And it is differences in those judgements across the members of the MPC that lead to the finely balanced vote outcomes like that we saw last week. Guiding monetary policy by the stars In discussing those judgements – and, in particular, in converting them into monetary policy decisions about Bank Rate – I am often confronted by questions about ‘starred variables’ in the standard new Keynesian model. In highly stylised form, three starred variables lie at the heart of these models: Pi-star, the steady state rate of inflation; R-star, the Wicksellian neutral real rate of interest; and Y-star, the potential level of economic activity. Pi-star is the easiest to dispose of. Within an inflation targeting framework, the steady-state level of inflation is determined exogenously by the central bank’s mandate. In that context, the inflation target should be as clear as possible: uncertainty about the target only adds unnecessary – and costly – volatility into the economy. The UK’s inflation targeting framework delivers on this score. The inflation target is defined as an annual rate of CPI inflation of 2%, which is given primacy in the remit delivered to the Bank of England by the Treasury and deemed to hold at all times. 9  All speeches are available online at www.bankofengland.co.uk/news/speeches  9  While there are inevitably times – like those we are experiencing today – when unforeseen shocks to the economy drive inflation away from target. These circumstances beg questions about how quickly it is feasible and/or desirable to return inflation to target.
Should they fall slowly in line with futures prices, inflation is forecast to fall below the 2% target by a meaningful margin at the policy-relevant horizon. Yet uncertainty on this dimension remains considerable. With the pandemic giving way to geopolitics as the driver of international energy prices, they are unlikely to become easier to forecast. This brings me to the second key element of the forecast: our treatment of the labour market and wage developments. Recent data confirm that the UK labour market is tight. It is tighter than we expected at the time of the previous Monetary Policy Report published in November.4 And we expect it to tighten further in the coming months. On the back of this labour market tightness and in light of our Agents’ recent wage survey – which embodied the highest expectation for pay settlements since well before the financial crisis 5 – we have revised up underlying wage growth in 2022 to rates approaching 5%. Given expected productivity developments, this rate is probably stronger than that consistent with the inflation target over the medium term. But we expect the forecast stronger momentum in domestic wage and cost growth to ease beyond this year, as headline inflation falls and unemployment rises owing to the impact of higher energy prices on real incomes and domestic demand. This is a crucial assumption – the ‘big call’ – underlying our inflation outlook.