Thursday, 20 October 2011
Have the MPC Blown It?
Inflation measured by either the CPI or the RPI has risen to over 5% this summer and autumn and is at levels clearly inconsistent with price stability. At these inflation rates the price level will double in less than fifteen years. The battle for price stability in the UK was fought over a prolonged period from the IMF programme of 1976 onwards and it seemed for a brief period in the 1990s and 2000s that the battle had been won. The war, however, continues and there has been a significant rearguard action.
The chart shows not only an upward creep in the level of inflation but also its volatility from around 2003/4 onwards. And to some degree that seems mirrored in the financial market perceptions of the inflation 10 years ahead, which also seem to have drifted up from lying in the range of 2-3% in 1997 through to around 2005 to now lie between 3-4% since 2008. There are a number of technical reasons why the inflation forwards cannot be read at face value, particularly given the liquidity characteristics, but the trend does not seem terribly encouraging. If we also believe that QE has lowered nominal forwards then the measures from the inflation forward may in fact be biased downwards. And worryingly the Bank's own survey of inflation expectations from August places the median of medium inflation expectations at 3.5% compared to 3.2% and 2.8% a year and two years ago. The temporary inflation overshoot looks as though it may turn out to be more persistent.
Perhaps it should not really surprise us. In response to a cost-push shock over the past few years, the MPC has eased monetary condition by allowing real rates to fall and committed to low interest rates via its programme of QE. In the kind of models the Bank used to use, a cost-push shock required higher interest rates not lower ones and the argument used to be that acting against inflation was the best way to ensure that an inflation shock was temporary rather permanent. It seems that we are now hoping that "something will turn up", or rather down.
Naturally, the policy decisions have been rather more complicated than having to deal with a single cost-push shock as we did not start from steady-state and financial conditions remained tight in a recession. As the cost-push shocks emerged at a time when there was considerable slack in the economy they will have acted to help close any output gap, it may then mean that the low current rate of growth is as likely to be related to the supply side as it is the demand side and so may not really be responsive to further monetary stimulus. Low growth and high inflation? That sounds curiously familiar.