A sideways look at economics

Thanks to the credibility of the Bank of England, consumer expectations do not jump around in the wake of shocks. The board at Leicester City FC should take note.

One of the key questions for the UK outlook is: how far will the rise in inflation that is attributable to the weaker exchange rate become embedded in inflation expectations, influencing wage growth and potentially requiring tighter monetary policy?

In our global model, UK inflation follows a short-run, expectations-augmented Phillips curve, where inflation (π) evolves according to:

where expected inflation is a function of lagged inflation and the inflation target:

And surprise inflation is a function of the lagged output gap (the amount of slack in the economy) and an inflation shock μ:

The question about expectations is a question about α. With a credible monetary authority, α ought to be low – in other words, after any shock to inflation, it should come quickly back to target if the central bank is credible. The evidence in the UK suggests that α is indeed low, at around 5% in an equation that uses data back to 1989, having been as high as 30% back at the end of the 1990s. That implies inflation will get 95% of the way back to target within a year after any shock – suggesting the MPC can be reasonably confident that the impact on inflation of higher import prices will be relatively short-lived. That is one reason why we believe the MPC will ‘look through’ the current bout of rising inflation, and not change interest rates.

But there is a current example of a much less credible authority: the board of Leicester City FC. Having won the Premier League last season, from a starting position as a 5000:1 outsider, they have now sacked their manager Claudio Ranieri, reflecting a much worse position in the league table this season.

The sacking reflects expectations that have adapted far too easily, on the part of the board and possibly the players (though perhaps not the fans). Leicester’s average end-of-season position since WWII has been 21st, implying they are typically fighting relegation from the top flight. The standard deviation is 10 places, implying they can expect to finish mid-table in a good year, and be relegated in a bad year. The exceptional year that was 2015/16 was a once-in-a-lifetime event. It is not reasonable to expect that performance to be repeated.

A reasonable expectation, based on an autoregressive model of deviations from a Hodrick-Prescott trend, would place Leicester in 10th position at the end of this season. They are currently languishing in 17th place, but that is comfortably within one standard deviation of their expected performance – perfectly normal, in other words.

There is a lesson for all managers here – whether football managers or fund managers. A strong performance in one season can be a mixed blessing, particularly if you attribute too much of it to judgement rather than to luck. Expectations adapt, sometimes mistakenly. And the mean reversion that is likely in the following season can be very painful. Expectations, like everything else, have to be managed.