The following is a lightly edited and condensed transcript of an FT interview with Bank of England governor Andrew Bailey that took place on May 29. The related news story is here.
What have you learned since the April meeting about how the UK economy is responding to the energy shock?
I don’t think we’ve had news since the April meeting in terms of response to the economy that particularly changes my view. We’ve had further evidence of gradual softening of the labour market, and the inflation number came in a little bit below what we thought it would be. But if you decompose that inflation number you get to the conclusion that, had these events in the Gulf not happened, we’d have probably been at target, which is broadly what we were expecting.
I think we have to be careful how much we interpret here, because we know that any energy shock will come through over time. The UK is a bit more delayed because of the way the Ofgem process works. It’s like running a race where we run a bit more slowly in the early part, but that’s not telling us a lot [in terms of] where are we versus others.
But it is going on against a softer labour market. We think there’s a smallish output gap opening up. And that’s the context for this judgment about second-round effects.
Energy prices have come down a bit. It’s also worth bearing in mind that this is more of an oil shock versus a gas shock, whereas 2022 was the other way around. Gas affects UK household energy prices more than oil.
On the energy front, I don’t think we’ve seen conclusive evidence one way or the other, in terms of which scenarios we’re in.
In April, your base case was scenario B with reduced second-round effects.
Yeah. I don’t think I’ve seen anything that changes that view.
If we did get a ceasefire agreement with a 60-day reopening of Hormuz, would that take us to scenario A?
No, I think it would not do that. I think it would give me a bit more confidence on my weight on B. But if you take apart what that would add up to, 60 days is worth having, but it would still create uncertainty as to what’s going to happen in 60 days’ time. That’s the first thing.
Secondly, I think we’ve still got this question about how much damage has been done to the energy supply infrastructure, where all the assessments we get suggest that oil would be disrupted for a period of time, whereas with gas, there has been actual damage to the physical infrastructure.
A 60-day pause would be helpful, but it’s not going to end the issue.
Does that mean that is Scenario A still extant?
Yes, I think it is still extant.
I would be looking at what was said about the 60-day pause. Is it an optimistic 60-day pause? Or is it something just a lot more vague?
The second part of A is the question of the infrastructure damage and the production capacity of the rest of the world. Before the war, we were looking at conditions of quite a surplus in the oil market. How optimistic would we be about going back there?
The third part is the second-round effects, where A had none. But that’s conditional on how long the war goes on for.
So, no, A’s not dead in the water. But the moment, my April judgment around B would be probably where I would stick if we had a 60-day peace.
If there is a pause, but no further noise about the future, would you say that that won’t have a material impact on energy prices?
I think a pause which just leaves uncertainty hanging over everything, is obviously not as good as a pause which is framed in terms of, look, we’re really making progress here.
On the data side, you have vacancies going down, you had private sector pay that was pretty weak, you had inflation that undershot, and the survey data is also quite weak. And the DMP is showing that there’s not really momentum in terms of wage growth expectations. So what makes you so worried about second-round effects?
If we do get a much more difficult energy price scenario, it’s going to put severe pressure on margins. And the question is, how much strength can those margins take?
In terms of the pay statistics, we have got more of a wedge opening up between private sector pay and public sector pay. Traditionally, in the MPC, we’ve put much more weight on private sector pay because we think it feeds more directly through enterprises. But I think the more that wedge opens up, you start to have a few doubts on that front.
I think that it is interesting that there’s a bit of a different read between the message we get from inflation expectations and the message we get from wage expectations. Now, how to interpret that? Well, the private sector wage story does look reasonably benign.
With inflation expectations, I’m not surprised that we’re getting a slightly different story, particularly on short-run expectations, because of what happened four years ago. Now, we don’t think the shock is anything like four years ago. But I can understand why we would see some that get reflected through into inflation expectations.
Would you say that you’re looking most closely at inflation expectations for evidence of second-round effects?
No, I’d be looking at the labour market story as well and the evidence we get from talking to firms, which have been for some time finding it hard to pass costs on into prices.
But is that not more evidence against the notion that there would be second-round effects?
Yes, but I just don’t think we’re at a point where we can conclude there won’t be very weak second-round effects.
But the data seems benign, would you say?
I do think that we have a different context today in terms of the labour market and of the potential for second-round effects. So that, combined with the fact that, in effect, we’ve already tightened policy, because of the shift that we did when we took the guidance on cuts off the table, leaves me where I was in April. I think we reached the right decision in April to hold.
If there was a deal, would that open up cuts, potentially, this year again?
Well, I think that’s where scenario A comes back in, because I think you’ve got to be pretty confident you’re into scenario A territory for that conclusion. We’re not retiring scenario A, but I think you’d have to be much more confident that this incident is not lasting.
And if we didn’t get a deal, how much time do you think you have before you have to make the next adjustment?
Well, that’s an interesting one, because that depends what not getting a deal means. We went through a period where we had a lot of upside on energy prices. In the last few weeks, we haven’t had that.
So I think it would be very state contingent. If the whole thing breaks down, we’re back into shooting and missile firing, then that’s a different story. If we get a protracted “we can’t agree, but we’re going to keep the ceasefire”, that’s going to leave us where we are.
Is that a hold for the rest of this year?
I think we’d want to observe the reaction to that and how it passed into the data, particularly the energy data.
Huw Pill has made the argument for a proactive approach to tightening. What do you think it would take to persuade you that that would be the right approach?
I think he started in a different place. Huw’s view is that there had been a structural change in the labour market, which meant we shouldn’t read too much into the short-run conjuncture. Where I start from is, we have effectively tightened policy already, because before the war I was expecting that we would cut once, twice this year, therefore the fact that we’re not is a tightening. Huw starts in a different place, so he wouldn’t conclude that we had tightened policy against his prior expectation.
There’s obviously been a fair amount of volatility in the gilt market, and you’re coming up to the next decision as to the envelope of QT sales. How much further do you have to go?
Our objective is to get to a balance sheet where we are not holding gilts outright to back reserves. It means the interest rate risk is off our balance sheet and into the private sector, which is where it should be. How quickly we get there, we obviously have a lot of choices over that.
But is it realistic to think that that’s really going on in the background with the amount of volatility that we’ve seen in the gilt market?
We’re doing a much lower level of sales this year, and we’re doing an even lower level of long-term sales this year. In fact, we’ve finished the long-term sales programme this year.
I don’t think that QT is a major part of the story on the gilt market. We watched it very carefully and I’ve been very clear that if we saw disorderly conditions in the gilt market, we would not be selling.
We’ve done that before. We re-framed the maturity buckets just under a year ago, precisely to reflect our view of market conditions. We felt it was sensible to wait away from the long end, so that’s why we did it this year. And as you say, we’re about to come up to considering all that again.
The other thing I think that’s always important to remember is that whatever the impact is, we then take that into consideration in setting Bank Rate.
So there’s an interplay there? Because I thought reducing the size of the balance sheet was an operational decision.
No, it’s both. It’s a monetary policy decision and an operational decision, and they’re not in conflict in that sense.
It’s a monetary policy decision because we want to get to a point where we don’t have reserves backed by gilts. It also helps us from an operational point of view because we take the interest rate risk out of our balance sheet.
We take whatever the impact of the process is on the yield curve into consideration in the interest rate decision. If we thought that the process was tightening and we didn’t want to tighten, we would offset it with a Bank Rate that’s lower than otherwise.
There’s been other drivers of volatility in gilt markets, and I was wondering if you’ve seen anything in the public debate that gives you financial stability concerns.
I think the biggest impact has been the Gulf.
Then if you look at the UK market, the structure of bond markets has changed hugely in recent years. There’s a lot more leverage and a lot more non-bank, particularly hedge fund presence in them. That has probably allowed more government debt to be sold. But there are underlying fragilities in that structure.
If the next prime minister came in and loosened the fiscal rules, would you be worried about financial stability?
Let’s go back to the Budget for a moment. The gilt market reacted positively to the it.
And once the conflict started, that caused a reversal. The UK had more of a reversal because the market had got into a view of the Budget which was positive. The war cast doubt over the sustainability of that position and probably caused somewhat more of a reaction in the UK market.
And that goes along with the deleveraging that was going on, and the news around the Gulf. There was a period for a week or two where there was some UK domestic political news in the market. I don’t think this has been a very significant factor.
The exchange rate is something I look at, at that point, to judge. In 2022, you saw the exchange rate move a lot. We haven’t seen that.
We got a brief period where there was a question over the fiscal rules, and that sort of went away.
And what if it comes back?
Bailey: Well, I think people can take a message from the market at that point. The fiscal rules are important.
