MNI POLICY: Iran War Shock To Magnify BOE's MPC Fractures

The energy price shock from the Iran war is likely to magnify existing fractures within the Bank of England's Monetary Policy Committee, with disagreements over the lessons to be drawn from the supply-side-driven price surges in the early 2020s and how policy should react to the risk of a jump in inflation expectations.

Whereas a March cut had been almost priced in before the outbreak of the conflict, markets no longer see any chance of easing on Thursday, and instead expect some tightening by the end of the year. A decision to hold this week is likely to be near unanimous as an otherwise divided MPC will want to wait in order to determine the impact of the rise in energy costs, at the very least until it has completed a full forecast round and new scenario analysis ahead of its end-April meeting. (See MNI: BOE Needs More Varied Scenarios - Bean, McMahon)

But as sharply higher energy costs feed through, they are likely to further fuel disagreements within the nine-member committee.

CONCERN OVER EXPECTATIONS

On one side, the generally hawkish Chief Economist Huw Pill has argued that the response of monetary policy to an energy price shock depends on "the magnitude of intrinsic inflation persistence", essentially the degree to which the initial shock becomes embedded in wage and price setting. The longer firms and businesses expect energy prices to remain high the greater the risk of more persistent elevated inflation.

Clare Lombardelli, as head of the Bank's monetary policy wing, has similarly urged caution in assuming that energy shocks are temporary, highlighting how the BOE’s models struggled to capture the jump in prices following the Russian invasion of Ukraine, in part due to structural changes in the economy. 

And Megan Greene and Catherine Mann, who have both opposed recent easing, have worried about the feedthrough from elevated inflation expectations, with Greene putting the spotlight on the evolution of core and services inflation measures. The most likely response from all four of the above is likely to err towards hawkishness.

However, on the more dovish side, Alan Taylor and Swati Dhingra, the two dissenters calling for a cut in February when Bank Rate was held at 3.75%, are likely to be less concerned about a rise in expectations. 

POST-UKRAINE POLICY

Taylor’s view of the Iran shock should mirror his reading of policy in response to the energy squeeze from the Russian invasion of Ukraine. He has pushed back on criticism of the Bank for allowing headline inflation to reach double digits in 2022, arguing that monetary policy cannot address the cause of supply shocks while its lags mean that any tightening tends to take effect long after the shock has passed. The path actually taken – by looking through much of the relative price shock and letting the price level adjust while keeping an eye on the medium-term anchor –  was the right choice, he has said.

In a similar vein, Dhingra, a trade economist, has highlighted that the impact of the previous energy price shock on inflation was not due so much to domestically-generated inflation as to higher costs feeding through supply chains with a lag. A weakening labour market allows for little cost-push inflation, she argues.

Deputy Governor Dave Ramsden may also be sceptical of the need to react quickly to energy-driven inflation. He has previously cited research by former MPC member Gertjan Vlieghe showing that while energy shocks can drive core and services inflation higher, these effects are temporary and do not provide reliable measure of underlying inflationary pressures. (See MNI INTERVIEW: Services Inflation Poor Policy Guide - Vlieghe)

The other deputy governor, Sarah Breeden, will probably calculate that the inflation impact of this round of energy price rises will be smaller in magnitude than that seen in 2022, given labour market weakness. 

All of this points to a split Committee. Making things harder to read, Governor Andrew Bailey, while a technically accomplished central banker who made his name dealing with financial crises, is not seen as a monetary policy thought leader, so his views cannot be looked upon as a guide to how he might adjudicate the divisions. (See MNI BOE WATCH: On Hold, Policy Guidance To Shift To Balanced)