Lloys TSB – Economics Weekly

Inflationary pressures around the world intensified in 2007. The reason was faster than expected growth in the global economy. This occurred despite the doubling of oil prices and the bursting of the housing market bubble in the US and the subsequent crisis in credit markets. But this faster pace of growth was also accompanied by higher than expected price inflation. Interest rates were raised in response in 2007,
but are now being cut in those countries that were most affected by earlier rate rises and the credit crisis.

Inflation Expectations Matter For Future Price Developments

Are central banks taking risks with inflation?

 

Inflationary pressures around the world intensified in 2007. The reason was faster than expected growth in the global economy. This occurred despite the doubling of oil prices and the bursting of the housing market bubble in the US and the subsequent crisis in credit markets. But this faster pace of growth was also accompanied by higher than expected price inflation. Interest rates were raised in response in 2007,
but are now being cut in those countries that were most affected by earlier rate rises and the credit crisis.

 

So interest rates are not being uniformly cut around the world, however. There have been rate rises in China, New Zealand and Australia, to name just a few. But there have been sharp rate reductions in the US – to 3% currently from a peak of 5.25% in August last year – and more modest cuts in Canada and the UK. Official rates, however, have remained on hold in the eurozone at 4% in this period. One of the key reasons why official rates are being raised in some economies is to head off heightened inflation expectations. Studies over many years have shown that higher actual future inflation is a function of where prices are expected to be – as much as from cost push pressures and from demand-pull factors. Most central banks around the world accept that there is a need to keep inflation expectations low in order to prevent higher actual inflation later. So where are inflation expectations in the
US, UK and Eurozone and what influence might they have on actual inflation and hence official interest rates in the year ahead?

 

Inflation expectations are rising

 

Starting with financial market expectations, chart a shows that there has been a sharp rise in inflation expectations in all of the economies concerned. In the US, inflation expectations are elevated, but the Fed is still cutting rates, because it argues economic growth will slow sharply and that inflation will fall back in the medium term so justifying cutting now, even with rising price inflation. Worryingly for the Bank of England, which is also cutting official interest rates, inflation expectations are also rising. In Europe, they are also high and rising, but the ECB is not yet cutting official interest rates.

 

Why does this matter? Charts b, c and d, show that rising inflation expectations are correlated with rising actual inflation, so cutting official interest rates when inflation is rising risks embedding it into the price setting structure of the economy. The danger is that this is hard to eradicate and the cost, in terms of lost output (and higher unemployment) in the future, from having to push up interest rates to higher levels, is greater than if rates were kept a little bit higher today. But central banks are well aware of this risk. This is why in the accompanying statement to the recent MPC decision, after the committee voted to cut rates by a quarter of one percent to 5.25%, the lowest since May last year, stated: "Given this outlook for inflation, some slowing of demand growth, by reducing the pressure on capacity, is likely to be necessary to return inflation to target in the medium term. The Committee needs to balance the risk that a sharp slowing in activity pulls inflation below the target in the medium term against the risk that elevated inflation expectations keep inflation above target.”

 

A similar view was expressed by the ECB at its meeting in February. The main message from the ECB remained its worries about price inflation and is a clear sign that it will not tolerate second-order effects (i.e., higher wage inflation as a result
of higher price inflation). So a top priority, the ECB says, is the anchoring of expected inflation, which is even more crucial at times like these when above-target inflation is expected to persist for “a protracted period.” Price risks are “confirmed” to the upside, ECB President Trichet insisted, even as growth slows. This, to us, means that the ECB will pay close attention to the evolution of inflation expectations.

 

What does the evidence suggest about central bank reaction to rises in inflation expectations?

 

We have used household inflation expectations, as these are most important in spreading actual inflation in the wider economy, for the US, UK and eurozone. Charts e,f and g show that there is a very strong correlation between changes in official interest rates and in inflation expectations. In the US, the Fed’s rate setting during the last 5 years has been to encourage price inflation expectations. In other words, Fed rates have been below inflation expectations. Currently, the Fed is once again cutting interest rates even though household price inflation expectations remain high. This is not so the case for the UK, where there is a closer link between actual interest rates and inflation expectations. But the UK has still cut official interest rates even though inflation expectations are rising, though rates are coming down from a high level.
Some argue that labour market trends suggest that inflation will be contained, due to high levels of immigration and greater participation in the active workforce of the UK labour market. However, the jury is still out on this and in the meantime interest
rates are likely to be cut further. Inflation expectations will limit the room for rate reductions, however, by the extent that they remain high, particularly if the MPC is serious about taking them into account.

 

The ECB is much more serious about inflation expectations than many other central banks. The chart shows that the ECB does not cut official short term interest rates if expectations are rising. This would imply that there will be little or no rate cuts
from the ECB this year, unless inflation expectations fall back. But the key point is that inflation expectations are still rising. The ECB will not raise rates, but the risk is that the current credit market situation clears up and actual price inflation – currently well above the target of at or below 2%, at 3.2% in the year to December – does not fall back and inflation expectations remain high. In that case the ECB will raise interest rates. In short, we need to watch the data for inflation expectations as much as for actual price inflation. In addition, comparing the path of official interest rates and inflation expectations would seem to us to be a good guide to whether the current monetary policy stance is too loose, too tight or just about right.

 

Trevor Williams, Chief Economist