A loss of confidence in the BoE could lead to stagflation

Keith Wade says the temptation to continue to blame UK inflation on temporary factors is dangerous.


Keeping interest rates at record lows is thought by some as the only answer to repairing both the household and government’s balance sheet. Meanwhile, the cost of doing so is higher inflation, a price worth paying according to some members of the Monetary Policy Committee.

There is a difference between actually meeting an inflation target and just promising to do so in the medium term. This seems to have escaped the Bank of England’s (BoE) attention of late despite inflation in 27 of the last 37 months being more than 1% above the Bank’s 2% inflation target.

Now that the BoE is forecasting inflation to rise above 5%, doubts are growing over the central bank’s ability, along with its willingness, to meet its 2% target.

Headwinds remain

There is a feeling of déjà vu at the moment. It’s May and the Greek sovereign debt crisis is hurting market confidence, another Icelandic volcano is spewing ash into the sky, and finally, the ONS is reporting weak first quarter growth, caused by a rise in inflation, which has been mainly driven by the increase in VAT.

Nominal GDP grew by 2.2% in the first quarter of 2011 (8.8% annualised) but the impact of higher inflation meant that growth in real terms was just 0.5% – very similar to the data seen for the first quarter of 2010.

What is different this year is that the Bank of England is not so optimistic with its inflation outlook. But we continue to hold the view that the Bank of England is over estimating the amount of spare capacity and therefore deflationary pressure in the UK economy.

ECB research

The temptation to continue to blame inflation on temporary factors is a dangerous one. The European Central Bank (ECB) compared and contrasted the US and German experience of the Great Inflation during the 1960’s and 1970’s.8 The US (along with many European countries) experienced prolonged, stubbornly high inflation for many years, where as Germany managed to return inflation more quickly back to more normal levels.

The ECB concludes that contrary to popular beliefs, the Great Inflation was not caused by a series of “bad-luck explanations… [and] a sequence of adverse supply shocks, the Great Inflation was mainly a result of crucial monetary policy mistakes.”

“The US experience of the second half of the 1960s…clearly shows that a few years of systematically disappointing inflation outcomes, in the absence of a clear definition of the monetary policy objective, can rapidly unanchored inflation expectations.”

The ECB goes on to highlight “…the dangers associated with an excessive reliance…on unobserved and therefore intrinsically poorly measured indicators, such as the output gap”, after showing evidence that real-time estimates of the output-gap during the period in question over estimates the amount of spare capacity in the economy relative to estimates that are done using mature data.

Bearing this in mind, there is a risk that if the Bank of England continues to downplay the threat of inflation in the medium term and keep interest rates at record lows, the public may eventually lose faith with the Bank’s ability to control inflation, and perhaps even its desire to meet the inflation target. More extreme cynics even question the Bank’s independence altogether.

The loss of faith could de-anchor long-term inflation expectations, and combined with our view of less spare capacity in the economy, could eventually lead to second round wage-inflation effects, resulting in a sustained period of elevated inflation in the UK, or even stagflation.


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