The UK CPI rate is now down to 1.7% over the twelve months to February 2014, a rambling post follows. It would be easy to point to the falling CPI rate in the UK and the rising CPI rate in Japan, then point and laugh at idiotic UK politicians celebrating falling inflation… my usual cheap gags, in other words.
It’s never that simple, because we still have to care about supply and demand. There is little evidence saying that UK aggregate demand growth has slowed over the last twelve months. There is a lot of evidence that UK aggregate demand is growing faster. Therefore it is something of a challenge that the inflation rate has fallen.
It is possible to argue that holding aggregate demand growth constant the falling inflation rate is mildly positive supply-side news, and we should grasp such news with both hands. This is how 99% of newspaper commentators interpret the inflation data anyway. Keynesians will find some vindication in their view that the inflation rate is related more to the “output gap” than to AD growth, although it comes after six years of UK macro data which generally did the opposite.
Despite some crowing from Tories in the press about the imminent rise of real wages, I see absolutely no indication that hourly wage growth has picked up at all. If anything, wage growth slowed through 2013. It remains hard to get reliable high frequency nominal hourly wage data (see previous post) but I can torture the data to give you this little graph:
The data really is tortured to produce that; I take the series for Average Weekly Earnings Regular Pay and divide by average weekly hours, and then apply a 3-month moving average; using the total pay measure inclusive of bonuses produces an extremely volatile result for hourly wages. Take all this with a pinch of salt. (What do erratic City bonuses imply for stickiness of hourly wages – arguments in the comment section?)
The other supply-side indicator giving me a little doubt about demand-side revival is a slight fall in total hours worked in recent labour market updates. I have said it before, but it is hard to overstate how strong the expansion in the UK labour market has been since 2012. Over the 24 months to October 2013, total hours worked grew 5%. There is no period of employment growth this strong since the Lawson boom in the late 80s. The survey evidence for UK employment this year is looking good so there is hopefully no reason to have doubts about the labour market.
A quick note. An ONS report today on hedonic quality adjustment carries the following table showing the items for which hedonic quality adjustment is performed in the CPI basket:
Table 2: Hedonic items in the UK consumer price statistics
|PCs||1996||CPI – 2003
RPI – 2004
Source: Office for National Statistics
And that’s it! (For background on hedonic quality adjustment, the BLS has a nice FAQ.)
I was very surprised to discover that hedonics are only applied to such a small set of items. The ONS note that the US, by contrast, adjusts for items described as “Clothing, Footwear, Refrigerators, Washing Machines, Clothes Dryers, Ranges & Cooktops, Microwave Ovens, TVs, DVD Players”.
The ONS say they find hedonics complicated and expensive; for goods which are now weighted less than than 1% in the CPI basket, it’s hard not to be sympathetic:
In practice hedonics has proven to be a resource intensive process in the ONS and therefore a costly method. This is due to a number of factors, including the technical nature of the method and the large volume of price and product attribute data that needs to be collected and managed for the production of each hedonic model. Additionally, each hedonic model is updated several times a year to stay relevant to technology changes (for example the introduction of Windows 8 in 2012) which compounds the work involved.
Those who believe that “the price index” captures something real, tangible, and objectively measurable, should be wondering how it is possible to make an objective assessment of the change in PC quality taking account of the “introduction of Windows 8″!
I’m still trying to stay intensely relaxed about the falling UK CPI rate. There is more than enough media coverage on that 1.9% number. What has not been so widely advertised is that the ECFIN Economic Sentiment Indicator rose in January to the highest level since 1997. The lesson of the last five years is that the CPI rate is not a good proxy for aggregate demand. Let’s not forget it!
For what it is worth, the Bank of England think monetary policy is a little too tight to hit their 2% inflation target on the two year horizon, where the median forecast is now 1.9%. And that is the way we should judge the stance of monetary policy under inflation forecast-targeting.
Why does employment fall when there is a negative shock to aggregate demand? Because nominal wages are sticky. Why does employment rise when there is a positive shock to aggregate demand? Because nominal wages are sticky.
Labour and HM Treasury are arguing about whether British living standards are rising based on some measure of real wages, and I find this very annoying.
The phrase “cost of living crisis” is still stupid. Labour spent most of the last three years arguing that the government should be doing more aggressive demand stimulus. Well, guess what the effect of faster AD growth would be, Dear Eds? That’s right, an even faster rise in the “cost of living”. And because nominal wages are sticky that would mean even lower real wages… oh and hopefully, even higher employment. That is the point in doing demand stimulus.
That’s what Abenomics is trying to achieve in Japan, following bog standard New Keynesian macro policy for the ZLB. That’s what happened when FDR and Chamberlain left the gold standard in the 1930s, it raised “the cost of living.” The reason “Old New Keynesians” argue we need fiscal stimulus at the ZLB is to “create inflationary pressure” because you think you monetary policy can’t “get traction”. Yet the Two Eds are arguing UK has “too much inflationary pressure” even WITHOUT fiscal stimulus… so just what was the point of all those “too far, too fast” arguments? Why does anybody still take this garbage seriously?
And HM Treasury’s argument that we should look at real wages to see whether living standards are rising is just as stupid. Almost any available measure of real wages rose in 2009… so was that good for “hardworking people” (™ The Tory Party)? Only if you ignore the inconvenient fact that a million people discovered they were suddenly unable to work at all, whether “hard” or not.
This data is sufficient to demonstrate, in my view, that “living standards” are rising:
Now enough stupid arguments, and get people back to work.
The UK inflation rate fell to 2.0% in December 2013. (!!!) This cannot pass without comment. What does this mean for UK macro policy? I will try to be consistent here. The two most important things about inflation are that:
a) Movement of inflation can represent supply-side or demand-side factors.
b) Macro policy is forward-looking; the inflation rate is backward-looking.
First, addressing (a). UK inflation is much lower than recent BoE forecasts; the February 2013 forecast expected the CPI to rise 3.1% in the year to 2013 Q4, the outturn is 2.1%. That’s a big miss! But real GDP is also much stronger than expected, and stronger by around the same magnitude. It’s likely we’ve seen at least 2%+ RGDP growth in the year to Q4, yet that February forecast was for 1.1% RGDP growth over the same period.
So this suggests either that the BoE is very bad at modelling the short run aggregate supply curve (which determines the split between inflation and output in the short run, given AD)… or that the curve shifted. I would say that both of these are somewhat true. The sharp rise in Sterling since mid-2013 is an obvious candidate for a supply shock, though it will have equal and opposite effects on different sectors.
(An obligatory dig at liquidity trappists on Sterling: nobody really believes that a central bank which is trying but failing to “create enough inflation” would stop printing money and then watch its currency appreciate by 10% over just nine months. The UK’s “liquidity trap” is a Very Serious Theory, in the Krugmanite sense of “Very Serious”.)
Moving on to (b). Does the current inflation rate tell us anything about whether monetary policy is too tight, looking forward? No, no, no. If you don’t answer “no, no, no” to that question, then you must also argue that the 5.2% inflation rate in September 2008 or September 2011 was telling us something useful about monetary policy at the time.
Relative to anything close to my ideal macro policy (say NGDPLT with a return to the 2009/10 trend), monetary policy is of course still much too tight. Relative to the actual goals of UK monetary policy I would be fairly relaxed about the outlook. The domestic equity market (FTSE 250) is rising 25-30% y/y. Inflation expectations are stable and consistent with hitting 2% inflation. I’d guess this is consistent with a continuation of 4-5% y/y NGDP growth. Those who thought running inflation 3.2% above target was not a sufficient reason for tightening monetary policy should also be relaxed about inflation going below target… or else admit that targeting inflation should not be a goal of macro policy in the first place.
No post is complete without a graph. It is interesting that there has been something of a decoupling of UK and US inflation expectations; the decline in the TIPS spread since early 2013 has not been matched by a decline in gilt market implied RPI. This stands in contrast to what happened to 2010 and 2011.
N.B. Yes, this graph compares apples (US expected CPI) with oranges (UK expected RPI), and the discontinuity in January 2013 caused by the RPI non-reform further distorts the validity of the UK data. But both countries have a 2% inflation target. Expected UK RPI of around 3-3.5% is consistent with expected UK CPI around 2%. And where’s that NGDP futures market?
Keynesians love to say that the deficit will come down with growth. This is 50% wrong, because when Keynesians talk about “growth” we know they mean real GDP growth 100% of the time. But it is nominal GDP growth which determines the course of the public finances; tax revenue follows nominal GDP and NGDP is the denominator in debt/GDP. (When we talk about “debt/GDP” it is the only time that “nominal” is implicit!)
Japan had positive real GDP growth for some of its “lost decade”; but it never had any nominal GDP growth. That is why Japan’s public sector debt/GDP went off the charts; not merely because Japan had insufficient real growth (though that is probably also true).
Keynesians are also 50% right, because under inflation targeting real GDP growth “determines” nominal GDP growth. This assumption is embedded in many macro models; we read that improving productivity will improve the public finances, which is true because higher productivity ⇒ higher real GDP growth ⇒ higher nominal GDP growth – if inflation is always held constant.
Maybe I’m beating a dead horse here, but Keynesians should be more open about the insane implications of macro models which embed the assumption of price stability. For example, such models tell us that it is roughly true that the collapse in productivity since 2007 has caused the collapse in the public finances.
This is what Resolution’s Matthew Whittaker had to say about inflation in a piece for the Independent earlier this month, titled “Why the Bank of England should target wages as well as unemployment“:
Nothing at all. There is no mention of the word “inflation”, nor of the “CPI”, nor even “prices” in a piece purportedly about UK macroeconomic policy – about UK monetary policy. I’m sure Matthew is a good guy, and I’m not trying to pick on him specifically, but that is a beautiful illustration of how I see centre-left/progressive economists addressing UK inflation over the last five years. The motto is “Don’t mention the
Yet at the same time the centre-left political movement has been obsessing about inflation – that is literally what the “cost of living crisis” means. Yes, you can come up with a different translation of that phrase, but the CPI really is how we measure “the cost of living”. It is going up, and that is a “crisis”. In fact it is even worse: progressives love to exaggerate the extent to which the “cost of living” has risen, by deflating nominal wages by the RPI (rather than the CPI) to show just how badly real wages are suffering.
This is all both depressing and frustrating to watch. I’d roughly agree with Mr. Whittaker’s eventual conclusion, that targeting nominal wages (or nominal incomes) is a good idea. But he gets there from talking first about real wages, and then median wages (which is almost as bad), without use of the word “nominal”, so it is not totally clear he even wants a nominal target, but let’s assume he does. And so does Mr. Whittaker want the Bank to continue targeting the CPI… and unemployment… and add nominal wages as well? Really? All of those things at once?
I have a relatively simple narrative about what the BoE has been doing for the last five years: roughly what they’ve always done, keeping the “risks to inflation broadly balanced”… around the 2% target. I construct that narrative based on what the MPC have been saying for the last five years, month after month after month. What that means in practice is that the Bank steer a course for nominal demand (NGDP) which is sufficient to keep the CPI on target.
And so the Bank defend their policy stance based on those damn CPI numbers. Is that wrong? Why should it be – hitting the CPI is their legal mandate! How can anybody possibly argue that UK macro policy was too tight ex post, at the same as attacking the government because “the CPI is too damn high”. That would be utterly ludicrous… and it is the critique of Coalition macro repeated endlessly for the last three years.
There are more complicated narratives too. Maybe that unexpected shocks to nominal demand have resulted somehow more in lower measured productivity and output, less in lower prices/inflation. OK, maybe that is a bit true, and I hope it is a bit true. But if that is even a little bit true, then inflation targeting is the worst possible monetary policy you can have, and you need to be openly screaming about that fact. “Inflation targeting is not working“, you might write.
Instead the best and brightest on the centre-left have been producing critiques of UK macro policy along the lines of:
a) Monetary policy is not a panacea. (Well, thanks so much. Jens Weidmann totally agrees with you.)
b) We need more infrastructure spending. (Brilliant. And what about macro policy?)
c) No really, we need more infrastructure spending. (Yeah, but that’s not a macro policy, is it?)
d) I insist there is a big output gap because X, Y, Z. (Fantastic! The Bank are still targeting the CPI.)
e) Infrastructure spending? (Please stop.)
f) How about we target a real variable like unemployment? (Yeah, the 1970s were brilliant.)
All of that serves only to duck the real question… the nominal question. The nominal question appears to me to be remarkably simple:
What is more important: (1) output/consumer price stability, or (2) nominal wage/income stability?
If you want “price stability” then you can’t have nominal income stability. We’ve tried that. Productivity shocks are horrible, and inflation-targeting seems to make them much worse. And if you want nominal wage/income stability then you can’t have “price stability”. We need to be open about that, with the politicians and the public; “price stability” was a good idea which failed. Can we do better?
Now, please, get off the fence and decide what you really, really want.
Egon Spengler: There’s something very important I forgot to tell you.
Peter Venkman: What?
Spengler: Don’t cross the streams.
Spengler: It would be bad.
Venkman: I’m fuzzy on the whole good/bad thing. What do you mean, “bad”?
The Bank’s forecasts for real GDP growth over the next two years. 2014: 2.8%, 2015: 2.3%. WHAT A BOOM. What an explosion of growth! In the Inflation Report press conference today, the press first asked lots of sensible questions about forward guidance and monetary policy – you know, the things the MPC are actually responsible for. But there was an elephant in the room, something was weighing on the minds of assembled hacks… see if you can spot it.
Richard Barley, Wall Street Journal: … Because I guess the concern is that so far we’ve seen perhaps some worrying signs of returning to the old normal and greater lending, reliance on house prices.
Guy Faulconbridge, Reuters: Just a follow on on the housing, I see you have a section on property. Do you see any signs of a bubble in any regions of the British housing market, because overall it’s fine to say that perhaps prices are still below the 2007 peak, but in London dinner parties the prices that you pay for prime real estate in London is kind of the main topic of discussion.
Tim Wallace, City AM: Governor, another one on housing.
Maybe hold the press conference up North somewhere next time?
Chris Giles’ post on demand vs supply made me very gloomy – look at the comparison with US productivity, the “cost of living crisis” is right there in that data. Here is a slightly different take based on today’s labour market figures.
You could say based on that, the UK demand-side recovery is basically complete. Hours worked is back on trend. The demand-side debate is dead. The stagnation of UK output is, and always has been, purely supply-side.
The fact that supply-side optimists find excitement in one month of a still-above-target CPI rate is even more depressing. Has nobody learned anything at all? If the CPI rate is irrelevant when it tells an “inconvenient story” about the aggregate supply/demand balance, it does not suddenly become relevant because one data point confirms your biases. Recognize that oh-so-wise policymakers might not share your rose-tinted view of the UK inflation data, and what implications that has for macro policy when the CPI rate is above target (see also 2008, 2010, 2011, 2012). Yes, the MPC really are steering us towards price stability.
And Dr. Carney… great job, really, great job.