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Expecting low inflation

The gilt market and households expect inflation to stay low. It doesn't much matter if they are wrong
June 2, 2020

Will inflation rise as demand bounces back when the lockdown is lifted? We’ll get a clue next week when the Bank of England publishes its latest survey of households’ inflation expectations.

These matter simply because there has been a good correlation between people’s expected inflation and actual inflation 12 months later. If we measure the latter by households’ perceived inflation rate rather than CPI, the correlation has been 0.67 since the survey began in 1999.

High expected inflation, then, often leads to high actual inflation. This could be yet another example of the wisdom of crowds. Although any individual is likely to be mistaken, across enough of them these mistakes often cancel out. Or it could be because expectations are self-fulfilling: if we expect high inflation, we’ll demand pay rises and companies will raise prices in anticipation of their rivals and suppliers doing so and so we’ll get high inflation.

In normal times, we wouldn’t expect expectations to change much. This is because they are strongly influenced by recent inflation. The typical household seems to follow a simple rule in forming inflation expectations: look at current inflation and reduce it if it is unusually high, but raise it if it is unusually low. This is perfectly sensible; it means they look through short-term fluctuations in inflation caused by things such as moves in oil prices or sterling.

But, of course, these are not normal times. In the 2009 crisis, inflation expectations were lower than actual inflation because people expected the recession to reduce inflation – rightly, as it happened.

Will they do the same this time?

If they are anything like gilt investors, they will. So far this year the market’s inflation expectations (measured by the gap between conventional and index-linked gilts) has fallen by half a percentage point for average inflation over the next three years. The gilt market, then, expects mass unemployment to depress inflation by more than it expects potential mismatches between the patterns of demand and supply to raise it. You can also read this as a vote of no-confidence in the idea of a V-shaped recovery: the market doesn’t expect demand to bounce back so strongly as to permit retailers to raise prices much even though many will want to do so to boost their near-term cash flow.

Do households think the same way? Obviously, we have no precedent for our current situation. But if the response to rising unemployment in 2009 is any guide, they too will reduce their expectations.

We can, though, say some things with confidence.

One is that households are not monetarists. In 2009 they did not expect quantitative easing to significantly raise inflation: they weren’t that daft. We’ve no reason to suppose they think any different now.

The other is that even if the gilt market is wrong and inflation does rise a little, it is not a huge problem. For one thing, moderate inflation causes much less unhappiness than unemployment, so the latter should be policy-makers’ priority. Also, slightly higher inflation could be a symptom of success – a sign that demand has bounced back strongly: it’s partly for this reason that there’s been a strong positive correlation in recent years between inflation expectations and share prices. And thirdly, we know how to reduce inflation if or when we need to. In our current predicament, problems we can solve are low priorities.