01 January 2011

2010/11 Rybczynski Prize Essay

Spare a thought for spare capacity

George Buckley, Chief UK Economist, Deutsche Bank

Many forecasts of inflation are based on the New Keynesian Phillips Curve approach – put simply, that the current rate of inflation is a function of spare capacity in the recent past, external shocks (such as commodity price and currency movements) and inflation expectations. However, these models have shown their limitations in forecasting inflation in the UK over the past few years, with CPI having proved stickier than might have been expected.

One reason such models might have failed to forecast the resilience of inflation recently relates to the difficulty in measuring spare capacity accurately. Not only that, but any given degree of spare capacity may now be imparting a smaller influence on inflation than was the case in the past. The evidence seems to support this hypothesis to the extent that the move to inflation targeting has been important in anchoring inflation expectations, and that globalisation has reduced the relative importance of domestic influences on prices, inflation may now be more stable for any given variation in output away from its trend.

So, in understanding inflation’s recent stickiness, we can add spare capacity to the explanations of weaker sterling and higher indirect taxes. While it seems reasonable for the central bank to partially overlook the currency and tax effects on inflation (as they are ‘one-off’ events that are unlikely to be repeated), if inflation turns out to be less sensitive to the output gap this may have more serious policy implications. In particular, if inflation falls by less than it did following previous recessions then the Bank may need to raise short-term interest rates earlier than is currently expected.

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