Okay, so inflation in the UK is 3 per cent. But do you really believe that? The retail price index, which includes council tax and mortgage payments, is 4.2 per cent – that sounds a little more believable But if you have to drive to work – and the journey takes more than say 20 minutes each way – chances are your monthly fuel bill alone has pushed your personal inflation rate higher than that.
The truth is there are different inflation rates – depending on you who are.
But according to the Bank of England, most of us think inflation is higher than the official figures say.
Back in February we thought inflation was 3.9 per cent, but by March we thought it was 4.9 per cent; at least that is what the Bank of England has found with its latest inflation attitudes survey. And by the way, since fuel has risen so sharply since then, chances are, when the May survey is out, we will find we think it is even higher than that.
Our expectations are pretty pessimistic too. According to a YouGov/Citigroup poll, we expect inflation of 4.1 per cent for the year ahead.
Why does this matter? Well, according to monetary economic theory, to the theories of Friedman and Edmund Phelps, expectation is everything.
It we expect inflation to rise, we expect higher pay increases. If we expect prices to go up we spend more money now, before they go up, creating more demand, and then creating a self-fulfilling prophecy.
Traditional economic theory used to put a lot of emphasis on something called the Phillips Curve – which was supposed to track a trade off between inflation and unemployment. But the monetarists said that if we expect inflation, then our expectation neutralises any economic boosting effect of inflation.
So it is not so much that there is a trade-off between inflation and unemployment, but a trade-off between the difference between actual inflation and expected inflation and unemployment.
By a margin of 70 per cent to 5 per cent, respondents to the Bank of England survey said they believed that the economy would end up weaker rather than stronger if prices started to rise faster. This margin was the widest since the survey began in November 1999.
Capital Economics homed in on this and said it may explain the apparent “break-down of the link between inflation expectations and wages…Alternatively, employees might not have enough bargaining power. Unemployment is rising and firms are under pressure to keep a lid on non-energy costs.”
“In fact,” added Vicky Redwood at Capital Economics, “the high level of inflation perceptions and expectations could ultimately have a strong deflationary effect. No wonder consumer confidence is so low if people think that inflation is 5 per cent, when their pay is rising significantly more slowly.”
It is a similar point to the one we have been making lately, see: Markets tumble again – wage inflation drops – is this more like the 1930s than the 1970s? (12 June) and The great shift – have we diagnosed the wrong economic disease? (9 June)
As for the rate of interest. When asked about the future path of interest rates, 48 per cent expected rates to rise over the next 12 months, compared with 43 per cent in February. Seventeen per cent of respondents expected interest rates to fall over the next 12 months, compared with 20 per cent in February.
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