And quite a bit of the high-frequency variation in the CPI arises from things that don’t directly affect nominal pay – taxes and import prices, for example – but do affect its real value. When taxes or import prices go down, real incomes rise (and viceversa). This produces a negative near-term correlation between inflation and real income growth; controlling for nominal pay, there is also a clear negative correlation between surveyed inflation expectations and household optimism (Chart 11). Chart 10 Consumer confidence has strengthened in US, Euro area  Source: European Commission, Conference Board  Chart 11 Surveyed household inflation expectations, optimism negatively correlated  Source: ONS, Gfk/EC, Barclays Capital. Note: * after controlling for current wage growth. These results might give one pause about whether the “delayed consumption” channel really is that important, or whether the surveys of inflation expectations are really telling you about what matters. The link between consumption and real interest rates is not an empirically strong one 13. Other measures of inflation expectations – for example from financial markets – are less depressed (Chart 9). A recent study using US data found that, even controlling for nominal income, there was no correlation across individuals between their reported expectations of inflation and spending 14. At the very least, the results are a reminder not to consider current inflation or survey measures of household inflation expectations on their own, but in the context of what’s happening to incomes and interest rates.
Of the 24 instances in which prices have fallen for more than one year, all but four – two in Japan, two in Bahrain – have occurred in developing countries with pegged exchange rates. In fact, there’s a general tendency for changes in inflation to be more persistent when the exchange rate is fixed. At least when policy has a degree of credibility, deviations of inflation tend to peter out relatively rapidly in countries with independent monetary policies. In part this may reflect precisely the freedom to ease policy that, if it’s not ruled out by an exchange rate peg, may nonetheless be compromised by the zero lower bound. At least until it began to conduct QE, almost a decade after the economy began to turn down, Japan was clearly in this position. But I suspect it’s also because, when there’s an independent and credible policy, the risk that inflation expectations become “de-anchored” from any target is lower to begin with. As I say, for us that target is 2%, not zero. Even if the current undershoot is due mostly to the effect on the level of the CPI of the sharp drop in commodity prices, and should therefore have only passing effects on its rate of growth, our central expectation is that inflation will still be below target in a year’s time.