MNI INTERVIEW: Services Inflation Poor Policy Guide - Vlieghe

Services and core inflation are unreliable guides to underlying inflation pressure following large energy price shocks, former Bank of England Monetary Policy Committee member Gertjan Vlieghe told MNI, adding that his research implies that the economy will not have to cool much to dampen the recent bout of price rises.

The BOE has pointed to sticky core and services prices as reason for caution as it moves towards easing. But, in a recent paper studying the impact of the recent oil and gas price shocks on inflation in various countries, Vlieghe found that half of the variance in core and services inflation from pre-pandemic trends could be explained by national differences in energy price increases

"The lesson from my paper is that because we know that there is going to be a temporary effect from higher energy prices on core inflation and on services inflation, you should not interpret core inflation or services inflation as a reliable measure of underlying inflationary pressure in the aftermath of a big energy shock," he added.

With UK energy prices peaking in late 2022, that effect will now be close to playing out, Vlieghe said.

"According to the estimates in my paper, you should expect to see ... a peak impact on core inflation and services inflation about a year later. And then you would expect to see that inflation rates come off, and I think we are in the early stages of that period, where these inflation rates come off.”

LOW SACRIFICE RATIO

The implications of this research, undertaken while Vlieghe was a research fellow at the London School of Economics and building on work by fellow former MPC member Silvana Tenreyro, point to less need for current monetary policy to push for a high “sacrifice ratio” with unemployment rising markedly to dampen inflation pressures.

"Because this is just the end of previous energy pass-through you don't necessarily need to see a lot of additional economic weakness for those inflation rates to come off," Vlieghe said. "The second phase is that not only are energy prices not going up anymore, they're coming down. So then with an even longer lag you would expect to see the reduction in energy costs to be reflected in a period of unusually low core inflation and services inflation.”

The findings raise questions about the MPC's caution over rate cutting as it closely monitors "indications of persistent inflationary pressure" including services price inflation. With investor focus on whether the MPC will launch an easing cycle by as soon as May, Vlieghe said it was wrong to obsess over the timing of a first rate cut. (See MNI INTERVIEW: BOE Right To Be Cautious Over Cuts - NIESR)

"You shouldn't wait with a rate cut until you're absolutely sure that it's the right thing to do because if you wait until you're absolutely sure, for sure you will have waited too long. So you need to do the first rate cut when on the balance of probabilities inflation is going to return to target. If you wait longer, you risk undershooting the target," he said.