Keeping UK inflation at 2 per cent will be a tough challenge

After three years at a very high level, inflation finally returned to target. In the 25 years before the recent surge, it had been very well behaved. Will it now return to the low and stable regime of the pre-pandemic years?
Unfortunately, the likely answer is no. Inflation probably will remain persistent and volatile, more so in the UK than elsewhere.
Britain is likely to be experiencing more large changes to the supply side than other economies. The pandemic and the recent energy shock have affected many countries, but the UK also left the European Union and the government wants to introduce significant labour and housing market reforms to raise potential growth.
The role of monetary policy is to match demand to supply to maintain inflation at 2 per cent. The Bank of England’s ratesetting monetary policy committee has reacted successfully to individual supply-side changes before, but when several occur simultaneously, leaving the overall supply-side effect unclear, it becomes hard to calibrate monetary policy to reach the 2 per cent inflation target with any degree of precision.
The neutral policy rate, at which monetary policy is just right to keep inflation at target, is likely to have moved in response to these changes. Given the lack of reliable estimates, the MPC will have to discover the level of the neutral rate via trial and error. As monetary policy operates with long and variable lags, it will become evident only after some time whether the Bank rate is below or above the neutral rate. There could be long periods when monetary policy is either too loose or too tight. This probably will result in persistent inflation overshoots and undershoots in the next couple of years.
I believe that stable inflation expectations and the Bank’s credibility promoted low and stable inflation in the past. When expectations are anchored, small shocks to inflation have only temporary effects on inflation and typically dissipate after a year or so. Because companies have confidence that inflation will return to 2 per cent, their beliefs shape their price-setting actions. This helps to maintain inflation at 2 per cent.
Yet firms need to believe that the inflation target is credible. And credibility is easily lost, but takes years to rebuild. Because of the persistent UK inflation surge, businesses are less likely to believe claims that the effects of shocks are merely temporary. Shocks to prices therefore are likely to have greater and more persistent effects on inflation in the future.
Of course, good monetary policy wasn’t the only factor keeping inflation at bay in the pre-pandemic decades. Globalisation, abundant labour supply from the EU and cheap energy all helped to keep inflation low and stable. Now, though, these supporting factors have gone into reverse. We live in an age of fragile supply chains, expensive energy and migration restrictions. None of this is the Bank’s fault, but these structural factors will make the job of monetary policy significantly harder.
There are plenty of prospective inflation shocks on the horizon. Geopolitics continues to negatively affect vulnerable supply chains. Tariff wars lead to greater costs for companies and consumers. The transition to net zero is likely to be inflationary at first. British labour shortages could contribute to high costs.
Calibrating monetary policy precisely to deliver 2 per cent inflation in the face of these structural changes and large shocks is nearly impossible. Economic forecasters, even the MPC, are not omniscient. When economic shocks are small, inappropriate monetary policy settings will be barely visible in the data. Inflation will be on average at target. But this is different when shocks are large and their demand and supply effects are uncertain. Making a monetary policy mistake will lead to substantial deviations of inflation from target down the line. After all, to err is human.
The MPC has been very successful in keeping inflation low and stable in the past, but it is faced with exceptionally challenging circumstances. Despite the MPC’s best efforts, returning inflation back to normal will be hard.
Tomasz Wieladek is chief European economist at T. Rowe Price and a research fellow at the Centre for Economic Policy Research