Andrew Bailey, governor of the Bank of England, has said that while energy-driven inflation will temporarily push prices above target, monetary policy should instead focus on preventing persistent second‑round effects, signalling that the Bank might not raise interest rates in response to the conflict in West Asia.
During a speech at the Reykjavík Economic Conference, Bailey noted that the outlook for UK inflation has been "significantly affected" by the war in Iran.
Before hostilities broke out in February, UK inflation was on track to fall to around the 2% target from April, with Bailey noting that "some further easing of monetary policy was on the cards".
Instead, the inflation number for April came in at 2.8% last week, driven by an increase in fuel prices. And Bailey agreed that inflation is likely to go higher this year as utility bills rise and firms pass higher costs through supply chains.
However, he acknowledged that "there is nothing monetary policy can do to prevent higher energy prices from affecting businesses and households". The shock will push up inflation, and weigh on activity. "How much will depend on how the situation in the Middle East evolves", he continued.
As a result, Bailey said monetary policy "generally looks through the direct effects of energy prices on inflation", as it takes time for changes in interest rates to affect the economy and inflation, and higher interest rates might only push inflation below target once the energy price shock has passed.
He continued: "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.
"That leaves monetary policy with a difficult judgement call. Because interest rate changes take time to take their effect, monetary policy cannot wait for conclusive evidence of the strength of 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 smaller than anticipated."
"Our decision to hold Bank Rate at 3.75% at our most recent meeting was an active choice given the range of possible outcomes", he added.
Bailey believes the Bank has already effectively tightened monetary policy by taking the prospect of future rate cuts off the table.
Expanding, he said: "Having taken expected cuts off the table for now, we have already tightened policy considerably in response to the shock relative to what had been expected by markets.
"The decision to hold reflected a judgement 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, while recognising that these effects are likely to be stronger, the larger and more persistent is the rise in global energy prices."
