Thursday, 14 August 2008

Forget the inflation report, we still need higher rates.

My post yesterday, where I thought that the BoE inflation forecasts hinted at a couple of rate rises, generated a lot of comments. Most of the comments were politely skeptical. My case wasn't helped much by Mervyn King's press conference, where he indicated that rates are likely to remain at their current level for some time to come. Meanwhile, financial markets took the more subdued BoE growth forecast as a strong hint that the next rate move will be downwards. To tell the truth, I was feeling a little isolated this morning.

I read the inflation report "cold" without looking at any of the press reports. As I said yesterday, the higher inflation rate, the upward revision in the central forecast and the subsequent steeper adjustment path only made sense if there was a more vigorous policy response. Well, if the Bank are now saying that rates aren't moving. That can only mean that their inflation adjustment path doesn't make much sense.

Nevertheless, the question remains what is going to make inflation come down? There is a widespread view that that slower growth will do the trick. While a dramatic decline in growth will eventually exert downward pressure on prices, I think that many commentors haven't appreciated just how large the slowdown needs to be for inflation to fall

After all, growth has already slowed by at least a full percentage point, both here and in the US. So far, the slowdown has had absolutely no effect on inflation. Parts of Europe are already experiencing absolute declines in output, and yet, prices keep pushing northward.

This complancy about growth is evident in the inflation report. The BoE are only predicting a marginal further decline in the growth rate. Their central forecast even suggests that the economy would actually avoid a recession. In other words, the BoE are not thinking in terms of a rapid rise in unemployment, bankruptcies and output declines. The BoE are pushing a story about a relatively painless inflation adjustment.

Recent economic history offers very little evidence to support the view that modest reductions in growth rates lead to large declines in inflation. On the other hand,there is another strategy with a very high success rate. That strategy comprises of higher interest rates, especially rates that are significantly higher than the prevailing inflation. However, more of that later; there is more to be said about growth.

Perhaps the BoE is making deeper miscalculation. There may be a mistaken belief that the long run growth rate of the economy has not changed, that the credit crunch has only affected the demand side of the economy, but left the supply side unscathed.

How might have credit crunch affected the supply of goods and services? There are several ways, but I will focus on one - the UK current account. The first victim of the credit crunch might have been Northern Rock; the second victim was sterling, which has fallen dramatically over the last year or so. Before the crunch, the elevated level of sterling kept import prices down and allowed us to consume huge amounts of foreign made goods.

The high value of sterling was an integral part of the debt-financed consumption boom. As banks cranked up the credit, increased consumption demand was not supplied by the domestic economy. The additional supply largely came from overseas, particularly Asia. The counterpart to this increased demand was a huge UK external deficit. The numbers are impressive. Last year, the UK had the second largest deficit in terms of GDP in fifty years and the third largest in the world, when measured in dollar terms.

Our overseas suppliers, particularly India and China, have now run into their own severe supply constraints. Inflation in both countries has picked up, and it should be no surprise that their price increases are showing up in our inflation. This week's producer and input prices provided ample evidence of this effect.

So, the UK can no longer rely on a rapidly increasing world supply to keep its inflation rate down. The UK is also operating at full employment, so domestic firms can not take up the slack. In other words, The UK economy is not lacking in demand; it is short of spare capacity.

Added to this, we must consider the plight of sterling. In the post credit-crunch world, foreign investors are dropping a very strong hint that our huge current account is no longer sustainable and that a painful adjustment is necessary. In short, this means the cheap, foreign financed consumption boom is over.

In this context, does it make sense to keep interest rates low? Of course not. Lower interest rates, which is the counterpart of rapid monetary growth, works on demand. However, if that demand can not be satisfied, lower rates and rapid monetary growth feed directly into higher prices. This is exactly what is happening in the UK right now.

The right policy response is higher interest rates. In the short run, this will restrain aggregage demand, and release the supply constraint. Growth will slow and a recession is probably a necessary short run cost. Over time, inflation will fall, and permit a market driven restructuring of the economy, where consumption is more restrained, households hold less debt, and the external deficit has moderated. The BoE should forget about trying to squeeze out a few pips of growth from a strategy based on low interest rates, rapid monetary growth and general willingness to placate banks every time they squeal about tight liquidity conditions.

Unfortunately, the BoE still think that a modest and temporary slowdown in growth beat down on inflation without the MPC having to throw a punch. I doubt that inflation is going to go away without a serious fight.


Anonymous said...

"I think that many commentors haven't appreciated just how large the slowdown needs to be for inflation to fall"

It's not complacency. Its a recognition of just how large the slowdown is GOING TO BE.


Alice Cook said...


Obviously, you see it, and I see it. However, I don't see much echo of this view in the wider world.


Alice Cook said...


I think we might have different perspectives on the time line here. I think inflation is going to get worse, and that growth will slowly drift downwards. Then, one day, the BoE will wake up and realized that a rate hike is the only way to regain control of the situation.

In contrast, I suspect you think that a deep recession is just months away.


yellerKat said...

From what I can see, both the Fed and the MPC seem to think a massive bout of demand destruction is imminent.

Rob said...

I wonder if the sterling devaluation was factored into their inflation fanchart? Are we heading for a unforseen sterling crisis?

Anonymous said...

Sharp rise in US foreclosures

U.S. Home Sales Fall to 10-Year Low as Prices Tumble (Update2)


aSteve said...

Growth will not "drift upwards" - because growth is 'inflation adjusted'... (aherm, if you use the right inflation figures in the right places.)

As I read the GDP projection - it is saying that we should expect a significant recession - lasting 8 months or longer of negative growth.

I think that there is something else you can infer from the transition between the projections... while the direction is clear, the time-scales are uncertain and the magnitudes of shifts are dramatically under-stated.

I'm willing to stick my neck out and say that I don't think CPI will be over 5% by Xmas 2008 - and that inflation will be falling sharply by then.

Morally, I support the idea of raising rates... pragmatically I accept that leaving them where they are is likely best for the average UK citizen... even if it gives some demographics an undeserved break.

Rob, my interpretation of what King said is that 'crisis' scale effects of any sort are excluded from the forecast. While a sterling crisis is something I consider more likely now than a few years ago... I remain to be convinced that it is imminent and significant... what's your evidence?

aSteve said...

Alice... a deep recession (actually a depression - since it is caused by excessive capital investment not excessive production) is just around the corner... a few months away - that's if it hasn't already started.

Anonymous said...

Alice, as usual a great blog. I guess you don't consider the deflationary arguments worth considering anymore.
I was extremely bemused by King talking Sterling down, which is what he effectively did, with the attendant consequences on import prices.
However, his role and that of government is for the good of the country, not savers or debtors, and he should of course mislead as and when necessary.
So I suppose my question would be, when does a central bank talk down their own currency ?
Given that most asset prices are falling I would suggest that he is looking to avoid speculation in a deflationary environment. As people sell Sterling with inflation, so will they buy with deflation.
Prior to deflation there is a horrible inflationary spike, maybe we are seeing that.
Anyway, fantastic blog and hopefully don't write off your consideration of any future deflation !


The inflation upswing has caught a lot of people off guard. It is really surprising and even a little scary.

Anonymous said...


Yes, I foresee a deep depression for the UK being only months away, the recession having already hit.

I don't know if you can be bothered to search my past posts, but from the beginning of 2008 my position has been:

- Fast shocking housing crash
- Technical recession from Jan 2008 (once numbers revised later)
- High unemployment especially in retail, finance and eventually public sector
- Short inflation spike on CPI-type things and deflation on assets
- End game of deep depression and serious deflation

I'll admit I was too early in the depression call, I expected markets to crash earlier and deeper rather than a protracted tumble with intermittent sucker rallies, and I basically underestimated how long the government could kick the can down the street. Oh yeah, I never thought the commodity bubble would last quite so long.

But so far I'm pleased with getting the stages right. I guess you will disagree with me on the deflation question until 2009 when it ought to be obvious which one of us gets it right.


Anonymous said...

Can we all stop it with the "Government Inflation Figures" discussion - it's just a mirage.

They were not believable on the way up, nor are they believable on the way down.

"True" price inflation figures should take everything that anyone pays for and divide it among the population. This means that both renting and mortgaging will appear in the figures - because we as a population pay for both. Again both Coke and Pepsi and Polar Cola would appear (though with different weightings) - because the population buys all of them.

This idea of determining some ideal basket of goods, then extrapolating is just hopeless, but helps keep the masses quiet.

So having filled in the background, I ask the question:

How much do carrots have to go up to offset a 10% drop in the price of a house? Especially given that (too) many people spend 50% of their wages on said house, and a little bit less on carrots.

andyrich29 said...


I'm with you on interpreting higher rates.

This is especially true if you watch the webcast on the BOE website, whereby the 2 common themes come out:

a) Inflation risk is generally more to the upside than downside.

b) The committee will take whatever action necessary to bring inflation back to target.

These points were made in a couple of questions. So, if inflation doesnt come down quick enough, which it probably wont, then we are likely to see some hikes.


sobers said...

We already have higher interest rates! You try borrowing money at 5%. You won't find many offers. There is also a built in rate rise for millions of mortgage holders still to come in the pipeline when their fixed rate deals come to an end. Don't forget we're only 12 months into this thing. Anyone who bought (or remortgaged) within the last 5 years could still be on a fixed deal. When those end the new rate WILL be higher. That will have enough tightening effect without raising nominal rates. Inflation is not the issue. A deep recession, even depression, is.

The economy is like a supertanker. There is considerable momentum. Even when the engines are turned off, it continues to go forward for some time. That is where we are now. The engines are dead. The activity you see in the economy now (esp the corporate sector) is stuff that was agreed before last August, contracts signed and finance in place. No new deals, projects etc are in the pipeline. Slowly, by next autumn, the effects will be obvious. Inflation will be falling rapidly, unemployment rising, repossessions rising, insolvencies and bankrupcies rising, govt spending rising and tax revenues falling. Not a pretty sight.

skinto said...

Good post. You make a good case for inflation, and certainly that's the outcome I'm insuring myself against with my own modest savings (in national savings RPI-linked bonds).

I can't however forget:

1. "Inflation [and by extension deflation] is always and everywhere a monetary phenomenon" &
2. Massive bad debts = eventual debt destruction = destruction of money

I hear sound, rational arguments on both sides of the inflation/deflation debate, an intelligent debate completely ignored by the those who think that a sluggish housing market is our only worry.

Kevin Depew on Minyanville has a consistently interesting deflationary viewpoint. In spite of this, your arguments agree in spirit:

"This is not an event, but a process."

Anonymous said...


Don't listen to what the BoE says, listen to what they do. They are jawboning over rate increases one day, then decreases the next. It doesn't mean much. Wait till they actually do something.

If you want to predict, then look at past performance as the best available guide. And that says "cut in recessions"