Inflation can become a self-fulfilling prophecy
Managing inflation expectations will be a key challenge in the coming year, says Daniel Mahoney
When does a prophecy become a reality? Since the 1970s, it has been conventional wisdom that the key to controlling inflation is controlling inflation expectations – but outside economics circles it is not often appreciated why. However, managing expectations increasingly looks like a key challenge for the coming year. So why must they be managed, and what does this mean in practice?
For the last half century most economists have agreed monetary policy is best run according to strict rules, rather than by giving central banks unlimited discretion to react to events. A number of different rules were tried between the 1970s and 1990s – incomes policy, money targets, exchange rates targets – but from the 90s, inflation targeting became the main aim of much of the western world. Central banks have aimed for low, stable inflation, typically of around 2 percent. This level allows businesses and consumers alike to plan for the future. Central banks dislike deflation, which creates difficulties owing to the ”money illusion”, whereby people focus on the face value of money rather than its purchasing power. This means they won’t accept wage reductions, which ultimately can lead to higher unemployment in a deflation scenario. Conversely, when people expect rapid price rises, they tend to front-load their spending in order to secure necessities at the current, lower, rate. They also demand salary increases so they can afford them in the future. Meanwhile, businesses do the same – bulk-buy what they need, and raise their own prices to secure more funds. This creates the classic “wage-price spiral”, and so fears of inflation quickly become that self-fulfilling prophecy. Thus, if central banks lose control of inflation expectations, they have to respond very aggressively – through hiking interest rates – in order to get inflation under control again. Otherwise they face losing credibility, something economists accept is “easy to lose, and hard to regain.” Indeed, we saw a process of aggressive interest rate increases to establish central bank credibility in the late 1970s and early 1980s in both the UK and the US.
Cause for concern?
So why is this a particular potential problem for the UK now? Since the Bank of England gained independence in 1997, inflation expectations have been fairly “anchored” – that is, they have been close to the Bank’s two per cent target. However, surveys show long-term consumer expectations are now much higher compared to the pre-pandemic average. So is this cause for concern?
The short answer is yes. Firstly, recent experience of high inflation can make anchoring harder. This is especially relevant as we have recently – back in 2022 – seen inflation as high as 11 percent, owing to post-pandemic shortages and energy prices rising. Second, evidence suggests the problem of expectations de-anchoring is exacerbated when the headline rate is over 2.75 percent – and the UK’s rate currently is. Thirdly, the UK is exposed to higher headline inflation rates we have a heavily service-skewed economy. Over the past twenty years, our headline rate of inflation has been 0.75 percentage points higher than, for example, the less services-orientated Eurozone.
Of course, it is not just consumers who have expectations of inflation rates, the financial markets do too. Currently, the markets are taking a more sanguine view of longer-term inflation, as shown by the inflation swaps market. Some believe that this is more relevant, as these expectations directly affect the financial ecosystem. Consumers, by contrast, are more easily influenced by short-term inflation spikes – which markets tend to look past – and prices in shops. But ultimately, it doesn’t actually matter what is influencing consumers, it matters what they think. Around 60 percent of GDP is made up of consumer spending. If they have high expectations, this has implications. So who is right?
The last time there was a major discrepancy between market and consumer inflation expectations was back during the global financial crisis. But then the position was reversed; market expectations soared, whilst consumers’ actually fell. That time, it was consumers who were proved right. So will they be right again? It’s worth considering – not least because this has profound implications for monetary policy.
We are currently in an interest-rate-cutting cycle, and many are hoping this will continue throughout 2026 – making borrowing cheaper, and acting as a spur to business. But unless the Bank of England sees tangible evidence of inflation expectations coming down, it will be very reluctant to cut rates too far or too fast, and those expectations will act as a brake on the economy. Ultimately, to borrow a phrase, our main economic fear for 2026 may well be fear itself.
Daniel Mahoney is UK economist at Handelsbanken