Monday, 14 April 2008

Every policy target needs at least one policy instrument

If the UK is heading for deflation, it is hard to see it in the latest output and input prices. Both series are rising quickly.

Input prices, which includes fuel and materials, is now rising at over 20 percent a year.

Meanwhile, output prices are now increasing at over 6 percent a year.

What should the Bank of England do in the face of such alarming numbers? It should remember the old rule, every policy objective needs at least one policy instrument.

The MPC has one just policy instrument - the interest rate. It has two potential policy targets. It can either try to bring down inflation, which requires much higher interest rates, or it can try to save the housing bubble with lower interest rates.

After the last meeting, the MPC announced that it would go with the housing market, while inflation can take care of itself for a while. It cut interest rates by 0.25 percent. The consequences were easy to predict. Sterling is now sliding, and commodity prices will continue to grow at double digit rates. Inflation is likely to keep on rising for the foreseeable future.

Unfortunately, a couple of feeble interest rate cuts was never likely to save the UK bubble from an ignominious crash. The market is going down in flames. Nothing can save it.

During the last meeting, the MPC made the wrong choice; it would have been better to push the costs of the housing bubble back onto the financial sector. Since the banks created this mess, let them take the hit.

The MPC should have focused on its core mandate - price stability. It is time to start hiking rates again.


Josh said...

Inflation is definitely running at 10 percent.

Anonymous said...

I think the BoE was wrong to cut interest rates but they did have the rationale in their favour - the commodity bubble is about to pop and coupled with severe economic contraction there really will be net deflation.

But yes, you can't have an asset bubble and low inflation at the same time. You can pretend for a while by one-time global wage arbitrage and exporting inflation to China, but that can't last.


Anonymous said...


There's an important question to ask here: How does a company pass on higher costs to the consumer?

The consumer is tapped out and can't pay. They can't increase the amount of take-home pay in a recession, especially if taxes rises. So every pound spent on higher fuel costs is a pound less on anything else. There is no net inflation from rising fuel or food prices - just price increases in one thing, price decreases in the other.

Look at Weimar Germany for an example - rent was about 2% of take-home at the end of the hyperinflationary episode.

Where is the ability to pass on costs?

- Food: people trade down from eating out, to eating in and from expensive branded prepared foods to raw ingredients
- Energy: people drive less, turn off lights or radiators when not in use, take less baths etc

Once you get to discretionary consumer goods it's even harder. People just delay purchases until something breaks and needs to be replaced. Which cash-strapped consumer will buy a £1000 Smeg fridge freezer when a Beko one costs £200.

Don't underestimate the margin of branded goods. Do you think Ted Baker can charge £80 a shirt in a recession when Primark can charge £5 (or even £10 if costs double).

And services? Can Toni & Guy charge £80 a haircut when Toppers charge £6.

Which universities can bilk students out of £5000 annual tuition if they can't get loans to cover it?

Sure, costs can go up but it doesn't mean prices have to go up. Companies charge what they can, not a simple cost-plus.

Also, there can never be net inflation without an increase in the money supply. That should be obvious. Until that happens, a higher price in one place means either a lower price or no sale in another place.


Alice Cook said...


The points you make are really about the tail-end of the adjustment process, when the economy is in recession. The UK economy is definitely not in recession right now. Q4 GDP growth was quite strong; retail sales data is good 'til February, and consumer debt (surprisingly) has picked up recently. As yet, I doubt that there has been much pressure to reduce margins. Also, money supply data has only slowed marginally. Only the housing market is actually in any trouble right now. Of course, this could all change as the year progresses, but my sense is that demand pressure is still strong and inflation has plenty of upward potential for a couple more months.

As for the commodity bubble, I still think it has some legs. I don't expect oil prices to come down any time soon. Perhaps, towards the end of the year, if the US is in a solid recession, then we might see some downward pressure on commodities.

As for the UK, we have a sliding currency, a huge current account deficit, and a loosening monetary stance. Inflation will be here for a while.


Anonymous said...


All good points and I'll agree to an extent becuase we are still early, just at the inflection point between bull and bear market, and still reliant upon lagging data.

However, all the retail news has been bad since the consumers last fling over christmas. Now they've gotten desperate. A whole bunch of retailers are in trouble and quite recently there were rent revision cos lots of them couldn't cover the quarterly rent. It's only anecdotal but I'm already seeing less footfall on Oxford Street, more and deeper discounting, and any excuse for a sale.

Sure, it's not a Florida style depression yet but I think the signs are unmistakeable. I think once the sovereign wealth funds ans hedgies come out of commodities everything will crash into deflation, except perhaps oil (but only because of peak oil - a real supply/demand issue not an inflationary one).

At a more distant point grains might go up because of water shortages (especially the US and China) but even then that could likely just lead to more budget-conscious vegetarianism rather than full-on bubble prices.


Anonymous said...

>If the UK is heading for deflation, it is hard to see it in the latest output and input prices. Both series are rising quickly.

I'm guessing deflation in anything purchased with borrowed money, inflation for everything else.

>The market is going down in flames. Nothing can save it.

That's ok then , "Nothing" seems to be Gordons plan.

>The MPC should have focused on its core mandate - price stability. It is time to start hiking rates again.

Until mid-07, the MPC used to simply follow 3-month Libor. Now the MPC is simply irrelevant and just a BoE marketing tool. Base rates are decoupled from savings and mortgage rates. I don't think there is any point worrying about what the MPC do. It has no control/influence.


Anonymous said...


Have you read Mish's "Fed Uncertainty Principle" piece? Excellent discussion on the effect (or lack of) of a rate-fixing committee.


Anonymous said...

Alice, do you have any pictures of yourself. On a scale of 1 to 10, how hot are you?