Inflation expectations a risk to inflation itself, says BoE

There is a risk that inflation expectations will rise and cause inflation itself to increase, the Bank of England has warned.

In an article in the Bank’s Quarterly Bulletin for Q2 2011, Clare Macallan and Tim Taylor of the Bank’s Monetary Assessment and Strategy Division and Tom O’Grady of its Structural Economic Analysis Division argue that inflation expectations play an important role in the transmission of monetary policy.

They explain that because the annual change in the consumer prices index has frequently been more than 1% above the 2% target set by the government over the last three years, there is a risk that households, companies and financial market participants will expect inflation to persist above the target.

The article says: “That might happen if they believe that the Monetary Policy Committee has become more tolerant of deviations of inflation from target in the near term than is in fact the case, or individuals might have doubts about the willingness or ability of the MPC to return inflation to target in the medium term.

“In either case, expectations of inflation would have become less well anchored by the monetary policy framework.”

It goes on to say that if inflation expectations do rise, inflation itself might become more persistent.

This is because companies may raise the prices of their goods and services and be more willing to grant increases in wages, in anticipation of inflation increases.

The article adds: “An increase in the persistence of inflation, other things being equal, would mean that returning inflation to target would require the MPC to tighten monetary policy by more than it otherwise would.”

It then goes on to provide a framework that the authors say can be used to monitor the risk to inflation from inflation expectations.

Elsewhere in the bulletin, the Bank says that as a result of weaker-than-expected economic data and falling swap rates, market participants now expect the MPC to have raised the base rate by 0.25% by February 2012.

This has been pushed back by seven months from an expectation of the first rate hike in July at the time of the previous bulletin.