The Bank of England has identified a rise in inflation expectations as a key risk in each of the last three Inflation Reports. The Bank's latest inflation attitudes survey suggests that, at least among UK households, this risk is crystallizing, with two- and five-year expectations moving significantly higher in addition to the more volatile year-ahead measure – see first chart.

Interest rate doves, therefore, have shifted tack, arguing that rising expectations matter only to the extent that they influence wage- and price-setting. In a recent speech, the MPC's Adam Posen claimed that "observed recent movements in short-term household inflation expectations will not affect wage bargaining, and so will not push up inflation outcomes". Dr Posen expects pay growth to remain stable in 2011 and 2012.

Private-sector regular earnings (i.e. excluding bonuses) rose by 2.1% in the year to January. This increase, however, reflected an average wage settlement of only 1.7% during 2010. According to pay research firm Incomes Data Services, the median settlement level moved up to 2.9% in both manufacturing and private services in the three months to January. If sustained, this implies a significant rise in earnings growth during the course of 2011.

The second chart compares annual growth in regular earnings with a 12-month moving average of settlements. The difference is "pay drift" – the additional boost to earnings from pay progression, interim adjustments and restructuring outside the annual review. (Pay drift also reflects changes in average weekly hours, which fell during the recession but recovered in 2010.)

If the median settlement level remains at 2.9%, and pay drift returns to its 2005-07 average of 0.7 percentage points, annual growth in private-sector regular earnings will rise to 3.6% by the end of 2011. If, in addition, bonuses pick up in response to stronger productivity and corporate profits, total pay expansion could reach 4% – too high for achievement of the 2% inflation target over the medium term. (Private-sector productivity is unlikely to grow by more than 2% per annum on average while unit labour costs probably need to rise by less than 2% pa to meet the target, allowing for imported inflationary pressures.)