Dr Andrew SentanceFormer MemberMonetary Policy Committee

UK inflation - Under control?

Presentation to Policy ExchangeLondon, 20 October 2011

Outline

Recent UK inflation performance

Why has UK inflation been so high?

Problems with the MPC

Reforming the UK monetary framework

UK inflation persistently above target

Source: Office for National Statistics

1995 Jan 1997 Apr 1999 Jul 2001 Oct 2004 Jan 2006 Apr 2008 Jul 2010 Oct0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%Value Target Ave 2008-11

% per annum increase in consumer prices index

Broad-based rise in consumer prices

Source: Office for National Statistics

Food and non-alcoholic beveragesAlcoholic beverages and tobacco

Clothing and footwearHousing, water and energy

Furniture & household eqpt/maint'ceHealth

TransportCommunication

Recreation and cultureEducation

Restaurants and hotelsMiscellaneous goods and services

-2 0 2 4 6 8 10 12

% annual rise in CPI categories, September 2011

Inflation far above the old RPIX target

Source: Office for National Statistics

1995 Jan 1997 Apr 1999 Jul 2001 Oct 2004 Jan 2006 Apr 2008 Jul 2010 Oct0

1

2

3

4

5

6Value Target Ave 2008-11

Annual % increase in retail prices index excluding mortgage interest

MPC – The inflation record

Source: Office of National Statistics

Period Target High Low Ave

May 1997 - Dec 2003

RPIX = 2.5% 3.2% 1.5% 2.4%

Jan 2004 - Dec 2007

CPI = 2.0% 3.1% 1.1% 2.0%

Jan 2008 – Sep 2011

CPI = 2.0% 5.2% 1.1% 3.4%

What has gone wrong?

• Global inflationary pressures

• Large sterling depreciation

• Persistent services inflation

• Limited impact of spare capacity

Global inflation on the rise% per annum change in consumer prices

Source: The Economist

USEu

roChin

aJap

an UKBra

zil CaInd

iaRuss

iaAu

str...

-2

0

2

4

6

8

10

12Year agoLatest

Global primary energy consumption

Source: BP Statistical Review 2010

Million tonnes oil equivalent

2000

2500

3000

3500

4000

4500

5000

5500

6000

6500

1980 1983 1986 1989 1992 1995 1998 2001 2004 2007

OECD

Non-OECD

The global economy and UK inflation

Global economy

Cost of imports

Demand

Pricing climate

Exchange rate

Domestic demand

Expectations and credibility

UK inflation

Impact of monetary policy

UK inflation in international context

Source: Office for National Statistics

2008

Jan

2008

Apr

2008

Jul

2008

Oct

2009

Jan

2009

Apr

2009

Jul

2009

Oct

2010

Jan

2010

Apr

2010

Jul

2010

Oct

2011

Jan

2011

Apr

2011

Jul

95

100

105

110

115UK Euro US

Index of consumer prices, January 2008 = 100

Sterling depreciation since 2007

Rebased to 100 in January 2005

Source: Thompson Datastream and Bank for International Settlements

*: Effective exchange rate

70

75

80

85

90

95

100

105

110

2005 2006 2007 2008 2009 2010 2011

Euro-Sterling exchange rate

Sterling EER *

Average EER *, 97-07

Episodes of Sterling depreciation

Index, base year = 100

Number of years from start of period

Source: Bank for International Settlements

50

60

70

80

90

100

110

0 1 2 3 4 5

1967-1971 1972-1977 1981-1986

1991-1996 2007-2010

Euro/UK inflation differential & exchange rate

Source: Thompson Datastream

*: Euro-Sterling exchange rate is expressed as the deviation from its average over the same period.

-0.4

-0.3

-0.2

-0.1

0

0.1

0.2

0.3

-3.0

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

1997 1999 2001 2003 2005 2007 2009 2011

Euro-area/UK CPI differential (RHS) *

Euro-Sterling exchange rate (LHS) **

Euro/ sterling %

UK goods price inflation

Source: Office for National Statistics

Jan-97 Jan-02 Jan-07-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%CPI goods Factory gate prices

% per annum change in goods prices

Persistently high services inflation

Source: Office for National Statistics

Jan-97 Jan-02 Jan-07-3.0%-2.0%-1.0%0.0%1.0%2.0%3.0%4.0%5.0%6.0%7.0%

Goods Services% per annum change in consumer prices

Capacity utilisation in UK economy

Source: Bank of England

Jan-98 Jan-03 Jan-08-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0Manufacturing Services

Bank of England Agents’ scores relative to normal

Unemployment in UK recessions

Source: Office for National Statistics, Labour Force Survey * Q3 based on Jun-Aug average

-8 -6 -4 -2 0 2 4 6 8 10 12 14 16456789

101112

77Q4-83Q4 88Q2-94Q2 06Q2-11Q3*Unemployment rate, % of labour force

Number of quarters from employment peak

Wage growth picking up

Source: Office for National Statistics

Jul-01 Jul-02 Jul-03 Jul-04 Jul-05 Jul-06 Jul-07 Jul-08 Jul-09 Jul-10 Jul-11-10.0

-8.0-6.0-4.0-2.00.02.04.06.08.0

10.0

Monthly 3-month m.aAverage since 2001

% per annum growth in private sector average weekly earnings

Problems with the MPC

• Emphasis on forecast has allowed the Committee to redefine its own target

• Persistent modelling and forecasting errors, reflecting analysis based on “groupthink”

• Assymmetric policy response

• “Benign neglect” of sterling

• Lack of effective scrutiny and accountability

• Perception that inflation target has been changed or downgraded

October 2011 MPC decision

“…the weaker outlook for, and the increased downside risks to, output growth mean that the margin of slack in the economy is likely to be greater and more persistent than previously expected.

“…measures of domestically generated inflation remain contained and inflation is likely to fall back sharply next year as the influence of the factors temporarily raising inflation diminishes and downward pressure from unemployment and spare capacity persists.

“The deterioration in the outlook has made it more likely that inflation will undershoot the 2% target in the medium term.”

Large official inflation forecast errors

Source: Bank of England

Mean of forecast percentage annual increases in consumer prices

0

1

2

3

4

5

6

2007 2008 2009 2010 2011 2012 2013

May-09 Nov-09

May-10 Nov-10

May-11 Actual CPI inflation

The view from the Governor

“Our objective must be to steer the UK economy slowly back to a position of more normal interest rates and lower budget deficits. With a lower level of sterling and a credible plan to reduce the fiscal deficit over the medium term, we were on track. But the problems in the euro area and the marked slowing in the world economy have lengthened the period over which a return to normality is likely.”

Sir Mervyn King, 18th October 2011

Proposals for MPC reform

• Strengthen and diversify external membership of the Committee: eg 6 (external) to 3 (internal)

• MPC should be held more firmly to account for inflation performance by the Government and TSC

• Letter exchange to be more substantial, with statement to Parliament and TSC hearings

• TSC inquiry into conduct of monetary policy and Bank forecasting record since the financial crisis

• Separate forecasting from decision-taking, as in the fiscal framework. An OMR to match the OBR.

• End policy of talking down the pound