A few things worth linking to, about which I have little to say:
1. Martin Weale’s speech from last week, “Slack and the labour market” is excellent. Weale estimates a 1.1% shortfall in total hours worked, accounting for over- and under-employment. This translates to a 0.8% shortfall in real GDP due to labour market slack. I would like to see some serious responses to this from supply-side optimists. One possible line of inquiry is on self-employment, which Weale only addresses briefly.
2. Tony Yates has a very interesting post on “One big hubristic consultancy jargon firework display” as he describes the BoE review. Worth a read if you are interested in BoE politics, as is Tony’s blog.
3. The John Mills/Civitas “There is an alternative” paper is out, and is very strange. Mills wants to devalue the pound, and sees that being an “alternative” to “monetary policy”. He doesn’t say how we should devalue the pound, though he favourably references the Yen devaluation under Abenomics. Mills does (implicitly) want faster NGDP growth and accepts that 3% CPI is a necessary consequence, but believes none of that has anything to do with monetary (or indeed fiscal) policy. The paper also exhibits a very, very bad fetish for manufacturing. Ben Southwood already provided a very good critique of the Mills proposal last year.
It’s the liquidity trap, stupid! Everybody knows you can’t devalue the currency at the ZLB. Everybody, that is, apart from the central banks of Switzerland, Japan, and the Czech Republic, everybody who has read about forex market gyrations after British, European or American central bankers engage in those almost daily “open mouth operations”, Lars E.O. Svensson, Ben Bernanke, students of economic history, and now Labour Party donor John Mills:
In the paper, which is due to be published this week with the think tank Civitas, Mr Mills has called for an immediate devaluation of the pound. He argues that the UK will be consigned to years of mounting debts and austerity unless manufacturing and productivity levels are boosted. As a major importer of goods, from kitchen gadgets, irons and sports bras, Mr Mills says manufacturing will only return to the UK if the costs come down. De-valuing the pound is the fastest way to achieve this. “We’ve got to get the pound down to make light manufacturing profitable,” he told The Telegraph. “At JML we would buy UK products but we can get everything we sell produced in China for two-thirds of the cost. This is almost entirely an exchange rate issue. And as a result, industrial output just goes down. We can’t pay our way in the world and the economy stagnates – that’s what we’re heading for.”
He said that UK politicians are only using two of the three major ways that a Government can influence the economy – fiscal policy, monetary policy and exchange rates. “Everyone is fixated on the first two and has totally ignored the third,” he said. “And this is the big, big policy mistake that has been made.”
It will be interesting to read the paper; the “real” policy mistake is the choice of nominal anchor, not the level of the pound per se. I hope the proposal is more substantial than a call for a “discretionary” one-off devaluation, but retention of the CPI target.
What’s the state of UK macro according to the NIESR?
Recent GDP growth has been driven by domestic demand growth, especially consumer spending, which contributed 1.6 percentage points to growth in 2013. This has come despite further falls in real consumer wages. We expect consumer spending to remain the key driver of recovery in 2014 and 2015, supported by continued buoyancy in the housing market. House prices have seen a dramatic rise throughout the year, concentrated in London and the South East. There is considerable uncertainty over the magnitude of the impact of the second Help to Buy Scheme: stronger house price inflation would lead to even stronger consumer spending growth in 2014.
That is from last month, I quote it only because it’s typical of what City commentators are saying about UK macro. It is interesting how ZLB macro narratives change in the UK. It appears to me we have have shifted into phase three:
1) In Phase 1 it was asserted that monetary policy will have no effect at the ZLB – it’s a liquidity trap – printing money is pushing on a string. Ergo, fiscal fiscal fiscal.
2) In Phase 2 it was accepted that in fact monetary policy will have an effect, but it will “only boost asset prices”, it will not help the “real economy.” Boosting asset prices had “distributional effects” and was zero-sum: rich people owning assets gained, poor people lost out. After all, if house prices go up, housing is “less affordable”! Similarly monetary policy could obviously boost commodity prices – again a bad thing for the little people who want to consume those commodities. Phase 2 was monetary policy viewed as creating supply-side inflation. Fiscal policy, in contrast, could build real things like bridges and ergo was a better idea.
3) In Phase 3 there is a recognition that boosting asset prices does have effects on the real economy but this was probably a bad thing because it’s “unsustainable”, and it’s also due to fiscal policy in any event.
It is not obvious to me why any level of house prices would be “unsustainable” any more than any level of consumer prices would be “unsustainable”. It’s just a price index. If macroeconomists really believe that house prices are really the key (or a key?) to boosting real growth and employment – then why not have the Bank of England target the house price index?
There is nothing magical about stabilising the CPI rate, but the HPI is special…. if only we’d known this in 2010! Worried about the effects of fiscal austerity on employment? Never mind, have the Bank of England target 20% y/y house price inflation, which will boost consumption and “drive the recovery”.
I liked the heading used in Draghi’s speech this week
Five years of monetary policy – the ECB has delivered
In the last five years, the ECB has continued to take the necessary measures with a view to maintaining price stability in the euro area.
The narrative for 2011 is fun:
Initially, while the economic impact of the sovereign debt crisis was limited and largely confined to vulnerable economies, the rapid global recovery put upside pressure on energy prices. This drove up inflation also in the euro area. We decided to raise interest rates in early 2011 given upside risks to the medium term inflation outlook stemming from energy prices and from ample monetary liquidity.
So you raised rates to fight an energy supply shock and “ample monetary liquidity”. How did that work out?
However, the sovereign debt crisis deepened and the euro area entered a second recession.
Oh. “However” is a bit out of place, don’t you think? “Naturally” would work better. We raised interest rates and naturally the Euro area then entered a second recession.
The inflationary pressures that had emerged before receded.
What a relief, bonuses all round, job well done.
It is – or should be – astonishing that unelected technocrats get away with this madness without being immediately ejected from office. From the Riksbank’s latest:
In the forecast, CPIF inflation reaches 2 per cent in 2015. An even more expansionary monetary policy could lead to inflation attaining the target somewhat sooner. But a lower repo rate could also lead to resource utilisation being higher than normal in the long run and to the risks linked to household debt increasing further. The current repo-rate path is expected to stimulate economic developments and contribute to inflation rising towards 2 per cent, at the same time as taking into account the risks linked to household indebtedness.
Low inflation, low output, low employment – it’s simply a policy choice. They know it is a policy choice. They think low inflation, output and employment are the right policy choice, because rising household debt leads to, well, um, maybe low inflation, output and employment.
Via Mr. Svensson, still methodically attacking the madness.
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.
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?
It was very good to see some monetarist analysis in the UK media this week – Ed Conway reported that “Households Raid Savings At Record Rate” for Sky News, and followed this with a blog post. The “raid” is actually a switch from long to short-term deposit accounts, which started mid-2012, as Ed’s graph shows.
Though the traditional broad money aggregates are growing steadily and at “decent” rates (M4ex at 4-5% this year), this shift towards liquidity naturally has a more profound impact on the Divisia indices. I would treat this more as an indicator of current monetary conditions; Duncan Brown has a very nice post earlier this year exploring the relation between UK monetary aggregates and nominal spending in great detail.
Here, anyway, is the current state of the data, showing M4ex, household divisia and nominal spending:
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.
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.