The UK Inflation Outlook If This Time Isn't Different

December 16, 2010

Thank you for having me here to share in your pre-Christmas cheer this morning. Even discounting what I've learnt from watching “The Only Way is Essex,” it is a pleasant surprise to see so many people out and interested in discussing economics on a winter morning. I gather that usually at this event there is some discussion of members' predictions, and I look forward to hearing yours for the New Year. In that spirit, I would like to offer a forecast of my own for inflation in the UK, but at a slightly longer two-to three-year horizon, since that is the medium-term over which the Monetary Policy Committee's [MPC] inflation target is to be achieved. Given a series of above target recent readings on CPI inflation for the British economy, this is a good time for members of the MPC -and for the public to which we are accountable -to think critically about what is the right forecast. For an inflation targeting central bank, like the Bank of England, monetary policy should follow directly from the medium-term forecast (barring the rare kind of rapidly evolving crisis we experienced in 2008-09).

The first point I want to make is that neither our forecast nor our policy going forward should overreact reflexively to that above target inflation, even though it will persist for the next few months after the coming VAT rise. As much as we may be tempted to demonstrate to the public or to markets how upset we are about being above target, we have to take the right lesson from our mistakes and try to forecast better in future–we help no one in this economy by getting our forecast incorrect, or worse, by setting our policy to compensate for past mistakes rather than basing it on our best forecast.

As I said to the Treasury Select Committee last month (Posen 2010d), the persistently above target CPI inflation the UK economy is experiencing is almost entirely due to the combination of the depreciation of Sterling prior to January 2009 and the increase in VAT in January 2010. As a committee, our forecast underestimated the size and particularly the persistence of these inflationary effects, and I accept my share of responsibility for that mistake. The lesson we need to take therefore is to update our estimates of transmission from external shocks going forward. That said, annual inflation in the UK as measured in the CPIY series, which excludes the price effect of indirect taxes, has been below target throughout this calendar year. Thus, if we allow for even just some exchange rate pressure upwards on prices over this period as well, underlying UK inflation has stayed well below target. Recognizing that fact has to be the starting point for our forecast.