The statement accompanying last week’s UK rate cut referred to elevated inflation expectations as posing an upside risk to medium-term inflation prospects. However, some economists argue that survey-based expectations measures provide little information about future inflation, with activity indicators playing a much more significant role.

To test such claims, I examined the statistical relationship between consumer price inflation one and two years ahead and measures of confidence and inflation expectations from the monthly European Commission surveys of households and manufacturing firms. The inflation measures are shown in the first chart below. (They are based on percentage balances of households and firms expecting higher prices.)

To summarise the results, inflation expectations of both households and manufacturing firms are useful for forecasting CPI inflation one year ahead but lose power at the two-year horizon. When combined with confidence measures, manufacturing inflation expectations retain significance at the one-year horizon but household expectations contain little additional information.

These results argue for caution in cutting rates any further until business inflation expectations subside but the MPC should be less exercised by high household expectations, at least while consumer confidence is weakening and there is limited evidence of pass-through to wages.

The MPC will use this week’s Inflation Report to signal its intentions. A useful summary measure of its bias is the mean inflation forecast two years ahead assuming unchanged rates. The November forecast, at 1.74%, was further below the inflation target than in any previous Inflation Report since the MPC’s inception, a clearly dovish signal – see second chart.

With Bank Rate down by 50 bp since November, and sterling’s effective rate 7% weaker, the new forecast is likely to be much closer to the 2% target. The extent of any negative deviation will indicate the Committee’s residual easing bias following last week’s cut.