Wednesday, 15 December 2010

The UK economy is operating close to full capacity

The November inflation numbers must have forced a cold shiver down the backs of many in the Bank of England. The Bank had been expecting a winter moderation of inflationary pressures. Instead, prices are rising far faster than anyone at the Bank had anticipated.

In a speech last week, Charles Bean, the Deputy Governor, said as much:

"While UK output growth has come in much in line with our expectations, the same cannot be said of our primary objective, inflation. Back in August of last year, our central projection was for CPI inflation to be around 1.5% now. But inflation has been markedly stronger than that – 3.2% on the latest reading."

The "latest reading" was taken in October. The November "reading" is even higher, with the CPI now at 3.3 percent and the RPI at almost 5 percent.

According to Mr. Bean, the higher inflation rate was due to three factors. The first two are old favourites - energy prices and the sterling depreciation. Well, if the Bank of England allows the currency to depreciate, then higher import and fuel prices is inevitable.

However, the third excuse was the most intriguing. Here is how Mr. Bean put it:

The third potential ingredient behind higher inflation is a more moderate drag from the margin of spare capacity in the economy. Pay growth has been subdued during the recession, and that has helped to ensure that unemployment has risen far less than many commentators feared. Rather the puzzle is on the pricing side, as prices have been higher relative to costs than expected. That could indicate that the margin of spare capacity is not as large as the collapse in activity might suggest.

What does this mean? For the last three years, the Bank of England had assumed that the financial crisis had created enormous spare capacity within the UK economy. The lack of credit had prevented consumers from spending and firms from investing. This meant that unemployment rose and factories were operating at levels far lower than during the pre-crisis days. In principle, this should have limited the potential for higher inflation.

Furthermore, there was a danger that the price level might actually fall. This would worsen the balance sheets of the private sector, making a recovery more difficult. It was this fear of deflation that prompted the Bank of England to begin quantitative easing.

The inflation rate was working with another script. Rather than moderate, the rate has for most of the last three years remained stubbornly above the Bank of England 2 percent target.

As Mr. Bean's speech testifies, the Bank of England are now considering the possibility that, contrary to earlier assumptions, the economy may actually be operating closer to full capacity than previously thought. Therefore, any further attempt at boosting activity, such as a further splurge of quantitative easing, will feed through into higher inflation.

Many in the Bank are harbouring two conflicting thoughts. Capacity may be tightening but the current inflationary spurt is still regarded as temporary.

This is how Mr. Bean explained it:

Ultimately, however, this period of elevated inflation should prove temporary. The standard rate of VAT is set to rise again at the beginning of next year, but once that drops out of the annual comparison a year later, so the inflation rate is likely to fall back sharply. The impact on prices of sterling’s past depreciation should be starting to wane. And the relatively moderate expansion that we expect over the next year or two should ensure that there is some, albeit uncertain, brake on inflation from spare capacity.

This statement reeks of self-doubt. With inflation well above target, and the economy approaching its supply limits, the sensible thing would be to raise rates. Despite the clear and alarming trends in the inflation numbers, the Bank of England isn’t quite ready to move.


Jim said...

Two words - incompetent or planned. Its one of them.

J said...

I went to a talk a couple of weeks ago by Mr Bean at the City of London Club and the overriding impression that I got was that the MPC didn't really know what it was doing; it was all a stab in the dark.....

Anonymous said...

I don't understand Alice why you take what they say at face value.
I thought it was a known fact that what bankers and politicians say in public isn't the same as they say in private.

They are keynesians which is an economic theory that doesn't match reality so isn't going to work anyway.

If the bank of england were trying to devalue the debt with massive inflation (which I believe they are since its our only way out of the unaffordable amounts of debt), they are not going to tell the public..

The British government/banking alliance are like the loser from the local council estate who has been living the high life on the credit card but who's now reached the limit, and now its time to pay up they are desperately flailing around trying to figure out how they can continue spending as much as before.