Thursday, March 17, 2022 / 07:30 PM / by Bank of England / Header Image Credit: Global Finance Digest

Monetary Policy Summary, March 2022

The Bank of England condemns Russia's unprovoked invasion and the suffering inflicted on Ukraine. The Bank is working closely with the UK Government to support its response in coordination with international authorities. The Bank's Monetary Policy Committee (MPC) supports this condemnation and welcomes these actions.

The MPC sets monetary policy to meet the 2% inflation target, and in a way that helps to sustain growth and employment. At its meeting ending on 16 March 2022, the MPC voted by a majority of 8-1 to increase Bank Rate by 0.25 percentage points, to 0.75%. One member preferred to maintain Bank Rate at 0.5%.

In the MPC's central projections in the February Monetary Policy Report, published before Russia's invasion of Ukraine, UK GDP growth was expected to slow to subdued rates during the course of this year. This in large part reflected the adverse impact of the previous, already large, increases in global energy and tradable goods prices on UK real aggregate income and spending. As a result, a margin of spare capacity was projected to open up and the unemployment rate to rise to 5% by 2025. CPI inflation was expected to peak at around 7¼% in April 2022. Upward pressures on inflation were expected to dissipate over time and, conditioned on the rising market-implied path for Bank Rate expected at the time of the February Report and the MPC's current forecasting convention for future energy prices, CPI inflation was projected to fall back to a little above the 2% target in two years' time and to below the target by a greater margin in three years.

Developments since the February Report are likely to accentuate both the peak in inflation and the adverse impact on activity by intensifying the squeeze on household incomes.

Regarding inflation, the invasion of Ukraine by Russia has led to further large increases in energy and other commodity prices including food prices. It is also likely to exacerbate global supply chain disruptions, and has increased the uncertainty around the economic outlook significantly. Global inflationary pressures will strengthen considerably further over coming months, while growth in economies that are net energy importers, including the United Kingdom, is likely to slow.

Turning to economic activity, UK GDP in January was stronger than expected in the February Report. Business confidence has held up and labour market activity data have remained robust. Consumer confidence has, however, fallen in response to the squeeze on real household disposable incomes. That impact on real aggregate income is now likely to be materially larger than implied by the projections in the February Report, consistent with a weaker outlook for growth and employment, all else equal.

Twelve-month CPI inflation rose from 5.4% in December to 5.5% in January, which triggered the exchange of open letters between the Governor and the Chancellor of the Exchequer that is being published alongside this monetary policy announcement. Inflation is expected to increase further in coming months, to around 8% in 2022 Q2, and perhaps even higher later this year. The projected overshoot of inflation relative to the 2% target to an increasing extent reflects global energy prices, with some further material contribution from tradable goods prices. Service price inflation has also picked up, although to a lesser extent than other components, with core services prices returning to their pre-Covid trend. Underlying nominal earnings growth is estimated to have remained above pre-pandemic rates, and is still expected to strengthen over the coming year.

If sustained, the latest rise in energy futures prices means that Ofgem's utility price caps could again be substantially higher when they are reset in October 2022. This could temporarily push CPI inflation around the end of this year above the level projected for April, which was previously expected to be the peak. Further out, inflation is expected to fall back materially, as energy prices stop rising and as the squeeze on real incomes and demand puts significant downward pressure on domestically generated inflation. That judgement also reflects that monetary policy will act to ensure that longer-term inflation expectations are well anchored around the 2% target.

The MPC's remit is clear that the inflation target applies at all times, reflecting the primacy of price stability in the UK monetary policy framework. The framework also recognises that there will be occasions when inflation will depart from the target as a result of shocks and disturbances. The economy has recently been subject to a succession of very large shocks. Russia's invasion of Ukraine is another such shock. In particular, should recent movements prove persistent, the very elevated levels of global energy and tradable goods prices, of which the United Kingdom is a net importer, will necessarily weigh further on UK real aggregate income and spending. This is something monetary policy is unable to prevent. The role of monetary policy is to ensure that, as this real economic adjustment occurs, it does so consistent with achieving the 2% inflation target sustainably in the medium term, while minimising undesirable volatility in output.

Given the current tightness of the labour market, continuing signs of robust domestic cost and price pressures, and the risk that those pressures will persist, the Committee judges that an increase in Bank Rate of 0.25 percentage points is warranted at this meeting.

Based on its current assessment of the economic situation, the Committee judges that some further modest tightening in monetary policy may be appropriate in the coming months, but there are risks on both sides of that judgement depending on how medium-term prospects for inflation evolve. The MPC will review developments in the light of incoming data and their implications for medium-term inflation, including the economic implications of recent geopolitical events, as part of its forthcoming forecast round ahead of the May 2022 Monetary Policy Report.

Minutes of the Monetary Policy Committee meeting ending on 16 March 2022

1: The Bank of England condemned Russia's unprovoked invasion and the suffering inflicted on Ukraine. The Bank was working closely with the UK Government to support its response in coordination with international authorities. The Bank's Monetary Policy Committee (MPC) supported this condemnation and welcomed these actions.

2: Before turning to its immediate policy decision, the Committee discussed: the international economy; monetary and financial conditions; demand and output; and supply, costs and prices.

The international economy

3: The global economic outlook had deteriorated significantly following Russia's invasion of Ukraine in late February, and the associated material increase in the prices of energy and raw materials. These price increases would further raise global consumer and producer price inflation in the near term from already high rates, and erode real aggregate income for net commodity-importing countries. Renewed supply chain problems were also likely to emerge as production of, and trade in, important inputs declined, due both to the physical disruption caused by the invasion and the effects of sanctions imposed on Russia.

4: GDP growth in the United States and in the euro area in 2021 Q4 had been broadly in line with expectations in the February Report, and was expected to be slightly stronger in 2022 Q1 than had been anticipated, particularly in the euro area. Euro-area PMIs had picked up sharply in February, indicating that the economic impact of the Omicron Covid variant had been less severe than expected. In the United States, household consumption had rebounded in January, although the rotation from goods to services spending had stalled. Unemployment rates had fallen further in the euro area and the United States at the turn of the year, and wage growth had continued to rise in the United States according to the Federal Reserve Bank of Atlanta's measure.

5: Chinese activity data for January and February combined, including industrial production and retail sales, had been stronger than expected, reflecting a smaller impact from the Omicron Covid variant at that time. Following a rapid pickup in Covid cases in Hong Kong accompanied by a high mortality rate, Covid cases had, however, started rising again in China, and Chinese authorities had continued to react with tight local restrictions in line with the country's current Covid strategy. There had been reports of factories stopping production in response, which could lead to supply disruption and weigh on economic activity.

6: Even prior to the most recent increases in energy prices, consumer price inflation had been high in many economies. Euro-area annual HICP inflation had increased to 5.8% in February, with core inflation at 2.7%. US annual CPI inflation had risen to 7.9% in February, and core inflation to 6.4%. The headline US CPI figure was consistent with annual PCE inflation around 6½%. In the euro area, HICP inflation had been driven in large part by increases in energy prices over recent months, in particular gas prices. Contributions to US CPI inflation had been broad-based across components: within core services, rent and healthcare price rises had contributed particularly strongly, while increases in car and household goods prices had pushed core goods inflation higher.

7: Since the invasion, commodity prices had increased substantially, while exhibiting marked volatility. Russia was a significant exporter of gas, supplying around 40% of the gas used in the euro area, and was also the second-largest global crude oil producer. Concerns that gas flows to Europe might be disrupted had led to exceptional volatility in European wholesale gas prices. Those prices had risen sharply following the invasion from already elevated levels in early March, with the Dutch Title Transfer Facility spot price rising to around 240 Euros per MWh, before declining again to around 115 Euros per MWh at the time of the MPC's meeting, around 40% above the average spot price assumed in the February Report. The futures curve six months out was a little below current spot prices. The spot price of Brent crude oil had also been volatile and had increased by around 17% since the February Report, to around $100 per barrel at the time of the MPC's meeting, in part driven by announcements by the US and UK governments that they would curtail oil imports from Russia.

8: Russia and Ukraine were also major producers of other raw materials, and prices of metals and food had risen by around 15 and 20% respectively since the February Report. Russia accounted for a significant proportion of global pig iron, steel, nickel, aluminium and copper exports that were a key input to many production processes. There had been reports of some car manufacturers having to shut European plants because of a lack of inputs from the region. Russia and Ukraine also accounted for almost 30% of the world's wheat exports and Russia supplied 16% of the world's fertiliser. Ukraine was a major producer of neon, which was a key input for the production of semiconductors, potentially leading to renewed supply pressures in this sector.

9: The increases in energy and other raw material prices were expected to boost global consumer price inflation significantly in the near term, directly through fuel, utilities and food prices, and indirectly through firms' costs. Supply chain disruption could also add further upward pressure to goods prices. Given Europe's reliance on Russian gas, and the fragmentation of the global market which meant that US gas prices had not increased materially, the effect was expected to be larger in the euro area and in the United Kingdom. Higher prices would reduce real incomes, exacerbating the policy challenges facing central banks around the world.

10: The Russian economy was expected to be affected significantly by sanctions. Financial sanctions announced shortly after the invasion began had been aimed at hindering trade with Russia, through restricting the ability of some Russian banks to process foreign transactions, particularly in dollars, and through curtailing access of some Russian banks to the SWIFT messaging service, which made it more costly to process transactions. Transactions with the Central Bank of Russia had also been prohibited, restricting its ability to use its international reserves to support the rouble, facilitate cross-border trade and service debt. More recently, the United States had announced a ban on Russian oil imports, the United Kingdom had declared that it would phase out its imports of Russian oil by the end of this year, and the European Union had set out plans to cut its gas use by the end of this year by around two-thirds of its gas imports from Russia in 2021. There had also been a wave of voluntary withdrawals of companies from activities in Russia. This had not only involved high profile consumer-facing firms, but also a broader range of companies supplying goods and services to the Russian business sector and mining companies. In late February, the Central Bank of Russia had raised interest rates from 9.5 to 20%, had ordered exporters to surrender 80% of their foreign exchange receipts, and had restricted the ability of residents to take capital out of the country. The rouble had fallen by around 25% since the start of the invasion. Central and Eastern European currencies had depreciated by 3 to 6%, and the Polish and Hungarian central banks had raised interest rates. Central and Eastern European countries had experienced a significant influx of refugees from Ukraine.

Monetary and financial conditions

11: Since the MPC's previous meeting, indicators of financial market volatility had increased and risky asset prices had fallen, reflecting the expected global impact of Russia's invasion of Ukraine. Advanced economy equity prices had fallen significantly and spreads on corporate bonds had widened. Option-implied distributions of equity prices suggested that these movements reflected increased pricing of downside risks to equity prices, as well as a shift down in central case expectations.

12: Short-term financial market inflation compensation measures had increased across advanced economies, in large part reflecting the impact of the invasion on energy prices. Medium-term measures had also increased over the same period. It was common for these measures to move together, but recent movements in medium-term measures were nevertheless noteworthy, given that oil and gas futures curves were consistent with energy price inflation falling back significantly beyond the near-term horizon.

13: In the United Kingdom, the increases in medium-term inflation compensation measures had taken their levels further above their average of the past decade. As the Committee had discussed previously, interpreting UK medium-term inflation compensation measures was not straightforward. The use of UK inflation markets for hedging large pension liabilities and the uncertain future wedge between consumer price and RPI inflation meant that inflation compensation measures did not provide a direct read of market participants' fundamental views on the inflation outlook. Nevertheless, models that attempted to extract medium-term market expectations for CPI inflation, and intelligence gathered from market contacts, suggested that higher inflation expectations and greater perceived risks of inflation persistence had probably accounted for above-average levels of UK medium-term inflation compensation measures, alongside other factors.

14: The sterling effective exchange rate had fallen by 1.7% since the previous MPC meeting, and to a greater extent against the US dollar.

15: The near-term path for market-implied policy rates in the United States had risen since the MPC's previous meeting, although some of this increase had pre-dated the invasion. The market-implied policy rate in the United States reached a little under 2% by end-2022, around 50 basis points higher than immediately prior to the MPC's February meeting. In the euro area, the near-term market implied path for policy rates had also risen since the MPC's previous meeting. At its meeting on 10 March, the ECB Governing Council had left its key policy interest rates unchanged, but had announced a faster reduction in the pace of net asset purchases.

16: In the United Kingdom, market-implied expectations for the path of Bank Rate over the year ahead had risen, with market pricing consistent with an increase in Bank Rate of 0.25 percentage points, to 0.75%, at this MPC meeting. The market-implied path for Bank Rate now reached around 2% by end-2022, around 70 basis points higher than immediately prior to the MPC's February meeting. The latest Bank of England Market Participants Survey suggested that respondents expected a slightly shallower path for Bank Rate than the market-implied path over the next couple of years, but a greater number of respondents viewed the balance of risks around that path as being skewed to the upside rather than to the downside.

17: Longer-term advanced economy government bond yields had increased since the MPC's previous meeting.

18: UK bank lending rates on mortgages with loan-to-value (LTV) ratios at or below 75% had risen further since the MPC's previous meeting. This was broadly consistent with a lagged response to the increases in risk-free rates since the autumn of 2021. Lending rates on some higher LTV mortgages had also started to increase. However, rates on higher LTV mortgages had, on the whole, remained lower than in autumn 2021, reflecting the normalisation of spreads in this market, which had increased significantly at the start of the pandemic. The subsequent further increases in risk-free rates that had occurred since the February MPC meeting would be expected to feed through to mortgage lending rates in due course. Interest rates on unsecured household borrowing, such as credit cards and personal loans had, as usual, been less sensitive to changes in reference rates.