Sunday, June 13, 2010
Andrew Sentance on inflation
Posted by David Smith at 12:00 PM
Category: Thoughts and responses

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This is the monetary policy committee's Andrew Sentance, writing today in The Sunday Times on inflation:

On Tuesday, inflation figures for May will be released. The last data, for April, showed consumer price inflation at 3.7% — significantly above the 2% target that guides the decisions of the Bank of England’s Monetary Policy Committee (MPC).

Inflation has been volatile, particularly because of changes in Vat and energy prices. But this is the second significant inflation spike in the past couple of years. This is unusual because we normally expect recessions to push down inflation. Yet since the start of 2008, CPI inflation in the UK has averaged 3% — above the 2% target and more than one percentage point above its average in the pre-recession period of growth.

External factors, such as a volatile oil price, have made control of inflation difficult. But if they were solely to blame there would be a similar effect elsewhere. America and the eurozone have seen lower and more stable inflation, averaging about 1.75% since early 2008. Higher petrol prices have pushed up inflation in America, but to a much lesser extent than in Britain.

So how do we account for the unusual behaviour of UK inflation? In my view, two main factors are at work. The first is the pound’s weakness. Since the middle of 2007, sterling has fallen about 20% against the euro and nearly 30% against the dollar. This has generated more upward pressure on import prices in our economy than elsewhere.

But there appears to be a domestic component. The GDP deflator captures the contribution to inflation of wages, profits and expenditure taxes. Since the recovery started around the middle of last year, it has risen by 5% at an annualised rate. This is about twice its normal rate and the biggest jump over three quarters since the early 1990s.

The rise in Vat can only explain a small part of the increase in inflation. It appears that instead of pushing down significantly on cost and price increases, the impact of spare capacity on domestic inflation has been muted.

It is true that wage growth fell back sharply last year, as many companies imposed or negotiated pay freezes. But it also appears lower wage growth was used by companies to help offset the impact of weak demand on profit margins, rather than being passed on into prices. We could see the impact of lower wage growth on inflation with a lag, and this partly underpins the Bank’s forecast that inflation is likely to fall back to target and drop below it over the next year or so.

But wage growth is picking up as the labour market stabilises and some firms start to recruit. In manufacturing, underlying pay growth is back to a pre-recession 4%-5%.

So there appear to be more fundamental reasons why spare capacity has failed to exert much downward pressure on inflation.

One candidate is the anchoring of expectations to the inflation target, despite a big downward shock to demand in late 2008 and early 2009. The MPC’s actions helped head off a downward shift in inflation expectations.

But there is now a challenge from the other direction, as surveys point to some upward pressure on public inflation expectations. There also appears to be less spare capacity in the economy than many had feared.

Unemployment has risen to a lower level than at this stage of the economic cycle in the early 1980s and early 1990s — it is at 8% of the labour force rather than 10%. The latest CBI survey shows 62% of manufacturers reporting spare capacity, in line with the average for the decade before the crisis. This evidence is hard to square with the drop in GDP figures, though these could be revised.

A third factor is the rapid turnaround in nominal demand. Since the middle of last year, all the main measures of spending in money terms have grown at close to an annualised rate of 6% or more — above their trend growth rates for the decade before the recession. This bounce in demand reflects a recovery in confidence and the strong stimulus monetary policy provided by cutting interest rates to 0.5% and injecting £200 billion into the economy through quantitative easing. Though real GDP has turned round more slowly than money spending, surveys suggest activity is gaining momentum.

In late 2008 and through 2009, the MPC put in place a highly expansionary monetary policy to offset the sharp contraction in demand driven by the financial crisis. However, the recovery in the economy and the resilience of inflation highlight the issue of how long such an expansionary policy will remain appropriate.

As spare capacity has not exerted much downward pressure on inflation so far, there must be a high degree of uncertainty about its future impact. And though some headwinds to growth will remain — including deficit reduction and weakness in some eurozone economies — these can be offset by growing confidence and momentum from private-sector demand, as in the 1990s recovery.

This will make for some interesting debates on the MPC in the second half of the year.

From The Sunday Times, June 13 2010