Inflationary dynamics appear to be “embedded” in the economy, according to a Bank of England rate-setter, as she advised a “guarded” approach to interest rate cuts.
Catherine Mann, who is one of the most hawkish policymakers on the Monetary Policy Committee (MPC), laid out a range of reasons why she has taken a cautious approach to cutting interest rates.
“Structural behaviours in UK labour and product markets appear to have systematically embedded inflation,” she said in a speech in Lithuania.
“Policy therefore needs to remain restrictive for longer to purge these behaviours.”
Mann worried that the wage and price setting behaviours might have changed given the range of shocks the economy has faced over the past few years.
In particular she warned that wage growth could keep prices in the services sector persistently above target if workers were to seek bigger pay packets in response to the inflationary shock.
“Workers may reasonably seek sustained above-equilibrium wage growth to recover the loss in purchasing power caused by the shocks I’ve described,” she said.
Partly as a result of these structural changes, Mann argued that the neutral interest rate – the rate at which an economy operates at full capacity with a steady rate of inflation – had increased.
This would imply that monetary policy has actually been “less restrictive” than the Bank’s models suggest.
Mann also flagged concerns over the potential impact of international spillovers onto the UK economy, particularly as the future path of interest rates among major economies is likely to diverge in the coming months.
“As a small open economy, the macroeconomic and monetary conditions of the UK’s largest trading partners matter significantly for the domestic outlook,” she said.
Given uncertainty over the likely performance of the US economy and the Fed’s response, Mann suggested that the Bank needed to be cautious.
If the Bank took a “dovish” approach, for example, this could cause sterling to undergo a major deterioration, which would then feed through into import prices.
For all these reasons, Mann said she favoured a “guarded” approach to cutting rates.
However, Mann suggested that once inflationary dynamics had been quashed, it was better for the Bank to reduce rates quickly.
“It is better, under inflation uncertainty, to remain restrictive for longer, until right tail risks to the inflation process dissipate, and then to cut more aggressively,” she said.
The speech comes after the Bank of England voted 8-1 to hold interest rates at five per cent yesterday.