Aside from the substantial communication and operational challenges involved, the very generous liquidity conditions established over more than a decade could have generated pockets of vulnerability in the financial sector, as the discipline on position-taking and balance sheet management imposed by liquidity constraints in normal times had been relaxed, at least for a time.5 To manage these concerns, the MPC set out a transparent strategy for normalising monetary policy centred on its plan to run down the stock of assets accumulated through QE in a gradual and predictable manner.6 This plan has governed the quantitative tightening (QT) programme over the past year. Addressing new inflationary shocks But monetary policy cannot be put on an autopilot. Any plan has to be conditional on economic conditions, and responsive to economic shocks and disturbances.7 The MPC has flagged that it will use Bank Rate as its active instrument to address new shocks as they emerge, leaving the QT programme to run ‘in the background’ as long as market conditions permit. Bank of England  Page 6  That naturally brings me to the second rationale for the substantial tightening of the monetary policy stance over the past year: the incidence of new inflationary shocks. Two shocks in particular stand out: the very sharp rise in wholesale European gas prices over the past year; and the decline in participation in the UK labour market (against a backdrop of sagging market competition in the goods market). The rise in gas prices has four important characteristics. First, it genuinely was a shock.
Taken together with the supply chain disruptions that accord firms pricing power in supply chains, this tightness creates conditions conducive to the emergence of the second-round effects we fear. Behind the labour market tightness lies a decline in participation rates among the working age population, particularly those in the 50-65 age group. The reasons behind this decline remain the subject of controversy, but the impact of the pandemic on early retirement and long-term health, as well as underlying demographic developments, all seem to have played a role.10 Crucially – and just like the rise in gas prices – rising inactivity among the working age population represents an adverse supply shock, which adds to the difficult shorter-term trade-offs facing monetary policy.11 Looking back to a year ago, the MPC debated whether the prospective end of the furlough scheme introduced during the pandemic would release furloughed workers into the labour market and ease the tightness emerging in the labour market. This was a difficult judgment to make, given that the furlough scheme was without precedent. As it turned out, that easing did not materialise: through the middle of this year, the labour market has continued to tighten and has proved tighter than we had expected, largely owing to the adverse developments in participation that we did not fully foresee. Now that the economy has slowed (and probably entered recession), we are starting to see labour market indicators turn. Vacancies have stabilised and there are tentative signs they will fall from their historically high levels.