Before 2005 the Monetary Policy Committee (MPC) of the Bank of England had done pretty well : since getting independence inflation had been close to the target…. Since 2005 inflation has been consistently above target, and seriously so over the last two years, hitting a peak of 5.2%. What have been the consequences?…
[T]he Bank did expect to exceed its target (it opened the floodgates!), but the extent of the inflation overshoot was not foreseen. The second is that inflation expectations, as measured by surveys of households, did rise to somewhere between the Bank’s forecast and what actually happened…. Market measures based on swaps show a similar story for longer term inflation expectations…. This is despite the Bank’s forecast, backed up by most other forecasters, which sees inflation coming back to target during this year.
So in a sense this seems to confirm some of the hawks’ fears. Inflation expectations are now above target, and they are not coming down in line with forecaster’s projections. Has this started a wage-price spiral, with inflation out of control? In a word, no. From the peak of 5.2% in September, inflation has fallen rapidly, and was 3.6% in January…. What we have seen is a classic and temporary cost push or supply shock caused by a VAT increase and rising commodity prices…. The latest figure for January, released yesterday, gives a year on year increase in earnings of only 1.4%.
So, despite a significant inflation overshoot (part planned, part unplanned), a (modest) rise in inflation expectations, and a huge increase in the monetary base as a result of quantitative easing, there is absolutely no sign of a take-off in inflation. This should not be a surprise. Sustained increases in inflation involve wage-price spirals, and given high and rising unemployment we are not seeing the wage part of this process. However, this does not prevent inflation hawks being inflation hawks, and others getting cold feet….
[T]he floodgates view makes it much more difficult to have a sensible public discussion about using promises of higher future inflation to mitigate the zero bound constraint. (This could involve temporarily raising the inflation target, or switching to a price level or nominal GDP target.) As I noted here, there is very little discussion of this option in the UK (although this is a notable exception)…. [I]f a significant proportion of the monetary policy making community view inflation above 2% as the equivalent of just one drink for an alcoholic, then using inflation as a tool rather than just a target will not happen…
[S]core one for the credibility of independent central banks. Yes inflation expectations rose above the target, but not enough to set off Stagflation…. [M]y favorite behavioral model of expectations… corresponds exactly to the floodgates hypothesis. Psychologists including Anreasson and Krause have found that people presented with a random walk make forecasts as if the data were generated by a broken trend. So generally they predict mean reversion, but a few increases in a row and they decide the variable is trending up, so they extrapolate. This behavior corresponds exactly to expectations which are currently anchored, but also to floodgates which can open…. [M]y favorite model of expectations failed this time.