Specifically, we have said that we do not expect to reduce the stock of QE either through outright sales or by ceasing reinvestment of principal until Bank Rate has reached a level from which it can be materially cut. Choosing to focus this part of the tightening cycle solely on Bank Rate will at the margin imply a faster increase than would have been the case were we to combine it with a tightening via a reduction in the stock of QE as well. This will be more likely to give us the ability to respond to an adverse shock using Bank Rate rather than tools which are inherently less flexible and with which we are less familiar. Based on past experience, the MPC currently judges that the level of Bank Rate which would provide room for a material reduction is around 2%. As Chart 4 shows, 67 of the 106 loosening cycles since the Bank was founded in 1694 were achieved by reducing Bank Rate by 2 percentage points or less. You could argue that there is a case for choosing a level higher than “around 2%”. To do so, however, would extend the horizon over which we would be expected to reach that level, and by implication extend the horizon over which the stock of QE would be held on behalf of the MPC. Given the gradual pace at which the equilibrium rate may rise, such an extension could be very long.
1 The second reason why it is reasonable for Bank Rate not to have increased already is that the relationship between the real economy and inflation has not been as one would have expected: Chart 2 shows that while most real variables – such as unemployment – are at or beyond levels at which Bank Rate had been raised in the past, most nominal variables – such as wage growth and inflation – are below. For example, despite unemployment declining by three percentage points from its peak in 2008, headline inflation has fallen by five percentage points over the same period to a record low of –0.1%. This is the inverse of what one would have expected based simply on the historical negative correlation between inflation and unemployment. 2 Of course much of this weakness in inflation is due to movements in commodity prices and the exchange rate. Since 2008 we have learned more about how movements in the exchange rate, in particular, affect inflation. Contrary to the body of literature developed during the period of Great Stability, changes in the exchange rate do have a large and persistent effect on inflation through their effect on import prices.