Paul Diggle

Hello and welcome to Macro Bytes the economics and politics podcast from abrdn. My name is Paul Diggle, Chief Economist at abrdn.

Luke Bartholomew

And I'm Luke Bartholomew, Senior Economist at abrdn.

Paul Diggle

And today we're talking about UK monetary policy and we're going to assess the job that the Bank of England has done navigating the economic environment. So, the UK economy continued to stand out internationally for the size and persistence of its inflation overshoot and financial markets price quite a different path for UK interest rates - higher for longer - than they do in say the US and some commentators, some economists, have pointed to the Bank of England's forecasting errors, and that being part of why hasn’t achieved its 2% inflation target. On the other hand, the macro environment is just extremely difficult to navigate at the moment. So we couldn't have a better guest with whom to discuss these issues than Michael Saunders. Michael spent 25 years at Citibank as a UK economist and Head of European economics. And then six years as an external member of the Bank of England’s Monetary Policy Committee between 2016 and 2022. And he's now a senior advisor at Oxford Economics, the leading macroeconomic consultancy firm. So he's an incredibly experienced UK economist and monetary policy maker. Michael, welcome to the podcast.

Michael Saunders

Thank you for having me.

Paul Diggle

So, Michael, I want to start our conversation by asking you about the pass through of monetary policy into the economy and in particular, one potential explanation for the UK’s inflation overshoot, despite a significant monetary policy tightening cycle, is the blunted transmission of monetary policy to the economy. What's changed to mean that the Bank of England's ability to influence the economy may have dwindled relative to the past?

Michael Saunders

So, the impact of monetary policy on the economy, especially on household finances, is smaller, and more delayed than it used to be. One of the key ways that monetary policy works to affect the economy is through what you call the household cashflow channel. When the Bank of England raises interest rates, for example, households with variable rate mortgages face an immediate hit to their finances as their mortgage payments go up, they cut back on their spending, the economy slows with a lag, inflation comes down. That channel used to be really powerful in the UK, it was powerful because many households had mortgages, and most of those mortgages were floating rate. And the reaction of mortgages to changes in their mortgage payments was usually quite large. What, in economist terms, you would call the ‘marginal propensity to consume’ in response to changes in their mortgage payments was relatively large. But all of that has changed over the last 10 to 15 years, the share of households with a mortgage has fallen quite sharply. Most mortgages in the UK are now five-year fixed, quite long-term fixed, very few are floating rate. And with higher levels of savings, the extent to which mortgagers cut back their spending, in response to changes in mortgage payments is also less than it used to be. In other words, their marginal propensity to consume has fallen. So the effects of all of these three changes has been to blunt that household cashflow channel, but also because it really only affects people as they roll off fixed rate mortgages and have to refix at higher rates. The effect is much slower than it used to be. So far, the Bank of England has raised interest rates by slightly more than five percentage points, from 0.1% up to now five and a quarter. Had we had the old structure, high levels of mortgage debt, floating-rate mortgages, and a high marginal propensity to consume among mortgagers, the economy probably would already be in recession. As it is, the economy has slowed, but it's not as bad as it would otherwise have been. The flip side of that, of course, is that monetary policy has not had as quick an impact in reining in inflation, as it used to be. And that's contributed to the UK is inflation stickiness, which you talked about Paul.

Paul Diggle

And have the other transmission channels, for example, through corporates or through the exchange rate – are there changes in the structure of those transmission channels or are they broadly working as you would expect based on historical precedent?

Michael Saunders

So those channels are working about as normal. Most corporate debt, most corporate bank debt, is floating rate. You haven't seen the big shifts to long-term fixed-rate debt that you have among households. And so, for companies, their interest rates, their interest payments have increased sharply, more sharply, than they have for average households with mortgages. One of the other ways that monetary policy works, as you referenced, is normally when you raise interest rates, the pound would rise. And we've seen that this year, the pound’s up 5 - 6% on the trade-weighted index since the start of this year. And that's helping to reduce import prices, which feeds through to inflation directly, as well as squeezing exports, which with a lag, weaker exports, weaker growth, less capacity pressures will also help to reduce inflation. But the household cashflow channel used to be the quickest, the most powerful impacting channel. Those other channels through companies borrowing costs, and the exchange rate a bit less powerful - and especially for companies the response on the economy is a bit slower than it used to be for households. So monetary policy still works. Right? There's still some impact through the household cashflow channel, there's an impact through companies, there's an impact through the exchange rate, but overall, less quickly and less powerfully than used to be the case.

Paul Diggle

So monetary policy still works, but the long and variable lags may be getting longer and more variable. Does that make policymaking more difficult for any central bank, for the Bank of England in particular, for example, does it imply more risk of policy errors both from under-tightening and allowing a period of high inflation to develop, but on the flip side, can you overcorrect from that and over tighten how much harder is policymaking in that changing environment?

Michael Saunders

So, it certainly makes it harder. I'm not sure what the right analogy would be. But you can imagine, if you're driving a car, you want the response from changing the steering wheel to changing the direction of the wheels themselves to be immediate, and easily predictable. That's how you manage to avoid obstacles. If there's a lag between changing the steering wheel, changing interest rates and the car - the economy - responding, then it's much harder to avoid obstacles and to keep yourself on the right path. But it's also, if you like, dealing with a change like this is made all the harder, because you don't quite know how much longer the lags have got. You know that they're longer than previously. But you can't be sure how much longer they've become, how much more you need to allow for that. And so in a world in which the Bank of England's also faced with big shocks from energy and food prices, inflation expectations having gone up, right, you're having to calibrate monetary policy, when the effectiveness of the monetary policy tool itself is more uncertain than previously. Difficult job.

Paul Diggle

Yeah, I've used the car analogy myself and moreover, it's not just that perhaps the transmission here from the steering wheel or from the brake and accelerator are slower than the past, but, you know, because your central banks are also using real-time economic data, subject to revisions, subject to lags in the way its released. It's like you're also steering in the rearview mirror, as well as with a steering wheel and a brake that don't work as you might expect. So it's a tough job. And you referenced there, Michael, incoming shocks. I mean, another challenge, it strikes me, that the Bank of England or Central Banks have had is perhaps the increased number of negative supply side shocks in the global economy. The data-generating process now just seems to involve pandemics, wars, geopolitical turbulence, climate change, and how that might be feeding through to weather shocks. So in the way that we got lucky during the Great Moderation, especially with China's entry into the global trading system a period of quite favourable shocks, perhaps we've got now unlucky in the series of shocks that central banks have had to experience as well.

Michael Saunders

Yes, I think that's right. And it's a very important point. If you look at the UK, in the 25 years before the pandemic, inflation was low,but what really stands out in that period is that the volatility of inflation was exceptionally low. It was the lowest volatility of inflation that you can find for any 25-year period going back in the last 800 years. And it's a similar picture in other countries, inflation was extraordinarily stable. There have been periods in the distant past when inflation has been lower. But none when it has been both low and very stable. And I think a good part of that was, as you described, the series of benign supply side shocks, factors, which helped to improve growth, and lower inflation, such as globalisation and the entry of China into the world trading system. And we, for those periods, we didn't get any of the big adverse shocks - wars, major wars, pandemics, energy price surges. So in the last few years, well, we've had a whole series of adverse shocks, I should add on Brexit, of course, which has helped to push up inflation in the UK. Energy shock, pandemic, and it may be that you look back at the pre-pandemic period, as being a golden and rather fortunate era, in which global conditions were unusually benign. And we're entering, perhaps reverting to, a world in which the distribution of supply shocks is more even. Sure we get some favourable ones, but we probably get more unfavourable ones than we did in those 25-years pre-pandemic. It's unlikely, I think, that we’ll have a big new wave of globalisation. Indeed, if anything, some reversal of that seems more likely. Climate change, and the effect of that on commodity prices, and indeed, economic activity more broadly, is becoming increasingly important. Other shocks, it may be that you don't know in advance what they're going to be. But it seems more likely that you will get more adverse shocks in the future than the extraordinarily low number that we had in the 25 years pre-pandemic. And that means more volatile inflation climates. And what we've seen from the last few years, is that inflation shocks from energy and food, for example, can ripple through to inflation expectations, especially if the labour market is tight. And then you get second-round effects, the pay growth picks up and unless corrected by monetary policy measures, a more persistent inflation overshoot. So a more volatile global inflation climate makes it harder for central banks to do their job of stabilising inflation, keeping it low on the 2% target in the UK.

Luke Bartholomew

So Michael, no doubt as you described there, changes to the structure of the economy and how monetary policy transmits, and also changes to the distribution of supply-side shocks have both made the Bank of England's job more difficult. And there's nothing they can do about that, really. But one way in which perhaps they've made their own job more difficult, or so the criticism goes, is that they haven't had a particularly spectacular forecasting record over the last couple of years. And the Bank has been quite prickly about this criticism previously. But maybe recently they seem to have tacitly accepted some elements of the criticism - insofar as they've just announced this review into their forecasting process led by Ben Bernanke, the former head of the Federal Reserve in the US. So I'm wondering, from your perspective, what do you think the biggest forecasting errors that the bank has made over the last couple of years are?

Michael Saunders

So Luke, a part of the inflation overshoot, which we’ve seen in the UK, and indeed in other advanced economies over recent years, was due to big global swings in energy and food prices. And I think it would have been hard to anticipate those a long way in advance. So you can perhaps forgive the central banks for failing to anticipate those. But where I think there is more discussion as to whether the forecast process was correct, is in the extent to which wages and domestic costs in general would get affected by those global external shocks. So the Bank of England's assumption, when energy and food prices rose sharply in 2021, and early 2022, was that UK wage growth would not pick up much in response. In other words, what you call second round effects in the UK will be very limited. And the idea underpinning that was that inflation expectations were strongly anchored on the 2% inflation target, and that people would sort of see this sudden rise in inflation from energy and food, but they wouldn't expect it to persist and therefore inflation expectations would stay low and pay growth would stay low. So that's thinking of a normal model, in which pay growth is driven by labour market tightness, inflation expectations, and trend productivity. If none of those change in response to the energy and food shock, then pay growth itself shouldn't change. Then you don't get second round effects. And while inflation picks up sharply in the near term in response to energy and food prices, it would just as it is quickly come down again 12-18 months later, once that energy and food price shock drops out of the annual inflation rates. So the assumption that the inflation expectations were strongly anchored was critical in the forecast that second-round effects wouldn't materialise, and hence thatinflation would quickly fall back to the 2% target. And I think the experience of the last couple of years suggests that assumption on inflation expectations has proved to be wrong. Inflation expectations were not as well anchored on the target as central banks had expected. And they did go up in response to this big energy and food price shock, not just in the UK, but elsewhere. But they went up more in the UK. And then in turn, second round effects have come through. And that's the problem which central banks are now having to deal with, especially in the UK. So it's one where I think going into the shock, I sort of have some sympathy with those who took the view that inflation expectations were well anchored, because they could look back at the experience the previous 10,15 years when pay growth had been very subdued in the UK and a range of other advanced economies. But ultimately, the test has been when you get a big inflation, shock, inflation expectations do move. And so I think probably that assumption has to be questioned – revisited in the review, which the Bank of England has commissioned.

Luke Bartholomew

So picking up on some of those themes, I want to explore the difference between a forecasting error and a policy error. Because, you know, at the end of the day, the Bank of England is not a forecasting institution, its job is to set monetary policy and achieve its mandated objectives. So, at the end of the day, the only reason it should care about forecasts are insofar as it affects policy. And you could certainly imagine cases where there are forecast errors that even if he had gotten them, right, wouldn't have necessarily changed policy too much. The examples you give there of food and energy prices, might be the paradigmatic examples of that. These are cases typically where they're extremely hard to predict but even once they happen, the central bank tends to want to look through the impact, or the thought is that the policy tradeoff is so great that you wouldn't want a different path of policy in that environment. But then the other kind of forecast error you were describing there - this sense that maybe they misunderstood the inflation generating process, how sticky inflation expectations would be, how much they would be affected by changes in other prices, had the Bank got those things right, then maybe the path of policy would have been quite different. And there has been a policy error as a consequence of that. And so that obviously raises the question that had the Bank had a better forecasting record, what do you think the path of policy might have otherwise been? And then related to that, presumably, if we had tighter policy, that would have meant, all else equal, lower inflation, but also lower activity. So is it possible we could be looking at a world right now where rather than being criticised for its inflation record, the Bank is being criticised for its unemployment and recession record?

Michael Saunders

So, you have to accept that forecasts will usually be wrong, always be wrong in some way. Obviously, as you said, you sort of want the most important parts of the forecast, the bits most relevant for your policy decisions, to be as good as possible. But there's always going to be uncertainty over those. The Bank of England would have been a bit better placed had they been more aware of the risks, put more weight on the risks, that pay growth will pick up in response to the energy and price shock. I think it's also worth considering sort of risk considerations. What I mean by that is that it seemed to me in late 2021, early 2022, when I was a member of the MPC that even though the evidence of second round effects, for pickup in pay growth, was at that stage, not totally clear cut, there was some evidence, but you know, you could debate over whether it would persist and so forth. The consequences of policy error were asymmetric. In other words, if policy reacted slowly, and then pay growth picked up, then you would have to subsequently tightened very significantly, and rather late. And that would be at a time when inflation expectations already had risen. And you would then face a fairly difficult job of getting the economy back to target. Whereas if you tightened promptly, and it turned out to be too aggressive a tightening, well, you could always stop at what would still be a relatively low level of interest rates. So, as well as seeking to improve the forecast, it's always, it's also important to consider whether the costs of policy error are asymmetric. And at that time, I felt it was a lesser error, probably, to tighten promptly, rather than too slowly. Now, of course, we are where we are. Had policy been tightened a bit faster, a bit earlier, then probably the economy would have cooled a bit more by now, and inflation expectations would be a bit lower. You can never be quite sure as to how things would have unfolded, but I suspect that the tightening cycle probably would already have been completed. And second-round effects would not be as great as they are now. But I do want to stress, it is much easier to do these things with hindsight. You know, when you look back now, you might think, well, that was a really obvious thing, that they should have done this. But ask yourself, you know, what did you think at the time? And at the time, when you're making decisions amidst great uncertainty, you always have to accept that policy decisions usually will not be perfect. But those two principles, considering the risks and the costs of the risks, I think deserve considerable prominence.

Paul Diggle

Michael I will ask you more about the second round effects into inflation expectations, then, because part of, I think the international comparison here is interesting, because part of the seemingly ‘immaculate disinflation’ that the US is experiencing at the moment may be down to well-anchored inflation expectations. Why would the UK, why is it a special case in terms of the strength of second-round effects?

Michael Saunders

So the strength of second round effects have been much greater in the UK than in both the US and the euro area. I think the key difference with US is that the energy price shock and hence the rise in inflation from that was just nowhere near as big in the US as it was in the UK. So inflation never rose as much, didn't stay as high for so long, because they're less dependent on gas from Russia. So then, therefore, the spillover effects inflation expectations wasn't as large and the second round effects never really got going. As you said, pay growth has then come down pretty promptly. Of course, the euro area had the same energy price shock as the UK more or less. Inflation reached pretty similar levels, the contribution of energy prices to inflation was pretty similar. But second round effects on pay growth in the euro area have been much smaller in the UK. And my suspicion is this is because the euro area went into this whole episode with a background of persistently, extremely low inflation during the 2010s. Inflation generally, well below the ECBs 2% target, very weak pay growth, and so then, although inflation expectations got pushed up by the energy price surge, they had this sort of lagging anchoring effect from the depressing period of what people then call secular stagnation. Many people, of course, criticise the ECB for having allowed inflation to be so low for so long in the pre pandemic period. But perhaps a fortunate consequence of that was that inflation expectations and second round effects didn't rise as much when the more recent energy price shock came along.

Luke Bartholomew

So we've talked about forecasting errors, we've talked about policy errors, maybe the final kind of error that the Bank has been accused of is a communication error. And I think some of that criticism is maybe a little bit unfair insofar as the macro environment the Bank’s had to navigate and describe is an unpleasant one. And this is always going to be somewhat unpalatable medicine they're going to have to be prescribing and talking about, but maybe there is some truth that there was a certain tone-deafness about aspects of that communication. But putting that stuff aside, the bit I'm interested in is this criticism about how the Bank communicate with the market. Because the Bank has this somewhat peculiar process at the moment of forecasting the economy on the basis of what the market price of interest rates and other asset prices looks like. And then on the basis of how the Bank is forecasting inflation, under that environment, whether inflation is higher or lower, the market and other decision makers are meant to infer something about the Bank's view as to whether the market price is right or not. And this does seem like a very roundabout way of talking to the market and other decision makers more generally. So do you think the Bernanke review is going to look into this question of how the Bank communicates with markets, and do you have a preferred way of how they would do this?

Michael Saunders

I hope he does look at that, or even if he doesn't, but the Bank themselves have a deep think about this. So I think it is very useful for the central bank to give a broad indication to households and businesses as to whether interest rates are likely to be broadly stable, going up, going down in the next year or so. And perhaps, you can say, well, maybe they're going to go up a lot or a little. I don't think it's really necessary for central bank to try to forecast where its interest rate is going to be to two decimal points, 6 months out, 12 months out 18 months out, because that spurious precision. Events will come along and with a two-decimal-point forecast, it's always going to be incorrect. But to give a broad sense to households and businesses, I think, is very useful. And so for example, you can imagine over the last year and a half the way that the Bank of England could have done that would be each time they make a statement or publish a forecast to say, we expect that we’ve still got further interest rate increases to go. Just a general statement like that without trying to be too precise. Now, they haven't done that. Their approach is to forecast the economy based on the market path for interest rates. And then project whether inflation will be above or below targets two to three years out. And on the basis of that outside observers are meant to conclude that the market path for interest rates is too high or too low. What share the population do you think understand that? 0.01%? Maybe even that's over-optimistic. It requires people to know what the market path of interest rates is, so that already narrows it down really sharply to a small pool of people, and then to be able to calibrate, okay, so if the Bank of England is saying that inflation is, let us say, .3 below target two years out, that means that the market path for interest rates is too high by x basis points. In other words, the responsiveness of interest rates to a given inflation overshoot or undershoot. So I think it’s just kind of lost on most people as to what the Bank of England is trying to say in its forecast, and a statementt from the Bank of England that the market path of interest rates is too high or too low I don't think it's terribly useful for that broad audience of households and businesses, which is where comms should be directed to. So as I said, to me, the way to improve it is to just give a general steer, on which way interest rates are likely to be going. For the last year and a half that steer would have been interest rates are probably going to go higher. Right now, I think that they will be looking to shift to a more balanced message. It’s possible interest rates will need to go a little bit higher, but the bulk of the tightening is probably past. Chances are interest rates will be staying high for some time to come.

Luke Bartholomew

Well, Michael, with that very clear steer on where interest rates are likely to go, I think that is all we have time for this week. So as ever, please do let me ask you to subscribe and like us on your podcast platform of choice. And then all that remains is for me to thank Michael for joining us today. And thank you all for listening. So, thanks very much and speak again soon.

This podcast is provided for general information only and assumes a certain level of knowledge of financial markets. It is provided for information purposes only and should not be considered as an offer investment, recommendation, or solicitation to deal in any of the investments or products mentioned herein and does not constitute investment research. The views in this podcast are those of the contributors at the time of publication and do not necessarily reflect those of abrdn. The value of investments and the income from them can go down as well as up and investors may get back less than the amount invested. Past performance is not a guide to future returns, return projections or estimates and provides no guarantee of future results.

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