The Committee’s latest projections for output, unemployment and inflation, conditioned on average market yields, are set out in the November Inflation Report. Output growth is expected to be stronger in the near term but weaker than previously anticipated in the latter part of the forecast period. In part that reflects the impact of lower real income growth on household spending. It also reflects uncertainty over future trading arrangements, and the risk that UK-based firms’ access to EU markets could be materially reduced, which could restrain business activity and supply growth over a protracted period. The unemployment rate is projected to rise to around 5½% by the middle of 2018 and to stay at around that level throughout 2019.
Largely as a result of the depreciation of sterling, CPI inflation is expected to be higher throughout the three-year forecast period than in the Committee’s August projections. In the central projection, inflation rises from its current level of 1% to around 2¾% in 2018, before falling back gradually over 2019 to reach 2½% in three years’ time. Inflation is judged likely to return to close to the target over the following year.
The MPC’s Remit requires that monetary policy should balance the speed with which inflation is returned to the target with the support for real activity. Developments since August, in particular the direct impact of the further depreciation of sterling on CPI inflation, have adversely affected that trade-off. This impact will ultimately prove temporary, and attempting to offset it fully with tighter monetary policy would be excessively costly in terms of foregone output and employment growth. However, there are limits to the extent to which above-target inflation can be tolerated.
Those limits depend, for example, on the cause of the inflation overshoot, the extent of second-round effects on inflation expectations and domestic costs, and the scale of the shortfall in economic activity below potential. In the MPC’s November forecast, the inflation overshoot is the product of a perceived shock to future supply, which has caused the exchange rate to fall, alongside a modest projected shortfall of activity. Inflation expectations have picked up to around their past average levels and domestic costs have remained contained. Given the projected rise in unemployment, together with the risks around activity and inflation, and the potential for further volatility in asset prices, the MPC judges it appropriate to accommodate a period of above-target inflation. That notwithstanding, the MPC is monitoring closely the evolution of inflation expectations.
Earlier in the year, the MPC noted that the path of monetary policy following the referendum on EU membership would depend on the evolution of the prospects for demand, supply, the exchange rate, and therefore inflation. This remains the case. Monetary policy can respond, in either direction, to changes to the economic outlook as they unfold to ensure a sustainable return of inflation to the 2% target.