Inflation uncertainty, inflationary shocks and the credibility of counterinflation policy

Abstract

This paper assesses the contributions of price shocks, general price variability, and the credibility of counterinflation policy to changes in inflation uncertainty in the U.K. Uncertainty is measured by the root mean square error of consumer inflation forecasts. In contrast to the assumptions of much theory, uncertainty is not significantly affected by noise in individual or aggregate inflation rates. Factors which determine policy credibility are more important — the political party in government, the proximity of elections, and, under fixed exchange rates, the rate of inflation itself. However, government initiatives to increase credibility, through incomes policies and monetary targets, have failed to reduce uncertainty.