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Getting inflation wrong

The Bank of England's longstanding idea of what causes inflation might be plain wrong
Getting inflation wrong

Has the Bank of England been consistently wrong about inflation? This is the question I hope next week’s Inflation Report answers.

For years, the Bank has believed that inflation rises when the level of output reaches its “potential” level – that spare capacity (the output gap) holds prices down while a lack thereof pushes it up.

Recent developments, however, are inconsistent with this. Unemployment is now at a 42-year low, and the Confederation of British Industry (CBI) estimates that capacity utilisation is at a 29-year high. But inflation has been high recently only because sterling slumped in 2016, and economists expect it to fall this year. A lack of spare capacity, then, is not raising inflation. Why?

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