Inflation expectations key to interest rate outlook

Rising prices prompted a small rise in the inflation expectations of UK households in August, according to the latest figures. Even so, there’s little sign of the spike in medium-term expectations that would make the Monetary Policy Committee (MPC) concerned that the recent lift off in inflation is becoming entrenched. As household inflation expectations play a large part in determining what inflation will actually be, the MPC should continue to look through the surge in inflation as long as expectations remain subdued. That’s one reason why we don’t expect the first interest rate hikes to come until the second half of next year. 

Inflation expectations will be near the top of the list of things for the MPC to think about ahead of its next meeting on Thursday, 23 September. If households expect inflation to be higher in future, they’ll demand bigger wage increases to offset the impact on their future purchasing power. This pushes up businesses costs and causes price rises, leading to higher inflation. This is why households’ expectations of the future inflation rate is a key decider of actual inflation. 

In contrast, the committee will be relatively happy to ignore those inflation increases driven by one-off factors, such as higher electricity prices because of a lack of wind to power turbines. It will also look through base effects, such as the inflation growth in the hospitality sector in August 2021, due to the Eat Out to Help Out scheme, and the VAT cut, which lowered prices in August 2020. 
After all, the influence on inflation from these factors will fade once they fall out of the annual comparison next year. Indeed, this is why we predict inflation will be back at 2.0% by the end of 2022 after reaching more than 4.0% in November 2021.

Given the recent media focus on higher inflation, it’s unsurprising that household expectations rose in August. Financial markets are now fully pricing in the surge in inflation that we anticipate over the rest of the year.

However, household inflation expectations remain well anchored around pre-pandemic levels. So far there’s no sign of a jump in expectations, especially in the MPC’s preferred measure of five years ahead – that would really cause it concern. It will be a key metric that the MPC will be watching over the next couple of years.