Home > Bank of England, Inflation, Monetary Policy > Time to take the inflation target seriously

Time to take the inflation target seriously

It appears my timing could have been better in calling UK macro boring.

UK Market Inflation Expectations, FTSE 100, 2013-4

UK Market Inflation Expectations, FTSE 100, 2013-4. Source: Quandl, BoE

Those are not my ideal measures but the closest for which I have good data.  The 2.5 year implied RPI has fallen by 0.5% over the last thirty days, to 2.4% as of yesterday, implying a significant undershoot of the 2% CPI target over the Bank’s forecast period (2-3 years).  The FTSE 250 is at the lowest level for a year.

I caught a Newsnight discussion on the UK inflation data which was perfectly introduced by Duncan Weldon, who asked the right question: is the fall in inflation driven by the demand-side or supply-side?  The studio debate which followed was a little disjointed from the reality in which the UK CPI rate has been a consistently bad indicator of UK demand-side strength.  In fact it’s a contrary indicator, since periods of stronger real growth have been associated with weaker inflation and vice-versa.  George Magnus would have us believe that the inflation data is giving us textbook (“Economics 101”) evidence of a “chronic deficiency of aggregate demand”.  Chronic deficiency!?  If you ignore the fact that CPI inflation has averaged 2.9% over the last eight years, sure, Mr Magnus.

But I’d answer Duncan’s question like this.  If we see inflation running below the expected path and real GDP above the expected path, that looks like a positive supply-side shock.  If we see both falling short, that’s a negative demand-side shock.

Here for each quarter I take the Bank’s median forecast of the CPI rate and RGDP growth from the Inflation Report four quarters earlier, and compare with the outturn:

Deviation from Bank of England Year-Ago Median Forecast

Deviation from Bank of England Year-Ago Median Forecast. Source: BoE, ONS

The unexpected weakness of inflation and unexpected strength of real GDP growth does look like favourable supply-side news so far this year.  That’s a backward-looking analysis.

What matters now is policy today, which is forward-looking.  If the fall in UK inflation expectations is evidence of a positive supply-side shock then we should see a symmetric rise in UK real growth expectations.  So who has upgraded their forecast of UK growth over the last month?  The answer is… nobody has… and the fall in the equity markets (and gilt yields) makes it clear that growth prospects are falling too.

The Bank’s defence of inflation targeting as a policy regime, and their defence of the MPC’s decision-making under that policy regime, has always been consistent: what really matters is ensuring that inflation expectations are firmly anchored.

So… do it!  Carney and friends have been making hawkish noises in speech after speech through the summer, trying to prepare the ground for rate rises.  Does anybody seriously believe that there is even a single MPC member who believes the Bank is stuck in a “liquidity trap”, desperate for higher inflation but doesn’t know how to get there?  No: that is just a convenient fiction.

For the MPC, the facts have changed, and policy needs to aim at raising inflation expectations so they are consistent with the target.  Bravo to Andy Haldane for shifting in a dovish direction.  As for Martin Weale… what can you say.

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  1. james in london
    October 21, 2014 at 16:15

    Great chart, and good to see you “man up” and admit your mistakes. Even better to see the FT editorial highlighted on TheMoneyIlusion. Big day for the FOMC next Wednesday, though. Especially those dots.

    • October 21, 2014 at 23:36

      I like to believe that I was correct, right up until I was wrong. Giles is writing for the FT now, no surprise their editorials are getting better!

      It looks like inflation expectations have retraced almost half of the collapse since mid-September, very good news. Well done Mr Haldane.

  2. james in london
    November 7, 2014 at 12:19

    “Real wages are rising for workers who stay in jobs”, no sh1t, Sherlock!
    http://www.ft.com/cms/s/0/a2d0426c-65ba-11e4-a454-00144feabdc0.html?siteedition=uk#axzz3INt6CFC9
    A pretty feeble attempt to get people worried about secret wage inflation. I hope no serious commentator picks up on this.

    “The detailed Resolution Foundation study has reinforced his view, estimating that without changes to the composition of the workforce this year, the official figures would show real wage growth 0.1 per cent in the first half of 2014 rather than a drop of 0.8 per cent.”
    Let’s party.

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