Sunday, October 23, 2005
Inflation on the horizon? No, it's just a mirage
Posted by David Smith at 11:00 AM
Category: David Smith's other articles

Like migrating birds (with or without flu) or the autumn leaves dropping from the trees, some things come round with monotonous regularity. One of them, to lurch into economics, is the warning that inflation is about to take off.

If I had a pound for every time somebody has sat me down and said in deadly earnest that inflation was about to return with a vengeance, I would have retired rich by now.

Twelve years ago, after inflation had painfully been brought down by the recession of the early 1990s, the air was thick with warnings of its imminent return. Sterling had fallen sharply following its exit from the European exchange-rate mechanism. And we all knew what would happen when the pound fell — inflation was bound to go up because of higher import prices.

Except that it didn’t. Nor did it on the numerous other occasions when the doomsters have been out in force in recent years. Sometimes it has been because of concerns about pay settlements, on other occasions because of worries about money and credit growth. Many saw the boom in house prices as a harbinger of high inflation, whereas higher house prices have acted more like a sponge, soaking up excessive growth in credit.

Through it all, inflation has kept remarkably low and stable. In the past, inflation’s twists and turns made it one of the most exciting economic indicators. For the past 12 years it has been — there is no polite way of putting this — boring.

But now people are starting to get excited again. Last week inflation measured by the consumer prices index (CPI) hit its highest level since 1996. The Bank of England’s monetary policy committee (MPC) was talking, not about cutting interest rates further, but fretting about whether they might have to go up if high oil prices started to convince people and businesses that higher inflation was here to stay.

The stock market, which was looking for a hint from the Bank about the timing of the next cut, took it badly, recording its biggest one-day fall since May 2004.

Let me deal with both matters. That nine-year inflation “high” is in fact rather good news. Against City expectations that consumer-price inflation would hit 2.7% last month, the rate rose only slightly, from 2.4% to 2.5%.

True, that is above the 2% official target but if there is one thing that has been drummed in since the Bank was made independent in 1997, it is that the inflation target is meant to be symmetrical. When inflation on this measure was 1.1% exactly a year ago, the worriers said that it was clearly unrepresentative of true inflation. Now it is above the target, they love it, and see it as evidence that the genie is out of the bottle.

In fact, for inflation to be as low as 2.5% in a month when petrol prices bore the full brunt of Hurricane Katrina was a minor miracle.

There is something else odd about the CPI inflation measure, which was foisted on the Bank by the chancellor in the wake of his last euro assessment in June 2003. This is that outside the Treasury, Bank and the City it means very little.

The index is not used as the basis for the vast majority of wage settlements, or for indexation. Pay negotiators still tend to look at the old retail prices index (RPI). This shows, not rising inflation, but the exact opposite. Retail-price inflation was 3.5% last December; now it is 2.7%. That is one reason why pay settlements remain reassuringly low.

Slightly more sophisticated types look at the Bank’s old measure, the RPI excluding mortgage-interest payments. A couple of years ago inflation on this measure stood at 3%. Now it is 2.5%, exactly where it was last December, having moved in a 2%-2.5% range in the intervening period, 2.5% being its old target.

I could go on — but the fundamental point still stands. The only things pushing up prices in Britain are high oil prices and. to a limited extent, past strong growth in the economy. But oil prices will come down, indeed have done from the Katrina peak, and have a long way to fall. The economy is no longer pushing against capacity limits. Retail-sales figures were higher than expected last month, but only because stores cut their prices aggressively in mid-season sales. There is no inflation out there: it really is a mirage.

I can already hear the sound of some people grinding their teeth. What about the continued growth in money and credit? Surely that will end up being inflationary?

The MPC in its October meeting, which resulted in a 9-0 vote for no change, fretted about “robust annual rates” of growth in money supply.
It should relax. Broad money, M4, has been about the worst predictor of inflation. In the past 10 years broad money has risen by more than 100%, while consumer prices have increased by only 16%. It has had nothing of value to say about inflationary pressures in the economy.

Does all this mean that the Bank should carry on cutting, bringing base rates down at the earliest opportunity next month? While it is tempting, that is not my view.

There has to be a good reason to change rates, and it is not there at present. The markets have concluded that nothing will happen next month and look to be right. While the inflation figures were not as bad as they might have been, the jury is still out on whether overall economic growth is as weak (1.6%) as official figures say it is.

Next year, when inflation is falling and if growth continues quite weak, will provide an ample opportunity for a rate cut or two. But the Bank can safely shut up shop for the rest of this year.

PS: According to which version you read last week, the Bank of England is either becoming a rest home for former Treasury mandarins who missed out on top civil-service jobs, or a haven for the best the public sector can offer.

The comment was sparked by the news that Sir Andrew Large, formerly of Barclays Capital, is relinquishing his post as Bank deputy governor early to return to the private sector — one can guess he didn’t enjoy it too much.

His replacement will be Sir John Gieve, permanent secretary at the Home Office, and before that a long-serving Treasury civil servant. The Bank has two deputy governors. The other, Rachel Lomax, is another former civil-service permanent secretary, who was also at the Treasury. There could be a pattern here.

In the old days, the search for the people to run the Bank began and ended in the City’s banking parlours. But that hasn’t happened for a while. The last clearing bank chairman to head the Bank was Lord Kingsdown, the former NatWest chairman Robin Leigh-Pemberton, who stepped down as governor 12 years ago.

The nature of the City has changed (most of it is foreign-owned and its top people earn mega-bucks) and so has the nature of the Bank. Getting down to the nitty-gritty of monetary policy is not nearly as much fun as attending ceremonial dinners and raising your eyebrows occasionally.

Does the fact that two deputy governors will be ex-Treasury mean that monetary policy will be steered in a way that suits the chancellor? That certainly hasn’t been the case with Lomax and I don’t detect that Gieve is a “Brownie” — part of the chancellor’s small inner circle.

A crucial point might come when a new governor is appointed. Some say Mervyn King’s increased willingness to criticise the chancellor on fiscal policy, coupled with his desire for a life beyond the Bank, means he will be a one-term governor. He is already nearly halfway through a five-year term that began in mid-2003. Interesting.

From The Sunday Times, October 23 2005


The RPI is a better measure of inflation for both employers and unions to use than the alternatives - as it includes housing costs. Employers and unions who ignored changes in disposable income of staff/members because of housing cost changes would be in gross dereliction of duty - and would ignore factors causing staff to seek better paid jobs elsewhere. Actually, you probably need separate indices for mortgage-payers and tenants to spot where trouble might arise. The crucial element is the value of the 'pound in your pocket' and CPI does not measure this as long as it excludes housing costs.

Posted by: Paul Bivand at October 24, 2005 10:03 AM

RPI probably is a better index for employers and unions to use as a guide for setting pay increases. But the RPI is no use as a target for the MPC, as every time the MPC reduces interest rates the RPI falls the following month. This explains why RPI fell in September, following the August interest rate cut, while RPIX rose.

But suddenly this whole target-setting business has become a burning issue with the choice of Ben Bernanke to replace Alan Greenspan. Ben (if we can call him that so soon) is an advocate of inflation target setting. Assuming Ben tries to introduce the same system for the FOMC as for the MPC (and the ECB) there are big questions about which measure of inflation to use as the target and whether to specify a target range.

Also, there’s been a lot of media comment recently about the Fed being more interested in the CPI-less-food-and-energy (core index) rather than the all-items CPI. It seems better to focus on the all-items index. But a graph of both shows the all-items index just oscillates around the core index over time. The core index gives a smoother picture of what’s happening to inflation.

This also raises the question of why a UK ‘core’ inflation index is never mentioned. And if the US ends up with a different target to the UK, should we change to match the US or stick with the EU approach?

Posted by: David Sandiford at October 25, 2005 12:15 PM

"Broad money, M4, has been about the worst predictor of inflation. In the past 10 years broad money has risen by more than 100%, while consumer prices have increased by only 16%. It has had nothing of value to say about inflationary pressures in the economy"

I'm no economist but I am a monetarist. If prices and the growth in goods and services don't rise in line with the growth in the money supply then the remainder must go into savings -- specifically the savings of the oil producers. These countries then loan it back to the oil consumers to finance their consumer spending. As long as the increased quantity (of primarily dollars) is kept stashed in surplus in the oil producers, inflation will remain benign. If these countries desire to spend it then the purchasing power of that currency must slide. The great danger starts with a trickle because if those holding vast quantities of dollars fear a devaluing of their reserves then they will rush to store it in another foreign currency.
What you see on the horizon is no mirage, its the formation of the worlds next reserve currency.

"The only things pushing up prices in Britain are high oil prices"

Agreed there are some second round effects of oil prices but a high oil price is primarily a symptom not a cause of inflation. Those petrodollars are useful for buying up FTSE and NYSE listed companies after all.

Posted by: assetpriceinflation at November 11, 2005 04:50 PM
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