The Bank of England’s inflation targeting framework is being tested by the Iran war in ways that go beyond simple questions of whether to raise or hold rates, as the committee voted unanimously to hold at 3.75% on Thursday and warned of potential rate hikes driven by an external energy price shock. The monetary policy committee’s challenge is whether the 2% inflation target, designed primarily for domestically driven price movements, is the right framework for responding to a geopolitically driven supply shock. Officials said inflation could rise above 3% and that borrowing costs might need to increase.
The inflation targeting framework has served the UK well in the three decades since its introduction, providing a clear anchor for monetary policy that has helped to keep inflation expectations stable. But the framework was designed with domestic demand-side inflation primarily in mind, and its application to supply-side shocks driven by geopolitical events raises questions about whether the conventional response — raising rates to bring inflation back to target — is the most appropriate approach when the inflation originates in a conflict the UK can neither influence nor insulate itself from.
Governor Andrew Bailey did not explicitly question the framework but his candour about the limits of monetary policy in addressing supply-side inflation suggested an awareness of the tension. His preference for a restored energy supply as the most effective solution to the inflation problem was an implicit acknowledgement that the framework’s tools were blunt instruments for the current challenge.
Financial markets continued to apply the conventional framework, pricing in rate hikes in June and later in the year. UK gilt yields rose, the FTSE 100 fell, and the pound strengthened against the dollar. The market’s application of the conventional framework created the financial market pressure that itself gives the Bank an incentive to follow through on rate hikes.
For monetary economists, the Iran war episode raises fascinating questions about the appropriate design of inflation targeting frameworks for open economies vulnerable to geopolitical energy shocks. The Bank of England’s handling of the current situation will contribute to that important academic and policy debate, whatever conclusion it ultimately reaches about the appropriate near-term policy response.
