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Measuring Inflation Expectations in Interwar Britain

Journal: Economic History Review

Date: 20230801

Author: Lennard, Jason; Meinecke, Finn; Solomou, Solomos

Abstract:
What caused the recovery from the British Great Depression? A leading explanation--the 'expectations channel'--suggests that a shift in expected inflation lowered real interest rates and stimulated consumption and investment. However, few studies have measured, or tested the economic consequences of, inflation expectations. In this paper, we collect high-frequency information from primary and secondary sources to measure expected inflation in the United Kingdom between the wars. A high-frequency vector autoregression suggests that inflation expectations were an important source of the early stages of economic recovery in interwar Britain.

Link: Google Scholar

Key Findings

Shift in Inflation Expectations

A significant shift in inflation expectations occurred in early 1933, marking a key turning point in Britain's economic recovery from the Great Depression

Policy Impact

The combination of leaving the gold standard, implementing "cheap money" policy, and setting price level targets gradually shifted expectations from deflationary to inflationary

Economic Recovery

Inflation expectations accounted for 69% of the 5.6% GDP growth between April 1933 and January 1934, playing a crucial role in Britain's recovery

Measuring Inflation Expectations

  • Shows the weights given to different measures in constructing aggregate inflation expectations
  • Quantitative news had the highest weight (0.68), followed by term premium (0.62) and commodity prices (0.39)
  • Demonstrates the multi-faceted approach to measuring historical inflation expectations

Correlation Between Different Measures

  • Visualizes the correlation between different measures of inflation expectations
  • Strongest correlation (0.24) exists between quantitative news and term premium
  • Shows how different measures capture distinct aspects of inflation expectations

Structural Breaks in Expectations

  • Illustrates the timing of major structural breaks in different measures of inflation expectations
  • Shows convergence of measures indicating a significant break in January 1933
  • Demonstrates the gradual nature of the regime change in British monetary policy

Contribution and Implications

  • First comprehensive measurement of inflation expectations in interwar Britain using multiple data sources
  • Demonstrates how policy regime change was generated gradually rather than immediately after leaving gold standard
  • Shows importance of both domestic policy and international factors in shaping inflation expectations

Data Sources

  • Weights Chart: Constructed using data from Table 3 showing principal components analysis weights
  • Correlation Chart: Based on Table 2 showing correlations between different measures of inflation expectations
  • Structural Breaks Chart: Derived from Table 4 showing the timing of structural breaks in different measures