Observations: Bank of England “Turtle doves” risk poorer UK
"Accepting" responsibility should come before hectoring citizens
Huw Pill, Chief Economist of the Bank of England, has generated a lot of attention – and blowback – over comments he made in an interview that to bring down inflation, Britons will need stop trying to “pass the parcel” and instead “accept” that they are poorer.1 To some extent, his comments were taken out of context, but his full interview casts a dark shadow over the outlook for the UK economy, gilts or sterling. They also well illustrated two important but still poorly accepted points I have long made regarding inflation: 1. Economists do not understand inflation as well as they believe; and 2. that consumer expectations for inflation – Being is believing effects – are more powerful than realized and the primary driver of inflation.
“Missingflation”
To better illustrate the dark cloud Mr. Pill’s comments cast over the UK, let’s start with the first of the two misunderstandings – economists (still) don’t understand inflation – as this is really the most frightening one since most central banks, like the Bank of England, conduct monetary policy to target inflation. Since 2014, I have written how economists – in private markets and central banks – have had consistent, one-way forecast errors dating back to the late 1990s. Mr. Pill excused central banks’ forecast errors with Yogi Berra’s quip that “It’s tough to make predictions, especially about the future”, which is fair to a point. But consistent one-sided errors, i.e. an error in the same direction, like over forecasting inflation as economists did for most of this century, or underforecasting inflation as the consensus has since the pandemic, suggests that economists have the wrong model.
My research has shown that economists’ persistent forecast error – which I called “Missingflation“ – is correlated across countries; is not forecast by other variables, e.g. capacity utilization, commodity prices, wage growth, demographics, globalization, et cetera; and appears to exhibit a “random walk”, i.e. does not mean revert (or in econometrics terms is non-stationary). While Missingflation was generally suppressing inflation in the 20-years before Covid, it since has flipped and pushed inflation higher. Together, these features suggest a “missing variable” is responsible for economists’ bias.
I long suspected that inflation expectations – which are generally poorly (or un-) measured across countries – were the missing variable, but the paucity of data make it difficult to prove. Indeed, despite my provocative claim that economists do not understand inflation, inflation expectations play a key role in many leading theoretical models of inflation. Mr. Pill explicitly nodded to their role in his podcast interview. But inflation expectations often are left out of forecasting models due to the difficulty in reliably measuring them. However, recent “natural experiments” – exogenous events – both appear to confirm my suspicions that inflation expectations are driving Missingflation and demonstrate how powerful Being is believing effects can be.
Covid was one such event, generating huge coincident demand and supply shocks that accompanied massive – and experimental – monetary and fiscal stimulus. This trifecta appeared to finally shift consumer inflation expectations from falling, as they had for over a decade, to rising. In the US, where a few different survey measures of consumer inflation expectations exist, they began to move higher in late 2020, before inflation itself, and similarly peaked before inflation did last fall. Another curious feature that one can observe in the multiple US survey measures is that the forecasting ability of consumer expectations seems to be inversely correlated with education: the more “common” the consumer, the better the inflation forecast (see Figure 1). Indeed, the more “expert” the opinion, the worse it has predicted: central banks’ inflation forecasts have underperformed inflation-indexed bonds, which have underperformed broad consumer expectations, and within consumer expectations, less-educated consumers have consistently better forecast inflation than their educated peers (see analysis in Clash of the Themes).
Being is believing
How does one explain this surprising inversion of intellectual and expert order? The answer, my second point about inflation, rests both in the greater number of non-experts and their collective “wisdom of crowds”: the more numerous common citizens both outweigh their expert-class peers in the market economy and relying on the full range of price signals rather than more limited, however well researched, models. These are Being is believing effects: a reality created by belief.
Consider how prices form amid differing expectations for inflation. If everyone expects stable inflation, it becomes self-fulfilling. When a producer attempts to raise prices, consumers that expect stable inflation quickly realize this is a relative price change and are incentivized to switch to a cheaper brand. As a result, producers, especially those with margins over cost, then maximize long-run profits by absorbing any temporary cost increases for fear that their customers might switch brands, costing the producer not only current-period but future profits. This pressure is even more intense when expectations for inflation are falling as they were for much of the last two decades. This helps explain why we experienced large cost shocks in the last decade but had nothing like the inflation we have observed recently.
But now consider what happens if instead everyone begins to expect inflation to accelerate. When consumers confront a price rise in their favored brand they now face a quandary: is this a relative price rise, i.e. versus other products? Or the general price rise (all products) that they expected? In this situation, producers now have an incentive to take a chance and “sneak through” a price hike if consumers might allow it without switching brands. Indeed, they may even use consumers’ confusion over the price outlook to increase margins. This is exactly what happened in the post-Covid environment: consumers were hit by a barrage of fiscal and monetary policies, supply and demand shocks, and as a result their inflation expectations became un-anchored.
Is there evidence for this thesis? Lots! As noted above, inflation expectations of the middle and lower classes were the best forecasts of coming inflation, significantly outperforming “professionals” who were too dependent on backward-looking models. Second, look at corporate earnings, especially among well established brands and niches with significant pricing power or low transparency. Pepsi, like many global brands, was able to expand its margins over the last two years despite double-digit increases in its input costs.2 Used car dealers – a notoriously non-transparent marketplace that experienced a sharp increase in demand with Covid – also were able to increase their mark-ups sharply.3
Is Mr. Pill right?
Does that mean that Mr. Pill’s “pass-the-parcel” model of inflation is right? No. Mr. Pill does acknowledge the importance of inflation and rightly pins persistence of inflation on Being is believing effects. But while he nods to “a series of unfortunate events” driving real relative price shocks – restricted supplies of microchips, Russian gas and chickens – Mr. Pill seems to miss that Britons’ game of pass the parcel reflects a shift higher in expectations for general price inflation rather than failure to “accept” adverse relative shocks. (Indeed, real wages and corporate profits in the UK demonstrate that Britons already have swallowed the negative terms of trade shocks Mr. Pill hectors them to accept.) Nor does Mr. Pill acknowledge that the Bank of England’s policy responses to those “unfortunate events” may have contributed to the de-anchoring of price expectations.
Yet, the most troubling part of Mr. Pill’s interview seems to have been overlooked. Towards the interview’s conclusion he states that with recent rate hikes, “we hope that we’ve broken the back of the inflation process.” There is no part of this statement that is defensible. One would hope that a leading Member of the Bank of England’s Monetary Policy Committee has a strategy for returning inflation to target rather than mere hope. Further, it is difficult to see from where this hope springs. UK inflation has lingered at its highest level in more than a generation for nearly half a year. An international comparison also shows that UK inflation peaked higher than any G7 peer economy this cycle and has been much more persistent (Figure 2).
Or a “turtle dove”?
Worryingly, his comments fully align with Governor Bailey, other MPC members and the Bank’s forecasts (for which Mr. Pill as Chief Economist and Executive Director for Monetary Analysis and Research is responsible). Yet, using a simple model of trade-offs between inflation and economic output, London School of Economics professor Ricardo Reis points out that the Bank’s forecasts not only imply that that Bank seems to believe it has no power to influence inflation (its mandate!) but indicate a degree of central bank dovishness so unprecedented as to require a new term: Mr. Reis suggests “turtle dove”.4
Another recent “natural experiment”, in Nigeria, illustrates the high cost the UK may face for the Bank of England’s failure to accept its role in de-anchoring inflation expectations and its sole responsibility for re-anchoring them. The more entrenched inflation expectations become at a higher level, the more difficult they are to dislodge and the larger the output fall necessary to do so. An error by the Central Bank of Nigeria in exchanging bank notes to prevent counterfeiting led to a 70% decline in currency in circulation between December and March, yet firmly held inflation expectations meant that output fell sharply instead of inflation, which instead hit a multi-decade high in March (see What Nigeria’s riots can tell us about US inflation).
Hard to be bullish Britain or sterling
Unfortunately, the Bank of England’s “turtle dove” policy stance makes it difficult to be positive on the UK economy, gilts or sterling. Sustained inflation directly undermines the value of both gilts (as yields rise) and sterling (as nominal depreciation is required to keep the UK competitive). But sustained higher inflation has two far more insidious effects: it entrenches higher inflation expectations, making them harder to dislodge without a severe recession; and it undermines the UK government’s – not just the Bank’s – policy credibility. In the post-Brexit world, the latter is something the UK can ill afford. Even the most optimistic Brexiteer’s vision for an independent UK relies on policy credibility to anchor British trade and attract both capital and human talent. Who wants to invest in or emigrate to an unstable, poorly managed economy with inflation closer to Nigeria’s than its central bank’s target?5
Even if the Bank does an immediate volta face on policy to dislodge higher inflation expectations, the persistence of inflation suggests a sharp recession would be required and inflation still may take a more than a year to return to target. That will not make the UK an attractive destination for capital in the near term, but at least may preserve its long-run attributes. One can only hope that the MPC, or the Treasury Select Committee of Parliament, begin to “accept” the policy choice before them.
Comments on “Inflation: Not Dead Yet”, Beyond Unprecedented podcast, Columbia University Law School, 18 April 2023.
“Price hikes pump up PepsiCo’s annual outlook,” Maria Monteros, Modern Retail, 12 October 2022.
“Car Dealer Markups Helped Drive Inflation, Study Finds,” Ben Eisen, The Wall Street Journal, 23 April 2023.
Ricardo Reis (@R2Rsquared) Twitter thread “*** Lambda (𝜆) and the turtle doves,” 28 April 2023.
True of the UK retail price index, but not (yet) of harmonized consumer price inflation.