Time to take the inflation target seriously
It appears my timing could have been better in calling UK macro boring.
Those are not my ideal measures but the closest for which I have good data. The 2.5 year implied RPI has fallen by 0.5% over the last thirty days, to 2.4% as of yesterday, implying a significant undershoot of the 2% CPI target over the Bank’s forecast period (2-3 years). The FTSE 250 is at the lowest level for a year.
I caught a Newsnight discussion on the UK inflation data which was perfectly introduced by Duncan Weldon, who asked the right question: is the fall in inflation driven by the demand-side or supply-side? The studio debate which followed was a little disjointed from the reality in which the UK CPI rate has been a consistently bad indicator of UK demand-side strength. In fact it’s a contrary indicator, since periods of stronger real growth have been associated with weaker inflation and vice-versa. George Magnus would have us believe that the inflation data is giving us textbook (“Economics 101”) evidence of a “chronic deficiency of aggregate demand”. Chronic deficiency!? If you ignore the fact that CPI inflation has averaged 2.9% over the last eight years, sure, Mr Magnus.
But I’d answer Duncan’s question like this. If we see inflation running below the expected path and real GDP above the expected path, that looks like a positive supply-side shock. If we see both falling short, that’s a negative demand-side shock.
Here for each quarter I take the Bank’s median forecast of the CPI rate and RGDP growth from the Inflation Report four quarters earlier, and compare with the outturn:
The unexpected weakness of inflation and unexpected strength of real GDP growth does look like favourable supply-side news so far this year. That’s a backward-looking analysis.
What matters now is policy today, which is forward-looking. If the fall in UK inflation expectations is evidence of a positive supply-side shock then we should see a symmetric rise in UK real growth expectations. So who has upgraded their forecast of UK growth over the last month? The answer is… nobody has… and the fall in the equity markets (and gilt yields) makes it clear that growth prospects are falling too.
The Bank’s defence of inflation targeting as a policy regime, and their defence of the MPC’s decision-making under that policy regime, has always been consistent: what really matters is ensuring that inflation expectations are firmly anchored.
So… do it! Carney and friends have been making hawkish noises in speech after speech through the summer, trying to prepare the ground for rate rises. Does anybody seriously believe that there is even a single MPC member who believes the Bank is stuck in a “liquidity trap”, desperate for higher inflation but doesn’t know how to get there? No: that is just a convenient fiction.
For the MPC, the facts have changed, and policy needs to aim at raising inflation expectations so they are consistent with the target. Bravo to Andy Haldane for shifting in a dovish direction. As for Martin Weale… what can you say.