One relevant area of active research is why inflation expectations seem to have been so stable over the past decade – the period of the so-called Great Stability. One supposition is that well anchored expectations reflect the introduction of credible inflation targeting regimes – people have understood that central banks are focussed on keeping inflation low, and will take action to reduce it if necessary. Another view is that people’s expectations reflect simpler rules-of-thumb based on actual inflation rates: if that’s the case stable expectations could simply be due to the fact that, over the past decade and a half, inflation itself has been low and stable. These alternatives are hard to distinguish empirically, on the track record so far. But it may make a great deal of difference which is true when it comes to forecasting what will happen to inflation expectations, if we have to deal with a future in which inflation is likely to be much more variable. If people put their trust in the regime, or a “credible central bank”, they are unlikely to revise their expectations about future inflation much, especially if the nature of the current situation is well and honestly explained, including how long it will take inflation to return to target. But if they forecast future inflation using simple rules of thumb based on past actual inflation rates, anything that dislodges inflation from target will affect what people use as their best forecast for future inflation.
On inflation, there’s only around a one-in-four chance that inflation will lie close to the central projection – that is, between 2 and 2.5%, but a more than one-in-three chance that it will be above 2.5%, and an almost 1 in 5 chance that it will be below 1.5%. As this illustrates, one implication of widening the fan charts has been to increase the perceived risk of some rather unattractive outcomes – either that growth slows too sharply, or that inflation does not return to target following an upward spike. In particular both the upper tail of the inflation forecast – where inflation expectations might well come seriously adrift – and the bottom tail of the output forecast – where there could be a risk of setting off a deflationary spiral – are to be avoided, if at all possible. In this situation, it is not unreasonable to suppose that the Committee will be more sensitive than usual to changes in the balance of risks. Since neither of the key risks to the outlook is readily modelled or measured, monitoring them is not going to be easy. But we do have a framework for thinking about them, and a variety of timely surveys and indicators which can act as early warning signs. On the impact of the credit shock, we will be monitoring our new quarterly credit conditions survey of lenders, and special surveys from our own Agents, as well as the full range of indicators of the price and quantity of credit.