Adaptive expectations?

For over ten years the Bank of England has been keen to manage expectations of inflation. It knows that if people fear a return of high rates of price inflation, they will factor that into their wage demands and there is a risk that the price stability we have enjoyed for fifteen years or more might be under threat. That would make the setting of interest rates even more complicated than normal, particularly given the current economic uncertainties at home and abroad.

With that in mind, the latest quarterly survey of price expectations published by the bank does not make happy bed-time reading for the Governor. Expectations of future inflation rose to 3.3 percent in February - the highest since the Bank started to publish the survey in 1999 and (importantly) more than a percentage point above the actual rate of CPI inflation.

Perhaps this survey is an example of adaptive expectations at work. Families see the rising cost of living every time they go to the supermarket, fill their car with diesel or check their quarterly energy bills. More people than ever before are discovering that the official measure of inflation (the CPI) bears little resemblance to the inflation they feel. The RPI inflation rate which includes housing costs, is much closer to their day-to-day experience.

It might be that we are unduly influenced by the prices we see around us and those highlighted in news broadcasts and on the front pages of the papers. Behind the scenes, the prices of audio-visual products continues to fall, as does the retail prices of clothing and second hand cars!

Whatever the cause, the reality is that rising expectations of inflation will make it more difficult for the MPC to sanction aggressive cuts in interest rates if and when the economy moves into a sharper than expected slowdown.