When it comes to monetary policy, inflation expectations matter. That’s awkward for the Bank of England, because UK inflation expectations are neither reliable nor logical.
One key thing about household inflation expectations is that they tend to move in lockstep with actual reported inflation. Because recency shapes perception, people often default to thinking that tomorrow’s inflation will be equal to today’s, or some fraction thereof.
This relationship started to fray for UK consumers after the 2016 Brexit referendum, then broke down last year. Such an unmooring of expectations from CPI readers — what economists call adaptive expectation — can make inflation more persistent by feeding into pay settlements and prices.
But if the reasons to diverge from CPI are rational, it’s no big deal. Adaptive expectations ought to decline as one-off spikes moderate (utility bills, etc) so there’s not much risk that inflation becomes self-perpetuating. So as long as the long-term view on inflation stays close to the central bank’s inflation target, its rate setting committee can look through all the potentially temporary stuff.
De-anchored expectations are more of a problem. When price perceptions lose their tether to reality, the bank needs to drive expectations back down by running a permanent output gap, says Robert Wood, chief UK economist at Bank of America.
Britain has been showing signs of de-anchoring, first in 2016 and then again last year, Wood says. It might all stem from the BoE gaining independence in 1997, which nudged public thinking from “tomorrow’s inflation will be the same as today” to “bank’ll fix it”, he speculates. Brexit first chipped away at that confidence, then came last year’s double-digit inflation to shatter all the old certainties:
We wonder whether developments in inflation expectations in 2022 would have been as large had expectations not already been dislodged to some degree by Brexit. Perhaps households were already inclined to reassess their traditional rules of thumb when inflation surged.
Whatever the reason, household inflation expectations seem to have become invariant to spot inflation since the start of 2022.
Making sense of the sentiment trend from official data is tricky, however, because in early 2020 the BoE switched from in-person interviews to online surveys. Reported inflation expectations dropped sharply at around the same time — but what’s odd is that independent surveys don’t show the same dip.
Here, in a very messy chart, is BoA’s proprietary inflation expectations data versus the BoE’s:
Evidence for a 2022 structural breakdown theory is therefore tentative. At first glance it also appears contradictory.
Below is a chart (equally messy, sorry!) showing one- and two-year UK inflation expectations. Immediately after the Brexit vote there’s a seemingly structural move, to about a 20-basis-point premium above CPI. Then last year, expectations stopped rising even as inflation surged:
BoA’s one-, two- and five-year scatter plots are even messier, though hopefully more clear about the long term trend. What they show are UK household inflation expectations flatlining at around the 4-per-cent level:
One possible conclusion is that UK consumers have become notably more pessimistic about inflation ever returning to the BoE’s 2-per-cent target level. That in turn raises questions about bank credibility.
What explains the flatlining? It might be adaptive expectations at work, Wood says, or it might be because the UK consumer has become catatonic:
It seems odd that households’ perception of the persistent component of inflation would remain invariant to economic news for a year. The BoE, for example, has revised its view a lot over that period and so have financial markets. The data have changed considerably. Inflation expectations becoming invariant to inflation may be more suggestive of households shifting from adaptive expectations to a more de-anchored rule; for instance, assuming inflation will be 4 per cent regardless of spot inflation. Households may have made such a change to their rules of thumb for inflation forecasting because those rules were performing poorly.
Other countries are not seeing similar trends. In the US and Europe, inflation expectations have continued to track the headline rate normally. And anyway, faith in the Fed keeps US inflation expectations in check irrespective of the spot rate, as shown by the below (very, very messy) five-year scatter plot. It’s hard not to conclude that sticky inflation may be a uniquely British disease:
And if UK household inflation expectations have de-anchored, what can the bank do about it? Talk tough until all alternatives are expended, BoA advises:
Slowing the economy and raising spare capacity would be the traditional answer. By running the economy below potential persistently the BoE may be able to reassert its inflation credibility.
Our proprietary consumer confidence survey suggests that words may matter as well as actions, however. [ . . . ] The more hawkish the BoE sounded over the past year the more inflation expectations fell.
BoA’s base case is for two more 25-basis-point UK rate hikes this year, followed by two cuts in 2024. The sharp slowdown in wage growth expected by the BoE may never arrive, but that’s next year’s problem, and there’s reason not to be seen to panic early on tentative data, Wood says. Better to tolerate “somewhat” higher pay and core inflation in the hope that expectations drift back naturally towards target.
And if they don’t? Rates up until it’s anchors away, he concludes: “The UK seeming like an outlier also leads us to think the risks skew to the BoE being the slowest of the major central banks to cut rates.”
