This is part of a series, “Economists Exchange”, featuring conversations between top FT commentators and leading economists
Like many of its peers, the Bank of England was badly wrongfooted by the scale of the inflationary upsurge in 2021. Since then, it has been attempting to prove it has got to grips with the problem, ratcheting rates up to the highest levels since the financial crisis and vowing to learn lessons from its sluggish reaction to the inflationary menace.
Huw Pill, the Bank’s chief economist, is at the heart of that response. A former Goldman Sachs and European Central Bank economist, he joined the Bank in September 2021, when the Consumer Prices Index was already heading rapidly north.
As part of the core team led by BoE governor Andrew Bailey, Pill has been seeking to better understand the drivers of the inflation while simultaneously seeking to improve the Bank’s ability to communicate the best way out.
He has championed the notion that policy will need to remain restrictive for an extended period of time given how sticky inflation is proving — an approach he dubs “Table Mountain” after the South African landmark. But a few days before we spoke, he wrongfooted markets by suggesting it was not unreasonable for them to expect rate cuts next year.
Pill took great pains to avoid repeating that message in our conversation last week, striking a decidedly hawkish tone on monetary policy. The Bank’s Monetary Policy Committee, he explained, has become more pessimistic about the UK’s supply capacity, a judgment that has important implications for interest rates and inflation.
Even if the headline inflation rate is retreating, as it did in October, this doesn’t mean the Bank can afford to relent on tough monetary policy. And central bankers may need to undertake a much wider rethink of the way they conduct monetary policy if supply capacity remains opaque and the geopolitical environment throws up more regular shocks.
Huw Pill: The challenge for the Bank, and other central banks too, is that headline inflation is coming down. Economic activity and employment growth are weakening. Most people read that through the lens of the Phillips curve (which maps the relationship between inflation and unemployment).
They say we’re moving along the Phillips curve and therefore that has implications for monetary policy. I think, though, that is a potentially very flawed interpretation of where we are — particularly in the UK but maybe in other jurisdictions too.
The decline in headline inflation is largely exogenously driven. It’s basically driven by the fact that we’ve seen this decline in energy prices and slowing food price inflation, and we’ve seen international goods prices basically stabilise. Those are the three main external sources that drove inflation up, and they have all now gone in the other direction and are bringing inflation down.
This is why I emphasise the supply side of the economy. To the extent that you think that slowing activity, spending and employment growth are associated with a deterioration in the supply performance of the economy — and not just a weakening in demand — you are not opening up that slack, that easing of resource pressures, which will bring domestically generated inflation down.
And so the challenge for the monetary policymaker is to ensure that there is enough persistence in the restriction of monetary policy to bring those components of inflation down. [And to do this] at a time when there would be lots of pressure in the face of weaker employment and activity growth and declining headline inflation, to declare victory and move on.
SF: Why has this supply story particularly now become more of a feature? Because we’ve been through a period of very poor growth for a while.
HP: I wouldn’t want to say it was either a seminal change between August and November, or that there is one specific thing.
There’s a view that the medium-term equilibrium rate of unemployment, the Nairu, may have risen somewhat. That is associated with a recognition, I think, that the ability of the labour market to match unemployed people to vacancies in the economy — we have a lot of vacancies still — has been less effective than we had judged in the past.
And so the degree of tightness in the economy — and particularly in the labour market, owing to that supply-side disruption — is probably greater. And behind that, to use a bit of jargon, is a view about the slope and the position of the Beveridge Curve, which maps vacancies into unemployment.
Judgments we make about the persistence of developments in wages and prices can come from the fact that there [is this] deterioration in labour market performance, but also from interactions in that wage-cost-price dynamic. On both dimensions, we took a more pessimistic view.
Despite the fact that activity has weakened in our forecast relative to what we anticipated, if you look at those key indicators of the persistent domestic underlying components of inflation [namely services price inflation and pay growth], those things have remained stubbornly high through the summer. Indeed, even in the most recent data, although both have shown a small — but welcome — sign of falling, they remain at very elevated levels.
SF: My colleagues did an interview with Bill Dudley, former head of the New York Fed, recently, where he said if you look at what’s going on in the US labour market, the Nairu could actually be lower than they thought. In other words, quite a positive story on supply and inflation there. If you look at the UK and the US, they are in very different places.
HP: We have been subject to quite different sets of disturbances and shocks to the economy, and, in particular, the impact of the Russian invasion of Ukraine and its impact through energy prices has been more disruptive in the UK.
That might have been both a disturbance to supply developments — those who are locked into certain energy sources or energy contracts will have had a kind of cost-push effect; it’s not costless to substitute alternative sources of energy. So that will have an impact on productive capacity in the economy.
The catalyst to that squeeze on incomes, which has led understandably to attempts to reestablish real spending power, has been the rise in energy and food prices. In particular as regards the former, this has been much more profound here, or was much more profound here last year than in the US.
SF: You suggested earlier this month, after the most recent set of forecasts, that it was not unreasonable for markets to expect rates to start falling from the middle of next year onwards. Since then, inflation has retreated more sharply than the BoE was expecting. So does that reinforce that judgment?
HP: For me, very much so in September and again in November, that decision between maintaining rates or raising rates was a very finely balanced decision.
We are entering, I think, quite a difficult phase for monetary policy where as yet I don’t think we have very positive news on the supply side. And the evolution of activity is one that has come in weaker than expected. So there’s slower growth in activity and employment as we’ve discussed. But because I think that is more supply-driven rather than demand-driven, the weakening of activity is not as associated with easing of inflationary pressures.
SF: But it seems a lot of the indicators of price pressures are going in the right direction right now — at least according to the data that we’ve had since the last MPC meeting.
HP: You have to be very cautious in terms of interpreting on the basis of one data release. So, I mean, by the same token, a lot of those indicators went in the wrong direction in preceding months. We’ve moved to having to rely, for good reason, on relatively late-cycle indicators of where we’re standing in terms of inflation.
When the supply side of the economy is very stable, very predictable, growing at a very standard trend, you could look at what the pressure on resources in the economy would be by focusing on indicators of demand, of which we have many. Because this was a very early-cycle, leading indicator, you could adjust monetary policy in a way that internalised the lags. Stabilising inflation in that environment was more straightforward.
What we face now is that the supply side has become more complicated, more volatile, more difficult to predict in the context of a global economy where we’ve had more volatility and more shocks.
I don’t think people anticipated Covid-19 or the Russian invasion at a relevant horizon that would have been informative or useful for monetary policy. So these are very significant and novel shocks. We haven’t seen these things for a century or for [several decades], in terms of a global pandemic or a kind of land war on continental Europe.
Given these large shocks, which have had significant supply effects in the UK, our ability to judge resource pressure and inflation can no longer just rely on looking at demand. That resource pressure is being influenced by very uncertain, very volatile, very difficult-to-predict things.
We’re having to sort of recognise that once we’re looking at more late-cycle indicators, we are not being so forward-looking.
SF: I was trying to make the case that since the meeting, the indicators had actually been showing a more conclusive cooling story.
HP: Precisely because we’re looking at these late-cycle indicators, if we respond to them aggressively we don’t have the ability to correct. We are not operating with this forward-looking ability. The crucial thing is we need to be sure that we’re looking at the signal in those indicators, the things that are really telling us about the persistent components of inflation.
There’s quite a lot of noise in the month-to-month data. When I look at the prints of those indicators through the past few months, I see more evidence of sort of stubborn, high-level rates of inflation or growth that are stronger than we would really see as compatible with price stability, 2 per cent inflation, over the medium term.
Of course, that’s not surprising. We’ve had a bout of inflation, things have to come down. But at the same time, I don’t think we can be complacent about the idea that a small decline in one month is really indicative of the pace of decline in those indicators that would lead us to be comfortable.
SF: There does seem to be a disconnect between what the markets think they see in the data and what central banks see as being necessary in order to ensure that they don’t move too prematurely to cut rates. What does it take to convince the markets they’re wrong?
HP: I hear different views from people in the markets. I guess that’s what makes the market; there are people with differing views on one side or the other side. We are making our judgments. They are making their judgments. Crucially, what we have to do as the MPC is to deliver the monetary policy through time that will ensure we get back to the 2 per cent inflation target.
I think the persistence of inflation, and the supply-driven character of that inflation, leads to this decision to put less weight than I might otherwise do on the apparent weakening: the observed weakening of employment and activity growth, in terms of a downward pressure on inflation.
SF: Do you think market pricing is reasonable at the moment?
HP: I generally make it a rule not to comment on market pricing, perhaps for good reason. So I won’t do that now. You only have to look at events in the Middle East — tragic events in the Middle East — as well as the experience of the past two or three years. The potential for new disturbances to the economy with potentially very large implications for inflation and therefore for monetary policy — those are all too evident. And those are the known unknowns.
The things that have proved difficult for us to manage, as we’ve seen over the past few years, are the unknown unknowns. By their nature we don’t know what those are. So we’re facing this uncertainty.
SF: Central bankers everywhere are licking their wounds from underestimating the inflation risks a couple of years ago. What are the key changes you anticipate being made to the Bank of England’s own forecasting process?
HP: Yes we have things to learn. And I think it’s important for any organisation with ambitions to be successful to be honest about its own weaknesses in the past, and show a willingness to learn from them. As you know, we have invited professor Ben Bernanke, who is very eminent in many dimensions, to come and help us with that [Bernanke is leading a review on forecasting for the BoE].
It’s not for me to try to lead him in one direction or the other. But I think we can talk to small things and we can talk to large things. I think there are a number of things on the small side; specific things that, with the benefit of hindsight, perhaps we could have known more about.
Probably there was an underestimation of the global character and complexity of the value chains. And that’s a little ironic because some very good research has been done, including by Bank staff members, on that issue, which probably was a bit undervalued.
I think another thing where we needed to learn more is around the behaviour of labour supply, the labour market, the furlough, which came to an end just as I arrived at the Bank. At the end of that period, there were still more than a half million jobs that were in furlough. As they were released out of furlough, they did not lead to an easing of the labour market.
And understanding why that was and what the implications of that are — and relating that to some of the subsequent discussions around the evolution of labour supply in the UK, early retirement, long term sickness and so forth — I think those are two spaces where we do have quite a lot to learn.
I think the weakness of labour supply in the aftermath of the pandemic and the end of the furlough was a surprise to us. The labour market was unexpectedly tight — and continued to tighten unexpectedly into 2022. And that meant that when we were unfortunate enough to be hit by rising energy prices following the invasion of Ukraine, the labour market was much tighter — and therefore more vulnerable — to second-round effects than I think we would have anticipated.
I do think that there’s a kind of broader and more strategic issue around the role of inflation forecasts within the monetary policy framework. Inflation forecasts can play a number of roles. They can be a way of analysing the data, so they force you to analyse the data in an integrated, comprehensive way that recognises the interrelations among different parts of the economy.
Related to that, but I think somewhat distinctly, the forecast can be a mechanism to calibrate and design monetary policy responses. It can be a vehicle for presenting, communicating and signalling those monetary policy responses. It can be a vehicle for trying to stabilise private sector inflation expectations.
Now, in the halcyon days of inflation targeting 20 years ago, in a much more benign environment, I think a single forecast and a fan chart could serve a lot of those roles simultaneously.
But in the face of very big external shocks, big deteriorations in the terms of trade, the big energy price shocks we saw in 2022, boosting inflation, disturbing the economy and making forecasting very difficult, I think it became more and more difficult to say a single forecast could serve all those purposes well.
We need an internal analytical framework to allow us to make the assessment in a comprehensive way; do we need to force all of that into a single forecast? Should we have different forecasts that we compare with one another? Should we be looking more at monetary data? Should we be looking more at financial data? I think those are all good questions.
That’s a much more complex framework for internal analysis. And I think it begs the question: is that too complex for external communication and signalling and those sorts of things?
[BoE watchers] have been trained over a very long period to look at the fan-chart that’s been published by the bank and extract from it all the information they need about why interest rates have been changed in the UK and where they are going to be changed in the future. And I think that hasn’t proven a very effective way of communicating, frankly.
So we need to come up and develop a new way. And what role forecasts will play in that, I think, remains a bit of an open question.
There are things we can do to improve the inflation forecast. There are certain spaces that — with the benefit of hindsight — we should have, or could have, known more about, maybe; or at least we know more about now.
I think there are more fundamental questions here about how we design the framework for monetary policy. And you know, my own view — and again, I don’t want to front-run the Bernanke report and how we respond to that — but my own view is that the experience of the past few years has made reliance on a single forecast quite a vulnerable way of approaching it.
An alternative is a presentation and analysis of monetary policy based on various scenarios, where those scenarios are descriptions of ‘this is how we see the world today’ and where it might lead to, but then complementing that by ‘what if’ questions. What if the world changed in this way? How would we reassess the world in that environment? What might that imply for policy?
I think that there may be advantages in using that type of framework for discussing and communicating policy, rather than fan charts of a single forecast.
SF: Especially, I suppose, given we are in a period of geopolitical turbulence, of more supply shocks or disturbances, which central banks find quite difficult to handle.
HP: Right. This is a deep question, and kind of an imponderable question. All those big shocks recently — are they just like all from one tail of the same distribution we’ve always had? Or has there been a shift in that distribution of shocks in the direction of more variance, more uncertainty, bigger shocks?
We’ll probably never know, definitely, the answer to that question. But any answer or any interpretation of what that answer might be will have quite big implications for how you think about the framework.
One thing I could say is we’ve just been really unlucky and there were lots of good things about the old framework that we should retain. There’s been a perfect storm. All of its vulnerabilities have become manifest together, and it’s been a painful period for people trying to design, communicate and implement monetary policy, but we can reestablish ourselves back in the old framework as those large shocks pass. I’m sceptical of that argument.
I think that we have entered — or perhaps gone back to — a world after the Great Moderation after the NICE [non-inflationary, consistently expansionary] decade, etc; a world that is more volatile. As people said at the outset of the inflation targeting here in the UK — for a smallish open economy subject to lots of external shocks — the ability to forecast, to keep inflation close to target on a pretty much continuous basis, those two elements were very key to the halcyon days of inflation targeting.
But they have been challenged by the events of the past two years. If this is a permanent shift rather than just a temporary phenomenon, then I think the framework for monetary policy needs to recognise that.
I don’t know what Bernanke will say and I don’t know where that may lead to. But I do think that thinking about how to address that sort of heightened level of uncertainty and in particular the potential for unknown unknowns — having the presentation of ‘what if’ scenarios as well as a ‘where we are’ scenario — could be a way of developing more robust thinking internally, and improving understanding externally of what a monetary policy formulation might be.
SF: None of that leads you to think that the inflation target itself is in the wrong place or needs to be thought of in a different way?
HP: This will sound like an elusive answer in the first instance, but I will not elude you completely. The inflation target is something for the government to set, so in a sense that’s a question for them, not for us.
But, having said that, moving the goalposts just because scoring a goal is more difficult doesn’t seem to me to be the right answer. I strongly believe that the framework we have, which puts price stability in at its centre and encapsulates that in the form of a 2 per cent target, is providing an anchor. Achieving that provides an environment that allows all the other actors in the economy to make those investment decisions and planning decisions, in a way that maximises innovation and dynamism and creativity, and creates the growth and productivity expansion that generates higher living standards.
So we are serving the broader interests of the economy by doing quite a narrow technocratic task. And I think that’s the way the framework is set up. If you shift the inflation target in any way that hints towards opportunism — it’s hard to meet, we like low interest rates, etc — that would be very, very detrimental to the credibility of the framework.
So I think it’s something that should be done with extreme caution, and from a position of strength, after a period where you reestablished and maintained stability at the target for some time.
And I think the arguments for moving in one direction or another are not strong, frankly. I mean, people tend to focus on one side or the other. I think there are arguments in both directions and the net of those arguments is not compelling to me as a reason for change.
It’s the job of the MPC to use [the tool of monetary policy] to get inflation to target. If we try to do other things, we will not deliver on our target, and we won’t be very effective in doing these other things that we’re sometimes asked to do. Because it’s a tool that is not well designed to achieve distributional [aims] or growth or other types of objective.
Don’t distract it by asking it to do things that it cannot do.
The above transcript has been edited for brevity and clarity
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