Sunday, April 22, 2007
Inflation: Far From a basket case
Posted by David Smith at 11:00 AM
Category: David Smith's other articles


When the Bank of England was granted independence 10 years ago, the expectation was that the chancellor and governor would become, if not pen pals, at least fairly regular correspondents.

A letter explaining why inflation had moved more than a percentage point above or below target (and “above” was always thought more likely) was expected roughly every 15 months.

As Mervyn King wrote in the first such letter last week: “The chances of going almost 10 years without an open letter being triggered seemed negligible.”

Actually, we could have had a few more governor letters had the current 2% target, based on the consumer-prices index (CPI), been introduced sooner. Inflation on this measure spent much of 2000 below 1%, and dipped below it again in 2001 and 2002.

That would have generated at least half a dozen letters; because if inflation stays more than a point above or below target for three months another has to be written.

But inflation on the original target measure — the retail-prices index excluding mortgage interest payments — never fell far enough, or rose sufficiently, to force the Bank to put pen to paper.

So how significant were last week’s events? After all, inflation hit 3% in December, which was not quite enough to trigger a letter. The Bank does not have a target range, as its remit from the Treasury makes clear. The letter is simply to explain why inflation has moved away from target.

One of the possibilities foreseen when the Bank was given independence was that a sharp rise in oil prices would push inflation up to 5%, 6% or even 8%, but that the wrong response would be to drive the economy into recession by jacking up interest rates. What happened last week was a pale shadow of that kind of scenario.

The fact that inflation hit 3.1% last month was disappointing but no more, since it is likely to fall quickly back towards the 2% target because of so-called base effects. Big increases last year will drop out of the year-on-year comparison.

Fathom Consulting, using cautious assumptions about cuts in gas and electricity bills, and assuming further rises in petrol prices, says the Bank will be in possession of information showing an April drop in inflation to 2.8% when it meets next month, presaging a fall to 2% in July and just 1.2% by December. RPI inflation, now 4.8%, will be 2.6% by the year-end.

But a letter had to be written some time, though it was a pity it happened so close to the 10th anniversary. These anniversaries tend to be blighted; ask Tony Blair or Gordon Brown. King, sensibly, had not booked the Mansion House for a celebratory bash.

As it is, the 10th anniversary will almost certainly coincide with a quarter-point interest-rate hike by the Bank to 5.5%. At least it will ensure plenty of headlines.

Could the Bank go for a half-point hike as some have been urging? Apart from the fact that it would look like a panic response to backward-looking news on inflation — 3.1% is history — it would require something extremely nasty to come out of the inflation-forecasting round. The Bank has cut by a half-point during the independence era, but all its hikes have been quarters.

One unfortunate consequence of the letter is that it has given ammunition to what I call the “City-editor tendency”. This is a view — this paper obviously excepted — derived from years of dining with crusty Square Mile types, that inflationary disaster is always about to happen and that interest rates should be at least two percentage points above whatever level they are at.

So the City-editor tendency leapt on last week’s average earnings figures, boosted by City bonuses to show 4.6% growth, while the underlying, ex-bonuses figure, 3.6%, remained benign, and ignored evidence of some softening in the labour market, with the broadest measure of unemployment up and employment down.

The City-editor tendency has also been waiting for an opportunity to give the Bank — and Brown — a good kicking for falling down on the job, and the letter provided it. In fact, a more valid criticism of the Bank over the past 10 years is that its inflation forecasts have been too high, not too low. We know that this particular episode of “high” inflation will soon pass. I say this particular episode with good reason. Why has Britain’s inflation rate gone well above Europe’s (1.9% on a comparable basis) after a long time below it? Gas and electricity bills here have risen much more, and are coming down more slowly than they should, thanks to a weak regulator.

The supermarkets, which dominate the food market, appear to have stopped competing on price. Rip-off Britain appears to be back, aided and abetted by “Rip-off Gordon” — higher petrol and other excise duties, air-passenger duty and tuition fees. Take these out of the basket and inflation would still be below 2%, and nobody would be suggesting Britain is in danger of becoming an inflation “basket case”.

The Bank has to play the hand it is dealt but there was, and is, no need to panic; no need for interest rates to rise above 5.5%.

Where the crusties may have a point, and where the Bank’s finest minds will be occupying themselves this summer, is over the longer-term outlook. A 2% CPI inflation target is roughly equivalent to 2.75% retail price inflation. In the 1950s, RPI inflation averaged 4.3%, dropping to 3.5% in the 1960s, then 12.6% in the 1970s, 7.5% in the 1980s and 5.1% in the 1990s. Achieving inflation of less than 3% was, as the sports commentators say, “a big ask”.

Strong growth in the money supply, currently nearly 13%, is not consistent with low inflation in the long term. Neither is current service-sector inflation of nearly 6%. Goods prices, even with the China effect and the helpful impact of a strong pound, cannot keep on falling for ever. Food prices have gone up particularly in Britain — 5.1% over the past year — but they are also strong globally, and are being boosted in part by the switch of crops to bioethanol fuels. The world backdrop is very strong.

So the question the Bank should be asking itself as it enters its second decade of independence is whether it has done enough to cement low inflation in Britain. Firms have been taking advantage of strong demand to raise prices. Customers, it seems, have not been as price resistant as they were.

Cementing low inflation does not mean draconian interest-rate rises, though it probably does mean not cutting interest rates as inflation falls in the coming months. It does mean working harder to get the Bank’s message across.

King chose to let his letter speak for itself last week rather than pop up on radio and television to explain what the Bank was doing. One fear was of being trapped into a soundbite; the other that a media blitz could have been interpreted as a sign of panic. But he and his monetary-policy committee colleagues have to do more to convince people and firms that low inflation is non-negotiable.

PS: It must be a coincidence, but on the day the inflation figures came out I was sent a copy of a new book, Economic Disasters of the Twentieth Century, edited by Michael Oliver and Derek Aldcroft, published by Edward Elgar. At £79.95, it is probably not one for the general reader but it contains plenty of good stuff.

The editors ask whether we learn lessons from past disasters or are condemned to repeat them. Irrational exuberance will surface from time to time. As Oliver and Aldcroft put it: “Whatever reforms continue to be made to the international financial architecture and however robust domestic financial systems are made, economists and policymakers will still be dealing with financial crises 100 years hence.”

But some things get better. The first two Opec oil crises, in the mid and late 1970s, were disasters for the world economy. What the book calls “Opec III”, the rise in prices in recent years, has been much better handled. The Bank may be enduring a little discomfort but is part of a much improved global macroeconomic policy framework.

From The Sunday Times, April 22 2007


What a load of crock. You're article is nothing more than a feeble attempt to disguise the truth: IR as shooting up, debt is real and there is very little the Govt can do about it.

Posted by: Mr Blek at April 23, 2007 09:13 AM

Always glad to have an intellectual response.

Posted by: David Smith at April 23, 2007 10:58 AM

just read the Item Club Spring review-looking long term I believe interest rates will stay at 5.5% for quite some time but trying to predict house prices/stock market is a fools game.

Posted by: william meston at April 23, 2007 12:19 PM

With money supply expansion still sustained at 14%PA, a growing sustained balance of trade deficit, a Govt massaging CPI down to an unbelievable 3.1% and with little growth of productive input to GDP, I think you'd better re-visit where inflation is going this year.

Real inflation to Joe Public is probably 8-12% currently. Why do you think Oil Companies are using 14% typically for their forward budgets?

Sensible people are being crucified for being prudent and saving and the IR rewards for saving are less than inflation. Its only the banksters who are being rewarded.

God I hate this Govt. Rank amateurs.......

Posted by: Randall Herbert at April 23, 2007 03:23 PM

That's novel - inflation to Joe Public is running at twice RPI inflation. Tosh.

Don't quite know what you mean by "little growth of productive input to GDP" - if you mean productivity it is currently growing at about 2%, more or less in line with its long-run average, while manufacturing productivity is growing by just over 4%.

I find that most people who talk about the money supply don't know what it means. M4 is growing by a little under 13% but is heavily distorted by lending to other financial institutions, while narrow money is growing by between 4% and 5%.

Posted by: David Smith at April 23, 2007 07:42 PM

Dear David,

What happens to that money lent to other financial institutions?

Luke Nazesh Radson

Posted by: lukenazeshradson at April 23, 2007 07:56 PM

Back in Jan - in response to the latest M4 figures, stated: "I undertand that the BoE stated: "Investors are likely to take advantage of this ample liquidity and the associated easy credit to purchase other assets, driving risk premiums down and asset prices up.” So they see a correlaton between the incredibly high M4 money supply figures and asset prices. Interesting. What's your take on this David?

Posted by: Luke Nazesh Radson at April 23, 2007 08:05 PM

This is quite a complex area - some of the growth in lending to other financial institutions/corporations has indeed been associated with M & A activity and has thus helped to boost the stock market. But a lot of it is explained by the changing structure of the financial system. This is a link to an attempt by the MPC member who probably knows most about this, Paul Tucker, to explain it. He's not complacent about M4 growth but believes the nature of it has to be properly understood. Here's the link:

Posted by: David Smith at April 23, 2007 10:32 PM

From your PS: I've not read Economic Disasters of the Twentieth Century but another book on a similar subject, that is possibly a more accessible (and cheaper) read for most is "A Short History of Financial Euphoria" by J K Galbraith.

Posted by: Peter at April 24, 2007 07:22 AM

David - given your views on monetarism and the importance (or lack of it) of M4 growth, what are your thoughts on todays comments from Charles Goodhart, Tim Congdon and Gordon Pepper?

I note that two of those three are on the Shadow MPC as well.

Posted by: Minh at April 24, 2007 10:04 AM

Well, it's not open enough to have made its way to me, and I don't trust the Telegraph's reporting. Tim Congdon's views are well known. In his submission to the Commons Treasury committee he said interest rates might have to rise further, "perhaps to about 6%". He also said: "My concern about the inflationary consequences of high money supply growth reflects a view of the economy's workings which is not widely shared among British economists."

Posted by: David Smith at April 24, 2007 10:17 AM

Here's the letter, in the FT. As you might expect, in the flesh it's relatively sober:

Posted by: David Smith at April 24, 2007 10:48 AM

Yes, the actual letter does seem more reserved than the Telegraph article, but the direct quote attributed to Tim Congdon by the Telegraph is:

"Inflation is back and it's going to get to 4pc by the middle of the next year, even though I expect the CPI to fall back a little over coming months first.

"You can't get away with money supply growth of 12pc or 13pc like this. It's not as bad as earlier cycles, but it is nevertheless bad and it's going to end the usual way. Rates will have to go to 6pc to 6.5pc, and may have to reach 7.5pc,"

Whether you trust the Telegraph's reporting or not, that is a direct quotation and sounds pretty severe to me.

Posted by: Minh at April 24, 2007 11:11 AM

As I say, Tim Congdon's views are well known - but it seems a little odd that he's moved from "perhaps 6%" to a definite 6% to 6.5% with a possibility of 7.5% when the rate of growth of M4 has, if anything, subsided in recent months.

Since 1993, M4 has risen by 200%. Prices, broadly measured (RPI) have risen by 45%. Money GDP (growth plus inflation), which you'd expect to exhibit the closest relationship with M4, has risen by 105%. We discovered in the 1980s that targeting a money measure like M4 was disastrous. The Bank acknowledges that there is "excess" growth in M4 at present - it should be growing by about 9%. The question is whether the additional 3%-4% is telling us anything, is distorted, or is, in the words of a recent research note by Goldman Sachs "more noise than signal".

Posted by: David Smith at April 24, 2007 12:31 PM


"Tim Congdon, a former professor at the London Business School and one of the Treasury's "Wise Men" in the late 1980s and early 1990s,"

So he was one of the "wise men", in the probably one of the worst period of financial mismangment that UK PLC has ever seen ;). I expect he likes being reminded of that ;)

Posted by: Kingofnowhere at April 24, 2007 01:05 PM

No, that's not fair. He was a "wise man" - a member of the panel of independent forecasters - from 1992-3 to 1997. This was the system put in place after Britain's ejection from the ERM, and marked the start of the current period of stability.

Posted by: David Smith at April 24, 2007 01:08 PM

That's what I mean about the Telegraph's reporting. He's never been a professor at the London Business School either.

Posted by: David Smith at April 24, 2007 01:11 PM

Dear David,
In line with what you say, academic research has always relied on narrow money rather than M4 to assess the ability of money to predict GDP, unemployment and prices in the UK or elsewhere.

Posted by: Costas Milas at April 24, 2007 06:33 PM

The only problem with narrow money being that these days it is very very narrow indeed! In fact, it makes up such a small part of the overall money supply as to be almost insignificant. I think M0 is something like 3% of M4 or less. Meaning that if the royal mint stopped producing notes and coins tomorrow, the effect would be so small as to be almost unnoticeable. Apart from the practical problems of not enough notes and coins in circulation, of course.

Posted by: Minh at April 24, 2007 07:10 PM

"crusty Square Mile types"

Ha. That's so funny. Are middle aged economics commentators such as yourself so sidelined these days that they feel they need to call city financiers "crusty"?

I'm 25 and work for a corporate bank in risk management. Am I crusty? We make and break sums longer than your telephone number every few minutes. THAT's why we resent being hoodwinked with meaningless 25 point rate rises on the back of contrived inflation stats. Mervyn's current nickname is The King of Wishful Thinking.

Keep watching though because currency traders will get the last laugh - if he takes his eye off the ball for too much longer, they'll dump the pound like yesterday's knickers.

Posted by: Jake Hywell at April 24, 2007 08:40 PM

The great monetarists always emphasised the monetary base, as Costas says, though the Bank has effectively ceased publication of M0. The fact that narrow money is a small proportion of total "money" shouldn't matter, if it is the base for credit creation.

As for Jake, I certainly wouldn't call you crusty; I'd have one or two other descriptions. But let us know which corporate bank you work for, so we know the calibre of the people they're hiring these days.

Posted by: David Smith at April 24, 2007 08:54 PM

Re M0 being the monetary base from which M4 is created - that may have been true in the past, but is it really true today? If there were such a relationship between M0 and M4 would you not expect to see some correlation in their growth rates? With the ever increasing amount of available exotic lending products, business leverage, carry trades and so on, I doubt M4 bears much relationship to M4 at all these days. If inflation could be controlled through credit all based on M0, shouldn't the MPC be given control of the speed of the printing presses too?

Posted by: Minh at April 24, 2007 09:33 PM

Dear David,

The cat is out of the bag for quite some time now.
As you know from my previous contributions, i am an economic fundamentalist. The amount of manipulating inflation figures in the past and present has now reached a point of irreversible incredibilty!
I agree entirely with co-contributor MINH who predicts market force intervention a la SOROS. No swervin by Mervyn will distract the execution of a orchestrated sell off in sterling when it comes, Speak to Mr Lamont he may still remember!
7% by december 2007 here we come.

Best regards to all
Arik Schickendantz

PS and may the forces of liquidity be with you!

Posted by: Arik Schickendantz at April 24, 2007 11:15 PM

I have no more faith in M0 as a target than I do in M4 - all I'm saying is that there is more than one money measure. The alarmists, understandably, focus on the one that is growing strongly. In a simple, closed-economy world, with no changes in velocity, controlling money might work, but even then we do not know whether money leads the economy or the economy leads money. In other words, M4 is a symptom of a buoyant economy and rising asset markets, not a cause.

As for sterling, people have been predicting a crisis for years. The past 11 years have seen the pound more stable than at any time in recent history. Running around warning that the sky is about to fall in hasn't been a sensible strategy.

Posted by: David Smith at April 25, 2007 09:27 AM

Dear David,
Some reports in the papers have overstated the pound "problem".
Back in 1991, Andrew Britton (the former director of NIESR) wrote in his book: "Attempts to use the exchange rate as a policy instrument misfired; attempts to control it failed; attempts to ignore it were no more successful."
According to the MPC minutes in April, "the sterling
effective exchange rate index [which is more representative than the $/£ one] was within the broad range it had traded in for much of the past ten years".
The statements above point to a zone of inaction. Recent research (refs available) shows that the MPC responds to exchange rate misalignments of more than 5%. Simple trend analysis suggests an "equilibrium sterling value" of around 106.2. With the effective rate currently fluctuating at around 104.7, the MPC will start worrying only if it rises to around 111.5 (i.e. 5% above "equilibrium"). In the meantime, the MPC will be happy (and rightly so) to see the exchange rate putting downward pressure on inflation.

Posted by: Costas Milas at April 25, 2007 10:02 AM

I agree that M4 growth is a symptom of a rising asset market rather than a cause, but in that case where do you look to for the real cause of the two? The answer has to be lending standards, with the possible underlying reason being changes in capital adequacy standards and reserve requirements. However the link between M4 and inflation is not so far removed, since all money is created as debt and when debt increases, so does the cost of servicing that debt. In fact to refer to M4 as the money supply is a bit misleading, it should really be called the "debt supply"!

Posted by: Minh at April 25, 2007 12:44 PM

"so we know the calibre of the people they're hiring these days"

and if the calibre is not up to scratch, and when I tell you who I work for, what you'll call up my boss and say "this Hywell chap he's really not the right sort ... ". Ha. Look who sounds crusty now.

If you wanted to talk to my boss then a) you'd need to speak good Japanese and b) you'd need to be twice as good at what you do and c) you'd have to be assuming that he (his name is Mr Tsuruga) really cares about your opinion. That Evan Davies on the other hand. He's very good at this economics commentator thing. Check out his blog:

His last entry got 57 comments, and most of them agree with him. You get twenty odd and most of them tell you you're wrong. Oh dear.

Posted by: Jake Hywell at April 25, 2007 08:25 PM

I suspect Evan gets a lot more comments than that but I'm sure the BBC employs a moron filter to keep out silly little idiots without an argument in their tiny brains.

Now run along, it must be way past your bedtime.

Posted by: David Smith at April 25, 2007 09:37 PM
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