A Trendy Approach to UK Inflation Dynamics

Abstract

This paper uses a "trendy" approach to understand UK inflation dynamics. It focuses on the time series to isolate a low-frequency and slow moving component of inflation (the trend) from deviations around this trend. We find that this slow-moving trend explains a substantial share of UK inflation dynamics. International prices are significantly correlated with the short-term cyclical movements in inflation around its trend, and the exchange rate is significantly correlated with movements in the slow-moving, persistent trend. Other variables emphasized in standard inflation models-such as slack and inflation expectations-may also play some role, but their significance varies and the magnitude of their effects is substantially smaller than for commodity prices and the exchange rate. These results highlight the sensitivity of UK inflation dynamics to events in the rest of the world. They also provide guidance on when deviations of inflation from target are more likely to be temporary, and when (and how quickly) a monetary policy response is appropriate.

Keywords: Exchange rate, inflation, Inflation expectations, monetary policy, Phillips curve, slack, UCSV, UK

JEL Classification: E31, E5