Home > Inflation, Monetary Policy > Two Point… Oh!

Two Point… Oh!

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.

UK vs US Inflation Expectations

UK vs US Inflation Expectations. Source: FRED, BoE UK 5 Year Implied RPI

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?

Categories: Inflation, Monetary Policy
  1. January 16, 2014 at 19:59

    Excellent blogging, as usual. We should be cheering that 3.25% expectation, shouldn’t we? Go the UK NGDP (vs the US). EZ isn’t even in the race, of course.

    I am still celebrating (now I understand it, I think) the decline in UK productivity and the hope it gives to our young that they really will get jobs.

    Off topic, congrats on making the Scott Sumner top 10:

  2. January 16, 2014 at 20:01

    And once all the young (and unemployed) have jobs, UK productivity can start to rise again.

  3. james in london
    January 22, 2014 at 17:32

    Should we cheer the unemployment numbers or worry aboutt he unemployment threshold and the confusing verbiage in the Bank of England Minutes today. Market spoke and called it monetary tightening. 2yr-10y government bond yields up between 5 and 10bps, and FTSE down 0.5% on the news. Come on Mark, speak up for the low waged and those with falling real incomes!

    • January 22, 2014 at 23:59

      James, the unemployment numbers are almost too good to be true, aren’t they? And the productivity numbers are almost too bad to be true! I will cheer the former and hope for GDP revisions. Otherwise, it looks like we are heading for two consecutive quarters of falling productivity in the second half of 2013. Whaaaaat!?!

  4. james in london
    January 23, 2014 at 10:33

    Surely, large chunks of the newly employed are those coming off welfare rolls, either longer-term unemployed or younger (non)workers. These people generally will be less skilled, less educated, (de facto) less experienced, and less well-aid than average. They also will be less productive than average. Therefore, a chunk of the fall in producitivity must somehow be labour-force mix changes. Not sure how one might measure this. But no bad thing.

    And, over time, as they get more skilled, more educated (on the job), more experienced, they will get better paid and be more productive.

    • January 23, 2014 at 11:29

      That’s a very interesting theory. Maybe some (cynics/pessimists) would add in those moving out of the public sector!? And I see dear IDS is making hay out of the MPC minutes hinting that welfare reform is creating a +ve labour supply shock.

      I looked at the data and the increase in the level of employment since the beginning of 2012 is coming from the 25-34, 50-64, and 65+ age groups. Weirdly there is a large fall in the 35-49 group.

      Employment in the 16-24 age group is kind of flat. Looking at levels is not ideal because it might obscure demographic changes though. Maybe I should repeat for employment rates.

  5. james in london
    January 23, 2014 at 16:57

    16-24 would be more people staying on in full time education rather than going out into the poor labour market. The US has excellent data on unemployment levels by quality of education, and there is a very clear negative correlation between educational attainment and unemployment levels.

  6. james in london
  7. james in london
    January 24, 2014 at 09:44

    Page 6 … but the data is a bit poor for this chart … done by job type rather than educational attainment. And it looks like a bit of a one off survey.

    A bit like the other ONS report that I linked. The spreadsheet for that chart cites “Labour Force Survey Person Datasets”. Those sound very inaccessible, and nothing like as good as that US data that is regularly published.

    I suppose if falling productivity is caused by the low skilled coming back to work, then we should have observed a sharp rise in productivity in 4q08 and 1q09 when they were all suddently thrown out of work.

    This effect could have been masked by the sharp drop off in financial and service sector incomes of highly paid professionals whose productivity was plummeting as “City work” (and bonuses) dried up completely. That City work has come back gadually over the last five years, but the lower-skilled workers have only just been coming back to work in significant numbers.

    A lot of currents, here!

    • January 24, 2014 at 10:07

      All very interesting. One thing which *is* clear in the productivity data is indeed a very sharp collapse in output/hour through late 2008. Another interesting thing is that the supply-side collapse *precedes* the recession by one quarter, with a massive fall in output/hour in 2008Q1; NGDP was very strong that quarter and did not start falling into Q2.

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