Central bank governor suggests he would be comfortable with inflation staying above target for a while
The Bank of England could allow inflation to run temporarily above its 2% target in order to support a weakening UK economy, governor Andrew Bailey has said – but only so long as second-round price pressures do not take hold.
Speaking at the Reykjavik Economic Conference in Iceland on Friday, Bailey said the Monetary Policy Committee (MPC) had already effectively tightened monetary conditions by removing market expectations for rate cuts, and that the central bank was prepared to tolerate a period of above-target inflation rather than risk further damage to an economy already feeling the strain of higher energy costs, weaker consumer spending and a softening labour market.
"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," he said. "But that tolerance would weaken if signs of second-round effects begin to emerge."
The remarks represent some of Bailey's most explicit guidance yet on how the MPC intends to navigate the inflation shock caused by the conflict in the Middle East, which has driven up global oil and gas prices following sustained disruption to transit through the Strait of Hormuz. The conflict has left the UK – a significant net importer of energy – exposed to deteriorating terms of trade and falling real incomes, with the effects already beginning to show in the inflation data.
Before hostilities broke out in late February, UK inflation had been on track to return to around the 2% target from April. Instead, the April reading came in at 2.8%, with Bailey warning that prices are "likely to go higher" as utility bills continue to rise and firms pass energy costs through their supply chains. The MPC held Bank Rate at 3.75% at its most recent meeting.
The governor made clear the MPC had already responded to the shock without resorting to a formal rate hike, by taking expected cuts off the table. "We have already tightened policy considerably in response to the shock relative to what had been expected by markets," he said. "Key quoted rates on mortgages have increased since the onset of the conflict."
The central question for policymakers now is whether the energy shock filters through into second-round effects – a scenario in which rising prices prompt workers to push for higher wages, forcing businesses to raise costs further and embedding inflation at a persistently elevated level. Bailey acknowledged this would materially alter the MPC's approach, noting "protracted indirect effects could keep inflation above target for too long unless monetary policy responds."
For now, the weakness of the domestic economy is providing cover for the BOE's more tolerant stance. The decision to hold rates reflected a judgement, Bailey said, that "continued weakness in the UK activity and the labour market is likely to lessen the strength of second-round effects from higher energy prices."
The governor was also explicit that there are limits to what rate rises can achieve against an energy shock of this kind. "Monetary policy generally looks through the direct effects of energy prices on inflation," he said, warning that attempting to offset them directly would produce "undesirable volatility in both inflation and activity."
Bailey pointed to the Bank's scenario-based forecasting approach, which was adopted following the Bernanke Review, as central to how the MPC is managing the current uncertainty. Rather than presenting a single central projection, the April Monetary Policy Report set out three possible economic outcomes over the next three years, reflecting the unpredictable nature of the situation in the Middle East.
"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," he said.
For mortgage borrowers, the immediate implication of Bailey's remarks is that a rate rise is not imminent, with the BOE content to hold its position while the labour market remains soft and second-round effects stay contained.
The governor has, however, left the door open, stressing the MPC would "monitor the situation in the Middle East and how it affects the UK economy and inflation very closely and adjust policy as required."
