BlackRock Investment Institute

For the Bank of England, honesty is the best (monetary) policy

Aug 19, 2022

By Nicholas Fawcett and Alex Brazier | The Bank of England has been honest that raising its interest rate enough to bring high inflation all the way down to its 2% target would lead to a deep recession in the UK. Its honesty means we expect it to do what’s necessary to get inflation down, despite that cost. 


And it raises some important questions for other central banks around the world.

UK inflation – not just an energy story

The UK has a broad, underlying inflation issue.


The cost-of-living crisis – as prices of gas and electricity, petrol and food soar – dominates headlines. Yet inflation is about much more than that. Core inflation – which excludes food and energy – was 6.2% in July.[1] Services prices have risen 5.7% in the last 12 months – the fastest pace since 1992 – and private sector pay (excluding bonuses) was up 5.8% in June – on par with the biggest increase since the financial crisis.[2]


All this tells us that the UK, like the U.S. and euro area, is operating at a level of activity that it can’t comfortably sustain. Demand is running ahead of what the economy can produce and supply without strain, even though it has yet to return to its pre-pandemic path – GDP is still 2.4% below the pre-pandemic trend[3] (see orange and yellow lines on the UK GDP and production capacity chart). The problem is an unusually low level of production capacity - how much economies can produce without creating price pressures.


Given where inflation is now, we estimate the level of activity the UK economy can comfortably sustain to be 5-6% lower than it would have been without the pandemic (pink line in the chart): the equivalent of Manchester, Birmingham and Bristol – three sizeable UK cities – no longer producing anything at all. The only way to have avoided an inflation problem would have been to choke off the economy’s restart from the pandemic shutdowns much earlier (stopping the orange line going above the pink).


Having not done that, the Bank of England, like the Federal Reserve, is between a rock and a hard place. It must now either slam economic activity down to the pink line with a deep recession, or live with persistent shortages and broad inflation pressures.

Breakdown of UK inflation
CPI inflation, broken down by components, 2017-2022

Energy accounts for the lion’s share of current UK inflation, but sizeable contributions come from non-energy industrial goods, food and – increasingly – services.

Source: BlackRock Investment Institute, UK Office for National Statistics, with data from Haver Analytics, August 2022. Notes: The chart shows the percentage-point contributions to year-on-year CPI inflation of different components: food, energy, core goods (non-energy industrial goods) and services.

UK GDP and production capacity


UK GDP is running well above our estimate of what the country can now produce without creating price pressures – hence why inflation is so high. The Bank of England is forecasting a sharp fall in economic activity to close that gap.

Forward-looking estimates may not come to pass. Source: BlackRock Investment Institute, UK Office for National Statistics, Bank of England, with data from Haver Analytics, August 2022. Notes: The chart shows demand in the economy, measured by real GDP (in orange), and our projection of pre-Covid trend activity (in yellow). The pink line shows our estimate of current production capacity, which we infer from how far core services inflation has exceeded the Bank of England’s 2% inflation target, and data and Bank of England projections of employment. The green line shows the Bank of England’s latest forecast of GDP under market rates from its August 2022 Monetary Policy Report.

Persistent production problem

The UK’s production problems stem mainly from low labor supply: the workforce has effectively been reduced by about 2 million people, or 6%, based on our above estimates of production capacity. Three forces are at play:


First, people of working age have decided to leave the labor force. The Bank of England expects more to do so over time. 


Second, there are fewer people of working age now versus what would have been expected based on pre-pandemic trends.


Third, companies are finding it hard to fill vacancies from the pool of unemployed. The number of unfilled vacancies is unusually high (see the Harder to fill open vacancies chart). We think companies are struggling to find a match between those who want a job and the skills they need, another dent in the effective supply of labor.

Harder to fill open vacancies

UK unemployment rate vs job vacancy rate

Since Covid, the number of unfilled vacancies vs the number of unemployed people is unusually high. We think companies are struggling to find a match between the skills they need and those who want a job.

Source: BlackRock Investment Institute, UK Office for National Statistics, with data from Haver Analytics, August 2022. Notes: The chart shows the vacancy rate and unemployment rate for the UK using three-month rolling averages of monthly labor market data. The vacancy rate is defined as the number of vacancies divided by the sum of employment and number of vacancies. The unemployment rate is adjusted for March 2020-September 2021 in line with assumptions from the Bank of England, that 10% of those on furlough in each month were looking for work.

Choosing recession over inflation

Central banks can’t do anything about a fall in labor supply. The Bank of England – unlike the Fed and European Central Bank – is being honest that, in the face of these constraints, it has to choose either recession or persistent inflation.


The Bank of England’s projections[4] show that getting inflation to 2% in 2024 is consistent with activity falling sharply next year, by 2.1% - echoing our assessment of what’s needed to close the gap between demand and what the economy can now comfortably produce and supply.


We think this honesty means the economic contraction we’re beginning to see in the data won’t deter the Bank of England from hiking rates.


The Fed faces similar production constraints, as we wrote earlier. Yet it appears to be assuming that it can get inflation down to its 2% target through rate hikes without causing a recession. That’s unrealistic, in our view. But it’s why we expect the Fed to change course once it sees a recession coming.



That doesn’t necessarily mean higher UK rates for long

The UK faces a deep energy shock that is poised to hit growth. This itself will go a long way to generating the recession the Bank of England considers necessary to curb inflation. In fact, unless the UK government intervenes to keep energy prices down or provides substantial help to billpayers, the energy shock might push growth down too much. Plus, lower energy prices wouldn’t do anything to solve the longer-term labor supply issues that are also a key driver of current inflation.


The Bank of England thinks there could be essentially no growth over a five-year window.[5] That would lead to a significant undershoot of its inflation objective in coming years – not an outcome it wants, in our view. The upshot: higher rates now as the UK heads into a contraction, but a swift lowering of rates as recession takes hold.


[1] As of August 2022, according to UK Office for National Statistics data.

[2] As of August 2022, according to UK Office for National Statistics data. This excludes a temporary surge in the year-on-year growth in pay in 2021 that followed a sharp drop in pay levels after the pandemic hit in 2020.

[3] Based on GDP data for Q2 2022 from the UK Office for National Statistics as of August 2022.

[4] See

[5] See

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