Andrew Bailey, Bank of England Governor, speaks to Global Finance about the aftermath of the pandemic and inflation rates.
Global Finance: What are some of the biggest challenges central banks face post-pandemic?
Andrew Bailey: What we are experiencing is a bumpy economic recovery. I’m not surprised by that in some ways. It has been exacerbated by supply chain issues we are experiencing in the world economy, which is part of the story behind the higher rates of inflation we are seeing. Moving forward, there are several challenges for central banks. Is inflation going to be temporary or transitory? If you look through the medium term, our two-to three-year forecast curves suggest we have every reason to think it will be transitory. You must remember prices were low a year ago, so some of it is because of an arithmetical effect. We’ve also seen strong increases in commodity prices.
There have also been some supply chain blockage effects of Covid-19, and the relative imbalance of goods and services. Goods demand remains strong, which is putting pressure on supply chains and prices. That’s also reflected in the labor market. We’re now seeing job vacancies are at a much higher level. There are approximately two million people not in active employment relative to pre-Covid levels. We need to see that labor supply come back. If that doesn’t happen, it will place even more upward pressure on inflation.
GF: While inflation is currently within the Bank of England’s 2% target band, it is expected to reach 4% by year end. What does that mean in terms of the bank’s current stance on interest rates?
Bailey: Inflation is currently within the Bank of England’s target band, but we expect it to rise in the next reading. A good example of this is second-hand car prices, which are linked to supply chain issues with semi-conductor chips. We saw a sharp fall in the production of new vehicles, which pushed up the price of cars. In our latest monetary policy report published in August, we indicated that we’re heading towards a path of inflation, which in order to bring it back on target we reasonably expect there needs to be some increase in interest rates in the next two years to achieve that path.
GF: In 2020, given the “unusual uncertainty” surrounding the UK economy, negative interest rates weren’t ruled out by the Bank of England. Where do you currently stand on negative interest rates?
Bailey: We see them as something in our monetary policy toolkit We have done work with banks and ourselves to enable our systems to handle negative rates. But I don’t think it is in our immediate future. It is a tool we could use, but we’ve had no policy discussions about doing it.
GF: Quantitative easing versus negative rates–what is the most effective monetary policy tool?
Bailey: We know a lot about the transmission of monetary policy when we are in a normal [economic] setting. But we’ve never used negative rates, so our knowledge is much less. We can observe what has happened in the small number of countries, including the European Central Bank, where they have been used. What we’ve discovered is that the economic context seems to be important. None of the central banks using negative rates made their rates more negative during the pandemic. They preferred to use Quantitative Easing (QE). In my mind there is a strong degree of state contingency. There is also a complex relationship between negative rates and how the banking system would respond to it.
Quantitative Easing is mostly effective in extraordinary market conditions. It tends to keep interest rates down further along the curve. Even in more normal market conditions it can be used to reduce risk, which is one reason why we have done further Quantitative Easing.
The Federal Reserve’s QE is open ended, but we announced a fixed stock of QE, which will run out in December this year. When that happens, we would have to take a decision to do more. There are different views between central banks on open-ended QE vs. fixed stock. I’m not saying the QE we’ve chosen is better. We don’t have the same sort of financial system others have. But it is the one we prefer. The markets have factored in the end of QE, and the view is that we won’t announce any more.
GF: Several central banks are launching central bank digital currency (CBDC) pilots. Where does the Bank of England stand on digital currencies in general?
Bailey: Digital currencies are one of the Bank of England’s strategic priorities in terms of new work. We need to have a strong understanding of the implications of digital currencies for the financial system, which is an under researched area. We have a lot of work to do there. The Bank of England published a discussion paper in June on digital money. I’m not against CBDCs, but it’s important when you’re doing something like this to have a firm understanding of what the underlying problem is you’re trying to solve.
Climate change is another important objective. There are two areas of focus. One is the question of how it impacts our corporate bond portfolio, which isn’t that big, but big enough to incentivize climate consistent transformation in areas such as disclosure standards.
We are also testing the resilience of the financial system and firms we supervise. We are running an exploratory exercise now testing banks against a few climate stress scenarios. Again, the macroeconomic impacts of climate change are an area where relatively little work has been done and more insights are needed.