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.
I see some fuss over the wage data (again)… but I’m not convinced, especially since this happened earlier in the year and it was a false “dawn”. Declaring my bias: I want to believe there is still a massive hole in labour supply, either in the form of unemployed workers, or workers not getting enough hours. Hence, we still have a significant output gap, and we can expect to see unemployment fall to somewhere near 5%. Fast wage growth now would be a disconfirmation of labour market slack, so in a sense it is not what I “want” to see. (I also prefer that we’d had a macro policy since 2008 which had aimed for 4% wage growth and avoided large shocks to unemployment.)
Martin Weale and others are citing survey measures of pay settlements. I don’t see any reason to trust that over the ONS data. But the ONS labour market update for 2014 Q3 gave us a spike in the 6m growth rate:
That measure is clearly quite volatile.
The annoying thing here really is the “policy-based evidence-making” by Weale (et al), who has spent the last four years cherry-picking whatever data best supports his preferred policy of higher interest rates. In 2011 Weale told us to look at the GVA deflator, in 2013 the excuse was unit labour costs, and in 2014 the excuse is that he spoke to some business owners who said wages were rising. And by the way in 2014 the GVA deflator is running below 2% y/y and unit labour cost growth is around 0%.
Anyway, here are trends and levels for private sector regular weekly wages:
That tiny spike is enough to warrant rate rises? Really, that’s the best argument there is? We also have the quarterly estimates of hourly earnings, with the update to the “EARN08″ table, although this survey measure excludes very high earners:
Again… there is no “inflation”.
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.