Bank of England Governor Andrew Bailey outlined the challenge facing monetary policymakers as higher energy prices linked to the Middle East conflict work their way through the economy. Bailey warned that the assessment of so-called second-round inflation effects presents a particularly difficult judgement call for the Bank.
He said the second-round impacts - the follow-on increases in prices that occur after the initial direct and indirect effects of a shock - tend to emerge more slowly. "Second-round effects build more slowly than direct and indirect effects," Bailey said, adding that it left "monetary policy with a difficult judgment call."
Part of the dilemma, Bailey explained, is timing. Interest rate adjustments do not act immediately on inflation or activity, so waiting for definitive proof of the strength of delayed inflationary pressures may not be viable. He stressed that this persistence of transmission delays complicates decisions over when to tighten or loosen policy.
"Because interest rate changes take time to take their effect, monetary policy cannot wait for conclusive evidence of the strength of second-round effects, but responding too early may generate undesirable volatility in output," he added. That sentence encapsulates the trade-off confronting the Bank: act pre-emptively and risk unsettling growth, or delay and risk letting higher prices become entrenched.
Bailey also linked the potential scale of the impact to the duration of the conflict, saying the longer the conflict in Iran lasted, the worse the effect on the British economy would likely become. He singled out food prices as a channel where indirect effects are expected to be felt most strongly as global cost pressures build over time.
The remarks underline the Bank's concern that energy-driven shocks can produce a layered inflationary process. Direct increases in energy costs can feed into production and distribution expenses, and subsequently into consumer prices in stages. According to Bailey, it is the slower, secondary stages that complicate the Bank's policy calculus, because their presence may not be apparent until some time after the initial shock.
Policymakers therefore face a balance between acting on incomplete information about these delayed effects and avoiding premature moves that could cause unwelcome volatility in economic output.