Bank of England can tolerate inflation above 2% target, says Andrew Bailey

By rules and how much discretion should be left to central bankers. Reflecting that debate, different jurisdictions have arrived at somewhat different answers to how constrained discretion should operate when you're in an inflation targeting framework. For example, the Bank of England's monetary policy remit bears many similarities to frameworks with a dual mandate. Given the widely held view that money is neutral in the long run, both involve a focus on inflation stability in the long run. In the short run, both involve balancing inflation volatility with a concern for output volatility, and both lend themselves to be formalized in terms of a quadratic loss function, which is where the Greek letter lambda comes into the story, of course. But there are subtle differences between these two, however, and I would highlight two. The first is in the clarity with which the remit acknowledges that achieving the inflation target is the best and only contribution that monetary policy can make in the long run. The primacy of price stability in the MPC's remit makes clear that there are times when the focus should be squarely on returning inflation to target and there are limits to how high lambda should be. In that sense, our remit is more constrained. But second, and subject to the first, the MPC's remit affords more flexibility over how management of a tradeoff should be approached than a dual mandate, which almost by definition can be taken to suggest that a balanced approach should be taken. I would argue that this additional flexibility that we have can be useful in allowing monetary policy to approach trade-offs in different ways depending on the circumstances. Explicit language on how trade-offs should be managed gives clear directions on how the choice should be approached, however, and a clear framework for accountability to parliament. So that begs the question, of course, so how does the MPC's remit suggest we should respond to the recent rise in energy prices caused by the conflict in the Middle East? Well, monetary policy generally looks through the direct effects of energy prices on inflation. It takes time for changes in interest rates to affect the economy and inflation. So higher interest rates might only push inflation below target once the energy price shock has passed, resulting in undesirable volatility in both inflation and activity. And even if the lags in the effects of interest rate changes were shorter, offsetting the direct effect of an energy price shock would require pushing down core inflation by generating additional slack in the economy. Looking through the direct effects of an energy shock avoids such output volatility as the MPC's remit calls for. In other words, a higher value of lambda is appropriate with respect to the direct effects of an energy price shock. Because they take longer to come through, the argument for looking through the indirect effects is weaker, and protracted indirect effects could keep inflation above target for too long unless monetary policy responds. This suggests a moderate value of lambda for the indirect effects. By leaning against indirect effects, monetary policy may also reduce the risk that higher inflation becomes embedded through higher inflation expectations and second round effects. Such effects could arise, for example, if a rise in inflation expectations leads workers to bargain more strongly for wage increases and firms raise wages to maintain real pay for their employees, which in turn would increase their costs and could lead them to set higher prices. Monetary policy should not look through such effects. For second round effects, the appropriate value of lambda is low, consistent with the primacy of price stability in the remit. But the size, of course, of any second round effects in addition to the direct and indirect effects is highly uncertain. And in addition to being highly uncertain, second round effects build up more slowly than direct and indirect effects. And that leaves monetary policy makers with a difficult judgment call. Because interest rate changes take time to take their effect, we can't wait for conclusive evidence of the strength of the second round effects, but responding too early may generate undesirable volatility in output and inflation may drop below the 2% target in the medium term if second round effects turn out to be smaller than anticipated. I would argue this speaks to the desirability of a state contingent approach, including with respect to the choice of lambda. Given the context of softness in the real economy and uncertainty around the scale and duration of the shock, tolerating temporarily above target inflation to provide some support for the real economy is an appropriate way to approach the trade-off. But that tolerance would weaken if signs of second round effects begin to emerge. So this takes me back to the scenarios. In the monetary policy report that we published at the end of April, we presented three scenarios A, B, and C for possible outcomes for the UK economy and inflation over the next three years without any one of them being designated as a central projection as we normally would do and without assigning any probability weights to them. This is not because we expect this to be the norm for the future. Rather, it reflects the uncertainty we face with the unpredictability of the situation in the Middle East. As and when we can be more confident about how world events will unfold, we will return to presenting a central projection, one that the MPC agrees is a reasonable baseline, using scenarios as vehicles then for exploring the inevitable risks around it and exploring differences of views within the committee. But for now, the scenarios we think give us a better way to think about the policy discussion. The reality of the situation we are in is that there is a range of possible outcomes and we have to be ready to respond to all of them. Using scenarios like this is part of being ready to make that response whatever happens, and it allows us to set policy now with a clear sense of the risks we have to balance. The scenarios are designed to capture the key questions that are relevant to the policy discussion. How long will the conflict go on? What will be the scale of the effects on energy prices of the conflict? And particularly important for us, could it lead to second round effects on inflation persistence? The scenarios do not pretend to be exhaustive of what could happen. They're meant to illustrate somewhere around the range of possible outcomes. While we are ready to adjust course as needed depending on how the situation evolves, our decision to hold the policy rate at 3.75% at our most recent meeting was an active choice given the range of possible outcomes. Having taken expected cuts off the table for now, we already tightened policy considerably in response to the shock relative to what had been expected by markets, and that's already affecting financial conditions and the economy. Key quoted rates on mortgages have increased since the onset of the conflict. So the decision to hold reflected a judgment that continued weakness in UK activity and the labor market is likely to lessen the strength of the second round effects from higher energy prices, while recognizing that these effects are likely to be stronger the larger and more persistent is the rise in global energy prices. Uncertainty about the strength of the second round effects means that monetary policy needs to balance the costs of leaning too little against these effects against the cost of responding too much. And the right balance is likely to change depending on how events unfold and how the economy reacts. To state the obvious, that means, of course, that we have to monitor very closely the situation in the Middle East and how it affects the UK economy and inflation and adjust policy as required. But whatever happens, the use of scenarios and the flexibility that we've built into our processes following the Bank of England review has prepared us well for responding to events as they unfold and to returning inflation to the 2% target in line with the remit and for the good of the people of the United Kingdom. Thank you.

That's a great question. Yeah. I think there are several differences that are important here. One is to remember that the energy shock in 2022 came in two parts. So we had a February 2022 initial outbreak of the conflict in Ukraine and then we had one in the bigger one came in around August really actually. So it had a different characteristic, but I think the bigger point I would make is the legacy of COVID. And the problem, and I look back on this particularly sharply now, the problem we had, I think, was judging how tight particularly the labor market was. Every forecast that I know, and we publish a summary of outside forecasts in every monetary policy report we publish, had unemployment going up in the UK, as clear as our forecast by the way, when the so-called furlough scheme came to an end. In other words, when the state paying for people to stay in jobs but not be at work came to an end. We all thought there was going to be, I got asked repeatedly how much scarring do you think there was going to be, and we all thought there would be and we all thought there would be an increase in unemployment. I mean, the furlough scheme was a great scheme in many respects, but it obscured the read of the labor market, I think. So of course what happened was exactly the opposite. We had no increase in unemployment. Labor market became tighter and it became very clear talking to companies that they were, quotes, hoarding labor deliberately, that they were worried about if they lost people they wouldn't be able to get them back. Now I think today we're obviously not in that position. I mean, there's always an interesting task with reading the labor market, but I don't think we're in that level of uncertainty. The picture of a gradually softening labor market comes through pretty consistently.

I think the legacy makes it a bit harder because I think if you look on the other side of the picture to the sort of softening labor market, softening activity, going the other way, put on the other side of the balance would be inflation expectations. And you know, I think we're very aware that the legacy of four years ago does weigh in people's assessment of what inflation expectations are in response to the shock we're having at the moment. So, you know, I don't think we should be surprised that there's some element of what you might call hangover from that period. But, of course, we have to take that very seriously into consideration because it's real.

Well, I think that's where it gets really interesting. Because I think that's a judgment that weighs very heavily. You're precisely right because what you can end up with is somewhat more elevated inflation expectations but it isn't coming through in wage expectations when they're measured and it isn't coming through in wage settlements at the moment particularly in the private sector in the UK. So again, you know, as I said in my remarks, that judgment is absolutely at the center of what we do and I think that judgment between those two things, you know, what weight do we put on the read from inflation expectations versus labor market expectations is very important.