The MPC’s problem: explained, but not solved

Some interesting research* on the UK’s inflation expectations was published this week by the Bank for International Settlement. The research helps explain, but not solve, the credibility problem bedevilling the Bank of England’s Monetary Policy Committee (MPC).

Does it matter if consumers’ views differ from that of the MPC? It matters a lot, because inflation expectations can affect real inflation.

The researchers compare the inflation forecasts of the MPC with the Bank of England/GfK NOP Inflation Attitudes Surveys of inflation expectations between 2000 and 2007. Through a torturous statistical trek they show there is consistent disagreement between the two forecasts. The MPC tends to forecast lower inflation while consumers tend to forecast higher inflation.

The MPC’s forecast is also more consistent over the period, while consumers’ expectations diverge not only from the Committee but also amongst themselves.

The MPC’s consistency, the researchers say, is probably due to its information advantage. Not only does it have an army of economists at its disposal but the Committee has the power to set interest rates: crucial knowledge unavailable to consumers until after the fact.

“Enjoying such information, internal communication and policy advantages, the MPC may be expected to be more certain about future UK inflation developments,” according to the research. Yet it is not, at least judging by the consumer surveys.

The researchers do not comment on the MPC’s ability to forecast inflation (academics and analysts are split on that question), but by showing the divergence they point to a lack of credibility on the part of the MPC.

“A wide dispersion of consumer forecasts could also suggest a possible lack of credibility regarding the Bank’s inflation target.”

If consumers don’t believe the MPC can forecast inflation accurately why then should they believe it can keep inflation to target; it certainly hasn’t been able to do so for the past year.

And that is what we are seeing played out today. At a time when inflation is much more volatile than during the period surveyed by the research, the MPC’s credibility is all the more important.

An un-credible MPC could struggle to: “anchor the UK’s inflation expectations”. That is, keep inflation expectation low, thereby preventing an upwards wage push, a key driver of inflation.

So there you have it, a key problem of the MPC explained – but not solved.

*BIS Working Papers No 339: Measuring disagreement in UK consumer and central bank inflation forecasts, by Richhild Moessner, Feng Zhu and Colin Ellis Monetary and Economic Department