Pressed to explain what has changed since August in the outlook for the UK economy, Mark Carney’s response could be summarised as follows. Consumers turn out to be entirely untroubled by the uncertainties unleashed by the vote for Brexit. Businesses are more worried: they are weighing the uncertainties and about half are revising their investment plans. Financial markets have arrived at a much harsher judgment. The resulting fall in the pound has immediate implications for inflation and for monetary policy.
This leads to some striking revisions in the Bank of England’s forecasts. In the short term, reflecting recent data, it expects UK growth to be much stronger than it anticipated in August. It now expects growth to slow more sharply in the medium term, once consumers start to feel the effects of higher imported inflation on real incomes.
It is important to note that this does not greatly change the BoE’s assessment of where UK output will end up, only the trajectory. Mr Carney maintains the central bank has made no new judgment on the nature of Britain’s post-Brexit trading relations, saying that, with negotiations yet to begin, “it is all to play for”.
Indeed, he has gone to some lengths to justify a largely unchanged estimate of economic activity at the end of its forecast horizon, despite the economy’s unexpected - and extremely welcome - resilience in recent months.
The incontrovertible change since the August inflation report, however, has been the further 6 per cent fall in the value of sterling. Its effect on consumer prices - whether in supermarkets or at the petrol pumps - is becoming visible. The BoE now forecasts that inflation will exceed its 2 per cent target for about three years, peaking at 2.8 per cent in early 2018.
Two important policy decisions accompany these forecasts. The first is that the Monetary Policy Committee is no longer guiding the public to expect any further cut in interest rates, as it had done previously. The committee’s unanimous endorsement of a neutral policy stance is clearly correct, given robust activity and the risks of triggering a further sell-off in sterling.
The more difficult judgment is how swiftly the BoE should attempt to bring inflation back to target. The choice it has made is to allow “a period of somewhat higher consumer price inflation in exchange for a more modest increase in unemployment”.
This too is the right decision. If Brexit represents a permanent hit to the UK’s economic potential, monetary policy cannot offset that damage. However, it can cushion the impact and influence how the adjustment takes place. It is preferable to spread the costs across the population, through temporarily higher inflation and a hit to real incomes, than to allow a sharp rise in unemployment, putting the burden on those least able to cope.
However, policymakers’ willingness to “look through” a short-term spike in inflation may come under increasing strain. Unemployment is set to rise but, at present, there is not much slack in the labour market. Mr Carney underlined there would be limits to the BoE’s tolerance of above-target inflation but he was careful to avoid giving any indication of where these limits would lie.
His assurance may be enough to keep inflation expectations in check for now. The BoE’s institutional credibility is high and markets have been reassured by Mr Carney’s decision to extend his tenure as governor. In a couple of years’ time, however, inflation will be starting to bite and political uncertainty may be at its height. The balancing act is only going to become more precarious.