Friday, 17 December 2010

When empirical regularities won't do what you want them to do.

The Bank of England seem rather confused about the recent alarming surge in inflation.

Adam Posen was the latest member of the committee to articulate his confusion. Earlier this week, he gave a talk at the annual christmas breakfast of Essex Institute of Directors, which was held in the "charming" town of Billericay.

Mr.Posen explained why recent inflationary develops were no different from earlier times. He argued that four important "empirical realities" affecting inflation were still at work in the UK, despite the recent upheavals caused by the banking crisis.

Those regularities were:

  • Unemployment affects inflation at 1-2 Year horizons:
  • Large output gaps persist after financial crises:
  • Private consumption contracts in the medium-term during fiscal consolidations
  • Unit labour costs are a significant predictor of inflation
According to Posen, these four regularities are at work right now in the UK, placing downward pressure on prices. The unemployment rate today almost twice as high as it was two years ago. A large output gap remains after the banking crisis. The government is about to implement a sizable fiscal consolidation, that will prompt a contraction in private consumption. Finally, wage pressure remains subdued and unit labour costs are under control.

In fact, downward pressure on prices is everywhere except in the data. Here, the inflation rate stubburnly refuses to adhere to Mr. Posen's empirical regularities.

So, where is the flaw in Mr. Posen's argument. I believe it is on this assumptions about the output gap. The UK was uniquely dependent on financial markets as a source of economic growth. The financial crisis has eliminated a key source of UK growth. More generally, the extended contraction in output has destroyed both human and physical capital, limiting the flexibility of the economy to jump back as aggregate demand picks up.

Therefore, the output gap isn't as wide as the Bank of England thinks. Competitive pressures in product markets are not that elevated, and firms can pass on the sterling depreciaiton and VAT hikes more easily into prices.

One final irony from Mr. Posen; he barely mentioned interest rates. The key policy instrument was only mentioned four times, and never in the context of a credible counter inflationary strategy.


Jim said...

I think you are spot on with the output gap myth. Most of the UK economy is services now, so the output gap only exists if people are prepared (and financially able) to start new businesses to replace the ones that have gone bust. Its not like when the UK was covered in factories that were still there but producing less goods because of lack of demand. Most manufacturing in the UK is high end stuff nowadays, for export. And produced on demand, not made on spec. They don't make it until the order is in. And because its specialist stuff they can price accordingly.

Most of the stuff we consume in the UK is imported, and therefore dependent on the pounds strength on the currency markets.

Imagine your average town - it might have had 4 hair salons prior to the recession, now perhaps 2. According to the BoE that's an output gap of 2 hair salons which will put downward pressure on the pricing ability of the other 2. But only if someone has the desire to open a new salon (and has the cash to do so, cos you're not getting any finance from the banks!).

Anonymous said...

What is the output gap?

Anonymous said...

The excellent answer

Steven_L said...

The UK is becoming more insignificant in the world, that's all that's happening.

It's just reality catching up. Until we can find something better than dodgy debts to export to our suppliers we'll get poorer.

Anonymous said...

I am not sure about the UK being "uniquely dependent on financial markets as a source of economic growth". However, your statement that "The financial crisis has eliminated a key source of UK growth" might not be entirely true, if by that you mean that the financial services sector has taken a hit.
In September 2007, there were 93,000 people working in financial and business services in Canary Wharf. Now, there are just around 100,000.
Crisis? What crisis?