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.
There’s been some discussion of UK productivity recently, Simon Wren-Lewis here, Martin Wolf here, and Scott Sumner indirectly too. What I find interesting is that UK productivity exhibits such a strong positive correlation with nominal demand growth. I’ve graphed here the growth rates of nominal GVA, and market sector output per hour.
Why do we see that procyclical movement of productivity? I’ll offer three views:
1. Firstly, this is simply what we should expect to see under an inflation-targeting central bank. The inflation-targeting CB is trying to control the gap between (growth of) aggregate demand and aggregate supply. When we have a negative productivity shock (2008, 2012) the CB must drive down nominal demand growth to prevent high inflation. That’s all this data shows; Mervyn King and the supply-side pessimists will settle for something like this view. There is no AD problem per se, it’s supply, supply, supply.
That story is muddied only a little by the difference between CPI inflation (the actual BoE target) and output price/GVA inflation. GVA inflation, averaging 1.8% over the last four years, has been stabilised by the BoE arguably more effectively than the headline CPI.
2. Another view is that the GDP data is wrong, at least post-2009. The 2012 productivity collapse is genuinely weird. The fall in market sector output/hour masks the fact that hours worked soared upward, up 2.6% over the four quarters to 2012 Q4, while market sector output contracted by -0.3% over the same period. (The GDP data still show a market sector ”double-dip” in 2012, offset by the positive contribution from the
savage fiscal austerity rise in the volume measure of government consumption). There are a few theories here:
a) The idea that the GDP data is wrong is neatly supported by work on measuring intangible investment (see Goodridge, Haskel et al). I find this quite compelling because it matches an anecdotal view of what is happening in some sectors, e.g. retail. With the shift towards on-line shopping; that sector is investing in intangible assets (web sites, software etc), and there is less demand for new tangible capital (shops).
b) Markit’s Chris Williamson made the argument recently that the official labour market data which is wrong. The ONS disagreed, needless to say. Given that the change in unemployment has roughly tracked the movement in the claimant count, I’m not sure how much weight to put on this idea.
c) The nominal GDP data is right, but the inflation data, and hence output and output/hour, is wrong. A pet theory of this inflation-sceptic blogger. Under five years of 1920s-style NGDP growth we have seen widespread discounting and substitution. For the latter, think about the success of UK budget hotels, airlines, and supermarkets; this is substitution between goods/services of different quality. I strongly suspect such changes are near-impossible for the ONS to capture “correctly” in the price indices, and hence measured inflation is far too high. This makes measured productivity appear to be more procyclical than it should be if we “correctly” measured inflation and output.
3) A third view… it’s demand, demand, demand. The slow growth of NGDP was simply a mistake, it was bad macro policy. Labour hoarding and hand-waving are used to explain away the productivity data. The correlation in the graph really is a causal relation, but it goes from demand to productivity; we’ll see a recovery in productivity with a recovery in AD. So jump to it Mr. Carney/Mr. Osborne.
In optimistic moments I can subscribe mostly to (3), and 2013′s apparent recovery in output along with a recovery in demand supports that argument, in my view. Martin Wolf argues the Bank can “correct… highly visible errors” on inflation later on, after “gambling on growth”. But what is a “highly visible error” if not the last five years of UK inflation?
Supply-side optimists cannot sit on the fence and pretend the 2008-201X CPI trainwreck never happened. It’s surely more convincing to argue we should take productivity – and inflation – out of macro policy altogether. Set a stable path for nominal incomes and let the supply-side puzzle itself out.
… that is the opposition front bench. Soon, we might be able to “celebrate” that even Japan has a higher inflation rate than most of the EU, thanks to Shinzo Abe and the ECB.