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Inflation expectations: forecasters' views on the credibility of UK monetary policy

Since 1996, the Bank of England has carried out a quarterly survey of economic forecasters. Gianna Boero, Jeremy Smith, and Kenneth Wallis have analysed the results to assess respondents’ views on the central bank’s commitment to fighting inflation.

When the Bank of England was given operational independence to set monetary policy in 1997, it quickly gained the credibility to fight inflation and thereby reduced economic uncertainty. What’s more, our research finds that after an initial period in which the Monetary Policy Committee (MPC) gained credibility, the Bank was perceived by independent forecasters as being more credible than the US Federal Reserve in its commitment to tackling inflation.

Independent economic forecasters trust the Bank of England to tackle inflation

As inflation reaches levels not experienced for several years and with strong recessionary fears in financial markets and the wider economy, the MPC’s credibility to meet its inflation target is being tested. But the evidence suggests that forecasters still trust the central bank to tackle inflation. In the Bank’s most recent quarterly survey, completed on 29 October 2008, expected inflation two years ahead has not responded to this year’s inflationary experience, but remains close to the Bank of England’s target, as shown in Figure 1.

Click here for Figure 1

Overall, the survey average forecast of inflation two years ahead has stayed close to the official inflation target irrespective of the actual inflation being experienced at the time the forecast was made. (The inflation variable shown is the official targeted variable at the time: the retail prices index, RPIX, target 2.5%, until the end of 2003; and the consumer prices index, CPI, target 2%, thereafter.) This means that the City and other forecasters have believed and continue to believe the MPC’s commitment to fighting inflation.

This is important since if inflation expectations are moderate, then wage claims and price increases will be less severe than they would otherwise be. So controlling inflation expectations is crucial to controlling inflation itself.

Since 1996, the Bank of England has carried out a quarterly survey of economic forecasters from the City and independent think-tanks. This assesses how they think inflation will develop in the future, and the summary results are published in the Bank’s quarterly Inflation Report. 

Because the survey asks respondents for their views on the probability that inflation will be within a variety of different ranges – for example, between 1% and 1.5%, 1.5% and 2%, etc. – it can be used to assess uncertainty about future inflation.

We have had access to individual responses to the Bank’s survey for the period 1996-2005, analysis of which shows how the MPC, newly established following Labour’s victory in the May 1997 general election, quickly obtained credibility.

UK uncertainty about the prospects for inflation has been consistently below US levels

Our survey-based measures of uncertainty extend the evidence on credibility presented in Figure 1. Figure 2 shows how uncertainty about inflation prospects two years ahead was sharply reduced after an initial period of learning and gaining credibility on the commitment of the MPC. It has been remarkably undisturbed since the turn of the century and, perhaps more remarkably, it has been undisturbed throughout 2008.

Click here for Figure 2

Comparisons with a similar source of data on US inflation expectations show that after this initial credibility-gaining period, UK uncertainty about inflation prospects has been below the US level.

This provides further evidence that "inflation targeting has helped to confer tangible benefits," as argued by the Governor of the Bank of England in his 2005 Mais lecture. He cited the falling volatility of expected UK short-term nominal interest rates over this period, relative to the United States, as evidence that inflation expectations are better anchored under inflation targeting than they were before.

Although the article describing our research findings (which is published in the Economic Journal) is based on a period that ends in November 2005, Figures 1 and 2 use more recent information (up to the end-October survey summarised in the Inflation Report published on 12 November). They show no diminution in forecasters’ confidence in the MPC’s ability to control inflation.

Publication details

The paper on which this summary is based was published as ‘Uncertainty and Disagreement in Economic Prediction: The Bank of England Survey of External Forecasters’ by Gianna Boero, Jeremy Smith, and Kenneth Wallis, in the Economic Journal 118 (July 2008). Our summary is updated from the Bank of England's latest figures, published on 12 November 2008.

The authors

Gianna Boero, Jeremy Smith, and Kenneth Wallis are respectively Associate Professor and Professor of Economics and Emeritus Professor of Econometrics at the University of Warwick