Macroeconomic studies argued that this was due to monetary policy’s focus on price stability which caused prices to adjust more slowly (Devereux and Engel (2001), Taylor (2000, 2007), Devereux, Engel and Storgaard (2004)). Empirical studies such as Ihrig et al (2006), found that the exchange rate pass-through to consumer prices in the U.K. had fallen from 0.20 before the 1990s to almost zero thereafter; similar effects were found in other G7 countries with the exception of Germany. 5  The February 2011 Inflation Report (Section 4 and the box on pages 34–35) describe estimates which suggest that import price increases since 2007 have added 4% to 6% to the overall price level. This equates to pass-through of between 66% and 100%. I discussed some reasons for why the degree of pass-through may have been larger or at least faster than predicted by earlier studies in a speech last year (Dale 2010). 6  The analysis presented here is based on the forecast made in February 2009. The extent of the surprise stemming from the degree of exchange rate pass-through in subsequent forecasts reduced more quickly than suggested by this analysis since the MPC learnt from this high pass-through and adjusted subsequent projections accordingly. 7  There are of course many other elements of the MPC’s forecasts which have differed from what was projected. For example, previous Bank analysis (see the box on pages 48–49 of the August 2010 Inflation Report) has highlighted the smaller than expected impact from the weakness of demand.
Many may use simple rules of thumb to form views about future inflation, such as “inflation will be equal to the target”.11 Or they may base their expectations on the views they hear expressed by others or they read about in newspapers.12 Importantly, expectations formed in this way may be relatively sticky.13 Rules of thumb are only changed when they perform poorly over a period of time. Expectations based on the views of others may be updated only occasionally. As such, it may be some time before we see the full effects of the extended period of above target inflation fully reflected in inflation expectations. Second, and more fundamentally, I worry that this binary approach to monetary policy credibility – credible or not credible, anchored or de-anchored – misses the key risk to inflation expectations. Despite some of the more lurid newspaper headlines, I don’t believe that many people think that the Monetary Policy Committee has adopted a secret aim to keep inflation above the 2% target indefinitely. Given that, I don’t find it surprising that when asked, many survey respondents have not significantly raised their expectations of inflation in the medium term. More likely, however, is that some companies and some households may look back at the prolonged period of above target inflation and infer that the Committee has perhaps become more tolerant of deviations of inflation from target. As such, inflation may be expected to return to target more gradually.