HEARD ON THE STREET: The Tyranny of Inflation Expectations

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By SIMON NIXON

The central reason for making central banks independent was to insulate monetary policy-making from the pressures of public opinion. Odd, then, that these days one of the most closely watched economic indicators among Bank of England policymakers is a quarterly poll of public inflation expectations. Two members of the Monetary Policy Committee—Spencer Dale and Martin Weale—have cited rising expectations to explain recent votes in favor of rate increases. Other members share their concerns. But opinion polls are a poor basis for policy, for central bankers just as much as politicians.
Sure, the GfK NOP survey shows expectations have risen slightly: U.K. households on average expect inflation to be somewhat above its 2% target, at 3.4%, in two years time. The risk is that high inflation expectations will feed through to higher wage settlements, leading to a wage-price spiral. Mr. Dale, for example, shares the MPC's belief that inflation will return to target in the medium term as a series of one-off shocks pass through, but worries people tend to base their expectations on what they read in newspapers and their views may prove hard to shift.
But how much useful information do these surveys really contain? For the first decade after the MPC's creation in 1997, inflation was often below target, yet expectations remained anchored around 2%, MPC member Adam Posen has noted. Why should expectations behave differently when inflation is above target? And if one believes expectations are rising now in response to a short-term jump, then why should they not fall back again as quickly if inflation falls as expected?
More importantly, does it matter what the public thinks about inflation? Wage-bargaining is much weaker now than in the 1970s, when union membership was significantly higher. Nor is there any statistical link between inflation expectations and wage settlements, Mr. Posen notes. Indeed, only 9% of respondents in the latest NOP survey expect to respond to higher inflation by pushing for higher wages. Crucially, there is little sign from the gilt market that investors think the Bank of England is losing control of inflation or abandoning its target.
The current focus on expectations amounts to a counsel of despair: the Bank of England has failed to communicate its message and so should appease the press with what Governor Mervyn King has called "a futile gesture." Nor is it the strongest argument available to the inflation hawks: Mr. Dale is on far firmer ground when he asks whether spare capacity the MPC has assumed was mothballed during the recession was in fact made obsolete, so that inflation is now kicking in at a far lower level of output than expected. This is where the MPC should focus its discussion as it meets to debate interest rates this week.
Write to Simon Nixon at simon.nixon@wsj.com