Unemployment would be materially higher and nominal wage growth materially lower. Ultimately, this reflects what is known as the “neutrality” of monetary policy: in the long run it has no impact on real economic variables (things like real output or relative prices). It can’t boost structural productivity, for example. Nor can it offset the consequences for real incomes of (say) disruptions to supply chains in Asia or Russia’s curtailment of the supply of gas to Europe. Indeed, in the first instance, at least for a period of time, tighter monetary policy lowers GDP and real incomes. I will say more about this shortly. For the time being, a better short-hand description is this: the pandemic and the war have led jointly to higher inflation and lower real incomes; the MPC will ensure the inflationary effects do not persist into the medium term; but the real-income hit exists either way, and will be reversed only to the extent the underlying shocks themselves go away. The second point I want to make is that we are inevitably having to learn, to some degree, about the scale of these “second-round” effects. The MPC has raised interest rates faster than at any time in its history but obviously more gradually than inflation itself. In the main, this is because the direct effects of the jumps in traded goods and energy prices, as violent  Bank of England  Page 6  as they are, are likely to fade before policy could really do much about them.
Despite a decline in recent days, that expected peak is now around 5¼%. This is by some distance the largest rise in market interest rates between MPC forecasts since the Committee was founded. By way of comparison, Chart 10 plots this increase in market interest rates against one particular, simple representation of how interest rates might have had to respond to a couple of key developments since August: the decline in sterling’s exchange rate and the original, two-year version of the Energy Price Cap. Both would tend to raise medium-term inflation, for any given level of interest rates, and would therefore tend to merit an additional response from policy (all else equal). This is expressed in Chart 10 as the change in something called an “Optimal Policy Projection”, or “OPP”. From time to time, the Committee is shown these OPPs to inform its policy judgement. The Annex provides more background on the OPPs. Bank of England  Page 18  Chart 10: Market interest rates have risen dramatically since the August MPR Percentage points 2.5  2.5 Yield curve news  2.0 1.5 1.0  “Optimal” response to demand effects of energy package and sterling depreciation  0.5 0.0 Dec 2022  2.0 1.5 1.0 0.5  Dec 2023  Dec 2024  0.0 Dec 2025  Chart shows the marginal impact on the OPPs of the original Energy Price guarantee, assuming that energy prices remain flat at a level consistent with the guarantee once it has expired.