Further interest rate cuts will be influenced by how employers respond to higher labour costs, according to a member of the Bank of England’s monetary policy committee.

Companies face significant increases in national insurance contributions and the living wage in April which could drive up inflation.

Sarah Breeden, the bank’s deputy governor for financial stability, told an audience in Edinburgh that businesses will respond to the Chancellor’s hikes in different ways.

Some might attempt to keep wages lower. “Indeed, this would be my assumption for where it ends up in the long run,” she said.

Alternatively, she said they may seek to protect wages and increase prices, especially in the short term. They might also respond by cutting jobs and eating into their profit margins.

“The reality will sit somewhere between these extremes and will depend on the specific circumstances that each business finds themselves in. Whether employers can pass on higher costs to consumer prices will depend on the overall demand environment in the economy.

“There is therefore uncertainty around what these shocks will mean for medium-term inflation. But they are likely to be considerably smaller than the large shocks of the recent past.”

She added: “The important questions as I look ahead are what combination of shocks explains the recent slowdown in activity and how will employers respond to higher employment costs.

“The answers to those questions will affect the outlook for medium-term inflation and so the speed at which restrictiveness needs to be removed.”

Ms Breeden told the audience that “global shocks” such as the pandemic and energy prices had been less damaging than expected and inflation had not been as persistent as she had expected.

“Inflation has fallen materially over the past year. That is welcome news, especially given
the painful high inflation period we found ourselves in during the prior couple of years,” she told the meeting at the Edinburgh University Business School.

“But as monetary policymakers we must stay focused on where the economy might be heading, not where it has been.

“That means taking a view on which shocks are hitting the economy and how they might play out over time. This is easier said than done. It is notoriously hard to know which shocks are hitting the economy in real time.”

She said that it has been well-documented that the UK economy faced a very large imported energy shock in 2021 and 2022. At the peak of the shock, household energy prices were directly adding almost four percentage points to CPI inflation.

Even so, the bank’s latest assessment is that the output gap impact of the increase in energy prices in 2021 and 2022 “was probably less negative than we thought when the shock first emerged”, she said.

“That is in part because energy consumers revealed a greater willingness and ability to substitute away from energy consumption than we had previously assumed, which reduced the effective hit to their real incomes in the face of the shock.”

Ms Breeden admitted that a year ago, when she joined the MPC, she was most concerned about an scenario where inflation persistence became entrenched, perhaps facilitated by stronger demand in the economy.

“It is clear to me that the risk of that upside scenario has now subsided sufficiently to no longer be a core consideration in setting policy. Over the past year headline inflation has come in below our expectations – indeed below both of the scenarios I considered – as global shocks abated more quickly than we expected.

“In December I judged that the evidence supported maintaining Bank Rate at 4.75% and that recent developments supported the case for a gradual approach to the withdrawal of policy restrictiveness in the coming months.”

She said that knowing how quickly the MPC should remove restrictiveness “is difficult
to know and will depend on how the factors above evolve over time.

“To be clear, I expect Bank Rate to come down over time as the effects of the large shocks of the past continue to abate.

She added: “The demand environment has been more resilient in recent years than we initially thought – partly because the response to the energy price shock was less negative than we thought, and probably also reflecting weaker supply.

“There is now some tentative evidence that activity is starting to weaken, though we expect it to pick up again.

“Recent evidence further supports the case to withdraw policy restrictiveness and I expect to continue to remove restrictiveness gradually over time.”