In his open letter to the Chancellor of the Exchequer, Alistair Darling, Mervyn King, Governor of the Bank of England, has given his explanation of why inflation in the UK has increased since last year. The open letter procedure is a useful part of the communication and accountability framework of the Bank of England. It requires the Governor to write an open letter to the Chancellor whenever the inflation rate departs by more than 1 percent from its target (in either direction). In that letter the Governor, on behalf of the Monetary Policy Committee (MPC) gives the reasons for the undershoot or overshoot of the inflation target, what the MPC plans to do about it, how long it is expected to take until inflation is back on target and how all this is consistent with the Bank’s official mandate. The current inflation target is an annual inflation rate of 2 percent for the Consumer Price Index (CPI). With actual year-on-year inflation at 3.3 percent in May 2008, it was time to sharpen the official quill and write an open letter.
I am distinctly underwhelmed by the Governor’s explanation of the reasons for the increase in CPI inflation. In the intermediate undergraduate macroeconomics courses I used to teach, his would have been a failing answer to the question: “What caused inflation to rise in the UK during the first half of 2008?”
Much to my surprise, the gist of the Governor’s analysis was: it’s all global commodity prices – something beyond our control.
I will quote him at length, so there is no risk of distortion:
“Inflation has risen sharply this year, from 2.1% in December to 3.3% in May. That rise can be accounted for by large and, until recently, unanticipated increases in the prices of food, fuel, gas and electricity. These components alone account for 1.1 percentage points of the 1.2 percentage points increase in the CPI inflation rate since last December.
Those sharp price changes reflect developments in the global balanc3 of demand and supply for foods and energy. In the year to May:
* world agricultural prices increased by 60% and UK retail food prices by 8%.
* oil prices rose by more than 80% to average $123 a barrel and UK retail fuel prices increased by 20%
* wholesale gas prices increased by 160% and UK household electricity and gas bills by around 10%
The global nature of these price changes in evident in inflation rates not only in the UK but also overseas, although the timing of their impact on consumer prices differs across countries. In May, HICP inflation in the euro area was 3.7% and US CPI inflation was 4.2%.”
Later on in the open letter the Governor amplifies the argument that this increase in inflation has nothing to do with the Bank of England falling down on the job:
“There are good reasons to expect the period of above-target inflation we are experiencing now to be temporary. We are seeing a change in commodity, energy and import prices relative to the prices of other goods and services. Although this clearly raises the price level, it is not the same as continuing inflation. There is not a generalised rise in prices and wages caused by rapid growth in the amount of money spent in the economy. In contrast to past episodes of rising inflation, money spending is increasing at a normal rate. In the year to 2008 Q1, it rose by 5½%, in line with the average rate of increase since 1997 – a period in which inflation has been low and stable. Moreover, in recent months the growth rate of the broad money supply has eased and credit conditions have tightened. This will restrain the growth of money spending in the future.”
Let’s see whether this makes sense. For those interested, my stylized view of the proximate determinants of the UK inflation process is given below.
The inflation process in the UK – a stylized view
The consumer price level, as measured by the CPI, say, is a weighted average of a price index for core goods and services and of a price index for non-core goods and services. Core goods and services are things like manufactures and traded and non-traded services. Their prices are sticky – these are the prices that account for Keynesian nominal rigidities (money wages and prices that are inflexible in the short run) and make monetary policy interesting. Non-core goods are commodities traded in technically efficient auction markets. It includes oil, gas and coal, metals and agricultural commodities, both those that are used for food production and those that provide raw materials for industrial processing, including bio fuels. The prices of non-core goods are flexible. The UK produces effectively only core goods and services at home. It exports part of these. It consumes both core goods and services and non-core goods. As a reasonable first approximation, assume that all non-core goods are imported. There are of course also imports of non-core goods and services into the UK. Non-core goods are both consumed directly and used as imported raw materials and intermediate inputs in the production of core goods and services. The weight of non-core goods in the CPI, which I will denote μ, represents both the direct weight of non-core goods in the consumption basket and the indirect influence of core goods prices as a variable cost component in the production of core goods and services. I haven’t seen an up-to-date input-output matrix for the UK, so I will have to punt on μ. To make the arithmetic simpler in what follows, I will assume that μ = 0.25 (one quarter). For the sceptics, I will also consider the case where μ = 0.10 (one tenth).
The inflation rate is the proportional rate of change of the CPI. If π is the CPI inflation rate, πc the core inflation rate, πn the non-core inflation rate and μ the weight of non-core prices in the CPI, then:
(1) π = (1- μ)πc + μπn
The inflation rate of non-core goods measured in UK sterling prices is the sum of the world rate of inflation of non-core goods π* and the proportional rate of depreciation of sterling’s nominal exchange rate, ε. That is,
(2) πn = ε + π*
It is absolutely correct that neither the Bank of England nor the UK government has any influence on the world rate of inflation of non-core goods, that is, π* is not under the control of the Bank or the Government. The same cannot be said, however, for the depreciation of the exchange rate. If global commodity inflation is, say 20 percent, the sterling price of commodities could be kept constant if sterling were to appreciate by 20 percent. With π* = 20% and ε = -20% it follows that πn = 0. Instead, what happened is that the effective nominal exchange rate of sterling depreciated by 12 percent since last summer. Other things being equal, with a non-core weight of 0.25, this would raised the rate of CPI inflation by three percent. Even with μ = 0.10 , this would have added 1.2 percent to the CPI inflation rate – the same as the increase in CPI inflation since December 2007.
While the direct and indirect weight of non-core goods in the CPI is undoubtedly at least 0.10, the one-for-one structural pass-through assumed in equation (2) for exchange rate depreciation on sterling prices for non-core goods is somewhat over the top, at any rate in the short run. But it is a reasonable benchmark for medium- and long-term analysis.
Core inflation, which can be identified with domestically generated inflation, included such things as the inflation rate of unit labour costs and of unit rents (for the use of land and property) plus the growth rate of the mark-up that covers the cost of capital and pure profits due to monopoly, monopsony and barriers to entry and competition. For simplicity, I will assume that core inflation depends on GAP, the output gap (domestic GDP minus potential GDP or aggregate demand minus productive capacity), on expected future headline inflation, Πe(+1), and on past core inflation, Πc(-1). So core inflation is driven by the following process:
(3) Πc = δ + γGAP + (1 – β)Πe(+1) + βΠc(-1)
The coefficient γ measures the responsiveness of core inflation to the output gap – it is the slope of the short-run Phillips curve. The coefficient β measures how much inertia or stickiness there is in the core inflation process; 1- β measures how much current inflation is driven by expectations of future inflation. If β = 1 the core inflation process is not forward-looking at all. The only way to get core inflation down in through pain, that is, though a smaller output gap, that is, through a lower degree of capacity utilisation and higher unemployment. If β = 0, the world would not be Keynesian at all. Past core inflation has no influence on current core inflation. Core inflation is purely forward-looking. You can achieve a painless transition to a lower rate of core inflation (no reduction is GAP is required) if you can make it credible that future headline inflation will be lower. Just to cover my posterior, I include an ‘anything else’ term, δ, in the core inflation equation. One thing it captures would be rising or falling mark-ups or margins of prices over unit variable costs.
The real world (and, appearances to the contrary, the UK is part of the real world), is somewhere between these two extremes. It is impossible to get inflation down without pain, but credible expectations of lower future inflation will help by diminishing the growth cost and employment cost of bringing down core inflation.
Monetary policy influences core inflation through two channels: by raising interest rates and expectations of future policy rates, it can lower GAP, that is, slow down the economy. If current policy actions, including policy announcements, influence expectations of future CPI inflation, that too will reduce inflation today, through the expectations channel.
What does the global increase in the relative price of non-core goods to core goods and services do to inflation in the UK?
The Governor is correct in noting that an increase in the relative price of non-core goods to core goods and services means an increase in the general price level but not, in and of itself, ongoing inflation. With the sterling price of core goods and services given in the short run, the only way to have an increase in the relative price of non-core goods is by having an increase in the money (sterling) price of non-core goods. With the sterling price of core goods and services given in the short run and the sterling price of non-core goods rising, the CPI increases. This one-off increase in the general price level will show up in real time as a temporary increase in CPI inflation. If there is a sequence of such relative price increases, there will be a sequence of such temporary increases in CPI inflation, which will rather look like, but is not, ongoing inflation.
However, an increase in the relative price of non-core goods to core goods and services does more than cause a one-off increase in the price level. It reduces potential output or productive capacity, because it increases the cost of producing core-goods and services through the increased cost of imported raw materials, intermediate inputs, energy etc. If labour supply responds positively to the real consumption wage, then the adverse change in the terms of trade that is the other side of the increase in the relative price of non-core goods to core goods and services, will reduce the full-employment supply of labour and this too will reduce capacity. Thus, unless actual output (aggregate demand) falls by more than potential output as a result of the adverse terms of trade change, GAP will increase and the increase in the relative price of non-core goods will create domestic inflationary pressures for core goods and services.
Clearly, the adverse terms of trade change should lower consumption demand measured in terms of the consumption basket, because it lowers the purchasing power of domestic production over the domestic consumption bundle. Real income measured in consumer goods falls, so real consumption measured in consumer goods should fall. But even if the increase in the relative price of non-core goods is expected to be permanent, real consumption measured in terms of the consumption bundle should not fall by a greater percentage than the decline in the real consumption value of domestic production. That means that consumption measured in terms of GDP units should not fall at all. The adverse terms of trade shock lowers potential output but does not reduce consumption demand. Unless investment demand, public spending and export demand fall in terms of domestic output, actual GDP will not fall. The output gap therefore increases as a result of an increase in the relative price of non-core goods to goods and services. Domestic inflationary pressures rise. Interest rates ought to rise. This inflationary impact of the increase in the relative price of commodities is ignored by both the Governor and the Chancellor.
The fact that nominal GDP growth (or the growth of nominal demand) has not risen does not mean that monetary policy is not too expansionary, because, if my analysis is correct, the increase in the relative price of non-core goods should, at least temporarily, lower the growth rate of potential output. The growth rate of nominal demand consistent with a constant rate of inflation is therefore lower now that it was before. Monetary policy is too loose.
Does modest earnings growth mean that inflation expectations are not influencing wage settlements?
The Governor notes that earnings growth has remained moderate despite the increase in median inflation expectations for the coming year to 4.3% in the Bank’s own survey. The Chancellor notes that earnings growth (including bonuses) is running at only 3.9 percent. Does this mean that inflation expectations aren’t translated into higher wage settlements? Not at all. Time series analysis ( earning growth is not rising) is not the same as counterfactual analysis (earnings growth would have been the same if inflation expectations had been different).
It is certainly possible that the global processes that have depressed the share of labour income in GDP in most industrial countries during the past 10 years (China and India entering the global markets as producers of goods and services that are frequently competitive with those produced by the labour force in the advanced industrial countries, increased cross-border labour mobility, weakening of unions etc.) have not yet had their full impact and that labour’s share will continue to decline. Arithmetically, this means an increase in the mark-up of the GDP deflator on unit labour costs. Clearly, the GDP deflator is not quite the same as the core price index, but even for core price formation, a reasonable case can be made that the equilibrium mark-up on unit labour costs may be rising. Too much comfort should in that case not be derived from the observation that money earnings growth is stable despite the increase in expected inflation: in the core inflation equation (3) mark-ups could be rising and δ could come back to bite you.
What is the right horizon to bring inflation back down to target?
The Governor argues that to try and bring back inflation to its 2 percent target in a year would lead to unnecessary and undesirable volatility in output and employment. (Volatility now means ‘deep decline in the path of’, apparently). CPI inflation is expected to rise to 4 percent or higher later this year. The credit crunch and the resulting reduction in the availability of credit and increase in its cost, declining house prices, stalling construction activity and general loss of confidence among households and firms are likely to cause a quite sharp slowdown in UK economic activity later this year and in 2009. Apparently, the Governor believes that this may be enough to bring inflation close to target over a two-year horizon. There is nothing magical about a two-year horizon, incidentally. It is not in any obvious way related to the transmission lags in UK monetary policy. It just happens to be the published forecast horizon for the MPC – dictated mainly by the width of the paper in the inflation report.
I believe the Governor is taking an unnecessary risk. By acting now on interest rates, say through a 50 bps increase or through two 25 bps increases, the MPC could send a strong, credible signal to the markets that they have not become inflation wimps. The signal would be credible precisely because interest rate hikes are costly. Higher rates would work not just through the output gap (GAP), which itself relies on credibility multipliers, if longer-term interest rates and other asset prices are to be leveraged by a change in the current policy rate, but also through expected future CPI inflation, Πe(+1) . If it turns out to be unnecessary, because the real economy is tanking faster and deeper than anticipated, these up-front cuts can be reversed. Central bankers tend to have an almost pathological fear of rate reversals – strange really, because they are easy and can be explained at length, in depth and in detail to the admiring public.
There is no doubt in my mind that the analysis of the causes of the recent expected future increase in UK inflation presented by the Governor is flawed. It does not follow that his policy preferences are necessarily wrong because of that. The weakness of the UK economy could indeed become so severe, even without further policy rate increases, that an early hike would be inappropriate.
But I worry about what I consider to be loose and sloppy talk about the relationship between global relative price changes and UK inflation.
When you aggregate the statements made by central banks all over the world, you have to conclude that there must be interplanetary trade: the world is importing inflation. Martin Wolf’s column in the Financial Times today, makes the point very well: “The world as a whole cannot import inflation: if every central bank assumes that the rise in commodity prices is the result of policies made elsewhere, general overheating must be the result.”
It is disappointing that even the sophisticated economists that lead the Bank of England and the MPC can spout such rot about the contribution to domestic inflation of changes in global relative prices. My estimates of the depth and duration of the slowdown in UK economic activity that is already underway may well turn out to be wrong. The Governor’s belief that two years is the right horizon over which to pursue the disinflation required to bring inflation back to its target value and his implied assertion that no immediate policy rate increases are necessary may well turn out to be right. But if the Governor’s views on policy are right, it is despite, not because of his analytical framework – his views on the transmission of monetary policy and of exogenous shocks to the economy. And that worries me.