Will a weak pound lead to a surge in inflation?
Many are worried about the UK inflation outlook as a result of a weaker pound. Core inflation rose from 1.5% in 2008 to 3% in 2011 after the pound fell. But inflation was also under attack from higher VAT and a surge in commodity prices. So we see a more gradual increase than consensus this time around.
I’ve yet to download the Pokemon Go app. But its recent hype encouraged me to watch the original series with my son on Netflix. He’s not allowed to watch it without me so he won’t have superior knowledge on monsters when we play our own Pokemon battles.
The gist of Pokémon battles is rock-paper-scissors strategy. Each monster has different strengths and weaknesses. For example, a fire-based monster is great against plant-based ones, but vulnerable to water.
You’re allowed to bring six Pokemon (pocket monsters) to a battle so the key to success is therefore to select a diversified set of characters - sorry Pikachu, we can't just pick you.
It’s the same with economic modelling; you need to use multiple variables to explain data.
UK core inflation jumped from 1½% in 2008 to 3% in 2011 after the pound fell sharply. Many commentators fear a repeat in coming years, which could explain the current pricing of inflation markets. But it wasn’t just the pound monster that attacked UK inflation back then. It was also under attack from VAT hikes and surging commodity prices.
So just as a Pokemon trainer needs to use more than one monster to win a battle, we need to use multiple variables to forecast inflation. When we take into account VAT hikes, commodity prices, growth and labour market tightness, as well as movements in the pound, we believe that the current attack on inflation is less severe than back then. So we see a more gradual rise in UK inflation than consensus.
One wildcard is the tightness of the labour market as highlighted in Tim's recent post. While economic uncertainty should reduce the demand for labour, a sharp decline in immigration could make it more difficult for firms to recruit.
Our economic model (see chart below) for UK core inflation captures the changes in inflation relatively well despite different monetary regimes over time. Still, the degree of pass-through from currency movements and the lags involved will vary due to other factors not captured in our model.
There are clearly a lot of variables to Pikachu over. But a limited inflation threat suggests the Bank of England can keep Pokemonetary policy loose.