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Mispredicting inflation

The Bank of England has got inflation wrong
January 9, 2020

The Bank of England got it wrong. This will be one message of next week’s inflation numbers. They are likely to show that consumer price index (CPI) inflation ended 2019 at around 1.5 per cent. In November 2017, however, the Bank raised interest rates because it feared that, with so little slack in the economy, “domestic inflationary pressures are likely to build”. (I take that period because it takes around two years for rate changes to fully affect inflation.) It forecast then that inflation today would be 2.2 per cent, with only around a one-in-three chance of it being 1.5 per cent or less.

So, why was it wrong? It is not because it called the path of unemployment wrong. In fact, the official jobless rate is likely to have ended 2019 within a gnat’s crotchet of the Bank’s forecast of 3.9 per cent.

Instead, I suspect there were two other errors.

One was to overestimate the responsiveness of inflation to low unemployment.

One reason for this is that there’s much more excess labour supply than the official unemployment figures suggest: there are 1.8m people out of the labour market wanting to work, and millions in work wanting longer hours. All these are holding down wage inflation.

So, too, is the fact that the workforce is now more atomised than it used to be. Workers cannot so easily club together to demand big pay rises.

And then, of course, there’s the fact that the very notion of economic 'slack' and the output gap is questionable. For companies in the intangible economy, where output is easily scalable, the idea makes little sense: what is Spotify’s capacity? Or Facebook’s? And even in the old economy, companies often respond to increased demand not by raising prices, but by tweaking working methods to eke out more production.

The Bank’s other error was to fail to anticipate the weakness of the eurozone economy. This has of course hit the UK: although unemployment is where the Bank expected it to be two years ago, real GDP is 1.2 per cent lower. And it has also reduced inflation here. This is partly because it has slightly strengthened sterling and reduced commodity prices, but also because lower inflation in the eurozone means lower import prices for the UK.

This second error is easily forgivable: short-term GDP growth cannot be accurately predicted. The first is perhaps more serious. But even it is not a mortal sin. Overpredicting inflation is one of the smaller errors of economic policy we’ve seen in recent years.