Winner of the New Statesman SPERI Prize in Political Economy 2016

Wednesday, 14 May 2014

Inflation risks

When it comes to the issue of when interest rates should start rising, one of the points I and others have often made is that the risks are not symmetric. If inflation starts rising faster than we expect monetary policy can quickly respond. Alternatively if we actually have more ‘spare capacity’ than we currently believe, it may take some time for this to become apparent (inflation is more sticky when it gets low), and the zero lower bound limits what monetary policy can do.

In this light, the following table from the Bank of England’s inflation report issued today is rather interesting. 

In scenario 1, there is more slack in the labour market than the Bank currently thinks. In scenario 2, firms are currently working at a higher rate of capacity utilisation than the Bank estimates. In both scenarios monetary policy is endogenous. Inflation is higher in scenario 2, but monetary policy succeeds in getting it back to target by the middle of 2017. In scenario 1, inflation remains below target throughout the period.

Now as a macroeconomist I really want to know more. These are different shocks, so they are not a pure test of asymmetry. The path of interest rates is not shown, so we do not know how much of a constraint the zero lower bound is (if at all) in scenario 1. In scenario 1 unemployment falls quite a lot more than in the central projection, but the additional GDP growth seems small by comparison. The opposite is true in scenario 2. This is undoubtedly a result of different shocks being applied, but all the report tells us is that judgement was used in deciding how to shock the model to best capture each scenario. As I am sure Tony Yates would say, it would be nice for those who are interested in this detail to know a bit more.

However, putting all these qualifications aside, these simulations are welcome given all the discussion underway. They suggest that the upside risks to inflation are small, because monetary policy is capable of responding quickly. Overestimating the degree of current slack does not lead to inflation ‘taking off’. Perhaps this helps to explain why the Bank appears to some to be rather relaxed about the need to raise rates.     


  1. It has been amazing how resolute the media's collective decision has been to count up how many months the interest rate has been at a 'historic low' every time the interest rate is set again at 0.5% by the BoE.

    This seems to be the case for the reports coming down the 'wires' as much as from the BBC - they are all in it together. VSP chatter.

    1. They also ignore (and are probably unaware of) a point made by Mervy King, namely that low interest rates cease to have any effect after a year or two, and for the following reason. Low rates (if they have any effect at all) work because they pull investment forward in time. But of course there is a limit to the amount of “pulling forward” that any household or firm will do. Thus the pull forward effect is exhausted after I don’t know how long, but I’d guess two years maximum.

    2. count me skeptical, I don't think the only mechanism is time shifting, and while there may be limits to time shifting, I doubt there are limits to wants which are good at begetting supply.

    3. Dan,

      What do you mean by “wants which are good at begetting supply”? Are you referring to investments – an investment is something that assists or “begets supply”.

      If so, then I don’t agree. That is, at a say 10% rate of interest it will pay a firm to invest some specific amount in machinery, computers, etc. If the rate then drops to 5% or whatever, then it will pay to invest a bit more. But the additional amount of investment warranted by the lower rate of interest will be strictly limited.

  2. Simon,

    You claim “If inflation starts rising faster than we expect monetary policy can quickly respond.”

    First, the evidence seems to be that there is not much relationship between investment spending and interest rates. See:

    Also, there is also no relationship between central bank base rates and credit card rates. See:

    As to “quickly”, there are definitely lags involved in the effect of monetary policy. Far as I know the lags are about the same as with fiscal policy.

  3. The continued reliance on inflation as a gauge of the health of an economy is one of the more perplexing issues in economics in the aftermath of the financial crisis. The rate of price increases seems to depend a lot more on commodity prices in global markets as shown by high inflation in the UK despite the weak economy in 2011 and 2012 and low inflation despite falling UK unemployment in 2013. As I have argued in my blog (, not only do domestic considerations have little impact on inflation at the moment but this also calls into question the relevance of using inflation as a gauge for monetary policy. A bit off topic but something I would like to think as still relevant.

    1. It could be argued that the obsession with inflation since the 70s is a prioritisation of the value of assets over unemployment - which fits nicely in line with those who already own a pile of assets.

  4. Interesting article. Thought it was an interesting comparison point that those figures presented by the Bank of England are similar to Australia's at Annual GDP around 2.8% (2013), Unemployment 5.8% and CPI the main difference around 2.8%.


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