How seriously should we take the Bank of England’s 2 per cent inflation target? If we do then we should stop worrying about inflation and worry about higher interest rates instead, because the Bank will raise rates to ensure that inflation stays around 2 per cent.
Markets, however, are not doing this. The five-year breakeven inflation rate, as I write, is at 3.5 percentage points, close to its highest since 2000 despite the market expecting three month rates to rise by almost a percentage point by mid-2025. Granted, this is based upon RPI inflation, but even allowing for the fact that this usually exceeds CPI inflation, this is above the Bank's inflation target.
There’s one good reason for this. In the next few months inflation will rise because last year’s drop in oil prices and cut in VAT on the hospitality trade will fall out of the data to be replaced by increases. The Bank cannot prevent this simply because it takes time for interest rates to reduce inflation. Instead, it says it will not raise rates until “there is clear evidence” of the inflation target being met “sustainably”. This suggests it will tolerate a few months of above-two per cent inflation. This is wholly consistent with the Bank doing its job. Its remit allows “inflation to deviate from the target temporarily” because of “shocks and disturbances”.
This, though, is not the only reason why breakeven inflation is above 2 per cent. Another reason is that there is a risk that the Chancellor could raise the inflation target: remember, it is he and not the Bank that decides this. Such a move has several advocates, such as James Smith at the Resolution Foundation, Joe Gagnon and Christopher Collins at the Peterson Institute for International Economics and Laurence Ball at Johns Hopkins University.
One case for doing so is that post-Covid changes to the patterns of supply and demand might require big changes in some relative prices. And to the extent that some firms are reluctant to cut prices, such changes are easier to achieve when inflation is higher. Cynics might add that raising the inflation target would be a way of preventing interest rates rising, thereby protecting house prices.
Personally, I’m surprised how little debate there has been about the level of the inflation target. But this could change, and markets are reasonable to price in a risk of it doing so.
There’s another risk. It could be that inflationary forces will prove so great that the Bank could only keep inflation to 2 per cent by clobbering the economy. Its economists estimate that a one percentage point increase in Bank rate eventually reduces inflation by around a percentage point, but at the price of cutting output by up to 0.6 per cent. If we see inflation combined with sluggish trend growth, the Bank might choose to err on the side of tolerating inflation. Such a scenario would, however, be a sign of a dysfunctional economy: if weak growth generates significant inflation, something is very wrong.
There are, therefore, inflation risks and it’s reasonable to price them in. But these risks don’t come from monetary growth or wages or commodity prices, but rather from policy or from structural failings in the economy.
