MNI POLICY: BOE Hikes Whilst Seeking New Inflation Model

The failure of the Bank of England’s standard model to predict the recent upsurge in prices has left policymakers applying a rough and hard-to-quantify upside skew to projections for inflation as they hike rates whilst Bank staff struggle to incorporate a new wave of modelling and research into their projections.

In May, the Monetary Policy Committee hiked by 25 basis points despite a modal, or most likely, projection, showing substantial inflation undershoot, choosing to highlight instead the mean inflation forecast which showed inflation at target. It is widely expected to hike by another 25 basis points at its June meeting, and while members will analyse a raft of recent data including the Bank's own survey of firms' expected price setting, they have also debated insights from new inflation research, much of it produced by academics linked to the Federal Reserve, which better explains the non-linear behaviour of prices since the Covid pandemic.

The problem is that ensuring these new insights transfer smoothly to the UK and building them into the BOE’s modal projections is proving a tough task. In May, the MPC said it "considered incorporating some of the additional factors suggesting more persistence into the modal projection for CPI inflation" in its forecast but "concluded that they were better reflected in a large upside skew as they are inherently difficult to quantify more precisely."

SUBJECTIVE SKEW

Describing a skew as “difficult to quantify” is uncomfortably close to saying that it is subjective, but for the moment the MPC, which market pricing implies will continue to tighten in 25 bps increments, is left with little choice given the proven inadequacy of its existing model, which external MPC Catherine Mann told the Treasury Select Committee last month is based on historical data from a low inflation era and failed to anticipate behavioural changes since the pandemic. (See MNI INTERVIEW: Models Of Inflation Expectations Need Refining)

Among new work which might help to improve it cited by BOE economist Galina Potjagailo at a May 18 ESCoE conference was a paper by NY Fed economist Mary Amiti and others highlighting how the pass-through of wages and input prices to producer prices grew during the pandemic, driving up inflation, as firms faced with supply chain disruptions substituted towards domestic labour. Other work, by former MPC member and NY Fed adviser Kristin Forbes and Joseph Gagnon, described “hockey stick” Phillips curves, with previously quiescent inflation only responding to the output gap when economic slack evaporated. (See MNI INTERVIEW: Inflation To Slide If Output Gap Closes-Gagnon)