Clare Lombardelli’s keynote speech emphasised the role of wage growth and trade policy for the inflation outlook. In your view, what are the main risks to UK inflation over the next few years?
I think that the Monetary Policy Committee (MPC) is right to focus on elevated wage growth when evaluating the upside risks to the inflation outlook. Wage growth continues to be well above pre-pandemic levels, with regular nominal pay growth of 5.6 per cent in the first quarter this year despite almost three years of labour market cooling. Furthermore, with some signs of lingering labour market tightness, increased inflation expectations, and successive above-inflation rises in the National Living Wage, we expect wage growth to remain high over the next five years as workers bargain for higher wages and seek to restore pay differentials in the bottom of the wage distribution.
However, wage growth is not the whole story. Upside risks to inflation are also posed by the significant rise in protectionism in the wake of President Trump’s “Liberation Day” tariffs. The United Kingdom is a relatively small open economy and is therefore vulnerable to supply chain disruptions. Tariffs could increase the prices of intermediate and final goods whose supply chains run through the United States, thereby adding upward pressure on UK inflation. Aside from tariffs, there is also the ever-present risk that geopolitical tensions across the world escalate. Should these risks escalate, the United Kingdom would likely see higher inflation owing to supply chain disruptions and/or sanctions.
There are also downside risks to inflation for the United Kingdom. Survey evidence from Deloitte’s CFO Survey and the Bank of England’s Decision Maker Panel indicates that businesses and households are highly uncertain at the moment and are therefore likely to postpone spending and investment decisions. This will weigh on UK aggregate demand and therefore inflation. Recent fears of a slowdown in the United States and world economy have led to a fall in oil prices, which will also push down on inflation. There is also the possibility that reduced global demand and trade diversion due to tariffs will weigh on UK inflation.
Lastly, it is worth highlighting the importance of exchange rates for the UK inflation outlook. Following 9 April, the sterling effective exchange rate appreciated while the US dollar depreciated. This represents a change in risk sentiment toward the United States among investors, as the US dollar is typically regarded as a “safe asset” in uncertain times which would anticipate appreciation in the current climate. With an abundance of risk over supply chain disruptions, scope for further trade policy volatility, and uncertainty over economic prospects across the globe, movements in the sterling exchange rate could be very consequential for the UK growth and inflation outlook. Importantly, exchange rate movements affect the price of both goods and services trade and are not confined to the US dollar. Movements in the euro are also important for the UK outlook.
Scenario analysis has become an important tool to for policymakers in an increasingly uncertain world. In light of the Bernanke review, the Bank of England has started to incorporate scenario analysis into their monetary policy reports. What are your thoughts on these developments?
It is my view that scenarios are useful for articulating “known” risks to a forecast. These are distinct from radical uncertainties, to which we can only respond as they unfold. The value of a scenario for communicating known risk is that it can articulate how distinct states of the world can transmit through the economy in a way that a fan chart cannot.
NIESR’s work on the effect of tariffs on the UK economy is a good example of effective scenario analysis. We have analysed scenarios ranging from 25 per cent tariffs on only Canada and Mexico to 10 per cent universal tariffs with 60 per cent on China and retaliation across the board. In each of these exercises, we discussed the key transmission mechanisms and assumptions, which allows for a nuanced discussion about how each tariff bundle could impact the global economy differently. Scenarios such as these help to identify the most salient transmission mechanisms, given our assumptions, and therefore tailor informed and considered policy recommendations.
The incorporation of scenarios into the Monetary Policy Report (MPR) is a step in the right direction. Scenarios allow us to understand how risks play out in the real world, which goes further than making us merely cognisant that things could be different. That being said, the value of scenarios somewhat washes out when they are not underpinned by a clear sense of what might signal that we are in one state of the world rather than another. In the case of NIESR’s tariff scenarios this is clear: we know which state of the world we are in when the tariff bundles are announced. However, I think that MPR in May could have gone further to communicate scenarios that articulate distinctly different states of the world and, importantly, how one might identify which state of the world they are in.
Another key theme, which was the focus of the afternoon sessions at the Bank of England Watchers’ Conference, was central bank independence. What are your views on recent challenges to central bank independence?
The Bank of England gained independence in 1997, which was 28 years ago as of this month. The uninterrupted longevity of independence in the UK, I think, speaks for itself: central bank independence adds to the credibility of monetary policy. However, we should not take central bank independence for granted – as neatly demonstrated by the pressure that President Trump has placed on the Federal Reserve.
I think that preserving central bank independence starts with the Bank recognising its limits. In their afternoon session at the conference, Lord King and Sir Paul Tucker made the important point that a central bank cannot defend its own independence because it hasn’t the democratic legitimacy to do so. Furthermore, as they pointed out, one should be mindful of the breadth of the Bank’s remit. Of course it is not for the Bank to decide, but one should think carefully about whether it is appropriate and/or productive for the Bank to have consideration for risks such as climate change in their remit, given that they are unelected officials with a primary responsibility for inflation and financial stability.
Throughout the conference, there was also discussion over whether the Bank should set its own inflation mandate. Again, the concern here is that the inflation mandate is inherently political as it has distributional consequences. Many would argue that the current balance of power between the government-set mandate and central bank autonomy is democratically appropriate.
I think that the most salient challenge for Bank of England independence at the moment comes from the precariousness of the public finances. Our most recent forecast indicates that the United Kingdom is not on track to meet its fiscal rules. Should the UK experience an adverse economic shock, such as supply chain disruption from trade or an escalation of geopolitical conflict, the government does not have room to loosen fiscal policy further to support the economy without agitating financial markets. This could put pressure on the Bank of England to do the heavy lifting. This is a particularly difficult conundrum in the face of a supply-side shock like trade disruption because these types of shocks are likely to reduce growth and increase inflation.
The Bank of England Watchers’ Conference was hosted by the Institution for Engineering and Technology, organised by David Aikman (soon to be NIESR’s Director) and Richard Barwell, and sponsored by PGIM.