Two years ago we presented a model for the rate of inflation in the UK and a prediction for 2010-2020. Actual rate in 2011 and 2012 was very close to the predicted one as Figure 1 demonstrates. There is no change to the model and we foresee another ten years of a reactively large (CPI) inflation rate in the UK – nearly 3% per year. In 2013, the predicted rate is 2.9%.
According to our concept, the original paper was published by the Euro Area Business Cycle Network, there exists a long-term equilibrium link between price inflation, CPIt, unemployment, ut, and the rate of change of labour force, lt=dLF/LFdt. We follow up our predictions for many counties in this blog. The UK is one of the world biggest economies with a relatively good statistics started chiefly from 1973. It is a major challenge to model inflation in the UK using our approach.
There is a structural break in the link between three defining variables in 1985, which is purely artificial and induced by the change in measurement units and definitions. Accordingly, we have to distinguish two periods to fit observations: before and after 1985:
CPIt = 1.0lt + ut - 0.046; t>1985
CPIt = -1.0lt -1.7 ut + .025; t<1985 (1)
For both periods, inflation does not lag behind unemployment and lt. Figure 1 presents the observed and predicted CPI curves, all variables were obtained from the OECD database in 2013. All in all, the predictive power of the model is good and timely fits major peaks and troughs. The change from negative to positive linear coefficient in 1985 needs a special explanation. But such effects were observed in other developed countries as well.
The NSO's labour force projection helps to predict the future inflation. Since the inflow of new employees is still positive, lt >0, and the rate of unemployment does not foresees any dramatic decline in the long run one can be sure that inflation will be positive in the near future, as Figure 2 predicts.
Figure 1. The predicted and measured rate of consumer price inflation (CPI) in the UK.
Figure 2. The predicted rate of CPI inflation in the UK between 2008 and 2020 estimated from the labour force projection by the NSO.