Dear Chancellor…

Dear Chancellor,

There it is: 3.x%, with x > 0. What can I say? As that great philosopher Forrest Gump said: “shit happens”.

I won’t insult your intelligence the way both of us have at times seen fit to insult the intelligence of the British public – by claiming that the rising world prices of energy, food and other commodities lie behind the increase in the rate of inflation in the UK, the USA, the Eurozone and most of the rest of the world. When the currency floats, as is the case for sterling, central banks make inflation. To be even more precise, whatever else drives inflation in the short term, central banks can drive inflation towards its target level in the medium term. Short run price level and inflation blips are beyond our control, but over a horizon of more than a year or so, the buck (or should that be the quid?) stops at Threadneedle street.

The terms of trade shocks

The adverse terms of trade shock suffered by most commodity-importing and manufacturing- and services-exporting countries will reduce both aggregate supply and aggregate demand, with an ambiguous effect on the output gap. It may be that, in the case of the UK, the effect of the terms of trade deterioration was to increase the output gap. Other things being equal, this would call for a higher path of interest rates to lower the level of aggregate demand. We did not foresee the magnitude and persistence of the increase in the relative price of energy, raw materials and food to manufactures and services (the relative price of non-core goods to core goods and services). Neither did anyone else. So we are behind the curve as regards interest rate increases because of that.

Even if the aggregate output gap is unaffected by the global developments that caused the deterioration in the terms of trade, the increase in the relative price of non-core goods to core goods and services will occur through a one-off increase in the general price level. This is because non-core goods prices are set in auction-like, technically efficient markets and are flexible. The prices of manufactured goods and of many services are Keynesian prices, determined by long-term contracts. They are sticky in the short run. This one-off increase in the general price level cause by a given adverse terms of trade shock, will manifest itself gradually over time as a temporary increase in the rate of inflation.

There has been a sequence of such unanticipated deteriorations in the terms of trade over the past couple of years. A sequence of temporary increases in the rate of inflation looks rather like a permanent increase in the rate of inflation. If we had known that such a sequence of terms of trade shocks was going to hit the UK economy, we could and probably should have raised rates temporarily. But we did not know about this sequence of terms of trade shocks and we did not raise rates. Again, we are behind the curve as regards raising interest rates because of that. But the Euro Area (HICP inflation at 3.7 percent in May) and the USA (CPI inflation at 4.2 percent in May) are doing even worse than us. Misery loves company. We have company!

Un-anchoring inflation expectations

Not only is inflation above target and rising, inflation expectations are also above the inflation target and rising. Inflation expectations extracted from break-even calculations using nominal and index-linked gilts are pretty useless because of the government’s reluctance to issue sufficient quantities of long-dated index-linked gilts. However, inflation swaps do show a distinct upward drift. Our own Bank of England inflation expectations survey and the YouGov survey of inflation expectations are horrible. Median one-year ahead expectations are now at 4.3 percent. We let this happen. Sorry!

What drives these expectations is not completely clear (it rather looks like RPI inflation with a half-year to one-year lag). I sincerely hope these new elevated inflation expectations indeed follow actual inflation with a short lag. In that case we can, by beating actual inflation on the head with a negative output gap, bring down inflation expectations quite swiftly. If the current high expected inflation rate is deeply embedded, we would have to beat the real economy down a lot harder and for a lot longer. Here’s hoping!

It may be that inflation espectations reflect the perception of the median surveyee, that the MPC has become wimpish and does not have the courage to raise rates when the economy is slowing down sharply, even though higher rates would be the best option for meeting the inflation target. In that case, raising rates when there is doubt about the MPC’s mettle may serve as a signal about our true intent and determination. To be credible a signal has to be costly. An early increase in rates (relative to what the markets, wage and price setters and households expect) could therefore have a double effect: once through the output gap (the costly bit), and once more through the restoration of our anti-inflationary credibility and thus through the expected rate of inflation (the gratis extra bit).

What now?
What are we going to do about it? Raise the path of the official policy rate, of cause – relative to what this path would have been without the adverse terms of trade shocks and without the loss of anti-inflationary credibility. Whether this means an increase in policy rates in a time series sense as well as in a counterfactual sense, is for the MPC to decide and for you to find out.

We are going to get quite a bit of help in combating inflation from the major slowdown in aggregate demand that is in the works as a result of the bursting of the housing and construction bubble and because of the tightening in the availability of credit and the increase in its cost caused by the local manifestations of the North Atlantic credit crunch. Housing investment is tanking already and will fall further.

The UK household sector has been living beyond its means for years. The excessive and unsustainable leverage of the financial sector has its real economy counterpart mainly in the household sector. The household saving rate will have to rise by several percentage points of GDP to restore financial sustainability. Higher household saving means lower private consumption unless there is a household disposable income miracle. It is clear from the growth of earnings and other sources of household income that such a miracle will not happen. With government finances as stretched as they are, help through lower taxes and higher transfer payments also cannot be expected, beyond your £2.7bn handout to buy peace/votes following the row over the abolition of the 10p personal income tax band.

In a perfect world, lower household consumption could be offset by an increase in government spending on goods and services, an increase in private investment or a smaller external trade deficit and would not lead to higher unemployment or slower output growth. Higher public spending is not really feasible because of past pro-cyclical fiscal incontinence on the part of the government (mainly your predecessor’s responsibility, actually). Higher private investment when the economy is going into a major slowdown/possible recession is also not something I would bet the farm on. We may get some joy from rising exports and falling imports, especially if sterling continues to weaken. Of course a further weakening of sterling would hurt headline inflation.

The financial sector of the UK – the banking sector especially – enters this slowdown in bad shape. Households have to go through an unavoidable belt-tightening exercise to adjust to the terms of trade shocks and to restore the external deficit to a sustainable level. The slowdown of demand growth is likely to be sharp and protracted. There may even be a recession. From the point of view of bringing inflation down to its target level, this will help. We may only have to raise rates by 50 bps or so as a result (relative to what would have happened in some counterfactual scenario, I hasten to say).

I expect the inflation rate to make a sustainable return to a level close to the 2 percent target in finite time with positive probability. As to how this whole episode is consistent with our mandate, I would like to refer you once again to the statement of Professor Gump in paragraph one of my open letter. Could things have been managed better? Let me just say that I would prefer not to have to start from here.

Yours ever,

The Guv

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website