Oil shocks amplify UK inflation above 3.1% threshold
A new Bank of England paper identifies inflation thresholds in the UK, finding that dynamics change once year-on-year CPI inflation rises above 3.1 percent. Global oil supply shocks have substantially larger effects in high-inflation regimes.
Inflation's tipping points
The paper applies a Self-Exciting Threshold Vector Autoregression (SET-VAR) model to identify UK inflation thresholds and state-dependent dynamics.
It finds that inflation dynamics change once year-on-year CPI inflation rises above approximately 3.1 percent in post-1989 samples, and 3.5 percent in samples extending back to 1976.
Oil price increases, driven by global oil supply news shocks, generate substantially larger and more persistent effects on UK CPI inflation when in high-inflation regimes.
Counterfactual analysis indicates that much of this amplification reflects stronger second-round effects operating through more responsive household inflation expectations.
The strongest amplification occurs when elevated inflation coincides with tight labour markets, suggesting an interaction between inflation and labour market conditions.
Beyond linear models
The research is motivated by the 2022–23 inflation surge, which highlighted that shock effects can be state-dependent, particularly with elevated inflation and tight labour markets.
Policymakers require tools to capture these non-linear dynamics.
The SET-VAR model, an extension of existing frameworks, estimates UK inflation thresholds endogenously and captures regime-dependent dynamics.
It uses an oil supply news shock series and incorporates survey measures of household inflation expectations.
An extended specification further distinguishes between periods of tight and slack labour markets, yielding four inflation–labour market regimes for a nuanced assessment.
Expectations amplify the pain
This paper offers a crucial tool for understanding how external shocks transmit differently across economic regimes, particularly in volatile times.
By quantifying the role of household expectations and labour market conditions, it explains why recent inflationary episodes had such amplified effects.
For policymakers, this underscores the necessity of considering non-linear dynamics and the state-dependent responsiveness of expectations when formulating monetary policy.