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A challenging year for monetary policy

We are having to navigate a set of unprecedented economic circumstances at the moment that are as challenging as anything the Monetary Policy Committee (MPC) has had to deal with before in its 25 years of existence.

Consumer price inflation rose from 7.0% in March 2022 to a peak of 11.1% in October 2022, before easing somewhat to 10.1% in the latest number for March 2023. This is much too high. The MPC has therefore raised Bank Rate by a further 3.5 percentage points since May last year, from 1.0% to 4.5% today. I can assure you that bringing inflation back to the 2% target remains our absolute priority.

Meanwhile, the UK economy has stagnated. After a swift beginning to the recovery from the sharp falls in economic activity seen earlier in the Covid Pandemic, the level of monthly gross domestic product (GDP) is yet to grow beyond its end-2019 level on a sustained basis, falling slightly below it in the latest data for March. The labour market has remained tight, however, driven in part by a significant reduction in labour supply. The primary cause of this reduction has been an increase in the proportion of the population that does not take part in the workforce either by working or looking actively for a job, in particular amongst the 50 to 64 year olds.

The need to bring inflation down has required a much tighter monetary policy stance. The best contribution monetary policy can make to the prosperity of the United Kingdom is to ensure that inflation returns to the 2% target sustainably, in line with the primary objective in the Government’s Remit for the MPC. Our commitment to doing so is unwavering.

Economic developments

It is important to understand the disturbances that brought about this situation.

It has now been over three years since Covid struck and changed our lives. The virus first disrupted economic activity on a vast scale, calling for public policy interventions few of us had ever thought we would see in our lifetimes. Then in subsequent waves, even as we learnt to adapt and benefit from effective vaccines developed at record speed, it continued to add immense uncertainty to outcomes for public health and through that for the outlook for the economy. Monetary policy and fiscal policy acted independently to counter the cyclical downturn. A key aim of these policies was to support businesses and households through the crisis, limiting lasting damage to the economy at a time when inflation was well below the target.

The recovery from Covid came alongside four big supply shocks that have continued to shape economic and inflationary dynamics over the past year. After the initial recovery in 2020, the level of economic activity has only very slowly returned to a little below its pre-pandemic level in early 2022 and has remained around that level since. That sets the United Kingdom apart from other advanced economies, such as the United States and the euro area, which have more than recovered the economic ground lost in the pandemic.

The first of these supply shocks was a sharp rise in the prices of globally traded goods as global supply chains were overwhelmed by an unexpectedly persistent shift in demand from services to goods across these advanced economies. Rising prices in these traded goods may have directly contributed as much as 2 percentage points to the level of inflation in the UK consumer price index (CPI) over the past year, and that is before taking the indirect effects working through domestic supply chains into account. This shock, however, is now much reduced as global supply pressures have gradually eased. Shipping rates, for example, have stabilised at around pre-pandemic levels.

The second supply shock has been caused by Russia’s appalling war on Ukraine. Russia’s actions have caused untold suffering for the Ukrainian people. By driving up wholesale gas prices in European markets, this has also continued to be the largest single contributor to CPI inflation in the United Kingdom. While making up less than one twentieth of the CPI basket, electricity and gas have directly added about 3.5 percentage points to overall UK inflation throughout the year.

That number would have been even higher had it not been for the Government’s Energy Price Guarantee (EPG), which capped the typical household energy bill at £2,500 a year over the winter. In the August 2022 Monetary Policy Report (MPR), prior to the EPG, the MPC projected CPI inflation to rise to just over 13% towards the end of 2022, with the risk that it would remain at very elevated levels throughout much of 2023 if wholesale gas prices remained high. This followed a near doubling in wholesale gas prices since May last year. With an expected 75% rise in Ofgem’s price cap in October, the direct contribution of electricity and gas could have risen to 6 percentage points. In the November 2022 MPR, reflecting the impact of the EPG, the MPC revised down the projected peak in CPI inflation by two percentage points despite a further uptick in medium-term futures prices for wholesale gas.

The third supply shock has been a domestic one. As Covid hit, UK labour supply growth came to an abrupt halt. The size of the workforce declined by more than 130,000 people, or nearly ½%, from the three months to December 2019 to the three months to January this year. That stands in stark contrast to a steady growth rate of around ¾% per year during the preceding decades. The primary cause of this reduction in labour supply is an increase in economic inactivity, not just reflecting the ageing of the population, but also driven by a fall in the share of working-age people taking part in the labour market. Between December 2019 and July 2022, the number of people not taking part in the labour market rose by more than 800,000. While there are signs in the more recent data that this trend may be reversing, the shrinkage of labour supply has contributed to continued tightness in the labour market throughout the past year.

Finally, a fourth supply shock has gained momentum since my last annual report in May 2022. This is the sharp rise in food prices. When I appeared before the Treasury Committee in May last year, I pointed to the risk that disruptions to Ukraine’s supply of agricultural products to the global market could drive up food prices to worrisome levels. Since then, the annual CPI inflation for food and nonalcoholic beverages in the United Kingdom has risen from 5.9% in March 2022 to 19.1% in the latest March 2023 numbers. This is not just happening here in the United Kingdom. Other European countries have similar food price inflation rates. Increases in energy prices and poor harvests, in addition to Russia’s invasion of Ukraine, have played a role throughout the continent. With a 12% weight in the UK CPI, food prices alone are now contributing more than 2 percentage points to inflation.

In sum, these big external shocks continue to account for a large part of the inflation overshoot above target. In turn, by worsening the terms on which we trade with the outside world, the rise in external prices has reduced our real national income. This is being felt by households across the United Kingdom, most acutely by those on lower incomes. Many people face difficult choices and have had to cut back even on essentials.

Through the Bank’s outreach programmes, we hear first-hand from people about the economic hardship they face, and from charities about how challenging it can be to muster resources to help people through these difficult times. These experiences weigh heavily on my mind.