Who is to blame for shrinking real wages in the UK? Nobody?

The squeeze on UK consumers through falling real wages has been regarded as a significant factor in the (until recently) anaemic economic recovery.  Employers have taken a good share of the blame for this – but is that fair?  Have employers deliberately kept earnings below inflation as a means of boosting their own profitability, or was this an unintended outcome of upside inflation shocks?

If we look at Eurostat’s nominal wage growth series in the UK since the credit crisis, it’s only in the last couple of years that nominal wage growth has been well below the Bank of England’s inflation target of 2%.  In 2008 nominal wage growth was 6.1%, 2009 1.8%, 2010 3.6%, and 2011 2.1%.

It’s only in 2012 that Nominal Wage Growth fell way below the BOE’s inflation target

And yet over those same years, Labour Productivity per Hour Worked (again Eurostat) was awful.  -1.2% in 2008, -2.3% in 2009, +1.1% in 2010, and +0.7% in 2011.  In other words companies appear to have, ex ante, attempted to compensate their workers for expected inflation, assuming that the Bank of England hit its inflation target, and have overcompensated them, ex post, for improvements in productivity.

Labour productivity has been very weak – and often negative

So has the problem for earnings been the unexpected inflation overshoot (since the credit crisis started CPI has been above the Bank’s 2% target in all but 6 months, in 2009), not the wage setting behaviour of companies? Had inflation come in at, or above target, workers would have been better off in real terms until 2012, and certainly better off than you might expect given the historically strong relationship between wage growth and productivity.  I’m not sure I’m blaming the Bank of England here either – to achieve the 2% inflation target, rates would have had to have been inappropriately high for the domestic demand conditions and the distressed balance sheet of the UK public and private sectors.  And productivity is weak in part because employment has been unexpectedly strong relative to the weakness of the economy.  So a low inflation, high productivity UK economy sounds nice – but in the circumstances would likely have only have been possible with a much deeper recession and higher unemployment rate.


The M&G YouGov Inflation Expectations Survey – Q4 2013

The M&G YouGov Inflation Expectations Survey for November shows that consumers in all countries surveyed expect inflation to rise from current levels in both one and five years’ time. In the UK, short-term inflation expectations fell over the quarter to 2.8%, following recent downward pressure on UK CPI. It may also suggest that the shock from recent increases in utility bills may be fading. Over five years, however, inflation is once again expected to rise to 3.0%, suggesting expectations for future inflation remain well anchored above the Bank of England’s (BoE) CPI target of 2.0%. We did not see the same spike in inflation expectations as in other recent inflation expectations surveys such as the Bank of England’s own survey, possibly as ours is more recent and was conducted between November 22-25.

In Europe, all countries surveyed with the exception of Switzerland, expect inflation to be equal to or higher than the European Central Bank’s (ECB) CPI target of 2.0% on both a one- and five-year ahead basis. All European Monetary Union (EMU) countries expect inflation to be higher in both one and five years than it is currently, while only two countries – Spain and Switzerland – anticipate it being less than 3.0% in 5 years’ time.

Comparing the results with those from earlier surveys reveals a number of noteworthy observations. Inflation expectations for one year ahead have fallen in all surveyed EMU countries since the start of 2013. This is unsurprising given the weak macroeconomic environment and the fact that commodity prices have declined by roughly 5.6% in the past three months. Consumers have also benefitted from a stronger euro, which has gained around 6.6% over the past year on a real effective exchange rate (REER) basis. Notably, short-term inflation expectations in France, Spain and Italy are now running well above their current inflation rates.

Survey respondents in Hong Kong show no signs of moderating their inflation expectations, which remain at a high level of 5.0% and 5.5% over one and five years, respectively. In Singapore, inflation expectations over one year are double current inflation (2%) whilst the five-year reading remains stable at 5.0%, as it has done throughout the course of 2013.

The findings and data from our November survey, which polled over 8,500 consumers internationally, is available in our latest report here or via @inflationsurvey on Twitter.


The M&G YouGov Inflation Expectations Survey – Q3 2013

Despite high unemployment rates, excess capacity and a sanguine inflation outlook from the major central banks, it is important to keep an eye on any potential inflation surprises that may be coming down the line. For instance, we only need to look at ultra easy monetary policy; low interest rates and improving economic growth to see that the risk of an unwelcome inflation shock is higher than perhaps at any time over the past five years. The development of forward guidance measures is a clear sign that central banking has evolved substantially from 2008 in the form of Central Bank Regime Change. It appears that there is a growing consensus that inflation targeting is not the magical goal of monetary policy that many had once believed it to be and that full employment and financial stability are equally as important.  Given that monetary policy appears firmly focused on securing growth in the real economy – at perhaps the expense of inflation targets – we thought that it would be useful to gauge the short and long-term inflation expectations of consumers across the UK, Europe and Asia. The findings from our August survey, which polled over 8,000 consumers internationally, is available in our latest report here.

The results suggest consumers continue to lack confidence that inflation will decline below current levels in either the short or medium term. Despite evidence that short-term inflation expectations may be moderating in some countries, most respondents expect inflation to be higher in five years than in one year. Confidence that the European Central Bank will achieve its inflation target over the medium term remains weak, while confidence in the Bank of England has risen.

The survey found that consumers in most countries continue to expect inflation to be elevated in both one and five years’ time. In the UK, inflation is expected to be above the Bank of England’s CPI target of 2.0% on a one- and five-year ahead basis. All EMU countries surveyed expect inflation to be equal to or higher than the European Central Bank’s HICP target of 2.0% on a one- and five-year ahead basis. Long-term expectations for inflation have changed little in the three months since the last survey, with the majority of regions expecting inflation to be higher than current levels in five years. Five countries expect inflation to be 3.0% or higher in one year: Austria, Hong Kong, Italy, Singapore and the UK.

Consumers in Austria, Germany and the UK have reported an increase in one year inflation expectations compared with those of the last survey three months ago. This is of particular relevance for the UK, where the Bank of England has stated three scenarios under which the Bank would re-assess its policy of forward guidance. The first of these “knockouts” refers to a scenario where CPI inflation is, in the Bank’s view, likely to be 2.5% or higher over an 18-month to two-year horizon. Short-term inflation expectations in Singapore and Spain continued their downward trend in the latest survey results, registering their third straight quarter of lower expectations.

Inflation expectations - 12 months ahead

Over a five-year horizon, the inflation expectations of consumers in Austria, Germany, Italy, Spain and Switzerland have risen. Whilst inflation expectations in Switzerland remain at the lowest level in our survey at 2.8%, consumers have raised their expectations from 2.5% in February. Long-term inflation expectations in France and the UK remained stable at 3.0%. Meanwhile, consumers in Hong Kong and Singapore have the highest expectations, at 5.0%, although the Hong Kong number shows a decline from 5.8% three months ago.

Inflation expectations - 12 months ahead


The Fed didn’t taper – what’s next for US monetary policy and bond markets?

Last night the Federal Open Market Committee (FOMC) delivered a massive surprise by deciding to not taper QE. For us, this isn’t a huge deal. Since May, the market has placed way too much emphasis and concern over tapering and lost focus on the fundamental economic situation that the US has now found itself in – an economy where unemployment has fallen to 7.3% (helped by a falling participation rate) and a central bank that remains dovish due to a declining trend in core inflation. Now we are through the Fed meeting, arguably the market will now re-focus on the economic data. With interest rate policy set to remain very accommodative for a long period of time – even after balance sheet neutrality has been achieved – the sell-off in government bonds may be close to coming to an end (as witnessed by the 19bps fall in the US 10 year yield from 2.89% yesterday afternoon to 2.70% this morning).

US 10yr bond yields during quantitative easing

Fed concern number 1: US core PCE inflation is flirting with historic low levels

It is well known that FOMC Chairman Ben Bernanke, a student of the US economic depression of the 1930s, has great concerns about deflation and in 2002 gave a speech outlining how the US could avoid a deflationary trap which gave him the moniker “Helicopter Ben”. In the speech, Bernanke makes the important statement that “…Congress has given the Fed the responsibility of preserving price stability (among other objectives), which most definitely implies avoiding deflation as well as inflation.”

The Fed’s preferred inflation measure, the core PCE, is exhibiting a worrying downward trend. This greatly concerns at least one member of the FOMC – St. Louis Federal Reserve Bank President James Bullard – who believes the FOMC should have more strongly signalled its willingness to defend its inflation target of 2 per cent in light of recent low inflation readings. The Fed minutes from the June meeting (at which Bullard dissented) showed that Bullard believed that the Fed was not doing enough to protect against the threat of deflation and that the FOMC must defend its inflation target when inflation is below target as well as when it is above target.

A key component of the Fed’s dual mandate – price stability – is clearly below where the FOMC wants it to be. There are big risks to reducing stimulatory monetary policy when core inflation is running at recessionary levels and on this measure suggests any interest rate hikes a long way away.


Inflation trending lower on both total and core PCE

Fed concern number 2: the labour market

The latest payroll report was weaker than market economists had become used to, with payroll growth averaging around 148,000 over the past three months. This is some way off the 200,000+ numbers that the consensus was expecting earlier in the year and confirms a deceleration in the trend in nonfarm payroll growth. Yes, the unemployment rate fell to 7.3%, but this was largely the result of the labour force shrinking and a decline in the participation rate in August. The labour market is not as strong as the headline number suggests.

Arguably, the fall in the unemployment rate has surprised most Fed members. Nonetheless, unemployment is not expected to fall to the 6.5% “think about raising interest rates” level until late 2014. It would have been a confusing message to start to implement tapering given the lower trend in job creation. The Fed reiterated that the economy and labour market have to be strong enough before in contemplates reducing asset purchases going forward. This helps to explain why the FOMC sat on its hands in September.


Unemployment rate quickly falling towards Fed thresholds

Fed concern number 3: the increase in mortgage rates

Following the moves in markets over the summer, the average rate for a 30-year fixed mortgage has now increased to around 4.5% from 3.4% in May. Essentially, the market has already tightened for the Fed. The housing market is a vital component of US economic growth, and this increase will cut into housing affordability. It could also force potential homebuyers out of the market. A slowing housing market means fewer jobs, less consumption, and lower growth. The increase in yields in the government bond market has been brutal, and does pose some risks to interest-sensitive sectors.


The rise in 30 year mortgage rates will concern the Fed

Given the above, it appears that the Fed refused to be bullied into tapering today by the bond markets, though tapering speculation may have reduced the “froth” that had developed in risk assets over the first half of 2013. It is likely that low inflation, a recovering labour market, and a slowing housing market will ensure that interest rate policy remains accommodative for the foreseeable future. The “Fed fake” suggests that tapering is truly data dependent and not predetermined. Macro matters.

As the market begins to refocus on the economic data, it is likely that government bonds may find some support. Additionally, the FOMC may reduce bond purchases slower than anyone currently expects. We expect that market concerns over the impact of tapering decisions will likely diminish over time as the Fed slowly and gradually moves towards a neutral balance sheet policy next year.


Monster Munch update – a victory for bondvigilantes.com

One of our most popular posts of all time was written back in 2011. The subject was not the US losing its AAA rating, the impact of the default of Lehman Brothers or any other weighty matter of great economic import, but rather a quick look at how packets of Monster Munch were getting smaller over time and the associated inflationary impact.

Hence my surprise when I went into a shop last weekend and saw that Monster Munch packets have now been restored to their old 40g size, replacing the measly and frankly unsatisfying 22g version of recent times.


Further research on the manufacturer’s website revealed that

“ … The re-launch comes in response to growing consumer demand and will take Monster Munch back to the original retro pack design and old texture, flavour and crunchiness that consumers remember and love … Consumers have made it clear through both our own research and within online communities that they miss Monster Munch the way it used to be ..”

I like to think that our blog was the spark that lit the fuse of this virtual nostalgia-laden fast food insurgency. A resounding victory for bondvigilantes.com fighting in the name of consumer activism!

But wait, it gets better. Back in October 2011, the M&G coffee shop charged 45p for 22g, or 2.05 pence per gram. Today, the same shop charges 65p (RRP 50p) for a 40g packet, or 1.63 pence per gram. This is a fall of 20.5% in nominal terms. Put simply, you are also getting more for your money.

However, before we applaud the manufacturer for their largesse, let’s look at the main raw material. Back in October 2011, we pointed out that the headline cost of Monster Munch closely followed the corn price.


Since October 2011 the corn future has fallen by around 28.5% in price to $4.64 per bushel, a rare case of deflation in recent times. In sterling terms, the fall is around 25.5%. Accordingly, the dramatic fall off in corn prices has allowed the manufacturer to pass on part of this benefit to consumers, reducing the headline per gram price, but at the same time retaining some of the benefit in the form of an enhanced profit margin.

So whilst we cannot claim all the credit for this victory, this is a rare piece of welcome news for the consumer of corn based snacks.


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In search of satisfaction – our analysis of the BoE press conference

Listening to the Bank of England Quarterly Inflation Report press conference – the first with Mark Carney steering the ship – a song immediately sprung to mind. The song was written by a former student of the London School of Economics, Sir Michael “Mick” Jagger with his colleague Keith Richards in 1965. There is no better way to analyse the current thinking of the Bank of England than through one of The Rolling Stones best songs, (I Can’t Get No) Satisfaction.

I can’t get no satisfaction

The new BoE Governor began with the positive news that “a recovery appears to be taking hold”. This wasn’t news to the markets, as more recently we have seen a remarkably strong string of economic data. However, the very next word in Mr Carney’s introduction was “But…”. What followed was, in my opinion, the most dovish sounding central bank policy announcement since the darkest days of the financial crisis.

Carney firmly announced his arrival as the global independent (excluding BoJ) central banking community’s uber-dove through the acknowledgement of a broadening economic recovery in the UK, and then making explicit that the BoE remains poised to conduct more, not less, monetary stimulus. Until now, these two conditions were considered by bond markets to be pretty much incompatible.

’Cause I try and I try and I try and I try

Carney told us that the BoE will maintain extreme monetary slack (in terms of both the 0.5% base rate and the £375 billion of gilts held) until the unemployment rate has fallen to at least 7%. He went even further than this, stating the MPC is ready to increase asset purchases (QE) until this condition is met. However, there are two conditions under which the BoE would break the new, explicit link between monetary stimulus and unemployment: namely, high inflation and threats to financial stability. Did the new governor have to put these caveats in place because other members of his committee would only agree to the announcement if they were mentioned?

Supposed to fire my imagination

The new framework announcements were broadly in-line with what we were expecting. In that respect, the Governor’s major announcement was not too much of a surprise. The market agreed and there was a relatively muted response. Carney was supposed to fire our imaginations, so the question is – did we learn anything new? The “yes” and “no” arguments are outlined in the below table.

2013-08 ben blog

When I’m watchin’ my T.V. and that man comes on to tell me how [the economy should] be…

The market suspected Mr Carney would bring in some forward guidance, but I think the most interesting implication of this announcement today is that he felt the need to do something, but did not feel the need to increase asset purchases through QE. Mervyn took on the first part of Friedman’s equation, the supply of money. This was not inflationary as the transmission mechanism was broken, and the cash was hoarded and not released into the real economy. Could Carney be the governor to focus on the second part of the equation, money velocity? Forward guidance is designed to give individuals and companies the confidence to borrow in order to spend or invest. If they do, velocity will return as the transmission mechanism repairs. I believe we are considerably less likely to see an increase in QE under the new governor.

If forward guidance does not have the consequences Carney intends, and my belief that he is more focused on the transmission mechanism than his predecessor, what might Carney do next? At that point, he might increase schemes akin to Funding for Lending, and hand banks cheap funds at the point at which the banks release the loans to borrowers. This way, banks are heavily incentivised to lend at levels that are attractive to individuals and companies.

He’s tellin’ me more and more, about some useless information

Carney told us that if and when unemployment reaches 7%, policy will start to tighten. But then he stated that if inflation exceeds 2.5% on the BoE’s shocking 2 year forecast (is this a rise in the inflation target?), or if inflation expectations move beyond some unannounced bound, or if financial stability is under threat, then he might have to break the newly explicit link between unemployment and monetary policy. And then he stated that even if unemployment hits 7%, this will not trigger a policy change, but a discussion around one.

I don’t think we actually got pure forward guidance, but a pretty muddled variant thereof. Bond markets are rightly unsure as to how to react, and have struggled for a satisfying interpretation. All we can really take from the BoE is that they will need to be sufficiently satisfied that the UK economy has reached escape velocity before hiking rates or reversing policy.


The M&G YouGov Inflation Expectations Survey

Today we have launched the M&G YouGov Inflation Expectations Survey with the aim of assessing consumers’ expectations of inflation over the short and medium term. There has never been a better time to gauge the views of consumers, with interest rates at multi-century lows, central bankers waist-deep in the experiment of quantitative easing and politicians wavering on whether or not austerity is the right thing to do. The report is available here.

Surveys of consumers’ inflation expectations are now a key component of monetary policy and there are a few in existence. However, our survey differs from existing surveys of consumer inflation expectations in a number of fundamental ways.

Firstly, it is the main survey of its kind to ask a consistent set of six questions to consumers in nine different countries across Asia and Europe. In total 8,000 consumers are surveyed on a quarterly basis by YouGov, the online market research company, in order to get timely and highly relevant results. Our consumer panels are weighted and are representative of the entire adult population of the country surveyed.

Secondly, by surveying consumers across the UK, Austria, France, Germany, Hong Kong, Italy, Singapore, Spain and Switzerland, policy makers and investors alike will be able to analyse how inflation expectations are changing over time across nine different countries. Importantly, the survey will also give a good indication of whether inflation expectations are becoming unanchored. If they are it could trigger changes in the nominal exchange rate, affect consumption and investment decisions, as well as wages and prices, and could cause inflation to persist above the target for longer than the central bank expects.

Finally, we have used best practice developed by the Federal Reserve Bank of New York in determining how we ask consumers about their inflation expectations. In late 2006, the Federal Reserve Bank of New York joined academic economists and psychologists from Carnegie Mellon University to assess the feasibility of improving survey-based measures of consumers’ inflation and wage expectations. The results of this project were announced in 2010 and can be viewed here. Interestingly, academic researchers found that there were a number of limitations in existing surveys.

For example, the Reuters/University of Michigan Survey of Consumers asks respondents to forecast changes in “prices in general” rather than changes in the “rate of inflation.” This wording, the researchers suggest, invites diverse interpretations and prompts many respondents to focus on price changes specific to their own experience rather than changes in the overall price level.

To address this limitation, the M&G YouGov Inflation Expectations Survey asks respondents to report their expectations for the annual rate of inflation in one year and five years from now rather than ask about prices in general. We also question respondents on whether rising inflation is a concern at the moment, how they think their net income will change in 12 months’ time, whether or not their central bank is pursuing the correct policies to meet its target of price stability, and whether their government is following the right economic policy. Importantly, this should allow us to gauge the public’s perception towards the credibility of central banks and governments.

The initial findings of the survey are shown below. The next report will be available in September.

Inflation expectations – 12 months ahead

Inflation expectations – 5 years ahead
The results of the May 2013 M&G YouGov Inflation Expectations Survey suggest that consumers in most countries surveyed expect inflation to be elevated above current levels in both one and five years’ time. In the UK, inflation is expected to be above the Bank of England’s CPI target of 2.0% on a one- and five-year ahead basis. All European Monetary Union (EMU) countries surveyed expect inflation to be equal to or higher than the European Central Bank’s CPI target of 2.0% on a one- and five-year ahead basis. All countries expect inflation to be higher in five years than currently, while four – Hong Kong, Italy, Singapore and Spain – anticipate it being equal to or higher than 3.0% in a year. Encouragingly, there are some signs of short and medium term inflation expectations falling from the levels reported in February in some countries.

We think that this report will be vital reading for central bankers, particularly as a time series is built up over the next couple of years which will allow us to monitor trends that may be developing. Ben Bernanke, Mark Carney, and Mario Draghi are all on the record stating how important inflation expectations are in achieving price stability and the economic benefits that go with it. It will also be highly relevant for both consumers and markets alike, particularly in a world where Central Bank Regime Change – where debt and unemployment rates become more important to central banks than inflation targets and price stability – is likely to occur. We aren’t there yet, but initiatives like the M&G YouGov Inflation Expectations Survey may be the bellwether that signals inflation expectations are becoming unanchored. And when that occurs, that is when central banks will face one of their toughest tests – trying to maintain their inflation-fighting credibility.


Video: whilst the market gets excited about unemployment falling to 6.5%, the Fed’s attention is turning to falling inflation

I spent a couple of days in New York last week seeing economists and academics. The US Treasury market had just seen a significant sell-off, with 10 year yields rising from 1.63% at the start of May, to over 2.2%, with much of the damage done by Bernanke’s surprise talk of QE tapering during the Q&A following his address to Congress’s Joint Economic Committee. US 30 year mortgage rates sold off in parallel, and are now around 4%, potentially damaging the housing recovery.

I came away with two main conclusions. Firstly, given the stuttering nature of the US growth recovery (and the second half of this year could be mediocre, thanks to some back-loading of fiscal cliff tightening) the case for a slowing of QE in the next few months is not at all strong. Economists point out that Bernanke’s prepared testimony to the JEC was very dovish and in no way suggested that tapering might happen this year. His Q&A response appears to have been a communication error, as evidenced by some rolling back over the last couple of days via well connected journalist Jon Hilsenrath in the Wall Street Journal. And secondly, whilst we all focus on the jobs data in the States and try to forecast the timing of hitting the 6.5% unemployment rate threshold, we might be taking our eyes off the Fed’s other concern, inflation. Having spiked higher in 2011/2012, thanks largely to higher commodity prices (cotton, oil), core inflation measures, and particularly the Fed’s preferred Core PCE Deflator statistic, are falling to around 1%. Wage growth is also weak. With inflation 1% below the target level, a Taylor Rule approach would see the Fed easing interest rates by 1.5%, not hiking or withdrawing monetary stimulus! And with rates at the zero bound and a cut impossible, unconventional monetary policy would have to take the strain. More, not less, QE might be more likely than any tapering.


Lessons from Zimbabwe

Stefan took some time off over Easter for a quick holiday in Zimbabwe and, as always, he remained on the lookout for economic insights.

As the only country to experience hyperinflation this millennium, Zimbabwe can certainly provide valuable lessons. From late 2008 its inflation was estimated to be running at a staggering 489,000,000,000% on an annual basis. The economy collapsed, and the population suffered food and fuel shortages, amid a mad dash for foreign currency.

Zimbabwe’s experience is particularly pertinent at a time when central banks are experimenting with unprecedented levels of monetary easing. At times, politicians may view inflation as a convenient way to reduce exorbitant debt burdens but inflation is a dynamic force and Zimbabwe’s cautionary tale teaches us to be careful what you wish for…


UK inflation: the Bank of England would have to generate significant disinflation in the majority of goods we consume to hit the 2% inflation target, killing any recovery. Food and administered price rises are the problems.

With the UK’s 2% CPI inflation target having now been exceeded for 39 consecutive months, last week’s budget formally acknowledged the on-going situation and changed the Bank of England’s remit.

Although chancellor George Osborne maintains that medium-term price stability represents “an essential pre-requisite for economic prosperity”, the updated remit simultaneously introduces the concept of flexible inflation targeting in the short term, asserting that the Bank of England committee “may wish to allow inflation to deviate from the target temporarily” in exceptional circumstances, i.e. as the result of shocks and other disturbances. In short, inflation targeting looks like it will continue to take a back-seat to the pursuit of growth and employment with the chancellor accepting that inflation is likely to rise further and may remain above the 2% target for the next two years. It is also interesting to note that there is no restriction on how far inflation is permitted to deviate from its target, nor has any time limit been set for any such deviations.

Allowing more flexibility simply reflects the reality, and it can therefore be argued that this is probably based on the theory that whilst current inflation rates are hurting consumers, hiking rates to bring inflation down – by raising mortgage and loan rates – would hurt even more. Wage growth is only just above 1% per year, so the authorities perhaps feel that overshooting the inflation target is unlikely to create an inflationary spiral based on rocketing pay settlements.

Citigroup’s Michael Saunders has presented an interesting piece of research which he believes breaks down the root causes of inflation stickiness. The research shows that for most of the inflation basket, there isn’t a problem and for the 27% where there is a problem, it is not clear that hiking rates would be a solution.

Causes of inflation stickiness


The first graph demonstrates the inflation generated from demand-insensitive areas (e.g. goods that have relatively static demand curves, regardless of changes in the price) such as utilities, education, tobacco, food and alcoholic beverages. This part of the basket contributes to 27% of the overall CPI figure. In recent years, this proportion has persistently exceeded the Bank of England’s 2% target thanks to formulae on these prices which allow “inflation plus” rises, and in the case of food, volatile weather. The Bank of England explains this away by treating it as a one off shock; Michael Saunders argues that this portion of the CPI basket is seeing a consistent series of small shocks, and is therefore predictable.  Therefore in order to compensate for the above-target growth in price level of these prices, the inflation rate of the remaining portion of the basket of goods would have to see much lower inflation to offset this and to meet the 2% target. The required adjustment is demonstrated by the green line in the second graph, while the actual inflation rate for this portion of the CPI basket is shown in yellow.

As you can see, Citigroup’s research shows that the actual inflation rate for the remaining portion of the CPI basket of goods must fall considerably ( from around 2% per year to around 0.7% per year) if the formal 2% inflation target is to be met. Indeed, in the aforementioned Bank of England remit, George Osborne himself concedes that the impact from both regulated and administered prices have together contributed to the persistent inflationary environment.

It is subsequently made clear that in the current environment of deliberately loose monetary policy and the ensuing departure from the inflation target, UK above-target inflation is baked into the cake unless the Bank of England tries to depress demand for the remaining demand-sensitive proportion of the basket. If this inflation overshoot is not curbed over time, this could potentially affect expectations of future inflation, calling the Bank of England’s ability to deliver medium term price stability into question. Therefore, despite champagne being removed from the CPI’s 2013 basket of goods, let’s hope that over time the Bank of England’s credibility is still something the UK can celebrate.

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