- What people think will happen dictates how long high inflation persists
- Policymakers have not done a good job of managing expectations
After 15 years of low and stable inflation, the past 18 months have been a shock to the system. But where we go from here is tied up in a web of muddled official communications from the Bank of England (BoE), unhelpful addtional comments from its senior staff and the fact that workers and businesses feel poorer and are taking action to stop that.
Although the overall rate of inflation slowed to 8.7 per cent from 10.1 per cent in April, some troubling dynamics are at play. Core inflation, which reflects domestic inflationary pressures, actually accelerated to 6.8 per cent– the highest rate since 1992. This will worry the BoE, which was already concerned about ‘second-round’ inflation effects because of rising wage demands and businesses upping their prices. Governor Andrew Bailey said earlier this month that these second-round effects were "unlikely to go away as quickly as they appeared”. The latest figures suggest he is right.
At 19.1 per cent, food price inflation will preoccupy the Bank, too. Though Bailey thinks that food price inflation should soon “start to ease”, he acknowledged last week that inflation is currently “concentrated in the essentials of life – fuel, energy and food”. As a result, the public will probably feel little relief from the cost of living squeeze, despite falling headline figures. After all, a lower rate of inflation means that prices are still rising – just at a slower pace.
But a big factor in whether or not inflation falls depends on what the BoE tells us and whether we believe it. Its own projections and consensus estimates suggest inflation will continue to drop for the rest of the year. But households and businesses aren't necessarily in agreement and they might have a point. The 8.7 per cent figure surprised both the Monetary Policy Committee and economists – the general public could rightly be losing faith in official expectations. This sentiment will feed into workers' wage demands and how businesses price their goods. It will keep influencing exactly the kind of second-round effects that the BoE is alredy worried about, pouring more fuel on the fire.
Policymakers have not helped matters in the slightest. In comments made to the Treasury Committee earlier this week, Bailey admitted the central bank had “big lessons to learn” about monetary policy and implied they themselves were losing faith in their ability to accurately forecast inflation – doing little to inspire confidence among the public.
The BoE also faced criticism for its management of inflation expectations in April. In an attempt to contain ‘second-round’ effects, the Bank’s chief economist made badly received comments suggesting that everyone in the UK should "accept" being poorer and stop trying to "maintain their real spending power by bidding up prices”.
Ashley Webb, UK economist at Capital Economics, said that Bank cannot really influence workers' wages or businesses profit margins. But, he said, it can be better at influencing inflation sentiment by "setting expectations for the level and direction of interest rates”.
Webb added that throughout the tightening cycle, the Bank “hasn’t really done this”, pointing out that rate-setters have consistently implied that rates wouldn’t rise very far even though markets now expect them to peak at 5.5 per cent, a whole percentage point from where we are now. He added: “If the Bank had sounded more hawkish, perhaps price and wage expectations would declined."
The government’s efforts in the fight against inflation may have made things worse. By setting a target of halving inflation this year, the Chancellor may have inadvertently planted a ‘focal point’ in people’s minds. In an article in The Times earlier this month, Jagjit Chadha, director of National Institute of Economic and Social Research, a think tank, argued this target means even medium-term inflation expectations now sit at around 5 per cent, rather than anything lower. "This is making inflation more persistent," he said.
So, will this week’s lower headline figure be enough to convince the public that inflation has turned the corner? Unlikely. And it's not really their fault. Kitty Ussher, chief economist at the Institute of Directors, said policymakers would be hoping expectations would come down following the single-digit figure. But the sticky numbers are undeniably unwelcome news for a central bank committed to hitting a 2 per cent inflation target and a government with a ‘top priority’ of halving inflation.
Former US Treasury Secretary Larry Summers perhaps described it best. He said the 2 per cent inflation target has morphed from “a ceiling that we were trying to reach" to being an "average that we hope to attain" to now becoming a "floor that we hope to touch". With UK headline inflation still at 8.7 per cent, this seems a particularly distant prospect domestically, and everybody knows it.
