made in the November MPR forecast. Overall as set out in the
November MPC, the EPG provides much more certainty about the near term path for
inflation, reducing the peak in CPI inflation by more than 2 per cent and bringing it forward
to Q4. The EPG and the accompanying more targeted measures also provide more
support for household incomes and demand and therefore more upwards pressure on
inflation in the medium-term.
The Autumn Statement also included a number of measures that will significantly tighten
the fiscal position in the medium-term pushing down on activity and inflation. However, the
vast majority of these measures do not come into effect until April 2025 so will have very
little effect over the MPC's
three-year forecast horizon, relative to what was assumed in
the November MPC. The MPC will be able to take full account of the Autumn Statement in
its December policy round, and its February forecast.
However, given the ongoing uncertainties, global and UK markets remain febrile and
sensitive to economic and financial developments. Those putting a forecast together
recently have faced the challenge of what to assume about the market implied path of
interest rates. In the November MPR forecasts, the MPC shortened the window for the
conditioning assumption on market expectations of Bank Rate13 (Chart 8). This gave a
path for expected Bank rate which still peaked at 5.25% and which, together with all the
other assumptions and judgements, resulted in a forecast for a more prolonged recession
and forecast inflation declining to well below the 2% target by the end of the second year
of the forecast and to zero by the end of the third year. In response the MPC took the
unusual collective step of communicating that we thought the assumption for Bank rate on
which the forecasts were conditioned was too high.
Responding to increased uncertainty
I've set out some of the key sources of uncertainty over the last year and how the MPC
adapted our forecast assumptions and judgements in response. Now I want to bring
together in one place some personal observations on how the MPC has developed its
approach to the forecast and to setting and communicating monetary policy, and how that
has framed my thinking.
In a speech I gave back in July 2021, I set out the hope that as the influence of the
pandemic waned, the MPC would be able to rely more on its forecasts to navigate a path
for setting policy to meet the inflation target. Things haven't turned out that
way. The
modal forecast presented in the text, tables and charts of this speech, together with the
mean forecast where we introduced a skew, remains the best collective judgement of the
MPC and a useful framing device. But speaking for myself it remains further away than it
was a year ago from determining my thinking on the economy and therefore my policy
response.
At different times and particularly since the pandemic struck in March 2020, the MPC has
made increasing use of scenarios, as a way of illustrating alternative possible futures on
the basis of different assumptions or judgements, assuming other things equal. Over the
last year I have increasingly thought of the forecast as more of the baseline scenario out of
a range of possible scenarios representing the future.
But given the high degree of uncertainty, at present, the assumption of all else equal, is
harder to maintain, particularly the further one gets into the future. To give an example,
over the next two or three quarters my assessment is that unemployment is likely to stay
close to its current level and perhaps move up to 4%, as demand and GDP in the
economy remains weak. But I am materially less confident that after that unemployment
will pick up quite markedly to end 2023 at close to 5% as in the MPR forecasts, which are
consistent with the past relationship between GDP and unemployment. There are many
other judgements in the forecast where the risks for me are more balanced but similarly
uncertain given the sources of uncertainty present.
I am not advocating ignoring the forecast in the framing and setting of policy and relying
instead on current, spot economic data. But I do support the MPC continuing to be more
explicit in recognising the uncertainties inherent in the future path of the economy and in
the forecasting process. One consequence of this approach is that I am more sensitive to
errors in the short-term forecast than I am to forecast changes further out.
A cross-check on the MPC forecast is to compare with other forecasters, which we
facilitate by including an annex on other forecasters expectations in every MPR (Chart 9).
Because the period running up to the November MPC was marked by particular volatility in
financial markets, other forecasts were more likely than usual to be based on different
assumptions to the MPR forecasts. Even allowing for that, the differences are noteworthy
though also reflective of the uncertainties forecasters have to contend with at present, both
on the demand side and the supply side.
All other forecasts for GDP in each of the three years from 2023 to 2025 were above the
MPC's modal projection. There was a similarly marked difference after the first year of the
forecast period for unemployment. For inflation the MPC's modal forecast was in
the top
half of the range for outside forecasts in 2023Q4 but below the bottom of the range in
2024Q4 and 2025Q4.
Notes: Thirteen respondents submitted projections. There are 12-13 projections for each variable at the one-year horizon,
and 7-8 for each variable at the two and three-year horizons.
Both the setting of monetary policy and the language used to communicate it have
developed significantly over the last year, which has seen the MPC increase Bank Rate at
By contrast, the MPC's
every one of the eight meetings by a cumulative 2.9% to 3.0%.
tightening has not changed. Consistent with the MPC's strategy
approach to quantitative
first set out in the August 2021 MPR, Bank Rate has been the active policy tool for
tightening monetary policy, while quantitative tightening has been conducted gradually and
predictably in the background, starting in March 202214.
As the MPC has become increasingly focused on the prospect of more persistence in
inflation, it has tightened policy more sharply. In the five meetings from December 2021 to
June 2022, Bank rate was increased by 1.15 percentage points in total. In the three
meetings from August 2022 to November 2022 Bank rate has been increased by a
cumulative 1.75 percentage points.
The MPC's
accompanying language has also developed significantly, communicating a
shortening time-frame for the outlook for interest rates and progressively strengthening our
language, while consistently emphasising data dependency.
rose to 1% the MPC's collective or majority
Up until May 2022, when Bank rate
communication still took what I would describe as a form of conditional forward guidance;
emphasising that some degree of modest or further tightening in monetary policy was
going to be appropriate in the coming months, depending on the balance of risks to
inflation and growth. Whereas since June 2022 we have consistently emphasised the risks
to more persistence in inflation and also made clear our willingness to act more forcefully if
required by key developments; which I think of as signalling more of a reaction function
based approach.
On my interpretation, our conduct of monetary policy has been in line with the literature on
Robust Control, in a world of increased uncertainty15. Such an approach is consistent with
policy aiming to achieve the best outcomes in the worst-case scenario, in this context,
inflation expectations becoming de-anchored and leading to persistently above target
inflation.
Before concluding let me provide a brief update on how my thinking on the immediate
outlook for the economy and policy is developing. Some near term sources of uncertainty
Because of the Government's Energy Price Guarantee
have eased but others remain.
there is more certainty about the outlook for energy prices and Government policy more
broadly is on a more stable and predictable footing. This has been reflected in pricing in
financial markets. The labour market remains tight and services inflation has hit 30-year
highs and is contributing more to overall inflation. I am not yet confident that domestically
firms' pricing are
generated inflationary pressures from increased costs and starting to
ease. Encouragingly survey and market based medium term inflation expectations have
fallen back from their peak, though they remain elevated.
Assuming that in the near term the economy evolves broadly in line with the latest MPR
projections and given my assessment of the balance of risks, then I expect that further
increases in Bank rate are going to be required to ensure a sustainable return of inflation
to target. Considerable uncertainties remain around the outlook and if the outlook suggests
more persistent inflationary pressures then I will continue to vote to respond forcefully.
are other uncertainties that I haven't covered
At the same time I am mindful that there
today, for example relating to the transmission mechanism for policy. We have increased
Bank Rate very rapidly over the last year and on past experience a change in interest
rates has its peak impact on inflation only after around 18-24 months. But it is possible that
the increased proportion of households on fixed rate mortgages means the full effect of
policy takes longer to come through and/or is larger when it does, such that inflation
comes down more quickly through 202316.
Given the uncertainties we face it is important also to be humble about what we don't know
or still have to learn. I favour a watchful and responsive approach to setting policy17.
Although my bias is towards further tightening, if the economy develops differently to my
expectation and persistence in inflation stops being a concern, then I would consider the
case for reducing Bank Rate, as appropriate.
Conclusion
Let me conclude with two salutary tales. First a personal one. In a speech I gave in
February 2022, I repeated the MPC's collectively agreed line that some further modest
tightening was likely to be appropriate in the coming months. I stressed the word modest
as being significant and went on to say that "I do not
envisage Bank rate rising to anything
like its pre-2007 level of 5%, let alone to the kind of levels we used to see before the MPC
was formed in 1997". That speech was on 22 February, two days before Russia's invasion
of Ukraine. Given the experience of the last year, we have to expect and plan for there
being further shocks and be ready to respond accordingly.
Second a historical one. That Was The Week That Was was a popular TV programme
which ran for two series in 1962 and 1963. That was the time when inflation was just
starting to rise and although it averaged well below 5 per cent throughout the 1960s it
picked up sharply in the early 1970s and didn't fall back to below the MPC's
current 2%
target until 1998 (Chart 10).
Sources: ONS and Bank calculations.
2022 has been a very challenging year for the UK economy. Millions of households and
businesses are experiencing great hardship as a result of the cost of living crisis. As a
member of the MPC I am acutely conscious that our actions are adding to the difficulties
caused by the current situation.
The past history of the UK economy demonstrates the damage to households and
businesses that would result if high inflation persisted. Unlike these earlier periods of high
inflation, exacerbated by ineffective policy and policy frameworks, we now have a
monetary policy framework which empowers us to take action. However challenging the
short term consequences might be for the UK economy, the MPC must take the necessary
steps in terms of monetary policy to return inflation to achieve the 2% target sustainably in
the medium term. By restoring low inflation, consistent with its remit, the MPC can best
contribute to securing stability and certainty, the foundations for sustainable growth.
With thanks to Rupal Patel for her assistance in preparing these remarks, and to my fellow
MPC members and numerous Bank colleagues, including Callum Ashworth, John
Barrdear, Kieran Dent, Izzy Dought, Swasti Gupta, Zish Jooma, Zaar Khan, Simon Kirby,
Nades Raviraj, Kate Reinold, Andrea Rosen, Harry Rigg, Saugata Sen, Fergal Shortall for
their many helpful contributions.