If you compared two periods:
1) Period One, where nominal asset prices fell 15%, nominal incomes fell 4%, the labour market was contracting sharply … oh, and the CPI rate was usually above 3%.
2) Period Two, where nominal asset prices are at all time highs, rising 5-10% p.a., nominal incomes are rising 3-4%, the labour market is expanding rapidly… oh, and the CPI rate was slightly negative.
… which period would you call “deflation”?
What do you expect to happen with a 2% inflation target, if productivity growth falls from 2% per annum to 0% per annum? You expect tight money. Nominal wage growth must be pushed down from 4% to 2%. If nominal wages are sticky you’ll need a nasty blast of unemployment to achieve this. But the labour market will adjust eventually to the new equilibrium. This is the EARN08 table which tracks one measure of nominal hourly wages, updated today, steadily tracking below 2% average growth since 2009.
Alternative view using nominal weekly wages, with the arrow highlighting that dangerous inflection point in Britain’s inflationary wage/price spiral which prompted Carney and other MPC members to insist last year that Bank Rate would soon rise:
Of course everybody knows that productivity growth will pick up to 2% per annum again, slash return to the pre-crisis trend, and then wages will rise 4% per annum again, slash soar into the heavens, and everything will be just fine. See also, Bank of England productivity forecasts today.
Welcome to Britain, have a nice day!
Carney has stuck by his line that the falling oil price is “unambiguously positive” for the UK economy, repeating it in the Inflation Report last week The oil price collapse started in September 2014. I’ve charted here the latest three median forecasts produced by the Bank in each Inflation Report, for both CPI inflation and real GDP growth:
What do we see? A huge downgrade to the expected path of inflation concentrated on 2015. You do not see revisions like that very often. At the same time we have a very slight downgrade to real GDP growth over the year to 2015 Q1, and a rather small upgrade, mostly in 2016. So, the “unambiguously positive” effect seems a bit ambiguous to me, less a Draghi-esque “with low inflation, you can buy more stuff“, but something more like: “with low inflation, a year later you can buy more stuff.”
Here’s a crazy theory – let’s call it the Bernanke, Gertler, Watson theory. The effect of the falling oil price has little to do with oil, or even the relative price of oil, but is mostly a reflection of the central bank’s reaction to the effect of the oil price on headline inflation. Though interest rates are definitely ambiguous, in September 2014 the Bank was expected be raising rates from early 2015. Today, the MPC is not expected to be raising rates until late 2016. The Bank’s CPI/RGDP forecasts are based on the market curve, and the forecast model will have “lower rates for longer” cause faster growth.
Alternatively we could look at the “unambiguously negative” effect of the rising price of oil in 2011 on the Eurozone: similarly, very little to do with oil, and everything to do with the ECB’s reaction to the rising oil price: two rate hikes aimed at slowing AD growth and inflation. They declared that policy a success!
Really, no big surprises here. An honest Governor could confess: “The falling oil price is a good thing because it means the MPC is less likely to screw up like it did in 2008 and 2011” – although he might look a little foolish.
A mea culpa. I posted a chart of UK inflation expectations last month which showed no decline in gilt market-implied inflation expectations with the decline in the oil price. I was puzzled that published forecasts of expected inflation did not show the same decline as the market data. The reason is that my data was wrong. Sorry!
In fact I had posted the chart which was based on data for the forward measures of inflation, which comes from a different sheet in the Excel spreadsheet which the Bank publishes for the yield curve.
The correct chart for implied RPI inflation over the next 2.5 years is:
By looking at the change in inflation expectations across different durations, we see that shorter-term inflation expectation have declined with the fall in the oil price:
Here is the comparison with the forward measure which I used by mistake in the old post; the green line is expected inflation over the period from today to 2018, the blue line is expected inflation over 2018 to 2021.
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.
Carney on supply shocks at the Financial Stability Report yesterday when asked a question about “oil price risk and deflation risk”:
Mark Carney: Yeah. The – in terms of oil, I mean, this is a net positive development. I went through some of the channels of risk in my remarks – geopolitical, uncertain high yield issuers and then this deflation point, which I’ll expand on.
But I think we should be clear that the 40% plus drop in the oil price will flow quite quickly through to consumers; it will increase real disposable income; it’s a net positive for the UK economy. And the relative exposure – the relative exposure – of the UK financial system to the energy complex is manageable. And so unambiguously – net positive.
I asked this before but I’ll ask it again. Who is upgrading their forecast for UK real GDP growth in the light of falling oil prices? The Treasury’s helpful comparison of independent forecasts came out today, and that upgrade is not showing up yet.
A quick post on this, this data deserves wider attention. You might expect that UK inflation expectations would have fallen recently, given the collapse in oil prices. You’d be wrong. This is the BoE data for this year for implied RPI from the gilt market.
UPDATE, January 2015: This data is wrong. See subsequent post.
(Reminder for non-Brits, expect the RPI rate to be roughly 1% above the CPI rate, 2% on the latter being the Bank’s actual target.)
That’s actually a very dovish (as in “high”) inflation forecast, when many forecasters are busy revising down their short-term inflation forecasts as the oil price falls. What are the markets seeing that the City scribblers have missed?
If we take the data as given… I could argue this one either way. On the one hand, an inflation-targeting central bank really should be judged on its success in stabilising the expected path of inflation. MPC members should be crowing about this data. On the other hand, we know that inflation-targeting central banks which try too hard to hit their targets in the face of large supply shocks tend to screw up time and time again.
So, let’s cheer a little, but perhaps quietly. I don’t see any reason to be concerned about near-term demand-side weakness as long as the the MPC continues to keep short-term inflation expectations steady in the face of a large supply-side disinflation.