GBP/USD remains subdued as Truss becomes UK’s Next PM

tweet at 12:24pm: BoE’s Mann: Whether BoE Should Raise Rates By 75Bps Is An Important Question - Must Ensure Inflation Expectations Do Not Drift Further From Target

At its meeting last month, the Monetary Policy Committee came together to deliver on its pledge that it would react forcefully in response to more persistent inflationary pressures. A large majority agreed that this condition had been met and that we were indeed seeing persistence so the hike by a half percentage point was the appropriate course of action at that meeting. This sends a strong signal that the MPC is committed to leaning against domestic inflation pressures becoming further entrenched. Now, some commentators have pointed out that the MPC’s central forecast projects a pro-longed recession over the next quarters, and that this slack would yield inflation falling below the target in year three.footnote[1] Therefore, they claim inflation to be vanquished already and indeed that monetary policy already has become contractionary. Further, since the shocks hitting the UK economy have come mostly from external sources – supply chain frictions, energy prices, war – they claim that the MPC need not tighten further, but rather can ‘look through’ these shocks, since they will mean-revert. In this speech I’m going to argue that, while some elements of this line of argument might hold in normal times, it is based on an incomplete view of the inflation process and of the channels through which monetary policy can achieve our remit. Specifically, in today’s environment, inflation expectations take a central role, alongside the standard channel of aggregate demand and slack. Looking through the lens of inflation expectations, achieving the remit depends on ensuring that inflation expectations in the short-term do not become adaptive, and that medium-term inflation expectations do not drift, so that long-term expectations remain anchored. What most people seem to have in mind when thinking about the determinants of inflation is a variant of the Phillips curve (Phillips, 1958), which relates inflation to some measure of slack in the economy. In the earliest version of this model, inflation today is determined by economic outcomes yesterday – inflation therefore will adjust slowly and with considerable lag. To bring inflation down, when the MPC raises interest rates, it increases borrowing costs for firms and households causing them to spend less, unemployment eventually rises and slack opens up. Only then do companies adjust prices in response to slowing demand for their goods and services. In Friedman’s (1961) story of “monetary policy having long and variable lags”, this is where the “long” comes from. Importantly, since lagged inflation is pre-determined, the only way to get inflation down from high levels is to depress aggregate demand for an extended period of time. In this formulation, disinflation is costly and necessarily so. I do not dispute that this mechanism exists, but I ho tweet at 11:30am: BANK OF ENGLAND'S MANN SAYS CREDIBILITY OF MONETARY POLICY IS INTACT tweet at 11:33am: BOE'S MANN SAYS THE GRADUAL PACE OF INCREASE IN BANK RATE HAS NOT TEMPERED EXPECTATIONS ENOUGH tweet at 11:33am: BOE'S MANN SAYS THIS HAS THE POTENTIAL TO CEMENT EXPECTATIONS INCONSISTENT WITH THE 2% TARGET WHICH WOULD NECESSITATE A PERSISTENTLY TIGHTER STANCE OF MONETARY POLICY tweet at 11:35am: BOE'S MANN: TO AVOID INFLATION, WE MUST ACT FORCEFULLY NOW.