Andrew G Haldane: Drag and drop
Speech by Mr Andrew G Haldane, Executive Director and Chief Economist of the Bank of
England, at BizClub lunch, Rutland, 19 March 2015.
* * *
The views are not necessarily those of the Bank of England or the Monetary Policy Committee. I would like to
thank Gareth Anderson, Jeremy Franklin, Richard Harrison, Riccardo Masolo, Becky Maule, Roland Meeks and
especially Tom Smith for their assistance in preparing the text. I would also like to thank Rebecca Burnham,
Rupert de Vincent-Humphreys, Will Dison, Fernando Eguren Martin, David Elliott, Nicholas Fawcett, Bob Gilhooly,
Jeremy Harrison, Simon Hayes, Chris Jackson, Phil King, Jenny Lam, David Miles, Francesca Monti, Liam
Parker, Kate Reinold, Gareth Ramsey, Matt Roberts-Sklar, Magda Rutkowska, Ali Schomberg, Kate Stratford,
Rahul Thakrar, Ryland Thomas, Dan Wales and Madeleine Warwick for their comments and contributions.
In March 2009 the Bank of England cut official UK interest rates to 0.5%, their lowest-ever
level. Financial markets did not expect this low level of interest rates to persist, with the first
rise expected nine months later in December 2009. Yet six years on, official UK interest rates
remain at 0.5%. The first rise in UK interest rates is still expected around a year hence
(Chart 1). Like a bad flight, the take-off time for interest rates has been repeatedly put back.
That pattern has been mirrored internationally. In March 2009 US policy rates were in a
range of 0-0.25%, their lowest-ever level. Markets expected them to rise within a year. In the
euro-area, policy rates were also at all-time lows, but were expected to rise within 18 months
or so. Six years on, US policy rates remain between 0-0.25%, while euro-area rates are
150 basis points lower. The first rise in US policy rates is still expected within a year, while
the first rise in euro-area rates is now not expected for over four years (Chart 2).
Chart 1: Date of first rate rises implied by Chart 2: Date of first rate rises implied by
forward market interest rates forward market interest rates
2018
2021
UK UK
2017 2020
US
2019
2016
€ area
2018
2015
2017
2016
2014
2015
2013
2014
2012
2013
2012
2011
2011
2010
2010
2009
2009
2009 2010 2011 2012 2013 2014 2015 2009 2010 2011 2012 2013 2014 2015
Sources: Bloomberg and Bank calculations. Notes: The y
Sources: Bloomberg and Bank calculations. Notes: The y axis
axis shows the date at which the instantaneous forward OIS
shows the date at which the instantaneous forward OIS curve
curve reaches 25bps above Bank Rate for the UK; the ECB
reaches 25bps above Bank Rate.
main refinancing rate for the euro area; the top of the FOMC
target range for the US.
Looking beyond lift-off, the expected pace of interest rate ascent is also remarkably gradual
by historical comparison. Chart 3 shows the paths of short-term forward interest rates in the
UK, US, euro-area and Japan for the next 30 years. They imply that rates will rise, on
average, by only 10 basis points per year in the US, 7 basis points per year in the UK,
6 basis points per year in Japan and 5 basis points per year in the euro-area. That is the
most gradual of interest rate glide-paths.
The eventual cruising altitude for interest rates expected by financial markets is also
remarkably low by historical comparison. The level of forward interest rates 30 years hence
is around 3% in the US, 2.5% in the UK, 2% in Japan and 1.2% in the euro-area. Up until the
crisis, the average level of policy rates in these countries in the post-war period was 3%, 7%,
4% and 3% respectively - for most, roughly double the levels currently expected. Interest
rate end-points are also remarkably low.
In a growing number of countries, interest rates are not just low but have recently turned
negative. At last count, eleven countries had negative shorter-term bond yields, including
nine within the euro-area. In part, that reflects the effects of a recent further round of policy
loosening by central banks. At present, two-thirds of countries globally have policy rates
below 3% (Chart 4).
Chart 3: Paths for policy rates implied by Chart 4: International policy rates over time
forward market interest rates
Higher than 5% Between 3% and 5%
UK US
Proportion
Per
Between 1% and 3% Between 0% and 1%
EA Japan
of regions
Less than zero
3.5
100%
3.0
2.5 80%
2.0
60%
1.5
1.0
40%
0.5
0.0
20%
-0.5
0 2 4 6 8 1012141618202224262830
0%
2000 2005 2010 2015
Sources: Bloomberg and Bank Calculations. Notes: Sources: Thomson Reuters Datastream, CEIC and Bank
calculations. Notes: Included regions are: Australia, Brazil, Canada,
Instantaneous forward rates based on OIS contracts for
China, Euro area, Hong Kong, India, Indonesia, Malaysia,
the UK and euro area and government bonds for the US
New Zealand, Norway, Philippines, Singapore, South Korea,
and Japan.
Sweden, Switzerland, Taiwan, Thailand, UK and US. Together
these countries account for approximately 70% of PPP-weighted
world GDP.
Of course, what goes down can also bounce back up. Recently, there has been some
upwards movement in UK and US yield curves. But yields elsewhere, especially in Europe,
have continued to fall. And the longer-term trend is clear: a persistent ratcheting-down in
interest rates across all maturities and virtually all countries, to reach unprecedentedly low
levels. As a recent example of that, Chart 5 plots the UK forward curve at monthly intervals
over the past 9 months.
What explains this remarkable pattern of
Chart 5: Evolution of the UK forward curve
global interest rates? And what
implications does it carry for monetary
Per cent
2.6
Bank Rate
policy, in the UK and internationally? I
2.4
want to offer some reflections on those
March 2015
2.2
two questions. To be clear, these views
July 2014 2.0
are personal ones, in my capacity as a
1.8
member of the Bank's Monetary Policy
1.6
Committee (MPC), rather than 1.4
1.2
necessarily representing the collective
1.0
view of the MPC.
0.8
0.6
The drop 0.4
0.2
A significant part of the explanation for
0.0
low interest rates, at least in the years
Mar Jul Oct Mar Jul Nov Mar Jul Nov Mar Jul Nov
2014 15 16 17
immediately after the crisis, was the
weakness of demand. Chart 6 looks at
Sources: Bloomberg and Bank Calculations. Notes: Chart shows
the path for UK output growth expected
UK instantaneous forward OIS curves.
in the MPC's Inflation Report each
February since 2009. Up until around
2012, growth significantly and repeatedly disappointed to the downside.
The same was true internationally, with IMF forecasts significantly and repeatedly revised
down. With recovery weaker and taking longer than expected, the expected date of interest
rate rises was repeatedly put back, and the expected level of future rates was lowered, in the
UK (Chart 1) and globally (Chart 2).
Over the past two years, this story has subtly changed. UK growth has, if anything, surprised
to the upside over this period. UK growth in 2013 and 2014 averaged over 2%. And the
MPC's February Inflation Report forecasts the UK growing above its historic trend over the
next two years.
Yet despite this, the expected path of UK interest rates has continued to drift down. That is
because macro-economic surprises have continued, but have switched from the real to the
nominal side, from stalling growth to falling inflation. Inflation has consistently and
significantly undershot the Bank's forecasts since 2012, in particular over the past 12 months
(Chart 7).
Chart 6: Inflation Report projections of Chart 7: Inflation Report projections of CPI
GDP growth
inflation
Percentage change on
Percentage change on
a year earlier
a year earlier
6.0 4.0
3.5
4.0
3.0
2.0
2.5
0.0
2.0
-2.0
1.5
-4.0
1.0
-6.0
0.5
-8.0
0.0
2008Q1 2010Q1 2012Q1 2014Q1
2012Q1 2013Q1 2014Q1
F09 F10 F11
F13 M13 A13
F12 F13 F14
N13 F14 M14
Latest data
A14 N14 Latest data
Sources: ONS and Bank calculations
Sources: ONS and Bank calculations
This pattern has been mirrored internationally. Global consumer price index (CPI) inflation,
on a PPP-weighted basis, currently stands at 1.2%, having fallen 1.8 percentage points over
the past two years (Chart 8). Around 40 countries internationally are currently experiencing
deflation (Chart 9). At a global level, inflation was undershooting national inflation targets by
almost 2 percentage points in January 2015.1
Chart 8: Global CPI inflation Chart 9: International inflation rates over time
Global PPP-weighted
Per cent
4
Higher than 5% Between 3% and 5%
deviation of CPI inflation
Proportion
Between 1% and 3% Between 0% and 1%
from target
of countries
Below 0%
3
100%
UK
2
80%
1
60%
0
-1
40%
-2
20%
-3
2000 2003 2006 2009 2012 2015
0%
1961 1971 1981 1991 2001 2011
Sources: Datastream and Bank calculations. Notes: Sample varies
Sources: Thomson Reuters Datastream, CEIC and
over time. Average sample sizes are: 30 countries between1960
Bank calculations. Notes: Global equates to
approximately 70% of world PPP GDP; inflation targets and1980, 55 between 1980 and 2000 and 110 from 2000 onwards.
fixed using 2014 targets and PPP-weighted according to
share over time.
1
See Carney (2015).
UK CPI inflation has closely followed global CPI trends since the crisis, with their correlation
strikingly high at 0.8 - double its level pre-crisis. UK inflation currently stands at 0.3%, its
lowest-ever recorded level. According to the MPC's latest Inflation Report, it is more likely
than not the UK will join those countries facing temporary deflation this year.
These global disinflationary forces are, in large part, the result of shocks to world prices. Oil
prices have fallen by over 50% since the middle of last year. By itself, this would be expected
to lower temporarily UK CPI inflation by around 3⁄4 percentage points. Beyond oil, agricultural
commodity prices have fallen by 25% in the past two years due to good harvests. Global
non-fuel export prices, on a UK trade-weighted basis, have fallen 2%.
These weak external price pressures go a long way towards explaining the fall in global CPI
inflation over the past two years. They also account for around two-thirds of the fall in UK CPI
inflation over the same period. If these are one-off shocks to the price level, their impact on
annual inflation measures should drop out after a year. Such temporary deviations of inflation
from target should be "looked through" in setting monetary policy.2
This is not, however, the whole inflation story. The weakness of global prices is not wholly
the result of one-off shifts in global supply. For example, although supply news is likely to
have been the biggest driver of the recent fall in oil prices, a weakening outlook for world
demand is also likely to have played a material role.
Moreover, perhaps between a quarter and a third of the fall in inflation, globally and in the
UK, is not explained by weak external prices. Another source of "drag" has been at work.3
Identifying those drag factors is important when accounting for disinflationary trends in the
past, but also when assessing whether these trends will persistent in the future.
The drag
If you consider the traditional determinants of inflation, there are at least three plausible
sources of disinflationary "drag": slack in the economy, a weaker relationship between slack
and wages and lower levels of inflation expectations.
These explanations are not mutually exclusive. Higher levels of slack, or a weaker
relationship between slack and wages, could lower inflation expectations - for example, if
demand is weak today, people may expect lower inflation tomorrow. And lower wage and
inflation expectations could themselves depress demand - for example, by raising levels of
real interest rates. Nonetheless, it is worth considering these explanations in turn.
(a) Slack and the Phillips Curve
The short-term relationship between unemployment or the output gap and wage growth or
inflation - the Phillips curve - is one of the most intensively studied in macro-economics.4
Despite that, empirical estimates of the Phillips curve have tended to be poorly-identified.
That may reflect the effects of structural and behavioural shifts, which have the potential to
alter historically-estimated Phillips curve relationships.
For example, changes in the credibility of the monetary policy regime can cause inflation and
wage expectations to alter, causing the Phillips curve to shift around over time for a given
level of slack. And changes in the competitive structure of labour and product markets can
influence the impact of slack on wage and price pressures, causing the Phillips curve to
change slope over time.
Chart 10 plots the historical relationship between wage growth and unemployment in the UK
over the period since 1856. Although noisy, it suggests a negative relationship between the
two, with an average slope of just under 1⁄2. In others words, a 1 percentage point increase in
the unemployment rate has, on average in the past, lowered wage growth by around half a
percentage point.
A somewhat clearer window on this long-run Phillips curve relationship is provided by looking
at distinct monetary regimes: exchange rate targeting regimes under the Gold and dollar
standards (1856-1970); discretionary monetary policy regimes without central bank
independence (1970-1997); and inflation-targeting regimes with independently-set monetary
policies (1997 onwards).
Chart 11 plots the Phillips curve relationship over these windows. The introduction of
discretionary monetary policy regimes, without independence, caused an outward shift in the
Phillips curve and a shift up in wage and inflation expectations. That is consistent with a loss
of monetary credibility. Since 1997, however, inflation expectations having shifted back
inwards, restoring the Phillips curve to something closer to its position prior to 1970.5
Chart 10: A long run estimate of the Chart 11: The wage Phillips curve under different
wage Phillips curve in the UK policy regimes in the UK
1856-1970
Wage
1856-2014
Wage
1970-1997
inflation
inflation
1997-2014
30
30
20
20
10
10
0
0
-10
-10
-20
0 5 10 15 20
-20
Unemployment rate (lagged 1yr)
0 5 10 15 20
Unemployment rate (lagged 1yr)
Sources: Crafts and Mills (1994), Feinstein (1972) and Sources: See footnote to Chart 10.
ONS. Notes: Unemployment is measured here by the
claimant count, and is lagged by one year. For more
information on the long-run data used to construct this
index, see Hills et al (2010, 2015).
If we look more closely at the most recent period, a second feature stands out (Chart 12). UK
wage growth has been puzzlingly weak over the past few years, lying below the Phillips
curve estimated since 1997. While UK unemployment has fallen more than 2 percentage
points since 2013, wage growth has remained in the range 1-2% per year.
This is, to a degree, a global phenomenon. For example, the US Phillips curve also shifted
inward after the Volcker disinflation of the early 1980s (Chart 13). And US wage growth has
also been puzzlingly weak over the past few years.6 Despite unemployment falling around 2
percentage points, wage growth has remained around 2%.
Chart 12: The UK wage Phillips curve Chart 13: The US wage Phillips curve
1971-1997 1998-2012 1971-1982 1983-2011
Wage Wage
2012-2014 Fitted 1971-1982
2013-2014 Fitted 1971-1997
inflation inflation
Fitted 1983-2011
Fitted 1998-2014
10
40
35
30
25
20
15
10
5
0
9876543210
0 5 10 15
0 2 4 6 8 10 12
-5
Unemployment rate
Unemployment rate
Sources: ONS and Bank calculations Sources: Thomson Reuters Datastream
These Phillips curve surprises can be
Chart 14: Inflation Report forecast errors on wage
clearly seen in the Bank's own forecast
growth and unemployment
errors for wage growth and
unemployment over the past few years Percentage
Unemployment Wages
points 4
(Chart 14). Since 2011, unemployment
has come in consistently below the
Bank's expectations. Yet despite this
2
unexpected strength in the labour
market, wage growth has come in
0
consistently and significantly lower than
the Bank's forecasts. In part, that
-2
reflects weak productivity, which has
also been significantly lower than the
Bank's forecasts. But wage growth has
-4
been surprisingly weak even allowing
for that.
-6
2005Q2 2007Q2 2009Q2 2011Q2 2013Q2
In response to this wage weakness, the
MPC has dynamically adjusted its
estimates of slack. For example, last
Source: ONS and Bank calculations. Notes: Chart shows one year
year the MPC revised upwards its
ahead errors. Wage forecasts were for Average Earnings Index until
estimate of the so-called "participation
2010Q2 and Average Weekly Earnings thereafter. The
discontinuation of the AEI series in 2010Q2 means it is not possible
gap" - the wedge between actual and
to calculate wage forecast errors for forecasts made between
equilibrium levels of participation in the
2009Q3 and 2010Q2, so those observations are left blank.
labour force. By increasing the
assumed drag from slack, that revision
explained away part of the wage puzzle.
Even after making these adjustments, however, the wage puzzle has persisted. This can be
seen by comparing the actual and estimated paths of wages from the Bank's suite of wage
equations, using as inputs the Bank's estimates of "slack" in the labour market, as well as
productivity and other wage determinants.
Wage growth has consistently and
Chart 15: Actual and estimated UK wage growth
significantly undershot its expected
path, even after controlling for slack
Percent change on
Actual
and other shocks. Cumulatively, this
a year ealier
8
Estimated
undershoot is large, with the level of
wages more than 2% below predicted
6
estimates over the past two years.
There are a number of possible
explanations for this wage puzzle.
4
These have potentially quite different
implications for future wage growth
and hence policy.
2
The first is simply that the lags from
lower unemployment to wage growth
0
are a little longer than in the past. That
might be the case because job-to-job
-2
flows in the labour market have been
2004 2006 2008 2010 2012 2014
low by historical standards, only
recently picking up towards
Sources: ONS and Bank calculations. Notes: Dashed line shows
prerecession levels. If so, we might insample fitted values from an estimated wage equation.
expect the recent undershoot in
wages to course-correct in the period
ahead, as labour market activity picks up.
In essence, this is the judgement underpinning the MPC's central view of wages in the
February Inflation Report. Wage growth is projected to rise, reaching 3.4% by end-2015. In
effect, wages error-correct. There is some tentative evidence of wage growth picking up over
the past few months, although yesterday's wage data were notably weaker. If this pick-up
were to continue, the wage puzzle would have been benign. Indeed, with slack eroding, we
might then be concerned that wage pressures could overshoot, posing upside risks to the
inflation target.7
But there are other explanations of the wage puzzle which pose downside inflation risks. One
is that the Phillips curve has become less steep than in the past. This would mean that a fall
in unemployment might have a lower impact on wage pressures than in the past. This might
arise because the pool of workers willing to enter the labour force at the existing wage rate
has increased - for example, older workers prepared to work longer than they had planned
or workers from overseas moving into the UK labour force.
There is evidence of many of these trends intensifying over the past few years. For example,
the unemployment rate among 18-to-24 year olds has fallen by almost 4 percentage points
over the past year. The trend in labour force participation rate has picked up significantly
among women and older cohorts over the same period. And net migration to the UK was
estimated to be almost 300,000 in the year to September 2014, almost double the level two
years earlier.
There is evidence, in the UK and
Chart 16: IMF estimates of global price Phillips
internationally, to support the Phillips
curve slopes
curve having flattened over time. For
Interquartile range Median
example, cross-country evidence from
the IMF suggests that the slope of the
2.0
price Phillips curve has fallen, from
around one in the 1970s to 0.1-0.2
today (Chart 16). That could reflect the 1.5
effects of globalisation, enhancing
competition in domestic labour and
1.0
product markets.8
The implications of a flatter Phillips
curve for future wage growth and 0.5
inflation can be assessed by
rerunning the projections from the MPC's
0.0
February Inflation Report. Specifically,
1961 1967 1974 1980 1986 1993 1999 2006
assume a halving of the Phillips curve
slope used in the model of Chart 15,
Sources: IMF (2013).
from 1 to 0.5.9 That slope is still well
above the levels in Chart 16.
Chart 17 shows the results from this exercise. Wages and prices are both weaker
throughout: at the two-year horizon, wage growth is 0.6 percentage points lower than in the
February Inflation Report, while inflation is 0.2 percentage points lower. In other words, a
flatter Phillips curve would generate a downside risk to the inflation outlook at the policy
horizon.
A final explanation for the wage puzzle is
Chart 17: Projection for wage growth and
that weak wages are signalling that the
inflation, assuming a flatter Phillips curve
output or unemployment gap is larger
than currently estimated. There are a
Percentage
number of potential sources of such
6
change oya
additional slack, including greater spare
4
capacity in firms, a greater willingness
among workers to increase their average
2
hours, or a lower long-term rate of
unemployment than is currently
0
estimated by the Bank.10
-2
How much additional slack? Imagine you
asked yourself how much slack would be
-4
needed to resolve the wage puzzle of the
past few years. Even with a very
conservative estimate of the Phillips
Wages - February IR projections
Wages - flatter Phillips curve
curve slope, the implied degree of slack
Inflation - February IR projections
could be somewhere close to 4%,
Inflation - flatter Phillips curve
materially above the MPC's current
Source: ONS and Bank calculations.
central view of slack of around 1⁄2%.
To give a sense of its implications,
Chart 18: Projection for wage growth and
imagine the level of slack were currently
inflation, assuming a starting level of slack of 2%
around 2% and was only gradually
eroded over the forecast. Chart 18
shows the resulting path of inflation and
Percentage
6
wage growth. Inflation and wage growth
change oya
are both materially weaker: at the
4
twoyear horizon, they are around
0.2 percentage points lower than in the
2
MPC's February Inflation Report.
0
Each of these three explanations of the
wage puzzle is empirically plausible. If
-2
some weight is given to the final two
explanations, the risks to future wage
-4
growth and inflation would be skewed to
the downside, not only in the short-term
Wages - February IR projections
but at longer horizons too.11
Wages - more slack
Inflation - February IR projections
(b) Inflation expectations
Inflation - more slack
A complementary explanation for the
Source: ONS and Bank calculations.
wage puzzle, which goes in the same
direction, is that inflation expectations
have shifted downwards. To the extent these weaker expectations shape firms'
wagebargaining and price-setting behaviour, this would impart downwards persistence into wage
and inflation dynamics.
There is an array of inflation expectations measures covering different sectors - households,
companies, financial markets - and horizons - short and longer term. All of these measures
have fallen over the course of the past two years, as actual inflation has fallen, though often
by differing amounts.
Among households, one-year-ahead inflation expectations, as reported by Citigroup, have
fallen by 120bp over the past year. At the five to ten year horizon, they have fallen by around
30bp (Chart 19). Shorter-term expectations are around 1.5 percentage points, and
longerterm expectations around 1 percentage point, below their pre-crisis averages. Over the same
period, households' inflation expectations from the Bank/NOP survey have fallen by 90bp,
60bp and 50bp respectively at the one, two and five year horizons.
Chart 20 looks at the term structure of expected inflation by households from the Bank/NOP
survey, relative to the past and the Bank's forecasts.12 The term structure of expected
inflation is currently lower than at any stage since the crisis. Moreover, household inflation
expectations are significantly below 2% at the two-year horizon and, to a lesser extent,
thereafter. That means it is unclear, at present, whether household inflation expectations are
consistent with the Bank hitting the inflation target.
Chart 19: UK household inflation Chart 20: Term structure of UK household
expectations inflation expectations
Citigroup 1 year ahead
Per cent
Per cent Vintage Series (2009 - 2014)
6
Feb 2015 IR
Citigroup 5-10 years ahead
5
CPI Data
NOP Feb 2015 5
4
4
3
3
2
2
1
1
0
0
2006 2008 2010 2012 2014
2000 2003 2006 2009 2012 2015 2018
Sources: Citigroup. Dashed lines show series 2005-07 Sources: Bank of England/GfK NOP. Notes: The red dots
averages.
show the adjusted inflation expectations at the one, two and
five year horizons in the February 2015 Bank/GfK NOP
household survey; grey lines show adjusted perceptions and
expectations from previous vintages of the survey.
Turning to financial market measures of inflation expectations, two-year ahead forward
inflation rates have fallen by around 40bp over the past year and 5-year ahead expectations
by the same amount. This appears to have been, to a degree, a global phenomenon, with
forward inflation rates also falling in the US and euro-area (Chart 21).
Chart 22 looks at the term structure of RPI inflation implied by inflation swap rates. Inflation is
near the bottom of its distribution over the period 2009-2013. Financial markets appear to
expect inflation to remain lower for longer than in the recent past. Because the period 2009-
2013 was associated with higher than target levels of inflation, financial market inflation
expectations may still be broadly consistent with the Bank's inflation target.
Chart 21: Changes in 5-year instantaneous Chart 22: Term structure of inflation swap
forward inflation swap rates since March forward rates
2014
5th to 95th percentile (2009-13)
Percentage
Per cent
0.2
points Interquartile range (2009-13)
4.5
Unconditional mean (2009-13)
0.1
Latest
4.0
0-0.1
-0.2
3.5
-0.3
UK -0.4
3.0
-0.5
Euro-area
-0.6
2.5
US
-0.7
-0.8 2.0
2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Mar 2014 Sep 2014 Mar 2015
Years ahead
Sources: Bloomberg and Bank Calculations. Notes:
Sources: Bloomberg and Bank Calculations.
Unconditional distribution from a parametric factor model using
data from January 2009 to August 2013. Data from May 2012 to
January 2013 are excluded due to uncertainty about proposed
changes in RPI methodology, which temporarily affected
expectations of the RPI-CPI wedge.
On either measure, inflation expectations have fallen over the past year at all horizons. At
longer-term horizons, that is difficult to reconcile with global disinflationary trends having
been the result of one-off falls in global prices. Measured expectations suggest that lower
inflation is expected to persist. To the extent this affected wage and price-setting, those
expectations could become self-fulfilling.
A number of plausible explanations for a shift in longer-horizon inflation expectations are
possible. One is greater slack in the economy than is currently assumed in the MPC's central
projections. A second is doubt about the ability of monetary policymakers to boost inflation -
for example, because of the constraint of the zero lower bound on interest rates.
A third explanation is greater expected persistence in low global price pressures. One factor
that could potentially depress global prices on a persistent basis is a shortfall in global
demand relative to supply. As Chart 23 shows, the IMF estimates the global output gap
currently to be around 2%. It is only forecast to close by 2019. This might be expected to
exert global disinflationary pressure for the foreseeable future.13
A final factor, with particular relevance to the UK over the past two years, is the exchange
rate. Sterling's effective exchange rate has appreciated by around 15% over that period and
by around 3% since the start of the year. A mechanical model treatment of the appreciation
this year would imply inflation in the UK, at a two year horizon, would be around
0.2 percentage points lower. What explains sterling's appreciation and might it continue?
Over the past few years, there has been a positive relationship between countries' effective
exchange rates and news about demand relative to overseas competitors (Chart 24).
Positive output surprises have increased the attraction of a currency relative to its
competitors, including by increasing the chances of a rise in relative interest rates.
This is a plausible explanation for the recent appreciation of sterling and the dollar, with
positive demand and interest rate surprises in the UK and US relative to the euro-area and
Japan. Indeed, those latter countries have in addition embarked on programmes of asset
purchase which might have intensified downward pressures on euro and yen assets.
This decoupling of the relative demand and monetary policy positions of the UK and US on
the one hand, and the euro-area and Japan on the other, might have on-going implications
for exchange rate movements. If these trends continued, they could result in some further
appreciation of sterling and the dollar relative to the euro and yen, which would tend to
increase disinflationary pressures in the UK and US.
Chart 23: IMF output gap estimates and Chart 24: Changes in effective exchange rate
world export prices indices and domestic demand surprises
Per pp
Percent Percent
cent
6 4
15 1.5
3
2
10 1.0
1
5 0.5
0
543210
-1 0 0.0
-1
-2
-2
-5 -0.5
-3
-3
-10 -1.0
-4 -4
Apr-13 Aug-13 Dec-13 Apr-14 Aug-14
2000 2003 2006 2009 2012 2015 2018
UK DD (RHS) EA DD (RHS)
Global output gap - UK wtd (rhs)
Global output gap - PPP wtd (rhs) US DD (RHS) €ERI (LHS)
World export prices - UK wtd (lhs) £ERI (LHS) $ERI (LHS)
Sources: IMF, CEIC, Eurostat, Thomson Reuters Sources: Consensus, FRB, ECB, BoE and Bank calculations.
Datastream and Bank calculations. Notes: The world export
Notes: Domestic demand series show revisions to average
price series shows domestic currency non-oil export prices
domestic demand growth relative to main trading partners.
of goods and services of 49 countries weighted according to
their shares in UK imports.
With inflation expectations having adjusted, how might this affect wage and inflation
behaviour? Table 1 shows estimates of two estimated Phillips curves, which include the
typical wage-determinants, such as productivity, but also include (lagged) measures of
inflation expectations for households (at a 2-year horizon) and financial markets (at a 5-year
horizon).
Both expectations measures are statistically significant in explaining wage growth. Every one
percentage point fall in inflation expectations results in a similarly-sized fall in wage growth
the next period. With household expectations having fallen 90bp, and financial market
expectations by 40bp over the past year, this implies they would be exerting a significant
drag on wage growth at present. That is consistent with survey evidence from the Bank's
agents, whose contacts cite falling inflation expectations as the most important factor
currently holding back wage settlements.14
Table 1: Estimated wage Phillips curves including measures of expected inflation
Nominal wage growth(a)
(1) (2)
Wage growth (t-1)(a) -0.31*** -0.35***
(0.09) (0.09)
Productivity growth(a) 0.36*** 0.31***
(0.11) (0.10)
Unemployment gap -2.22*** -2.23***
(0.36) (0.36)
Labour share (t-1) -0.52*** -0.33**
(0.14) (0.17)
2-year household inflation expectations (t-1)(b) 1.13***
(0.35)
5-year breakeven inflation rate (t-1)(c) 1.02***
(0.28)
Interaction with inflation targeting dummy -0.14 -0.04
(0.29) (0.29)
Constant 0.02 0.03*
(0.02) (0.02)
Observations 105 101
R-squared 0.50 0.50
Sources: Barclays Basix; Bloomberg; Bank calculations. Notes: Estimated using quarterly data between 1987 Q1 and 2014 Q4.
(a) Annualised quarter-on-quarter growth. (b) Excludes the period between 2012 Q2 and 2013 Q1 due to effects of the CPAC
review on RPI-linked financial instruments. (c) Barclays Basix 2-year head household expectations.
It is possible to simulate the effects of
Chart 25: Projection for wage growth and
lower inflation expectations on the MPC's
inflation, assuming i