Understanding UK inflation: the role of openness

In this paper, inflation dynamics in the United Kingdom are re-examined. Standard specifications of traditional Phillips curves have tended to overpredict inflation in the recent low inflation, low unemployment era in the United States, the United Kingdom and the euro area. This has stimulated the 'New Phillips Curve' approach, which has had success for the United States and the euro area, both less open economies than the United Kingdom. The paper is divided into two parts. First, the overprediction problem is documented for the United Kingdom, and an attempt is made to solve it in a traditional Phillips curve framework by introducing external shocks (terms of trade shocks or domestically generated inflation). This does not fully solve the problem. It is argued that there is a further misspecification problem with traditional Phillips curve estimates, due to the presence of the regime changes and structural change in the UK economy. Second, 'New Phillips Curve' estimates are examined. They perform badly; real marginal cost is not significant in the baseline specification. The relationship between marginal cost and inflation disappears in the mid-1980s. When a labour share measure is used, real marginal cost becomes significant, but goodness of fit based on fundamental inflation remains poor. The 'New Phillips Curve' model is then extended to allow for open economy influences, taking into account imported intermediate goods. This is found to mitigate substantially the breakdown of the relationship between inflation and marginal cost. Fit improves, but a tendency to underpredict and then overpredict inflation remains. Finally, the open-economy measure of marginal cost is decomposed. The wage mark-up component is important and highly countercyclical. Relative price movements, of taxes relative to overall prices and of imported intermediate goods relative to wages, are found to have been a negative influence on marginal costs over the 1990s. Understanding likely future developments in these relative prices could contribute to the assessment of prospects for marginal costs and the pressures on inflation.