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.
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?