MNI INTERVIEW: Recent Inflation Shocks Restrict Policy - Monti

Recent experience of inflationary shocks make households and firms more likely to anticipate higher inflation ahead, a complicating factor for policymakers now looking to ease, Francesca Monti, professor at UCLouvain and formerly a senior Bank of England official, told MNI.

With UK inflation back well above the 2% target at 3.4% in May, there is debate among officials over whether their ability to cut rates is curtailed by the legacy of recent episodes of soaring CPI. Monti said past inflationary surges do make things trickier.

"There's a lot of evidence that people overweight recent experiences ... and that people put more weight on their own lived experiences. People that have lived through the high inflation of the 1970s had on average higher inflation expectations than people that ... only lived through the low inflation, or relatively stable inflation," after the 1980s, Monti said in an interview.

BOE research has found that food prices matter most for household inflation expectations, and, with food price inflation jumping to 4.4% from 3.4% in April, it is unclear that expectations are anchored to the 2% target.

"These inflation expectations matter. If you would see an acceleration, a big acceleration, of inflation expectations, you should be worried. And I think this is really what this anchoring versus dis-anchoring is more about,” she said

Still, any concerns about de-anchoring in the UK or elsewhere in Europe are less pronounced than in the U.S., as inflation dynamics have diverged and American expectations are also being pushed higher by government tariff policy, she noted. (See MNI INTERVIEW: Inflation Expectations Troubling-Gorodnichenko)

NO FIXED TRIGGER POINT

Monti rejected the idea that there is any fixed inflation number which acts as a warning light for policymakers.

"The recent bout of high inflation has brought the households' attention back on to inflation, so now even smaller shifts might ... make the inflation expectations more reactive," she said.

This echoed remarks by BOE Monetary Policy Committee member Megan Greene at the National Institute of Economic and Social Research (NIESR) on June 24. Greene noted that academic literature had previously suggested that people did not notice inflation if it was under 4%, but that now a 3-4% range may be salient for households.

Monti’s own work shows that the response of the economy to monetary policy shocks is contingent on inflation expectations, and in particular, on whether people fear high inflation outcomes or low inflation outcomes.

"The good thing about this is that in periods of where a lot of people are more worried about high inflation, we find that monetary policy is more effective in controlling inflation, while in the periods of low inflation, monetary policy moves output, but is less effective in moving inflation," she said.

HUW PILL

BOE Chief Economist Huw Pill, who voted against the most recent rate cut, has placed weight on the risk that high inflation readings could further feed expectations and trigger second-round effects.

Given that people are worried about high inflation, Monti interpreted Pill's message as "more about communication to the public than just being hawkish. He is signalling that 'we are listening to you. They know their job is to hit the 2% target (and) want to show that 'We're doing it ... we're not dropping the ball'.’”

In a related research strand Monti, together with former BOE colleague and the new head of NIESR David Aikman, is creating an index to measure trust in central banks.

"If inflation is high trust goes down. And we find that these trust shocks have the effect of increasing inflation expectations, albeit temporarily, but have persistent negative effects on things like stock prices," she said.