What does the evidence suggest about central bank reaction to rises in inflation expectations?
We have used household inflation expectations, as these are most important in spreading actual inflation in the wider economy, for the US, UK and eurozone. Charts e,f and g show that there is a very strong correlation between changes in official interest rates and in inflation expectations. In the US, the Fed’s rate setting during the last 5 years has been to encourage price inflation expectations. In other words, Fed rates have been below inflation expectations. Currently, the Fed is once again cutting interest rates even though household price inflation expectations remain high. This is not so the case for the UK, where there is a closer link between actual interest rates and inflation expectations. But the UK has still cut official interest rates even though inflation expectations are rising, though rates are coming down from a high level. Some argue that labour market trends suggest that inflation will be contained, due to high levels of immigration and greater participation in the
