The Bank of England published Staff Working Paper No. 1,146 examining how trade fragmentation can change inflationary pressures and what monetary policy response would be needed to keep inflation at target. Using a two-sector small open economy framework, the paper’s core result is that the inflation impact of fragmentation is not determined only by higher import prices, but also by how aggregate demand adjusts as real incomes and productivity fall, with outcomes depending on whether fragmentation is gradual or front-loaded. The model combines tradable and non-tradable sectors, imperfect international risk-sharing, imported inputs and household heterogeneity (unconstrained households versus hand-to-mouth households). It contrasts outcomes under Taylor-type monetary policy rules with a constrained-efficient allocation and studies three fragmentation scenarios: a gradual, permanent rise in import prices that can generate a prolonged demand-driven disinflationary outcome with a lower natural real rate consistent with monetary easing; a front-loaded, permanent import price rise that produces a sharper near-term inflation-output trade-off and implies tightening to return inflation to target; and a gradual, permanent fall in tradable-sector productivity that is moderately inflationary in the paper’s calibration. The working paper is published to elicit comments and debate and does not represent Bank of England policy.
Bank of England 2025-10-01
Bank of England publishes staff working paper modelling how trade fragmentation affects inflation and monetary policy
The Bank of England's Staff Working Paper No. 1,146 analyzes trade fragmentation's impact on inflation and necessary monetary policy responses. Using a two-sector small open economy model, it finds inflation effects depend on aggregate demand adjustments and fragmentation's nature, whether gradual or front-loaded. The paper explores scenarios under different monetary policy rules, highlighting varied inflationary outcomes and policy implications.