The Bank of England’s inflation problem is even worse than it seems

When it comes to monetary policy, inflation expectations matter. It is awkward for the Bank of England because UK inflation expectations are neither reliable nor logical.

An important thing about household inflation expectations is that they tend to move in lockstep with actual reported inflation. Because recency shapes perception, people often believe that tomorrow’s inflation will be equal to today’s or a fraction thereof.

This relationship began to break down for UK consumers after the Brexit vote in 2016, then collapsed last year. Such a release of expectations from CPI readers — what economists call adaptive expectations — can make inflation more persistent by leading to wage settlements and prices.

But if the reasons for deviating from the CPI are rational, it’s not a big deal. Adaptive expectations should decline as one-off increases moderate (utility bills, etc.), so there is not much risk of inflation becoming self-reinforcing. So as long as the long-term view of inflation remains close to the central bank’s inflation target, its interest rate committee can see through all the potentially temporary stuff.

Anchored expectations are more of a problem. When price perceptions lose their connection to reality, the bank has to drive expectations down again by running a permanent output gap, says Robert Wood, chief economist at Bank of America in the UK.

The UK has shown signs of anchoring, first in 2016 and then again last year, says Wood. It may all stem from the BoE gaining independence in 1997, which pushed public thinking from “tomorrow’s inflation will be the same as today’s” to “the bank will fix it”, he speculates. Brexit first knocked that confidence away, then last year’s double-digit inflation came to shatter all the old certainties:

We wonder whether the development in inflation expectations in 2022 would have been as large if expectations had not already been to some extent displaced by Brexit. Perhaps households were already inclined to reassess their traditional rules of thumb as inflation rose.

Whatever the reason, household inflation expectations appear to have become invariant to spot inflation since the start of 2022.

However, it is difficult to understand the sentiment trend from official data because in early 2020 the BoE switched from personal interviews to online surveys. Reported inflation expectations fell sharply around the same time – but the strange thing is that independent surveys do not show the same decline.

Here, in a very messy chart, is the BoA’s proprietary inflation expectations data versus the BoE’s:

Evidence for a theory of structural breakdown from 2022 is therefore tentative. At first glance, it also seems contradictory.

Below is a chart (equally messy, sorry!) showing one and two year UK inflation expectations. In the immediate aftermath of the Brexit vote, there is an apparent structural move, at around a 20 basis point premium over CPI. Last year, expectations stopped rising even as inflation increased:

BoA’s one-, two-, and five-year scatter plots are even messier, but hopefully clearer about the long-term trend. What they show is UK household inflation expectations, which are flat at around 4pc.

One possible conclusion is that UK consumers have become significantly more pessimistic about inflation ever returning to the BoE’s 2pc target. This again raises questions about the banks’ credibility.

What explains flatlining? It could be adaptive expectations at work, says Wood, or it could be because the British consumer has gone catatonic:

It seems strange that household perceptions of the persistent component of inflation would remain unchanged in response to economic news for a year. The BoE, for example, has revised its outlook a lot over that period, and so have the financial markets. The data has changed significantly. Inflation expectations that become invariant to inflation may be more indicative of households shifting from adaptive expectations to a more liberalized rule; for example, assuming that inflation will be 4 per cent. regardless of spot inflation. Households may have made such a change to their inflation forecasting rules of thumb because those rules performed poorly.

Other countries do not see similar trends. In the US and Europe, inflation expectations have continued to follow overall interest rates normally. And yet faith in the Fed keeps US inflation expectations in check regardless of the spot rate, as shown by the (very, very messy) five-year scatter plot below. It is hard not to conclude that sticky inflation may be a uniquely British disease:

And if UK households’ inflation expectations are de-anchored, what can the Bank do about it? Talk tough until all alternatives are exhausted, BoA advises:

Slowing down the economy and increasing idle capacity would be the traditional answer. By persistently running the economy below potential, the BoE may be able to restore its inflation credibility.

Our proprietary consumer confidence research suggests that words can matter as well as actions. [ . . . ] The more hawkish the BoE sounded over the past year, the more inflation expectations fell.

The BoA’s starting point is for two more 25 basis point UK interest rate hikes this year, followed by two cuts in 2024. The sharp slowdown in wages growth that the BoE expects may never come, but that is next year’s issue and there is reason not to seen in panic early on preliminary data, says Wood. It is better to tolerate “somewhat” higher wages and core inflation in the hope that expectations naturally move back towards target.

And if they don’t? Rates until it is anchored away, he concludes: “The UK, which seems like an outlier, also leads us to believe that the risks are skewed to the BoE being the slowest of the major central banks to cut interest rates.”

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