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Economics Weekly

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UK inflation expectations take−off makes cutting rates difficult

Tue, Jun 3 2008, 09:58 GMT
by Trevor Williams

Lloyds TSB Financial Markets

Inflation expectations are rising…
A worrying aspect of the recent rise in actual inflation in the UK has been the accompanying rise in inflation expectations. Expectations matter for actual inflation. The reason is twofold; first, if companies believe that inflation is likely to remain high, they are more willing to raise their prices and to pay workers more. Second, if consumers believe that inflation will remain high they are more likely to accept price rises and to push for higher wages to compensate them for a loss of real purchasing power. A sharp rise in price inflation has destructive economic effects; it makes companies less likely to invest, as they demand a higher rate of future profit growth (to compensate for inflation) to justify investing today. This means weaker economic growth, resulting from weaker employment and higher unemployment. Moreover, those on fixed incomes are likely to suffer more, as they are unable keep up with inflation eroding their real income, so poverty levels are likely to rise and put upward pressure on public spending.

…this is worrying for economic growth as high inflation means less investment and weaker consumer spending
Yet another negative from rising inflation is that it makes the average level of interest rates in the economy higher than it would be otherwise. This is true for short term interest rates and long term interest rates, so compounding a weaker growth trend. If inflation expectations are anchored on a central banks’ price inflation target, for instance, it means that the actual rate of interest required to keep inflation, and the economy, stable, is lower than if inflation is high and unstable. This may seem obvious but it is a lesson that has taken policy makers around the world many years to learn. Of course, long term interest rates matter for an economy – if not more than short term rates - and they are not in the purvey of government. In that case, the worry is that those with an investment paying a fixed rate of interest (or, in other words, a fixed nominal amount) will receive less in real terms in future the higher is the rate of inflation. This not surprisingly means that these investors will demand a higher rate of interest to compensate for the erosion of future real returns by accelerating inflation, meaning the price of fixed rate bonds fall.

Expectations are now higher than when the Bank of England was made independent in 1997…
Chart a shows that 10 and 20 year break even inflation rates (nominal yields minus index linked) have jumped up sharply in the last few months and are now the highest they have been since the Bank of England became independent in May 1997. This must be very worrying for the central bank, as it implies that it has lost inflation credibility, in other words, investors no longer believe that it can keep inflation low and stable. The chart shows the sharp fall that occurred in these rates in 1997 when the Bank was first made independent. Thus higher inflation expectations carry a potential economic cost, as higher long term bond rates will keep upward pressure on mortgage rates and company bonds, so weakening economic activity more than intended by the Bank of England. Moreover, households/consumers are more sceptical about inflation than at any time in our survey, see chart b and perhaps more worrying, on the Bank of England’s own NOP survey that has been carried out since 2000, see chart c. The aim of the latter was to see whether the MPC was keeping inflation expectations low and stable around the inflation target, in other words anchored. On this basis, they can be said to have failed.

…as actual inflation is already at 3% and an acceleration to 4% is likely in the months ahead
But the reason for the sharp rise in inflation expectations is not a surprise, given that actual annual CPI inflation is now at 3% relative to the 2% inflation target. Moreover, our own inflation forecast suggests that it will get to a peak of about 4% later in the year, see chart d. This means that official interest rates in the UK will have to remain higher for longer. Whether price inflation then falls back in 2009 as expected will partly depend on factors beyond the central banks’ control, like the rise in imported price inflation and global commodity price pressure. Chart e shows that imported inflation is closely correlated with the rise in domestic UK firms’ output prices and with the rise in CPI inflation. To that extent, though, the burden of getting overall inflation down implies that there will have to be a squeeze on domestic inflation. But chart f shows that this means that the level of economic activity must fall further, i.e. growth must be below its long term trend, in order to bear down on overall price inflation.

This makes cutting UK rates highly unlikely even if growth slows sharply unless accompanied by a fall in inflation expectations
What this means is that sub trend UK economic growth does not mean that UK interest rates will fall as many expect in 2009. Any rate cuts are likely to depend on overall inflation falling back to about 2% in 2009, or at least expected to fall back to that rate. This will be a tough challenge, as with consumers real incomes being squeezed by earning growth running below price inflation, see chart g, the risk is that people start demanding faster pay growth to compensate for the loss of real earnings, as they did in the 1990s. More worrying for the MPC is that high inflation expectations may make workers more likely to make such demands as they no longer believe as much that the central bank will keep inflation down. So cutting interest rates without there first being a fall in inflation expectations will be a big risk for the MPC to take.

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Published on  Tue, Jun 3 2008, 10:13 GMT