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Outgoing Bank of England chief Mark Carney is leaving his successor with a mystery to puzzle over.
As Andrew Bailey takes over from the Canadian in March, he’ll find officials at the U.K. central bank closely studying why inflation isn’t as strong as labor costs and import prices would suggest it should be. The matter was so perturbing for policy makers at Carney’s final decision that, even after an in-depth discussion, they pledged to keep working at it in coming months.
In the meantime, the Monetary Policy Committee added a new caveat to its guidance on interest rates, placing “relatively weak” prices on its list of reasons why more support for the economy could be needed in future.
Officials acknowledge that their problem could be part of the wider global phenomenon that has left counterparts similarly confounded. The European Central Bank’s struggle to get inflation back to its goal despite unprecedented stimulus unleashed on the euro region is a key focus of the strategic review the Frankfurt institution has just begun. That could result in a tweak to the institution’s goal, or method of measuring inflation, both of which could be longer-term options for the U.K. if the government deems its necessary.
“We could end up in a similar position to the rest of the world where we are stuck in a low inflation, low growth environment,” said Sanjay Raja, a U.K. economist at Deutsche Bank AG in London. “It’s becoming more of a concern going forward given how fast inflation has fallen since it peaked a couple of years ago.”
With inflation in the U.K. having just dropped to the lowest in three years, and with core prices -- stripping out energy, food and tobacco -- also showing sudden weakness, BOE policy makers are now contemplating an outlook where they will undershoot their 2% target all through next year.
That’s particularly troubling given the jobs market is historically tight, with unemployment at the lowest since the 1970s and wage growth running above 3% for almost a year and a half.. It suggests traditional models of the relationship between inflation and the joblessness may need revisiting.
“The fact is you have unemployment sitting below the Bank’s equilibrium unemployment rate for some time now, with no evident signs of inflationary pressure -- particularly in services,” Raja said. “So the belief that inflationary pressures may come eventually is starting to look doubtful.”
As officials put the debate in an international context, they could find the U.K. is actually in a better position than many of its peers, particularly once next month’s budget is factored in. There’s still a risk that inflation could pick up as the central bank has expected for years.
“We have extremely tight labor markets here, we have a fiscal boost which is going to be appearing this year and we have changeover at the central bank but the expectation of still supportive monetary policy,” Lucy Macdonald, chief investment officer at Allianz Global Investors, said in an interview with Bloomberg TV last month. “All of those things suggest more of a move to the upside and more pressure within a very inflation-prone economy.”
Still, the phenomenon is viewed as as long-term issue, meaning that even an expected energy-driven rebound in January inflation data, due to be released on Feb. 19, will not shift the view that the overall outlook for price gains remains subdued.
As they start exploring the matter in depth, the MPC have said they will be particularly looking at the issue of companies’ margins to explain the disconnect between prices and costs.
Officials noted that “consumer-facing companies’ mark-ups of prices over costs appeared to have declined,” and that while this trend may have limited room to run, “weak demand could lead companies to continue to raise prices by less than the increase in their costs.”
Shrinking margins have long been a theme in U.K retail, particularly among supermarkets who have kept a lid on price gains because of intense competitive pressures. That’s meant higher input costs from commodities, or pay increases thanks to the national living wage, haven’t translated into price inflation.
In a speech in December, Jonathan Haskel, a BOE official already pushing for a rate cut, identified the same issue, and said with competition strong, its seems unlikely firms would raise prices, preferring instead to keep a lid on wage increases.
Policy makers also suggested that margins are dropping thanks to more structural and technological changes in retailers’ models, or that other factors, such as slowing increases in rents, may be to blame.
Whatever explanation officials settle upon will have big implications for policy.
“Identifying particular factors driving recent trends could have implications for the extent to which monetary policy might need to respond in order to return inflation sustainably to the target,” the BOE said.
--With assistance from Deirdre Hipwell.
To contact the reporters on this story: David Goodman in London at firstname.lastname@example.org;Craig Stirling in Frankfurt at email@example.com
To contact the editors responsible for this story: Paul Gordon at firstname.lastname@example.org, Brian Swint, Lucy Meakin
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