Economists are raising the alarm over a critical challenge facing the UK economy in the coming year: the risk of inflation becoming a self-fulfilling prophecy. The central issue hinges not just on current price rises, but on what businesses and consumers expect inflation to be in the future.
The Psychology of Price Rises: Why Expectations Matter
For decades, a core principle of monetary policy has been that controlling inflation is fundamentally about controlling the public's anticipation of it. When people and companies brace for rapid price increases, their behaviour changes in ways that can make those very rises a reality.
Consumers, fearing higher costs tomorrow, may bring forward purchases to lock in today's prices. Simultaneously, they demand higher wages to maintain their purchasing power. Businesses, anticipating increased costs for supplies and labour, pre-emptively raise their own prices and stockpile goods.
This dynamic creates the notorious 'wage-price spiral', where fears of inflation trigger the actions that cause it. If a central bank's credibility on controlling prices wavers, it can be forced to impose aggressively high interest rates to re-anchor expectations, as seen in the UK and US in the late 1970s and early 1980s.
Why the UK is Particularly Vulnerable Now
Since the Bank of England gained independence in 1997, long-term inflation expectations have remained steadily 'anchored' close to its 2% target. However, recent surveys indicate a worrying shift.
Long-term consumer expectations are now significantly higher than the pre-pandemic average. Several factors make this de-anchoring a tangible threat:
- Recent Experience: The memory of inflation hitting 11% in 2022 makes it harder for the public to believe it will swiftly return to low levels.
- Current Headline Rate: Research suggests expectations begin to drift when inflation exceeds 2.75%, a threshold the UK currently surpasses.
- Economic Structure: The UK's service-heavy economy has historically produced inflation rates around 0.75 percentage points higher than less services-oriented regions like the Eurozone.
A Clash of Forecasts: Markets vs. The Public
An intriguing divergence has emerged between different groups forecasting inflation. Financial markets, gauged by instruments like inflation swaps, currently take a more relaxed view of long-term price pressures.
Consumers, however, are more influenced by short-term spikes and the prices they see on shop shelves. With consumer spending constituting around 60% of UK GDP, their expectations hold immense practical weight, regardless of what influences them.
The last major discrepancy between market and consumer views occurred during the 2008 financial crisis. Then, it was the public's lower expectations that proved correct. This historical precedent adds significance to the current gap in outlooks.
Implications for Interest Rates and Growth in 2026
This debate over expectations has direct consequences for everyone from homeowners to business owners. The UK is in an interest-rate-cutting cycle, and many hope for further reductions through 2026 to stimulate borrowing and investment.
However, the Bank of England faces a dilemma. If it does not see clear evidence that inflation expectations are falling back towards its 2% target, it will be very reluctant to cut rates too far or too fast. Persistently high public expectations would, therefore, act as a brake on the economy, limiting the scope for cheaper credit.
In essence, the UK's main economic hurdle for 2026 may not just be inflation itself, but the pervasive fear of it. Managing this psychology will be a pivotal task for policymakers in the months ahead.
Analysis by Daniel Mahoney, UK economist at Handelsbanken.
