How will spare capacity in the economy affect inflation?

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Published on 12 October 2020
The economy is likely to have spare capacity as a result of the Covid-19 pandemic. A number of factors will influence how that spare capacity affects inflation, including the frequency of price changes across different sectors.

The output of the UK economy fell by more than 20% in the first half of 2020 as a result of the Covid-19 pandemic and measures to contain its spread. Although activity has recovered somewhat, the Monetary Policy Committee (MPC) expects the economy’s output to remain below its potential level for some time.

This means the economy will have spare capacity, which tends to put downward pressure on inflation — the rate at which prices go up. But the relationship between spare capacity and inflation may currently be weaker than usual for a few reasons.

First, inflation tends to be less responsive to spare capacity when demand is weak. In the economics world, this is known as a ‘non-linear Phillips curve’. This could be because firms are less able to increase demand for their product by lowering prices when consumers are less willing to spend.

Second, uncertainty about the economy may make prices less responsive to spare capacity. Firms might expect the current shock to be temporary and choose not to change prices to avoid having to reverse the changes when conditions improve.

Finally, different sectors change their prices at different frequencies. Businesses selling services tend to change their prices less often than those selling goods (Chart A). And it is consumer services — particularly hospitality and entertainment — which have been hardest hit by the Covid-19 pandemic. As a result, any spare capacity in these sectors may have a smaller, or more delayed, impact on inflation.

For these reasons, the MPC expected the impact of spare capacity on inflation to be a little smaller than normal in their August 2020 Monetary Policy Report projections.

Chart A Services prices adjust less frequently than goods prices

Proportion of prices changing each month in the CPI basket (a)

Proportion of prices increasing and decreasing each month for goods and services from 2014 to 2020, shown in per cent.

Footnotes

Sources: ONS and Bank calculations.

(a) Prices of locally collected items only, including sales. Data are not seasonally adjusted. This work was produced using statistical data from ONS. The use of the ONS statistical data in this work does not imply the endorsement of the ONS in relation to the interpretation or analysis of the statistical data. This work uses research data sets which may not exactly reproduce National Statistics aggregates.

This post was prepared with the help of Marilena Angeli, Lee Robinson, Rupert de Vincent-Humphreys and Boromeus Wanengkirtyo.

This analysis was presented to the MPC in July 2020.

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