Lea Havemeister, Nicholas Bloom, Philip Bunn, Paul Mizen, Gregory Thwaites and Ivan Yotzov

Monetary policymakers carefully craft their policy decisions and communication, and financial markets respond quickly. Yet the effect of policy on the economy ultimately depends on how firms perceive and anticipate monetary policy. We present new data from an economy-wide UK business survey on Bank Rate perceptions and expectations. The data provide direct evidence on monetary policy transmission, specifically on how firms form and update policy rate expectations. Firms’ perceptions of current policy rates are precise, and expectations adjust rapidly to policy decisions within days. Moreover, more productive firms and those with higher levels of borrowing forecast policy rates more accurately. CEOs and CFOs also link policy rate expectations to inflation expectations in ways consistent with standard macroeconomic models.

New data on Bank Rate perceptions and expectations

We use the Decision Maker Panel (DMP), a monthly online survey representative of UK businesses with ten or more employees. Launched in 2016, it is run by the Bank of England in collaboration with King’s College London and the University of Nottingham. Since November 2024, the DMP has asked firms about their perceptions of current Bank Rate (the interest rate set by the Bank of England’s Monetary Policy Committee) and their expectations at three-month, one-year, and three-year horizons. By April 2026, these questions received over 12,000 responses from almost 4,000 firms. We study how firms form policy rate expectations, which characteristics predict accuracy, and how quickly expectations respond to policy decisions and macroeconomic news. To the best of our knowledge, this post provides the first direct survey evidence of policy rate perceptions and expectations over time and across businesses.

Current Bank Rate perceptions are very accurate, but forecast errors increase over longer horizons

Firms’ perceptions of the current Bank Rate are remarkably accurate. Between November 2024 and April 2026, the mean actual Bank Rate was 4.21% compared to a mean perceived rate of 4.22% as shown in Chart 1 (left panel). Firms are better informed about current monetary policy than households: 81% of DMP firms correctly identified the current policy rate, compared to 46% of households who were asked the same question in the UK Survey of Working Arrangements and Attitudes (SWAA-UK) in December 2025. Firms in the DMP sample may be particularly attentive because the survey is run by the Bank of England. However, past research has shown that firms are highly attentive to current CPI inflation trends as well.

Chart 1 (right panel) shows how Bank Rate expectations have evolved in recent months. Between February and April 2026, expected rates rose at short and medium horizons, reflecting a slower anticipated pace of rate cuts following geopolitical developments in the Middle East. Firm expectations moved in the same direction but remained consistently lower in level compared with the overnight index swap (OIS) forward curve, which is the main financial market instrument used to measure market expectations for Bank Rate. The gap between firms’ expectations and OIS rates widens at longer horizons, likely capturing a growing term premium in financial markets in addition to the expectations for Bank Rate levels. Consistent with this, firms’ three-year ahead Bank Rate expectations are much closer to comparable Bank Rate expectations in the Bank’s Market Participants Survey results.

Chart 1: Firms accurately track Bank Rate and their expectations respond to economic developments

Over the full sample, firms are generally accurate in their Bank Rate expectations, but their forecast errors increase at longer horizons. Chart 2 (left panel) shows the distribution of forecast errors, measured as the gap between the realised and expected policy rates at different horizons. Positive values indicate actual Bank Rate was higher than earlier expectations for that period. At the three-month horizon, the mean forecast error is -1 basis point and around 60% of forecasts prove to be correct, while most other errors are 25 basis points. At the one-year horizon, the mean error widens to -17 basis points, and the distribution broadens considerably, with a standard deviation of 60 basis points versus 31 basis points at three months.

Disagreement across firms, measured as the cross-sectional standard deviation, increases with the forecast horizon: disagreement about three-year ahead rates is roughly double that for current perceptions (Chart 2, right panel). Furthermore, this disagreement is systematically higher among smaller firms (10–249 employees) than larger firms (250+ employees) at every horizon. Smaller firms appear to have less precise information or to devote fewer resources to monitoring monetary policy. These findings are consistent with models of so-called ‘rational inattention’. where collecting and processing information is costly.

Chart 2: Forecast errors and disagreement increase at longer horizons, especially for smaller firms

More productive firms and firms with higher borrowing make more accurate forecasts

We find that forecast accuracy is related to several firm characteristics. Larger, older, and more productive firms have systematically smaller absolute forecast errors across all horizons. The left panel of Chart 3 shows the relationship between firm labour productivity and three-month absolute Bank Rate forecast errors, controlling for firm characteristics and sector and time fixed effects. Each point represents around 5% of the full sample. The relationship is highly statistically significant, but also economically meaningful. Moving from the 25th to the 75th percentile of the productivity distribution corresponds to a 12% improvement in accuracy compared to the mean absolute error of 19 basis points.

Firms with more interest-bearing borrowing are also found to make significantly smaller forecast errors. Moving from the 25th to the 75th percentile of the borrowing distribution is associated with forecast errors that are roughly 16% smaller relative to the mean (Chart 3, right panel). One possible explanation is that financial exposure sharpens attention to monetary policy. Still, we note that the relationships presented in Chart 3 are correlations; the causal relationship may run in either direction, as firms that make better forecasts could be better positioned to make more informed decisions and therefore become more productive.

Chart 3: More productive and more indebted firms forecast policy rates more accurately

These findings suggest that larger, more productive, and more financially exposed firms may be better placed to anticipate monetary policy changes, potentially supporting their role in the monetary transmission mechanism.

Bank Rate expectations are tightly linked to inflation expectations and respond to policy rate changes

Next, we investigate how firms’ policy rate expectations are related to inflation expectations, macroeconomic data releases, and monetary policy announcements.

Firms’ policy rate expectations are closely linked to their inflation outlook. The correlation between changes in one-year-ahead CPI inflation expectations and one-year ahead Bank Rate expectations is strongly positive and robust to employing firm controls and sector and time-fixed effects (Chart 4, left panel). This is consistent with standard macroeconomic models, although the evidence is correlational and does not necessarily imply a causal link.

Chart 4: Bank Rate expectations are strongly correlated with inflation expectations

We further test the link between inflation and monetary policy expectations using event studies in the days around CPI data releases. We measure CPI surprises as the difference between the published CPI inflation rate and Bloomberg median forecasts. These surprises range from -0.3 to 0.2 percentage points over the sample period. Chart 4 (right panel) shows that CPI releases above market expectations lead firms to revise up their Bank Rate expectations at three-month and one-year horizons, consistent with expected monetary policy tightening in response to inflation surprises.

We also conduct event studies around releases of other macroeconomic indicators. We find that unemployment rates above market expectations lead to downward revisions in rate expectations, as firms expect the MPC will respond to labour market weakness with more accommodative policy. These patterns suggest that firms incorporate macroeconomic news into their rate expectations in ways that align with traditional channels of monetary policy transmission.

Finally, Chart 5 presents event studies of firm expectations around MPC meeting dates. Prior to the announcements, there is no systematic relationship between the eventual rate change and firm expectations, suggesting no anticipation. Policy rate perceptions adjust quickly following MPC meetings (top left panel): in the first five days after an announcement, a 100 basis point rate change translates to a 74 basis point update in perceived rates, on average, relative to the four days before the MPC meeting.

At longer horizons, three-month expectations adjust by about 68 basis points per 100 basis point move, and one-year expectations by 91 basis points. Three-year expectations show a weaker, statistically insignificant response, consistent with the interpretation that current policy decisions provide limited information about the more distant future and that long-term rate expectations may be more ‘anchored’ at a neutral rate. These results confirm that MPC communication is effective: firms absorb new policy information quickly and incorporate it into their forward-looking views.

Higher expected Bank Rate is also associated with higher expected borrowing rates, indicating firms understand policy pass‑through to their own financing costs.

Chart 5: Firms update Bank Rate perceptions and expectations within days of MPC decisions

Conclusion

New evidence from the DMP reveals that UK firms form interest rate expectations that are accurate, internally coherent, and responsive to new information. Firms track the current policy rate closely, update expectations within days of MPC decisions, and link their rate outlook to expected inflation.

However, important differences across firms exist. These patterns suggest that the transmission of monetary policy may be uneven. Larger, more productive, and more financially exposed firms forecast more accurately and may therefore be better positioned to incorporate policy signals, while smaller firms exhibit greater disagreement and larger errors.

For policymakers, our findings are largely encouraging. MPC decisions are quickly understood by firms. Expectations respond to macroeconomic data releases in ways consistent with the traditional transmission mechanism. Future work could examine how firms’ rate expectations translate into investment, employment, and pricing decisions, shedding further light on how monetary policy affects real activity and inflation.

Lea Havemeister is a PhD candidate at the University of Cambridge and a PhD intern in the Bank’s Structural Economics Division, Nicholas Bloom works at Stanford University, Philip Bunn works in the Bank’s Structural Economics Division, Paul Mizen works at King’s College London, Gregory Thwaites works at the University of Nottingham and Ivan Yotzov works in the Bank’s Structural Economics Division.

If you want to get in touch, please email us at bankunderground@bankofengland.co.uk or leave a comment below.

Comments will only appear once approved by a moderator, and are only published where a full name is supplied. Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees.

Ludovica Ambrosino, Jenny Chan and Silvana Tenreyro

Recent technological advances raise an important question for policymakers: will higher productivity be disinflationary or inflationary? A coming wave of AI-driven productivity growth is often described as a disinflationary tailwind that would allow central banks to hold interest rates lower without reigniting inflationary pressures. Yet faster productivity growth can just as plausibly call for higher, not lower, interest rates. By raising expected future income and the returns to investment, it stimulates consumption and investment today, pushing up the natural rate of interest. Neither view is entirely wrong and our model reconciles the two by showing that the answer depends on the timing, permanence, and sectoral origin of the productivity shock.

The intuition that producing more output from the same inputs should lower prices is a partial equilibrium argument, as it describes how productivity affects supply while holding demand fixed. In general equilibrium, higher expected income and returns also raise consumption and investment. Whether inflation rises or falls therefore depends on the balance between expanding supply and demand, and, crucially, on how monetary policy responds.

Methodology

To illustrate these dynamics, we analyse three scenarios for how a 10% rise in productivity can unfold: a temporary increase, a one-time and permanent increase, and a gradual and permanent increase (Ambrosino et al (2026)). All three scenarios capture the partial equilibrium intuition that higher productivity allows firms to produce more output per unit of input. Each scenario gradually builds up the demand-side effect to show how the overall impact on inflation depends on the interaction between supply, demand and expectations. The sectoral incidence of the shock will also matter: we begin by discussing the implications of higher productivity in the services sector, before considering the same three scenarios in the tradable sector.

We capture these dynamics in a small open-economy New Keynesian model with two sectors: a non-tradable sector, or ‘services’ sector, whose outputs are priced and sold only at home (such as haircuts or restaurant meals), and a tradable sector, whose goods are traded internationally and priced with reference to world prices. Households consume both types of goods, save, and supply labour. Firms in each sector hire workers and capital and adjust prices so that inflation depends on both current costs and expectations of the future. A central bank sets interest rates in response to inflation.

When higher productivity temporarily lowers inflation

We start with a textbook example: a temporary increase in the level of productivity (Chart 1, Column 1). Consider a new technology that allows firms to produce more efficiently. Production costs fall, and firms can supply more goods and services. This increase in supply places downward pressure on prices. In this scenario, the productivity shock causes a temporary fall in inflation because it leads to a one-off adjustment in the price level rather than a permanent reduction in the inflation rate. Once the shock dissipates, inflation returns to its steady-state level. The natural real rate of interest also falls temporarily, before recovering alongside inflation as the shock fades.

When higher productivity increases demand

The demand-side effect is stronger if the increase in productivity is permanent rather than temporary. If technology permanently raises the economy’s productive capacity, households and firms expect higher income and profits in the future. These expectations can affect behaviour today. Households may increase consumption because they expect future income to be higher, while firms may increase investment because the expected return to capital rises as productivity increases. As a result, aggregate demand begins to increase alongside the expansion in supply. Business investment and household spending both move ahead of realised productivity gains, as many argue is happening now with investment in AI infrastructure.

These two forces may offset each other. Higher productivity expands supply, while higher expected income raises demand. Whether inflation rises or falls therefore depends on the relative strength of these two effects. If the expansion in productive capacity dominates, inflation falls. But if demand responds strongly, the effect of higher productivity can be less disinflationary or even neutral for inflation (Chart 1, Column 2). The natural real rate of interest is little changed in this scenario, reflecting how closely the expansion in supply and the strengthening in demand offset one another.

When higher productivity is inflationary

Instead of an immediate increase in productivity, consider a scenario where productivity increases gradually over time (Chart 1, Column 3). This pattern is plausible if general purpose technologies diffuse slowly through the economy. For example, firms may need to reorganise production, complementary innovations need to be developed, or bottlenecks in skills or infrastructure may slow adoption. As a result, productivity gains materialise only gradually over time. Historical examples of general-purpose technologies, such as electricity and information technology, show a similar pattern: productivity gains materialised over many years as applications developed and firms reorganised around the new technology.

Again, if households and businesses expect productivity to rise in the future, they anticipate higher future incomes and profits, which changes behaviour today. They may start spending and investing before those gains actually materialise. Firms may invest more to take advantage of higher expected returns, while households can increase consumption because they expect higher future income. This increase in investment and consumption raises overall demand.

This creates a scenario where demand rises first while supply takes time to catch up. If demand grows faster than supply, inflationary pressures can emerge. This increase in demand shows up as a higher natural real rate, which requires monetary policy to tighten in order to dampen inflationary pressures (Chart 1, Column 3). This dynamic is not just theoretical. Similar debates occurred during the technology boom of the late 1990s: strong productivity growth initially coincided with low inflation, prompting then Federal Reserve Chair Alan Greenspan to argue that productivity gains were holding down inflation (Greenspan (1999)). But in the same speech, Greenspan also warned that rising equity prices and wealth effects were fuelling domestic demand and tightening labour markets faster than productivity gains could offset, and that wages would eventually outpace productivity, leading to inflationary pressures. This is broadly what occurred: demand kept outpacing supply and the Federal Reserve raised interest rates as inflation rose steadily until the 2001 recession (Furman (2026)).

Chart 1: 10% increase in service productivity

Notes: This chart shows the responses of various macroeconomic variables following a 10% productivity shock in the services sector, under three timing assumptions. The exchange rate is defined as the domestic-currency price of foreign currency, so a decline corresponds to an appreciation of the domestic currency (a rise corresponds to a depreciation).

Where productivity gains happen matters

So far, these scenarios have described a productivity gain in the services (non-tradable) sector. However, the inflationary consequences also depend on where productivity gains materialise.

In our model, prices for internationally-traded goods are pinned down largely by world prices, so a productivity gain in the tradable sector does not show up mainly as lower prices for tradable goods. Instead, the adjustment happens through higher wages and income, which raise demand for services, a sector where supply cannot expand as quickly. The resulting rise in services prices can dominate, so aggregate inflation rises even though productivity has improved. This is the classic Balassa-Samuelson mechanism (Balassa (1964) and Samuelson (1964)), applied to the timing of a tradable-sector productivity gain.

The sectoral incidence of a shock can reverse the pattern described above. A front-loaded productivity gain is disinflationary when it happens in services, but inflationary when it happens in tradables, because it leads to demand-driven services inflation rather than a fall in the tradable sector’s own costs (Chart 2, Column 2). A gradual productivity gain yields the opposite pattern: while this had been inflationary when the productivity increased in services, it is now disinflationary when the productivity shock occurs in tradables (Chart 2, Column 3). In this case, the exchange rate appreciates in anticipation of the future productivity gain more quickly than domestic resources can be reallocated, placing downward pressure on imported and tradable goods prices immediately (Broadbent et al (2024)).

Chart 2: 10% increase in tradables productivity

Notes: This chart shows the responses of various macroeconomic variables following a 10% tradable-sector productivity shock, under the same three timing assumptions. The exchange rate is defined as the domestic-currency price of foreign currency, so a decline corresponds to an appreciation of the domestic currency (a rise corresponds to a depreciation).

Policy implications

For central banks, higher productivity is neither inherently inflationary not disinflationary. The inflationary consequences are a priori ambiguous because productivity affects both supply and demand. The overall impact depends on how quickly productive capacity expands relative to demand, whether the shock reflects a temporary level effect or a persistent increase in growth, how expectations affect spending and investment, where productivity gains occur across sectors, and whether monetary policy adjusts in line with changes in the natural rate of interest. The task for policymakers is therefore to assess in real time, whether productivity gains are generating demand pressures and shifting the natural rate of interest, while looking through temporary relative price movements that do not affect medium-term inflation dynamics.

Ludovica Ambrosino is a PhD student at London Business School, Jenny Chan works in the Bank’s External MPC Unit and Silvana Tenreyro is the James E. Meade Professor of Economics at the LSE.

If you want to get in touch, please email us at bankunderground@bankofengland.co.uk or leave a comment below.

Comments will only appear once approved by a moderator, and are only published where a full name is supplied. Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees.