How real is the inflation threat?

Recent developments have raised concerns that the UK
could be facing an upsurge in price inflation over the
coming years. Since early March, oil prices have doubled;
the economy has found a firmer footing; and broad
measures of inflation expectations have shifted higher.
The rise in some of the forward-looking inflation indicators
has occurred as the Bank of England has embarked on
an unprecedented loosening in UK monetary policy.
Having cut interest rates to a record low, the Bank has
turned to the unorthodox policy of quantitative easing (QE)
in an effort to stimulate lending and demand through
expanding money supply.

Recent developments have raised concerns that the UK could be facing an upsurge in price inflation over the coming years. Since early March, oil prices have doubled; the economy has found a firmer footing; and broad measures of inflation expectations have shifted higher. The rise in some of the forward-looking inflation indicators
has occurred as the Bank of England has embarked on an unprecedented loosening in UK monetary policy.
Having cut interest rates to a record low, the Bank has turned to the unorthodox policy of quantitative easing (QE) in an effort to stimulate lending and demand through expanding money supply.Inflation expectations have turned upwards The concern about future potential inflation has started to unsettle bond markets. Medium and long-dated gilt yields have backed up sharply since early March (see chart a). Part of this upward adjustment reflects rising concerns over the current and prospective level of public sector debt issuance. Part of it reflects rising real interest rates and a more general reassessment of risk premia
as equity markets have improved. But the rise also reflects a noticeable shift higher in the market’s perception of inflation risk.
Since the Bank unveiled its quantitative easing programme in early March, long-dated breakeven inflation rates have risen by around 1 percentage point, to 3.7%. RPI inflation swaps tell a similar story. Since last November, the annual RPI two years forward has risen from less than 1% to 3% (see chart b). Adjusting for differences in methodology and definition, the increase in inflation expectations suggests financial markets doubt the ability of the Monetary Policy Committee (MPC) to meet the government’s 2% inflation target over the medium term. But it is not just the markets that have started to exhibit some scepticism. The latest Bank of England/NOP Inflation
Attitudes Survey shows that the public’s perception of the inflation outlook over the next twelve months picked up slightly in May, to 2.4% from 2.1% in February, despite slower actual inflation (see chart c).

But medium-term inflation concerns are overdone While there may be justifiable concerns about the inflation outlook over the longer term, the creeping pessimism about the medium-term prospects looks misplaced. With the economy still in recession and unemployment
continuing to rise sharply, the current economic environment is more consistent with deflationary, rather than inflationary conditions. Although ‘green shoots’ have started to emerge, the prevailing level of space capacity indicates that businesses are operating well below potential – hardly a recipe for a significant demand or supply
induced rise in prices. We estimate that the UK is currently operating with a negative output gap of around 6% – i.e. the level of actual output is about 6% below the level that could potentially be produced given the current pool of available labour, labour productivity and capital stock (see chart d).

Not surprisingly, inflation and the output gap are reasonably closely correlated. As demand weakens,
unemployment tends to rise, putting downward pressure on wage and, with a lag, consumer price inflation.

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