Should We Worry About Post-Covid Inflation?

 Question 1: Which of the following scenarios is most likely to hold on average for most of the upcoming decade?

Question 2: Which of the following will be the greatest inflationary (or deflationary) force facing the UK economy?

Summary

The CfM panel of experts is split between those predicting that UK inflation will be roughly at its current target and those believing that inflation will be above target in the upcoming decade. A smaller minority worries that the UK growth rate will be too low for the Bank of England to stimulate inflation. Beyond the growth rate of the economy, additional factors to look at in projecting inflation are the effects of Brexit, rising public debts, and global factors.

Background

The January 2021 CfM survey asked members of its UK-based panel to whether inflationary or deflationary pressures would dominate in the upcoming decade and the main driving forces of inflation.  

Should We Worry About Post-Covid Inflation?                                  

Since the global financial crisis, inflation expectations have been subdued in most advanced economies. Central banks have made herculean efforts to hit their inflation targets from below. The consensus prior to Covid-19 was certainly that high rates of inflation would not be a major threat to advanced economies in the foreseeable future.

This past year new voices have emerged expressing concern about inflation. In a provocative book, Goodhart and Pradjan (2020) argue that deflationary (and low interest rate) pressures have been supported by a longer-term demographic cycle that is close to turning (see also their Vox article, Charles’ Goodhart’s Vox article, and Martin Wolf’s FT article). Except for Africa, populations in all world regions are now turning from growth to decline. In Europe, the baby boom generation has entered retirement age. China’s labor force is increasingly dominated by the one-child generation. Retirees in Japan and elsewhere have accumulated massive stocks of savings that may be spent in retirement.

The authors also argue that the deflationary pressures have been partially due to a massive increase in the global labor supply, with low wage workers in China, other parts of East Asia, and Eastern Europe integrating into an economy increasingly reliant on global supply chains.

Ilzetzki, Reinhart and Rogoff (2020) argue that monetary forces may also have more of an inflationary bias this time. During the global financial crisis, the money base increased more than four-fold, but broader money measures (e.g. M2) barely changed. In contrast, since the beginning of the Covid-19 pandemic, not only did the money base increase by 50 percent, but also M2 increased by 25 percent to date. This indicates that this time quantitative easing policies have been matched by a rise in bank deposits rather than remaining as bank reserves. Ilzetzki et al also point to the disruption in global supply chains as a potential inflationary threat. Reis (2016) argues that a central bank balance sheet will not on its own lead to high inflation. Ellington and Milas (2019) show that UK money growth leads to inflation only when inflation is already high (above 3%).

Top UK investors are expressing concern that UK monetary policy is increasingly driven by fiscal rather than monetary considerations. This could reflect an additional upside risk to inflation. Looking at the historical record, however, Miles and Scott (2020) show that large debt accumulations of the Napoleonic and two world wars led to no more than moderate inflation and sometimes to deflation.

Surveys of inflation expectations for 2021 indicate an uptick in inflation expectations, with household inflation expectations at 3.8%. Expectations implied by inflation protected gilts predict that inflation will exceed its target well into the upcoming decade. The 10-year inflation projection read off the UK instantaneous implied inflation forward curve is 3.5%. In contrast, similar breakeven calculations for the US show expectations of inflation at 2 percent. Eurozone inflation expectations are below target at all forecast horizons. Reis (2020) presents a model of inflation expectations and estimates that inflation expectations have been trending downward in the Eurozone since 2015. This suggests that UK inflation expectations might reflect domestic UK factors, including the UK’s exit from the EU, rather than the Goodhart and Pradjan’s global ones.

Despite annual inflation of only 0.6% in December, the Bank of England (BoE) insists that inflation is still on target in its Monetary Policy Reports. Chief economist Andy Haldane views up- and down-side inflation risks as balanced. Further, he insists that although the Bank is willing to allow inflation to exceed its target for a period, the Bank wouldn’t allow high inflation expectations to become entrenched.

On this backdrop, panel members were asked to give their opinion on whether inflationary or deflationary pressures will pose a greater challenge to the Bank of England in the decade ending in 2030. In the first question they were asked about the Bank of England’s ability and wiliness to avoid inflation rising above or dropping below its current target in the upcoming decade. This means that scenarios where HM’s government increases (or decreases) the Bank’s inflation target were classified under the category of “allowing” inflation to deviate from its target.

Question 1: Which of the following scenarios is most likely to hold on average for most of the upcoming decade?

Twenty-seven panelists responded to this question. More than a third of the panel predicts that inflation will remain at its current target on average. This view is even more common and reflects a majority opinion when weighing experts’ answers by their self-assessed confidence levels. More than 40% of the panel predicts that inflation will exceed its current target on average over the next decade. This group is roughly equally split between those who believe that this will be by (BoE or government) design and those believing that the Bank will be unable to meet its target. 15% of participants think that the Bank will be unable to stimulate inflation and it will remain below its target.

Question 2: Which of the following will be the greatest inflationary (or deflationary) force facing the UK economy?

Twenty-nine members of the panel responded to this question. The panel expressed a diverse set of views, with all factors receiving some support as a driver of inflation. Further, many respondents think that several of these factors will play out over the upcoming decade, based on their comments. The most common response was that the growth rate of the UK economy is the most important factor in determining inflation, receiving close to a third of the votes.

Several factors were raised as leading to inflation concerns. Panelist responses point to Brexit as the most common inflationary threat in the first half of the decade. Thorsten Beck (Cass Business School) writes that “Brexit has put upward pressure on costs, which will ultimately result in higher prices.” He further notes that “population decline due to emigration of EU citizens will cause upward pressure on wages and ultimately prices, e.g., in agriculture and services.” Kate Barker (University Superannuation Scheme) agrees that “The UK in particular may struggle with inflation early in the decade - Brexit and Covid costs into a labour market with a lot of mismatch as different sectors and places flourish and fade. Possibly also downward pressure on sterling with concerns over breakup of the Union.” These factors could further lead to higher inflation expectations in her view.

A longer-term concern is public debt. Roger Farmer states that “inflation… is almost and everywhere a fiscal phenomenon (to mis-paraphrase Friedman). Once national treasuries become hooked on deficit finance, it will be very difficult for them to put down the crack pipe.” He qualifies that “The level of public debt is much less important than the rate of growth of public debt. The danger is that the public finances will become dependent on nominal borrowing that will become politically, very hard to reverse.” Ethan Ilzetzki (London School of Economics) agrees that “the combination of high public debt and low nominal interest rates might lead the UK government to raise the BoE's inflation target.” He argues that “This may in fact be a desirable policy if inflation doesn't materialize.”

Interestingly, Simon Wren-Lewis, on the other side of the debate, warns that fiscal policy may be a deflationary factor. He warns that “a Conservative government may return to fiscal contraction involving spending cuts, leading to an economy with subdued inflation and requiring the Bank of England to keep rates low.”

Finally, some participants pointed to the past and forecasts of the future to support their prediction. Wendy Carlin (University College London) notes that “inflation modestly exceeding the target has been the pattern running up to the COVID crisis and I don't see strong reasons for it to be very different.” Ethan Ilzetzki points to above-target inflation forecasts “based on the yields of inflation-protected gilts”.

Respondents with more benign inflation forecasts argue that inflationary and deflationary factors are more equally balanced. Further, they argue that the BoE has the required tools to respond if inflation were to emerge. Nicholas Oulton (London School of Economics) predicts that “If growth revives then there would be upward pressure on inflation but these would be much easier for the BoE to manage.” Morten Ravn (University College London) adds that “The increase in public debt” and other factors “probably means that inflation will come up although I do not see this happening within a short horizon. To the extent that the BoE retains its independence, I would have thought that inflation could be kept at or close to its target.”

Those concerned about deflation mainly pointed to sluggish growth of the UK economy. As David Miles (Imperial College) puts it: “The near term - very substantial - rise in UK unemployment is likely to persist and keep wage pressures low for several years. That makes a significant and persistent rise in UK inflation less likely so that the Bank of England may face inflation under 2% for much of the next few years.” Dawn Holland (NIESR), predicting that inflation will be on target, argues that the short-term inflationary pressures will be “by technological developments, and neither should necessarily pass through to longer-term expectations.”

References

Ellington, Michael and  Costas Milas, “Global liquidity, money growth and UK inflation,” Journal of Financial Stability, 42, pp 67-74, 2019.

Goodhart, Charles and Manoj Pradhan, The Great Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival, London, UK: Palgrave MacMillan, 2020.  

Ilzetzki, Ethan, Carmen Reinhart, and Kenneth Rogoff “Will the Secular Decline in Exchange Rate and Inflation Volatility Survive Covid-19?” Brookings Papers on Economic Activity, Fall 2020.

Miles, David and Andrew Scott, “Will inflation make a comeback after the crisis ends?” VoxEU.org, 4 April 2020.

Reis, Ricardo, “Funding Quantitative Easing to Target Inflation,” Jackson Hole Symposium, Federal Reserve Bank of Kansas City, 2016.

Reis, Ricardo, “The People versus the Markets: A Parsimonious Model of Inflation Expectations,” Centre for Macroeconomics Discussion Paper 2020-33.

 

 

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How the experts responded

Question 1

Participant Answer Confidence level Comment
Jumana Saleheen's picture Jumana Saleheen CRU Group Inflation will be at the current target rate Very confident
The UK is a medium sized economy with a flexible exchange rate. Inflation targeting has worked well in this country and so may work well again in the future. That said, the inflation targeting regime is under threat globally, given the lack of monetary firepower and greater reliance on fiscal stimulus. Should the regime survive the pandemic, inflation is likely to average its target rate over the coming decade. Buckle up your seat belts – the path of inflation is going to be bumpy over the next decade. Inflation is likely to recover from the 2020 lows in 2021; it is likely to rise above target 2022, as economies open-up and spending returns with a vengeance. The profile of spending thereafter will depend on how the recent period of accommodative fiscal and monetary stimulus ends. It will also depend on how the UK adapts to its post-Brexit trade arrangements.
Wendy Carlin's picture Wendy Carlin University College London The BoE will allow inflation to exceed its current target Not confident
Inflation modestly exceeding the target has been the pattern running up to the COVID crisis and I don't see strong reasons for it to be very different. Weakness in the labour market is likely to persist so that the BoE will tolerate inflation somewhat above its target (in the absence of channels for a process of rising inflation to become entrenched).
Thorsten Beck's picture Thorsten Beck Cass Business School The BoE will be unable to avoid inflation exceeding its target Confident
Several factors will push inflation upwards in the UK (unlike in the euro area!) over the next few years. One, population decline due to emigration of EU citizens will cause upward pressure on wages and ultimately prices, e.g., in agriculture and services. Two, Brexit has put upward pressure on costs, which will ultimately result in higher prices. Three, fiscal dominance will prevent the Bank of England to take aggressive action to keep inflation on target as well as the fact that the two before-mentioned factors are supply- rather than demand-related.
Morten Ravn's picture Morten Ravn University College London Inflation will be at the current target rate Confident
The increase in public debt and in the broader montary base combined with pressures on the sterling exchange rate (due to lack of inward FDI flows in the aftermath of Brexit) probably means that inflation will come up although I do not see this happening within a short horizon. To the extent that the BoE retains its independence, I would have thought that inflation could be kept at or close to its target.
Martin Ellison's picture Martin Ellison University of Oxford The BoE will be unable to avoid inflation falling below its current target Confident
Angus Armstrong's picture Angus Armstrong National Institute of Economic and Social Research No opinion Extremely confident
I do not know what will happen over the next decade - hence I have answered no opinion with extreme confidence. I would be surprised if anyone really thinks they do know what will happen with any strong conviction. However, based on the background notes in the text I would add the following. First, the rise in deposits is simply the result of the sudden stop in spending due to lockdowns. Second, what really matters is whether the increase in deposits is accompanied by higher lending. In fact, we see the opposite. The ratio of loans to deposits has collapsed. Yes, it will rebound once lockdown is lifted, but I do not see why it will rise further as this would imply more leverage. Therefore, I think the risk is that inflation will be below target and until the Bank of England changes its policies then I don't see why deflationary pressures will persist. On a third and final point, I am sympathetic to the longer term global challenges and I think these are far more important than domestic policy changes.
Wouter Den Haan's picture Wouter Den Haan London School of Economics Inflation will be at the current target rate Not confident
The arguments given for upward pressure on inflation are good ones. But we still have persistent downward pressures. I don't know which ones are going to dominate.
Michael Wickens's picture Michael Wickens Cardiff Business School & University of York Inflation will be at the current target rate Extremely confident
There is no good reason why the Bank of England should change its inflation objective. The question is whether it will succeed in doing so. I expect inflation to increase as the economy picks up after the pandemic. This success of the Bank will depend in large part on whether it correctly identifies the likely sources on this increase in inflation. This is question 2.
Federica Romei University of Oxford No opinion Extremely confident
I think it is very difficult to predict inflation in 10 years from now.
Paul De Grauwe's picture Paul De Grauwe London School of Economics The BoE will allow inflation to exceed its current target Confident
Ethan Ilzetzki's picture Ethan Ilzetzki London School of Economics The BoE will allow inflation to exceed its current target Not confident
First, the market is predicting this outcome based on the yields of inflation-protected gilts. Second, the combination of high public debt and low nominal interest rates might lead the UK government to raise the BoE's inflation target. This may in fact be a desirable policy if inflation doesn't materialize. Third, I am a little concerned that the Bank, like other central banks, is fighting the last war. Despite the aforementioned market signals, there appears a relatively broad consensus that deflation is a bigger risk than inflation. I have no doubt that the BoE will do what it takes to combat the former.
Dawn Holland's picture Dawn Holland NIESR Inflation will be at the current target rate Confident
Short-term inflationary pressures may be linked to exchange rate depreciation or higher energy prices, but offset by technological developments, and neither should necessarily pass through to longer-term expectations.
David Cobham's picture David Cobham Heriot Watt University The BoE will allow inflation to exceed its current target Not confident
I expect the overshoot to be relatively low on average
Ricardo Reis's picture Ricardo Reis London School of Economics Inflation will be at the current target rate Confident
I see a large risk of high inflation; but a likewise high risk of near deflation. Overall, I see the two roughly balancing out, so on average I think inflation may well be at current target rate. But, perhaps more relevant, I put a quite high probability that it will not be there. (I also think there is a good chance that the target will change.)
Roger Farmer's picture Roger Farmer University of Warwick The BoE will be unable to avoid inflation exceeding its target Not confident
Making statements about future inflation is a dangerous game. But in evaluating the likely alternatives, the scenario promoted by Goodhart and Pradjan is, IMO, more likely than the alternatives. Inflation, as we all know, is almost and everywhere a fiscal phenomenon (to misparaphrase Friedman). Once national treasuries become hooked on deficit finance, it will be very difficult for them to put down the crack pipe.
Francesca Monti's picture Francesca Monti Kings College London The BoE will be unable to avoid inflation falling below its current target Not confident
Chryssi Giannitsarou's picture Chryssi Giannitsarou University of Cambridge, Faculty of Economics The BoE will allow inflation to exceed its current target Not confident
Natalie Chen's picture Natalie Chen University of Warwick The BoE will be unable to avoid inflation exceeding its target Not confident
Lucio Sarno's picture Lucio Sarno Cambridge University Inflation will be at the current target rate Confident
David Miles's picture David Miles Imperial College The BoE will be unable to avoid inflation falling below its current target Not confident
The near term - very substantial - rise in UK unemployment is likely to persist and keep wage pressures low for several years. That makes a significant and persistent rise in UK inflation less likely so that the Bank of England may face inflation under 2% for much of the next few years.
Nicholas Oulton's picture Nicholas Oulton London School of Economics Inflation will be at the current target rate Not confident
My answer is a mean between two very different outcomes: see my answer to the next question.
Simon Wren-Lewis's picture Simon Wren-Lewis University of Oxford The BoE will be unable to avoid inflation falling below its current target Not confident
Apart from possible short term blips caused by first Brexit and then the end of the pandemic, a Conservative government may return to fiscal contraction involving spending cuts, leading to an economy with subdued inflation and requiring the Bank of England to keep rates low.
Kate Barker's picture Kate Barker British Coal Staff Superannuation Scheme and University Superannuation Scheme The BoE will be unable to avoid inflation exceeding its target Not confident
The UK in particular may struggle with inflation early in the decade - Brexit and Covid costs into a labour market with a lot of mismatch as different sectors and places flourish and fade. Possibly also downward pressure on sterling with concerns over breakup of the Union. Inflation expectations may shift upward.
Sir Charles Bean's picture Sir Charles Bean London School of Economics Inflation will be at the current target rate Confident
Panicos Demetriades's picture Panicos Demetriades University of Leicester Inflation will be at the current target rate Confident
I agree with Andy Haldane’s views, which carry a lot of weight for me, as they are informed by all the research done to support the Bank’s monetary policy framework. The pandemic is exerting downward pressures on aggregate demand and these will continue well into 2021, as its unlikely we will return to normality any time soon. Fiscal policy only partially mitigates the negative effects on demand and so is monetary policy. Disruption of supply chains and increase demand for health products and services are reflected in relative price changes but overall should not lead to inflationary pressure. Brexit on the other hand is likely to result in higher prices for imported goods from the EU due to higher transactions costs and some trade diversion, as well as a weaker sterling, which could exert upward pressure on prices, but these pressures will not translate into sustained inflation, if anything they will help to get inflation up on target during 2021. Beyond 2021, we should see the UK economy adjusting to a post brexit and post pandemic equilibrium, with inflation more on less on target, as I expect monetary policy to do whatever it takes to achieve that target.
Linda Yueh's picture Linda Yueh London Business School The BoE will be unable to avoid inflation exceeding its target Not confident
Costas Milas's picture Costas Milas University of Liverpool The BoE will allow inflation to exceed its current target Confident

Question 2

Participant Answer Confidence level Comment
Angus Armstrong's picture Angus Armstrong National Institute of Economic and Social Research Global factors Very confident
Since we advance by learning, any set back to integrated national economic systems will surely be temporary. The UK is a very open economy in trade, capital, humans, ideas. It has had very limited control over pricing power or market interest rates for at least two decades. I expect global factors to continue to dominate.
Jumana Saleheen's picture Jumana Saleheen CRU Group None of the above, other, or no opinion Not confident
2020s is going to be a decade of big changes for the UK economy. Post-Brexit trading arrangements and implications of the pledge to be net zero by 2050 are two big unknowns. These create great uncertainty, particularly about the "supply of the economy". For example, will the UK maintain its current industrial structure post-Brexit or will it need to change. How much will labour supply growth fall given the end of EU freedom of movement? To meet the government’s climate pledge to be net zero by 2050, requires investment in new markets and new technologies. It also requires consumers to change their behaviour. My sense is that the biggest threat is inflationary pressures coming from a deterioration in the supply potential of the economy.
Wendy Carlin's picture Wendy Carlin University College London None of the above, other, or no opinion Not confident
Plausible arguments can be made in relation to many of these factors and it is difficult to judge which of them are likely to dominate over the course of the period to 2030.
Thorsten Beck's picture Thorsten Beck Cass Business School The UK’s exit from the EU Confident
Emigration of workers especially in the lower-paid segments of the economy will increase wage pressures. International trade-related costs will also be passed on (partly) to consumers. At the same time, increased public debt, related to both the pandemic and to support payments for Brexit disruptions will create fiscal dominance and thus prevent the Bank of England from taking aggressive action to keep inflation on target.
Morten Ravn's picture Morten Ravn University College London None of the above, other, or no opinion Confident
As indicated in my prrevious answer, I think it is a mixture of factors including debt, monetary expansion and, indirectly, Brexit. It will ultimately be a question of politics which one of these become the dominating force.
Martin Ellison's picture Martin Ellison University of Oxford The growth rate of the real UK economy Not confident
Wouter Den Haan's picture Wouter Den Haan London School of Economics Global factors Not confident
Michael Wickens's picture Michael Wickens Cardiff Business School & University of York The growth rate of the real UK economy Very confident
The main cause of the expected increase in inflation will be none of the above. It is the excess accumulation of household savings and the effect this will have on demand and supply in the future as lockdown is eased. The build up of monetary liabilities at the Bank through purchases of gilts need not be a cause of inflation as the Bank can sell off these gilts. The main issue for government policy is how to deal with its build up of debt. There will need to be a balance struck between correcting the deficit through higher taxes, lowering the level of debt to keep debt interest payments sustainable and how much debt to buy back or to continue monetising. These are not problems for the Bank alone. Monetary and fiscal policy co-ordination will be required.
Federica Romei University of Oxford Global factors Confident
The UK is an open economy, therefore what happens in the rest of the world is very important.
Paul De Grauwe's picture Paul De Grauwe London School of Economics Past monetary policy decisions and other monetary factors Confident
Ethan Ilzetzki's picture Ethan Ilzetzki London School of Economics Global factors Not confident
All these factors are important. I emphasize global factors for a simple reason. It is unlikely that that low inflation rates in almost every country in the world is due to 190 central banks having simultaneously figured out how to cap inflation. The more likely explanation is that common trends in all these countries have led to deflationary pressures worldwide. This is reinforced by the fact that the global real risk-free rate has declined over time. We need to consider these global factors carefully and whether they might be at an inflection point.
Dawn Holland's picture Dawn Holland NIESR The UK’s exit from the EU Not confident
The risk premium on the exchange rate may widen.
David Cobham's picture David Cobham Heriot Watt University The UK’s exit from the EU Not confident
I expect this to be the driving force in the first half of the decade, with demographic and monetary factors kicking in in the second half.
Ricardo Reis's picture Ricardo Reis London School of Economics Past monetary policy decisions and other monetary factors Very confident
I wanted to pick two: public debt and monetary factors, as they are tightly linked.
Roger Farmer's picture Roger Farmer University of Warwick Public debt Confident
Let me qualify. The level of public debt is much less important than the rate of growth of public debt. The danger is that the public finances will become dependent on nominal borrowing that will become politically, very hard to reverse.
Francesca Monti's picture Francesca Monti Kings College London The growth rate of the real UK economy Not confident
Chryssi Giannitsarou's picture Chryssi Giannitsarou University of Cambridge, Faculty of Economics Public debt Confident
John VanReenen's picture John VanReenen London School of Economics The growth rate of the real UK economy Not confident
Natalie Chen's picture Natalie Chen University of Warwick Public debt Not confident
Lucio Sarno's picture Lucio Sarno Cambridge University The UK’s exit from the EU Confident
David Miles's picture David Miles Imperial College The growth rate of the real UK economy Not confident
Persistent above target inflation in the UK is unlikely to happen if wage settlements remain low and that is likely if unemployment (which is certain to rise near term) is slow to fall back after Covid risks fall back.
Rachel Ngai's picture Rachel Ngai London School of Economics The UK’s exit from the EU Confident
Simon Wren-Lewis's picture Simon Wren-Lewis University of Oxford Public debt Not confident
See previous answer. This is not because public debt somehow causes inflation, but because attempts to reduce debt cause deflation.
Nicholas Oulton's picture Nicholas Oulton London School of Economics The growth rate of the real UK economy Not confident
Current forecasts of UK GDP and productivity growth by the OBR are extraordinarily pessimistic by historical standards. Non-monetary policies can potentially raise growth but we have yet to see much in the way of concrete proposals here. If growth is as low as currently expected then I would expect inflation to be below target. If growth revives then there would be upward pressure on imnflation but these would be much easier for the BoE to manage.
Kate Barker's picture Kate Barker British Coal Staff Superannuation Scheme and University Superannuation Scheme Past monetary policy decisions and other monetary factors Not confident at all
Selected monetary factors but think it will be a mix of pressures.
Sir Charles Bean's picture Sir Charles Bean London School of Economics Past monetary policy decisions and other monetary factors Not confident
Panicos Demetriades's picture Panicos Demetriades University of Leicester The growth rate of the real UK economy Confident
The growth rate captures aggregate demand pressures and summarises all the forces at play. The only exception to this that I can see is a scenario in which negative supply shocks reduce growth and at the same time increase inflation. However, I do not see any such shocks at the moment, disruption of supply chains and brexit will only have a small ans transitory effect on prices and will not lead to sustained inflation.
Linda Yueh's picture Linda Yueh London Business School The growth rate of the real UK economy Confident
Costas Milas's picture Costas Milas University of Liverpool The growth rate of the real UK economy Confident