Why we did this research
Monetary policy influences economic outcomes through its influence on demand, inflation expectations, and financial conditions. Counterfactual analysis provides a structured model-based framework for assessing how alternative monetary policy settings might have influenced economic outcomes during a turbulent period when inflation was well above target.
This Analytical Note contributes to Davies (2025)’s review of the recent tightening cycle (2021 to 2024), while more broadly supporting public discussion of monetary policy, informing the next Review and Assessment of the Formulation and Implementation of Monetary Policy, and helping to identify processes that can strengthen future policy performance.
Key findings
- We contrast the Monetary Policy Committee’s (MPC) path for the OCR over the 2021 to 2024 tightening cycle against two counterfactual scenarios. These scenarios differ in timing, responsiveness, and information sets and are designed to explore how macroeconomic outcomes might have differed under alternative monetary policy paths.
- The monetary policy settings in these scenarios are illustrative, rather than indicative of settings the MPC might actually implement. They omit some key aspects of monetary policy strategy, for instance real-time uncertainty and asymmetries in possible future economic outcomes. Accordingly, the results should be interpreted as mechanical, model-based illustrations of potential economic outcomes. This analysis also rests on simplifying assumptions about the effect of monetary policy on the economy, for example that: 1) monetary policy transmits through the economy in line with historical experience, and 2) monetary policy effects on the economy are linear.
- Earlier and steeper monetary tightening during the 2021 to 2024 tightening cycle could have reduced the peak rate of inflation, but inflation would likely still have remained elevated for an extended period. Implementing such a path would have required policy decisions under substantial real-time uncertainty, increasing the risk of less favourable economic outcomes relative to the baseline if downside risks had materialised.
- Maintaining inflation within the target band throughout the 2021 to 2024 period would have required significantly tighter monetary policy settings, resulting in materially weaker economic outcomes. Even with perfect foresight, it is unlikely that the MPC could have kept inflation in the target band while remaining consistent with its medium-term orientation and with requirements under the Remit to support maximum sustainable employment, avoid unnecessary instability in output, interest rates, and the exchange rate, as well as have regard to the efficiency and soundness of the financial system.
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