There exists a long-term equilibrium link between price inflation, CPIt, unemployment, ut, and the rate of change of labour force, lt=dLF/LFdt, as was demonstrated in this blog for many countries. The UK is one of the world biggest economies with a relatively good statistics started chiefly from 1973. It is a major challenge to model inflation in the UK using our approach.
We have to separate two periods to fit observations: before and after 1985:
CPIt = 1.0lt + ut - 0.046; t>1985
CPIt = -1.0lt -1.7 ut + .025; t<1985 (1)
For both periods, inflation does not lag behind unemployment and lt. Figure 1 presents the observed and predicted CPI curves, all variables were obtained from the OECD database in 2011. All in all, the predictive power of the model is good and timely fits major peaks and troughs. The change from negative to positive linear coefficient in 1985 needs a special explanation. But such effects were observed in other developed countries as well. A labour force projection could help to predict the future inflation. Since the inflow of new employees is still positive, lt >0, and the rate of unemployment does not foresees any dramatic decline in the long run one can be sure that inflation will be positive in the near future.
Figure 1. The rate of CPI inflation in the UK, predicted and measured.
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