Chart of the Week: UK policymakers edge towards the ‘sustained’ inflation camp

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Data published last month showed that UK CPI inflation had reached 3.2% in the twelve months to August, triggering an open letter from the Governor of the Bank of England to the Chancellor, explaining why inflation had moved more than a percentage point away from the target, and setting out the actions that the MPC would take in response. As our chart shows, since the introduction of the CPI-based target in 2003, there had until then been just four separate occasions where inflation had overshot the target to this degree. The proximate cause had been either a spike in energy prices (in 2007 and in 2008-09), a sharp fall in sterling (2008-09 and 2017) or increases in the rate of VAT (2010-12). All three of these economic shocks tend to make UK households worse off, and can reasonably be expected to be self-limiting, requiring little or no monetary policy response.

The current situation feels somewhat different, with a period of exceptionally loose monetary and fiscal policy meaning that UK households are sitting on pandemic savings worth some 10% of GDP. It is not obvious to us that the current UK inflation overshoot will prove to be temporary. The Bank of England’s new Chief Economist, Huw Pill, last week said that, in his view “the current strength of inflation looks set to prove more long lasting than originally anticipated”. In our latest Global Economic and Markets Outlook, we saw a broadly evens chance that the pickup in UK inflation would prove to be sustained, by which we meant that it would not fall back to the 2.0% target of its own accord. If it does continue, we believe it is far more likely that policymakers in the UK and elsewhere will ‘roll with it’, and accept a prolonged period of higher inflation, perhaps by raising inflation targets, than ‘deal with it’..