Inflationary pressures often strengthen in the early stages of economic slowdowns, for at least four reasons. First, output is typically above its trend or potential level when the slowdown begins; a fall beneath trend is needed to stem inflation momentum. Secondly, productivity tends to slow along with output, as employers are initially reluctant to cut workforces, implying faster growth in unit labour costs. Thirdly, monetary expansion often remains strong well into an economic downswing; ample liquidity accommodates price increases and may boost inflation expectations. Fourthly, a slowing economy may be associated with a fall in the exchange rate, putting upward pressure on import prices. This last effect can be particularly important if world output is still growing solidly, pushing up prices of tradable goods and raw materials.

Forecasters who expect the current inflation overshoot to prove short-lived, implying scope for the Monetary Policy Committee to continue to reduce Bank rate, emphasise the likely moderating impact of a widening negative “output gap”. Estimates of the gap are never uncontroversial but even inflation pessimists concede that output is unlikely to be far above its potential level at present. OECD calculations are probably representative of the consensus, suggesting a positive deviation of just 0.1% in the first quarter. Forecasters expect GDP to grow by just 1.1% in the year to the fourth quarter of 2008 and by 2.1% in the subsequent year, according to Consensus Economics. Based on the OECD’s estimate of potential growth of 2.7% pa in 2008 and 2009, this implies a negative output gap of 1.3% by this year’s fourth quarter and 2.0% by late 2009.

The impact on inflation of rising slack may, however, be outweighed by the three other factors cited above. Import prices soared 10.4% in the year to February, the largest annual gain since 1993, following sterling’s expulsion from the ERM. With the effective rate down 3% since February and global commodity prices rising further, the pick-up is likely to continue. Monetary expansion also remains robust, despite tighter credit conditions: M4 rose 11.9% in the year to March and has outpaced nominal GDP by a cumulative 22% over the last three years – slightly greater than the peak differential reached in the late 1980s Lawson boom. Meanwhile, productivity is slowing as the economy cools: aggregate hours worked rose an annual 1.0% in the three months to February, up from 0.4% a year earlier, despite a fall in GDP growth over the same period.

To investigate these issues further two models were estimated, the first explaining inflation by its own history, GDP growth, the output gap and indirect tax changes, the second also incorporating import prices and M4 expansion. The price measure used was the domestic expenditure deflator – covering investment and government spending as well as private consumption – and the models were estimated on data back to the early 1970s, when sterling was floated. Forecasts were generated based on assumptions about the inputs. Specifically, GDP growth and the output gap were assumed to follow the path described above, import prices to stabilise from the second quarter of 2008 and M4 expansion to moderate steadily, reaching an annual 6% by late 2009.

The results are shown in the chart. The simpler model excluding import prices and M4 suggests annual inflation will fluctuate around 3% during 2008 before embarking on a sustained decline in 2009 and beyond, reflecting the restraining impact of a widening negative output gap. By contrast, the extended model forecasts a further sharp rise in inflation over the coming year, with recent import price gains and excessive M4 growth offsetting the output gap effect until late 2009. The extent of the near-term increase is probably exaggerated, since the estimation period includes the 1970s and 1980s, when monetary policy had less credibility and inflation expectations were therefore more volatile. Even allowing for some overstatement, however, the forecast suggests inflation will rise by further and for longer than most economists expect.

Component-level analysis of the consumer price index confirms the possibility of an extended inflation overshoot over coming months. Energy suppliers have raised electricity and gas tariffs by 14% since the start of 2008, reflecting wholesale price rises during 2007. One-month sterling forward prices of Brent crude and natural gas have climbed 33% and 24% respectively since the fourth quarter. A further rise in household tariffs looks inevitable if these levels are sustained; a 10% gain would ensure annual CPI inflation moves well above the 3% upper target limit later in 2008, sustaining the breach for several months. Additional risks stem from pass-through of recent food and import price increases and a possible effort by retailers to rebuild margins.

The above analysis questions consensus hopes of a steady progression lower in Bank rate over the remainder of 2008. Further cuts are possible but are likely to require dramatically weaker economic news. The MPC will also need to calibrate any action against money and credit market developments; a continuation of the recent small improvement – particularly a fall in LIBOR / Bank rate spreads – would substitute for policy easing. Indeed, a rapid normalisation of market conditions could leave the current level of Bank rate looking too low relative to prospective inflation.