Bank of England’s Lombardelli: Policy likely to need to tighten if energy risks persist

Deputy Governor Clare Lombardelli of the Bank of England suggested on Thursday that "policy is increasingly likely to need to tighten if elevated energy prices persist, absent clear evidence of disinflation or weaker activity." Wages have remained too high to align with inflation targets. The commentary does not imply that monetary policy should be reactionary to energy price fluctuations.

The current monetary policy remains restrictive, striving to strike a balance between reduced inflation and potential declines in demand. The main concern lies not in the spot price of energy, but in the complex interaction between the underlying economy, heightened energy prices, and how these factors are transmitted within the system.

Ultimately, this will determine whether the base lending rate needs to be increased. The British Pound has demonstrated minimal movement in response to these remarks, maintaining a range around 1.3250 as of publication. The Bank of England (BoE) is responsible for determining monetary policy in the United Kingdom, with its primary objective being to achieve 'price stability' or a steady inflation rate of 2%.

It accomplishes this through adjustments to base lending rates. The BoE sets the rate at which it lends to commercial banks and banks lend to each other, thereby influencing the overall level of interest rates in the economy and, consequently, the value of the Pound Sterling (GBP). When inflation exceeds the Bank of England's target, it responds by raising interest rates, which makes it more costly for individuals and businesses to access credit.

This has a positive impact on the Pound Sterling as higher interest rates make the UK an attractive destination for global investors to store their assets. Conversely, when inflation falls below the target, it signals economic growth deceleration, and the BoE may contemplate lowering interest rates to devalue credit in the hope that businesses will borrow for investment in growth-promoting projects – a negative for the Pound Sterling.

In extreme circumstances, the Bank of England may implement a policy known as Quantitative Easing (QE). QE involves the BoE significantly increasing the flow of credit in a struggling financial system. QE is a last resort measure when lowering interest rates will not achieve the desired outcome. The process entails the BoE printing money to purchase assets – typically government or AAA-rated corporate bonds – from banks and other financial institutions.

QE typically results in a weaker Pound Sterling. Quantitative tightening (QT) is the opposite of QE and is enacted when the economy is thriving and inflation begins to rise. While QE sees the BoE buying government and corporate bonds from financial institutions to stimulate lending, QT involves the BoE halting the acquisition of additional bonds and ceasing to reinvest the principal maturing on the bonds it already holds. This is generally positive for the Pound Sterling.