MNI INTERVIEW: UK Inflation Expectations More Loosely Anchored

Inflation expectations have remained anchored to the Bank of England's 2% target following the Iran shock, though less securely, and assessing how well they are holding firm will be a significant factor for policymakers in upcoming meetings, London School of Economics professor and academic consultant at the BOE Ricardo Reis told MNI.

Using decomposed inflation swaps data, Reis and BOE economists found that market participants' inflation expectations had risen more in the UK than in the U.S. and euro area since the start of the Iran conflict, but remained close to the target.

The work provides "a very clear measure of the long-run anchor and the short run, the one year and the 10 year [and] ... they moved a little bit, but not to the point of it seeming that we're lost," Reis said.

One-year expected inflation in the UK has risen by around 0.8 percentage points since the conflict began, higher than the 0.4 percentage points seen in both the euro area or the U.S., the cleaned data show. UK 10-year expectations are only up about 0.2 percentage points.

While some have argued that the surge in inflation following Covid and the invasion of Ukraine de-anchored inflation expectations, leaving the BOE less room to look through price rises this time around, Reis said the data do not support this. (See MNI INTERVIEW: Oil Shock Means Europe Needs Higher Rates)

"The anchor is back in place, but it's not quite as deeply in the sand as it was," he said, adding that expectations have tended to move more than previously but in both directions in response to relatively small changes in inflation. Not even the Iran shock has dislodged the anchor, he said, though “it has moved a little bit.”

KEY SIGNAL

This signal within the inflation swaps data "is what policy makers are measuring on a day-to-day basis, and absolutely one of the big inputs into the decisions in the next two or three rounds,” of central bank decisions, he said.

Reis, along with co-authors including BOE research adviser Robert Czech and research manager Saleem Bahaj, decomposed inflation swap rates into a fundamental, or risk neutral component and a frictional one, with the latter capturing moves due to supply or demand constraints. They found that UK fundamental one-year inflation expectations rose by 0.84 percentage points from the time when the Iran war started up until a couple of weeks ago.

"It doesn't seem to have moved a lot," Reis said, but he added that this could change and that central bankers are saying that while there is no reason for aggressive hiking "we're looking at the measures, and all cards are on the table for the next policy meetings.”

The BOE is expected to keep Bank Rate unchanged at its meeting this week, though markets price in a hike by December.

LOW PASS THROUGH FROM ENERGY PRICES

Other, Hidden PDF has found that energy price rises alone have only a slight effect on inflation expectations.

"People respond more to energy prices than they do to any other piece of information, but still not that much to energy prices, so the first impact on inflation expectations is not that big," he said.

A doubling of the price of electricity raised expected inflation by a bit less than a percentage point, his work found.

The scale of the shock to expectations is determined by how it "transmits to other goods, including food [and] ... that depends not just on the energy component of the good as much as it does on how credible the central bank is, the actions it takes," he said, adding that other factors, including the fiscal policy response, also had an impact.

UK energy prices were two to three times higher than in the U.S. before the shock, but rather than amplifying the impact on inflation, this disparity “goes in the opposite direction, because energy prices in Britain had been falling in the last 12 months. They're still high, but they've been falling.”

Households might place more weight on the fact that their own "energy price, no matter what's happening in Iran, is still lower than it was 18 months ago," Reis said.