ONS Mocks Britain’s Vain Search for AS-AD
CPI rate at 0.5%! It appears we are well clear of the “boring period” for UK macro. Shame. I am impressed by the media commentary around inflation. Go read our good friends at the FT, and Allister Heath at the Daily Telegraph.
A quick reminder of the modus operandi of inflation hawks witnessing above-target inflation:
1. Acknowledge that inflation can be driven away from target by supply-side shocks as well as demand-side shocks.
2. Identify an alternative inflation measure which attempts to strip out those supply-side effects and supports a demand-side interpretation of high inflation.
3. Remind the world that there are serious consequences of allowing inflation to deviate from target (unanchored inflation expectations, a wage/price spiral, the 1970s, civil unrest, meteor strikes, etc), ergo we need tighter monetary policy.
I exaggerate only slightly there. Now here is Simon Wren-Lewis:
This is also why looking at some measure of core inflation is important. If below target inflation is just due to lower oil prices, say, which in turn are just lower because of increased supply, say,  then this is no reason to think resources are being wasted. Just as inflation targeting central banks should largely see through any inflation caused by higher oil prices, they should also do the opposite. However in the UK, US and Eurozone core inflation is significantly below target, suggesting resources are being wasted everywhere.
I groaned all the way through Simon’s post. There is no official measure of “core inflation” in the UK, and the MPC rarely makes any reference to such an index. The ONS variant of the CPI which strips out energy, food, alcohol and tobacco is probably closest to what would be a textbook “core inflation” index. Here is the chart of that series:
As you can see, “core inflation” was above 2% all the way from 2010 through late 2013. I’ll predict the response: “Look at 2010 and 2011. Obviously we should strip out VAT too, you idiot!” OK, that’s sensible, I agree, but there is no ONS index which does that. The ONS produces literally hundreds of different price index series, and you want to argue that the one which really matters when setting monetary policy… doesn’t actually exist. Really?
Regardless, even with stripping out VAT in 2010/11, we are left with above-target “core inflation” in 2012 and and most of 2013. So, who was citing that data and arguing that we obviously had a too-expansionary monetary policy, and clearly there was little or no output gap with inflation pushed safely above target? I don’t remember Simon doing so. Yes, we can qualify the inflation data even further. Let’s strip out train fares, water prices, tuition fees, other administered prices, all prices which went up, etc. Those are (ahem, mostly) reasonable arguments. But recognize that this is basically the same logic followed by the hawks.
I could make a fence-sitting argument where I say the hawks might have been “correct” to take a demand-side view of high inflation in 2011, just as Simon might be “correct” to take a demand-side view of low inflation in 2015. But I don’t believe that. I think the hawks were mostly wrong before and I think Simon is mostly wrong now in taking a demand-side view of supply-side shocks. From my previous post, the recent downward revision to forecasts of inflation for 2015 happened at the same time as downward revisions to forecasts of unemployment. That is simply not what a negative demand-side shock looks like.
The “balance of risks” argument is reasonable, and it might be true that a slightly looser monetary policy will do little harm now – hey, after all, there is a risk house prices in London stopped going up*. In fact, sterling fell in response to the inflation data surprise, indicating precisely that money got slightly easier, so a “dovish” reaction to low inflation surprises is already embedded in current policy. In the long run I think we’ll have a more stable economy if monetary (and fiscal) policy makers can be encouraged into looking at “inflation” in a way which doesn’t require sharp swings in aggregate demand in response to supply shocks.
* This is a joke. Also it’s not a joke. Having UK monetary policy target the oil price with too high a weight would be likely to create excessive volatility in nominal demand and hence other nominal asset prices, so I think we’d expect to see more boom-bust housing cycles.