UK Monetary Policy Report April 2024

Introduction

Following a series of economic shocks (such as Covid-19, Brexit, and the combined impact of the Ukraine War and the Global Energy Crisis), the UK remains within a turbulent economic landscape. Fully understanding the impact of these shocks is paramount, requiring the use of robust methods such as the three-equation model. This model offers crucial insights for exploring the dynamic relationships between these shocks and their impacts on consumption, unemployment, inflation, and the responses of the Bank of England.

By employing the three-equation model, policymakers can gain valuable insight into both the immediate and potential future of the economy. This model enables policymakers to anticipate and potentially mitigate forthcoming shocks (such as persistent productivity issues, increasing strain on the labour market, potential disruptions in the Middle East and nearby shipping routes, and the investment in low-carbon technologies) and facilitates recommendations to be made based upon the model's assumptions and dynamics.

Three-Equation Model

The three-equation model is particularly useful for policymakers as not only does it describe the impact of a shock on the economy but it also explores the mechanisms involved in reaching this new state and how it changes through various time periods. Whilst the model is somewhat abstract, it still has empirical underpinnings, through its modelling of consumption, unemployment, and its link to inflation, as well as a central bank’s policy remit. The model is also particularly useful for informing policymakers on where the economy is headed, while being helpful for modelling hypothetical shocks so that the government may be prepared.

In motivating this model, it is important to understand why the traditional IS-LM/MP model is not used, with the primary reason being the model’s disconnect from how a central bank conducts policy. It is unrealistic as central banks do not target money supply but instead target the interest rate (Carlin & Soskice 2015), evident by the Bank of England having an inflation-targeting remit as a policy goal (Bank of England 2024a).

The first component of the model is the Investment-Savings (IS) curve, which a function of consumption in the economy (household, firm, or government), and is characterised with two equations as follows:

The IS curve equations describe the level of consumption (y) (equation 1) and the sensitivity of consumption with a change in the interest rate (equation 2). As a change in the level will prompt a change in the set interest rate to stabilise the economy, or a change in the interest rate to intentionally alter consumption.

The next component is the Phillips Curve (PC), which describes the link between unemployment and inflation:

The PC equation (3) seeks to explain the impact of the output gap, as well as the previous rate of inflation on the current rate, reflecting a form of backwards-looking inflation expectations.

Finally, the Monetary Rule (MR) curve is a function that seeks to model the central bank’s approach to setting an interest rate, and is described as follows:

The MR equation describes the inflation gap through building upon the PC (α), the central bank’s attitude towards inflation/unemployment (β) and finally uses consumption to model the output gap (y_t - y_e).

The central bank’s loss function is characterised as follows:

This equation describes the central bank’s response to changes in output and inflation, with inflation or unemployment aversion expressed through the β term. The central bank attempts to minimise the loss function subject to the Phillips Curve, resulting in:

Another element of the model is based upon central bank behaviour and how it relates to setting the interest rate. The central bank can only affect the nominal interest rate, but is able to affect the real interest rate through the Fisher identity:

As a result, the central bank is therefore able to affect the real economy, given the previous period’s inflation rate.

Whilst most of the model is endogenous, there are still assumptions to examine. The first assumption is that inflation is persistent and slow to adjust, known as inflation-inertia, allowing inflation to remain (Carlin & Soskice 2025).

Secondly,  the model explores the difference in adaptive expectations (backwards-looking) and rational expectations (forward-looking), and it is reasonable to describe expectations as predominately backwards-looking for various reasons, with the key reason being that backwards-looking expectations places upwards pressure on inflation during inflationary periods, based upon the assumption of inflation inertia. Backwards-looking inflation is also supported by disinflation being a painful experience due to disruption in employment and consumption (Carlin & Soskice 2015; Bank of England 2019).

The final assumption relates to time between a change in monetary conditions impacting inflation taking between one to two years to manifest. With 1 year between a change in the Bank Rate to affect output, and a further year for output to impact the inflation Rate (Catherine 2023).

Current UK Macroeconomic Climate

Currently, the UK is in a turbulent period, experiencing shock after shock. Major shocks to the economy include the Pandemic, the UK’s withdrawal from the EU (Brexit), as well as the combined impact of the Ukrainian war and Global Energy Price Crisis.

The Monetary Policy Committee (MPC) report (Bank of England 2024) suggests that the UK economy has experienced significant impacts from the Pandemic. Due to the Lockdowns and general uncertainty in the early days of the Pandemic, consumption fell for almost all goods and services except for essential items. Using Appendix 1,  the three-equation model curves explain the near instantaneous collapse of consumption with the new IS curve. This negative consumption shock pushed inflation down and output below the long run target for the economy.

As the Pandemic continued and inflation expectations were able to form, combined with inflation inertia, inflation was further pushed down together with decreasing output. As the economy experienced the shock, the Bank of England was prompted to decrease the Bank Rate to 0.1% (Bank of England 2024b).

However, to prevent a total collapse of consumption, the UK Government introduced the Job Retention Scheme, designed to prevent mass unemployment and support households through the Pandemic. Although, this scheme created massive amounts of disposable income, with the household M4 to annual gross disposable income jumping to 115% (Bank of England 2024) from 100% (pre-pandemic trend). As a result, when Pandemic conditions eased and Lockdowns lifted, households who possessed pent-up savings when on to suddenly spend large sums of money, graphically explained in Appendix 2.

However, due to varying Pandemic responses in different countries, supply chains were severely disrupted, increasing costs and shortages for various goods and services, impacting both households and firms. Thus, as inflation began to rise, combined with newly forming expectations and disruption to trade, the rate continued to rise further.

The MPC report (2024) continues to discuss Covid’s unwinding impact on the UK economy through various means (productivity recovery, labour participation, lending to businesses, etc.), it remains unclear whether the Pandemic’s direct economic effects will be permanent, however, as demand is not yet back to ‘normal’ pre-Covid levels and with changes to consumer preferences that have adjusted to the Pandemic is unlikely to change, potential second-round impacts may be likely to make the economic effects of the Pandemic permanent.

The MPC report (2024) also suggests that the UK economy experienced significant impacts from Brexit, particularly for investment, employment, and consumption. The nature of the Brexit, combined with the agreements that have been negotiated, have led to increased trade friction, increasing the costs of goods and services for households and businesses. As Brexit continues to impact the economy, the first area of consideration is investment and uncertainty, as firms were likely to postpone any planned investment and change their forecasts. However, this was not always possible due to the uncertain nature of the withdrawal agreements (Bank of England 2024).

Using Appendix 3, this drop in investment can be visualised using the new decreased IS curve. This negative consumption shock pushed down inflation and output below the long run target for the economy. However, due to the fundamental changes to trade for the UK, this is likely to be permanent, with the initial shocks to the economy unwinding as expectations form and stabilise (Bank of England 2024).

Following Brexit, the UK has experienced major shifts in the labour force, with labour market tightness significantly increasing due to a large number of EU nationals leaving the UK (Portes and Springford 2023) combined with increases in vacancies within various sectors (Office for National Statistics 2024a). Through the Phillips Curve and its linking of unemployment to inflation, the Phillips Curve is set to rise (Appendix 3) as wages required to attract labour increase, however, this would be in direct contrast with the negative consumption shock relating to Brexit, leading to further uncertainty in forecasting and modelling, further delaying investment.

Finally, general household and firm spending relating to essential goods and services increased due to trade frictions. Using Appendix 4, these additional costs are able to be explained through the small increase in the IS curve. This positive consumption shock pushed up inflation and output beyond the long run target for the economy, mostly relating to new increased shipping and bureaucracy costs, especially for small & medium enterprises.

The combined impact of the Ukrainian War and the Global Energy Crisis was particularly disruptive to the UK for different aspects of CPI inflation (Bank of England 2024). Both shocks had significant impacts to food & beverage and energy inflation (Office for National Statistics 2022), severely placing pressure upon households and various sectors of the economy, especially hospitality and energy-intensive industry (Bank of England 2024a), quickly pushing consumption, and the IS curve, up, as suggested by Appendix 4. This positive consumption shock led to quickly increasing inflation due to the instantaneous impact on supply chains and essential imports for the UK, which in turn pushed output beyond the long run target, however, this is unlikely to be permanent as data from the Office for National Statistics (2024b) shows that inflation in these areas has slowed, with major reduction in food & beverage inflation.

A similar trend is shown in energy prices, with inflation returning to lower levels once more (Office for National Statistics 2024b). However, whilst inflation in the food and beverages industry has stabilised, consumer attitudes have shifted towards being more price sensitive than before with consumers seeking brands that are more value-for-money (Bank of England 2024a). This change in consumer preferences is likely to be permanent, especially when considering how consumers now value more sustainable and healthier options (Bank of England 2024a), which is likely to alter consumption and how firms operate, further increasing uncertainty for the economy and its economics actors.

The Future: The ‘New Normal’, Energy, and Geopolitical Instability

Whilst the aforementioned shocks and the more major impacts to the economy have begun to wind down, some quicker than expected (Bank of England 2024a), there is still uncertainty for the UK economy surrounding productivity, labour supply, and geopolitics, as well as the shift to a low-carbon economy. Gross Value Added (GVA) estimates the Pound Sterling value of each hour worked and its contribution to Output or GDP and is typically used as a measure of productivity and is useful for analysing various sectors (Office for National Statistics 2024c). As Appendix 5 shows, there is a clear trend for the economy as a whole, with the shocks for the Great Financial Crisis (GFC) and the Pandemic evident as drops in GVA. However, more current data shows a minimal growth, across all industries (categorised by SIC codes) throughout the UK. 

As Mason et al. (2020) confirm, the UK has been suffering low productivity growth and has not returned to trend since the GFC, and Appendix 5 shows no upticks in growth for future forecasts, suggesting that this will continue to be a long run issue.  The sluggish in growth in output makes it difficult for long run output targets to grow with the economy, as setting targets beyond the natural rate output is likely to lead to inflation bias (Carlin & Soskice 2015). Inflation bias can particularly be an issue because as governments or central banks target beyond the natural rate, the resulting new output places pressure upon inflation to increase and in following time periods, expectations adjust for increased inflation, further pushing inflation up and prompting the central bank to increase the Bank Rate, returning output to the target with increased inflation (Carlin & Soskice 2015).

Mason et al. (2020) also explore the possibility of labour supply and poor skill matching being a potential cause of the poor productivity growth that the UK experiences and suggests that subpar readiness of graduates and other entrants to the labour market. This, combined with increased labour market tightness from the heightened vacancies (Bank of England 2024a; Office for National Statistics 2024a) is likely to put further strain on the labour supply and, through the Phillips Curve, create upwards pressure on inflation for firms due to increased operating costs as the firm will need to spend more on wages to attract workers and invest more on training unprepared employees, reflected through increases in prices for goods and services, evident from the heightened wage growth in the economy (Bank of England 2024a).

April 2024 also saw an increase of nearly 10% for the National Living Wage (NLW), which was also extended to 21-year-olds (Bank of England 2024a), this came as a shock to firms and businesses that were not well positioned for this increase. This, combined with the already heightened labour costs will push consumption up in the IS curve and the Phillips Curve (due to tight labour market) and may create inflationary pressures on the economy. However, the Bank of England (2024a) is forecasting a slowdown of wage growth, suggesting that this source of inflationary pressure will be temporary as the economy moves to a new normal.

There also remains risks around the projection for inflation due to international factors, such as the recent events in the Middle East with the Bank of England (2024a) beginning to model potential impacts of disruption if shipping through the Red Sea were to be compromised. Disruption in the Red Sea may lead to shipping and transport becoming more costly, combined with decreased imports of essential items raising prices for households and firms in the UK (IMF 2024). Using Appendix 4, this increase in consumption would translate to an increase in inflationary pressures within the UK economy, which may prove problematic at a time when the Bank of England is attempting to reduce inflation through increased Bank Rates (Bank of England 2024b), and any further increases in the Bank Rate will make disinflation even more painful for households and businesses. However, beyond standard cargo shipping, the Red Sea is also important for oil and gas imports and the Bank of England (2024a) suggests that any further disruption to the shipping routes is likely to create a second Global Energy Price crisis, as the current downwards trend of oil and gas wholesale prices would instantly reverse due to a sudden drop in supply.

As the UK Government’s deadline of zero emissions by 2050 approaches, there are likely to be fundamental changes in the structure of the economy, especially for the energy sector and related labour markets. As the UK Government explains in the Growth Plan 2022, the justification for low-carbon technology, beyond fighting climate change, is to decrease household and business spending on energy. However, this will require large amounts of both public and private sector investment (HM Treasury 2022). Using Appendix 4, this increase in investment from both sectors can be modelled using an increase in the IS curve. However, this increase in investment is likely to lead to inflationary pressures, especially when such investment is likely to create new jobs and place further strain on the labour supply creating an environment where the Phillips Curve is likely to increase, further pushing inflation up. Although, the Bank of England (2022) explains that a smooth and controlled transitionary period may be enough to protect the economy from these inflationary pressures, until a new low-carbon economy is established, and that the intended reduced spending on energy is able to take place. However, the Bank of England (2022) cautions that any price shocks during the transition (such as sudden increased costs for the import of carbon-intensive energy) may be different to shocks that the UK has faced in the past, such that any resulting impacts from a shock may become entrenched and the new natural state of the economy. 

Policy Recommendations

In the current economic landscape, with the effects of Covid unwinding and Brexit continuing to evolve, the UK finds itself at a pivotal moment, demanding nuanced and agile policy responses to navigate through complex economic challenges.

Initially, the Bank of England (2024b) set the Bank Rate at 5.25% to curb high inflation which peaked at 11.1% (Office for National Statistics 2024b). Despite inflation decreasing to 3.4%, near the 2% target set within the Bank of England’s remit, the Bank maintains this rate. When considering the concept of time lags set out by the three-equation model, maintaining this Bank Rate risks over-adjusting for the various shocks and pushing inflation below the 2% target.

Moreover, amidst the ongoing geopolitical tensions, it is imperative for the Bank of England to adopt a proactive stance and regularly monitor global developments that may impact domestic economic conditions. This would provide more opportunity for agile monetary policy that enables swift adjustments to the Bank Rate in response to evolving geopolitical events, in contrast to the Bank’s previous response lag of almost one year before increasing rates when inflation was already increasing past 5%.

Therefore, it is advisable to slightly reduce the Bank rate to prevent over-adjustment and gently steer inflation back to the 2% target. Doing so will also prevent the need for frequent adjustments in the future Bank Rate as inflation fluctuates around the inflation target before returning to the target.

This slight reduction in the Bank Rate, combined with regular monitoring and revisions for more agile Bank Rates, is also likely to provide households and businesses with gradual relief. Furthermore, it will support businesses in their efforts to advance towards low-carbon targets since borrowing will become more affordable, which is an ongoing concern for businesses (Bank of England 2024a), thereby preventing a sudden increase of investment spending as the UK approaches targets set out by legislation and avoiding future inflationary pressures.

Furthermore, drawing from insights of Carlin & Soskice (2015), announcing changes to the Bank Rate prior to implementation can play a crucial role in shaping inflation expectations, and can help direct inflation downwards towards the target even further. Transparency about forthcoming changes in monetary policy also enhances understanding and forecasting ability amongst households and businesses, thereby reducing uncertainty and allowing for more stable inflation expectations.

Conclusion

The current economic landscape of the UK is characterised by a series of complex interacting shocks, including Covid, Brexit, and the combined impact of the Ukraine War and the Global Energy Crisis. As these shocks unwind, the Bank of England begins to model further impacts of decreased productivity, tightening labour markets, heightened geopolitical tensions and the incoming low-carbon deadline.

Through the use of the three-equation model, policymakers can gain valuable insights into the dynamics of these shocks and their impacts on the economy, namely consumption, unemployment, and its link to inflation, as well as modelling the Bank of England’s response. By understanding these dynamics, policymakers can create more targeted and effective responses to ensure economic resilience and growth.

Whilst the Bank of England has taken steps to reduce inflation through the Bank Rate, there is the possibility that the Bank may over-adjust and bring inflation below the 2% target, resulting in future periods where Bank Rates may fluctuate to help bring inflation in line with the target. Therefore, a marginal reduction in the Bank Rate is necessary to gently bring inflation down without creating unnecessary pain to households and businesses through disinflation, and achieve a 'soft landing'.

Moving forward, it may also be in the interest for the Bank of England to pay further attention to geopolitical events to anticipate and design responses before high inflation takes hold once more.

Appendix

Appendix 1: Economy in equilibrium, followed by a large decrease in the IS Curve (IS1) , translating to a decrease in inflation (π1) and inflation expectations (π2). Decrease in the Bank Rate to return the economy to the original output and reduce the output gap.

Appendix 2: Economy in equilibrium, followed by a large increase in the IS Curve (IS1) , translating to an increase in inflation (π1) and inflation expectations (π2). Increase in the Bank Rate to return the economy to the original output and reduce the output gap.

Appendix 3: Economy in equilibrium, followed by a small decrease in the IS Curve (IS1) , translating to a decrease in inflation (π1) and inflation expectations (π2). Decrease in the Bank Rate to return the economy to the original output and reduce the output gap.

Appendix 4: Economy in equilibrium, followed by a small increase in the IS Curve (IS1) , translating to an increase in inflation (π1) and inflation expectations (π2). Increase in the Bank Rate to return the economy to the original output and reduce the output gap.

Appendix 5: Gross Value Added for the UK between 1955 – 2023 (ANNUAL) (a) (Office for National Statistics 2024c)  and 2022 Feb – 2024 Feb (MONTHLY) (b) (Office for National Statistics 2024d)

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