MNI INTERVIEW: BOE Shouldn't Rely On Price Expectations-Weale

The Bank of England should pay more attention to labour market trends and less to inflation expectations as it tries to anticipate future price moves, former two-term Monetary Policy Committee member Martin Weale told MNI.

Pitching in to a debate now underway on the MPC as inflation expectations spike at the same time as the labour market tightens, Weale noted that evidence from his and his co-authors’ work shows firms’ price expectations are strongly influenced by recent outturns, reducing the accuracy of the BOE’s models of future inflation.

"What is happening in the labour market is a much better guide to inflationary risks than people's expectations,” Weale said in an interview. “When past price increases have been high we found price expectations tended to be a bit overblown.”

When, as now, inflation is elevated, firms’ price expectations are likely to become even less reliable guides to future price changes, he said.

“They would become worse because there is just more noise going on, there are more surprises," said Weale, currently an economics adviser to the Office for National Statistics and a professor at King’s Business School.

INTERNAL BOE DEBATE

Divisions are evident among current MPC members over the relative importance of inflation expectations. At a November agency briefing, Deputy Governor Dave Ramsden cited upside risks from wage developments and inflation expectations but Chief Economist Huw Pill placed more emphasis on the labour market.

The role expectations play in wage-setting can vary depending on the state of the labour market, Weale said.

"What is going on in the labour market tells you about the expectations that actually matter," he said, "Once you have costs rising then that is pushing up on prices and my view is that is where we are now.”

Bank of England models factor in new-Keynesian thinking placing heavy weight on price expectations, assuming that keeping these anchored on the BOE’s 2.0% objective will eventually bring inflation back to target. (See MNI INTERVIEW2: BOE Too Optimistic On Inflation- Mortimer-Lee).

“In the traditional New Keynesian model, actual price growth depends about one-for-one on expected price growth. The coefficient we found was of the order 0.2 to 0.3, depending on how we specified it. That points to a much weaker role for expectations," Weale said.

But placing a lower weight on expectations must not be confused with any lessening of the Bank’s determination to meet its inflation target, he stressed.

“If people stopped believing that then we could go closer to the 1970s quite easily,” he said, recalling a time when when inflation on the CPI measure peaked at 22.6% rather than 6 or 7% plausible now.