- Inflation expectations are rising, with high levels anticipated for years to come
- This matters: inflation expectations often come true
Inflation expectations are the rate at which people expect prices to rise in the future – and they matter. This is because inflation is partly influenced by what we expect it to be. If firms anticipate inflation of 5 per cent over the coming year, they will plan to raise their prices by 5 per cent (or more). Workers and trade unions will demand a similarly-sized pay rise, wanting their wages to keep up with higher prices. Suddenly, wages and prices are 5 per cent higher and – like a self-fulfilling prophecy – inflation rises too. Research from the Brookings Institute finds that, all other things being equal, if inflation expectations rise by 1 per cent, actual inflation will tend to rise by 1 per cent too.
For a long time, inflation expectations in the UK were firmly anchored. This meant that businesses and consumers had a clear idea of what they expected inflation to be, and were happy to ignore any short-term price spikes. This anchoring was due in part to a prolonged period of stable inflation. As the chart shows, inflation rarely exceeded 4 per cent between 1998 and 2021, remaining at low levels for most of the period. Consumers had no reason to expect runaway prices, and their well anchored inflation expectations reflected this.
The second reason for these was the Bank of England’s inflation target, set at 2.5 per cent in 1998 and lowered to 2 per cent in 2003. The Bank’s Monetary Policy Committee (MPC) is tasked with adjusting interest rates to keep inflation within 1 per cent of this target – and for a long time it succeeded. Expectations were anchored to the MPC’s inflation target.
But today, inflation expectations seem to be drifting away. According to the Bank of England’s latest inflation attitudes survey, the public expected inflation to reach 4.6 per cent over the next 12 months. The real picture is actually much grimmer: inflation is currently at 9 per cent, and forecast to rise to 11 per cent by the end of the year. The Bank of England forecasts that the rate of price growth will come down next year, before returning to target in 2023. But the public aren’t buying it: inflation expectations for five years’ time are currently at 3.5 per cent. There is evidence that businesses are revising their expectations too. Bank of England research found that firms expected CPI inflation of 6.9 per cent in a year’s time and 3.8 per cent in three years’ time.
This is a headache for the Bank of England. If firms and households are expecting inflation to remain about 3.5 per cent over the long term, bringing inflation back to target will be all the more difficult. Businesses will be reluctant to raise prices by less than 3.5 per cent, and workers will be uneasy about pay rises below that level.
The inflation target is one powerful tool at the Bank’s disposal: by reinforcing their commitment to hitting 2 per cent inflation, they can hope to re-anchor expectations. Another tool is communication. Central banks can use ‘forward guidance’ to signal the likely future course of monetary policy. The MPC made it clear after its latest rate setting meeting that it expected inflation to return to the 2 per cent target in the medium term, and that "the committee will be particularly alert to indications of more persistent inflationary pressures, and will if necessary act forcefully in response".
But messaging has been muddled. Just two weeks later, Andrew Bailey, governor of the Bank, warned at an ECB conference that UK inflation was likely to stay higher for longer than other nations. He has previously faced criticism for telling MPs that "there isn't a lot we can do about" inflation, and admitting to sounding "apocalyptic" on food prices. Unanchored inflation expectations leave firms and households more sensitive to suggestions of rising inflation rates. Statements like this carry more weight than ever.
