Reasons to Tighten Monetary Policy

In previous posts, I have suggested underlying 'core' inflation is less than headline inflation. Combined with sluggish growth, weak pay growth, large output gap and deflationary fiscal policy (government spending cuts / tax rises) it would be a mistake to depress the economy. I also believe that in a period of cost push inflation, there is a case for a higher inflation target.

Yet, despite agreeing with this analysis and feel interest rate hikes should currently wait, I still find Andrew Sentance's speech quite compelling. He lists Ten Reasons to Tighten.

Essentially, his argument is:

• UK CPI inflation above target
• Global inflation rising.
• Less spare capacity in UK economy than you might expect.
• Depreciation of Sterling has caused imported inflation and it is worth protecting value of sterling.
  
• Increasing interest rates will help maintain credibility of monetary policy
• Increasing interest rates will give firms a signal they need to increase efficiency rather than rely on the artificial benefit of deprecitation.
• Increasing interest rates now - slowly and gradually will make the increase in rates less dramatic and potentially less painful.
• Historically monetary policy is very loose.
  

There is economic logic to both sides in this interest rate debate. To complicate matters, data from the economy is giving mixed signals. The recent fall in GDP in Q4 2010, was reassessed to be even deeper at -0.6%. Yet, other signals such as expectations of producer prices give a different perspective.

You really can choose the data to give a certain impression.

Because interest rates are so low, increasing interest rates may have less impact than expected. (see: will higher interest rates have much effect?)
The only thing for the Bank to do, is to take it on a month by month basis and weigh up which is stronger case.

If anything, given recent improvement in public finances, I'd like the government to scale back its spending cuts or delay for another year. This would help the MPC as there would be less need for a very loose monetary policy to compensate for the highly deflationary fiscal policy the government are implementing.

Paradox of Thrift

• 'Paradox of thrift; is a concept that if individuals decide to increase their private saving rates, it can lead to a fall in general consumption and lower output.
• Therefore, although it might make sense for an individual to save more, a rapid rise in national private savings can harm economic activity and be damaging to the overall economy.
• In a recession, we often see this 'paradox of thrift'. Faced with prospect of recession and unemployment, people take the reasonable step to increase their personal saving and cut back on spending. However, this fall in consumer spending leads to a decrease in aggregate demand and therefore lower economic growth.
  

Paradox of Thrift in 1930s

In the great depression of the 1930s, GDP fell, unemployment rose and the UK experienced a long period of deflation. In response to this disastrous economic situation, mainstream economists were at a loss as how to respond. Such a lengthy period of disequilibrium didn’t sit well with Classical theory which expected markets to operate smoothly and efficiently.

One policy the National government did approve was the cutting of unemployment benefits. The rationale was that in times of a depression the govt should set an example by reducing its debt. This example actually inspired members of the public to send in their savings in the hope that it would help the economy.

By reducing benefits they further reduced consumer spending and AD. This made areas of high unemployment even more impoverished. When people saved rather than spent their money it just made the recession worse.

J.M. Keynes argued that this 'paradox of thrift' was pushing the economy into a prolonged recession. He argued that in response to higher private saving, the government should borrow from the private sector and inject money into the economy.

This government borrowing wouldn't cause crowding out because the private sector were not investing, but just saving.

In the UK and US Keynes was largely ignored until after the war and as a consequence the UK economy experienced high levels of unemployment for the remainder of the decade.

Related

• Impact of expansionary fiscal policy

Output Gap and Inflation

In a recession, a fall in aggregate demand leads to a negative output gap. A negative output gap is a situation where actual GDP is less than potential GDP. This output gap is indicated by the rise in unemployment and unemployed resources.

The level of the output gap is crucial for determining inflationary pressures in the economy. A large negative output gap suggests inflation should be low. It is a situation where monetary policy will be lax (low interest rates to stimulate growth and reduce negative output gap).

A positive output gap - where growth is above the trend rate of growth, should lead to inflationary pressures.

A very simple measure of the output gap may be to assume productive capacity increases at 2.5% a year (close to the UK's average post war growth rate). Therefore, if you have a fall in GDP of 6% (like 2009), you would expect a large negative output gap, and minimal inflationary pressures.

Measuring Output Gap in Practise.

In practise it can be more difficult to measure the output gap. For example, in the aftermath of a recession, there may be much less spare capacity than you might anticipate.

• Unemployed workers may leave the labour market and become economically inactive.
• Firms close down leaving depressed areas and regions
• Banks may have lost money in recession and therefore become very strict with their lending.

Also the situation may be confused by supply constraints in some industries, but spare capacity in others.
Nevertheless it is possible to make an estimate of how much spare capacity there is in the economy.

UK Output Gap and Inflation

source: HM Treasury (see bottom)

This graph shows the UK's estimated output gap (by HM Treasury) and inflation.
As you might expect there is often an inverse relationship. In the late 1980s, the Lawson boom led to a positive output gap and inflation rose to just under 10%. After the 1991/92 recession, the output gap became negative and inflation fell.

However, the 2008 rise in inflation was unrelated to the output gap. This is because the inflation was temporary and cost push inflation.

The graph doesn't show the recent rise in CPI inflation to 4%, but this rise in inflation has not been combined with a decline in the negative output graph.

The HM Treasury report suggests that many factors can affect inflation apart from the output gap.

• Indirect taxes.
• Effect of devaluation on import prices
• Rise in commodity prices.
• Inflation expectations.

Graph showing Contributions to Inflation in UK

Nevertheless, estimating the output gap helps give a broader understanding of the nature of inflation and the degree of underlying (demand pull inflation)

References

• Inflation and Output Gap in UK - HM Treasury

Related

• Government borrowing and output gap
• Exchange rates and inflation
  

Exchange Rate and Inflation

In recent post, Will higher interest rates reduce inflation, I should have mentioned higher interest rates in UK would increase the value of the Pound. A stronger exchange rate will have the effect of reducing inflation. An appreciation in the Pound:

• Makes imports cheaper (approx 40% of goods are imported), a stronger pound makes these cheaper for UK consumers.
  
• Reduced demand for UK exports should put downward pressure on prices.

Another graph showing how underlying inflationary pressures are still hard to see. This graph shows how wage growth is close to 2%. Also CPI-CT is 2.3% (CPI - CT, excludes the effect of changes in taxes on prices). Both these important measures - wages and CPI - taxes, show underlying inflationary pressures are close to the government's target.

Since 2008, wage growth has been more or less below CPI.

Recent evidence makes me think there is a stronger case for a higher headline inflation target, at least when you have a situation of high unemployment and rising commodity prices.

Another graph showing impact of rising energy prices on recent rise in CPI

Source: ONS - Time Series data

Related

• Definition Inflation

Will Higher Interest Rates Reduce Inflation

There has been much speculation about when the Bank of England may increase interest rates. With CPI inflation at 4% and RPI inflation at 5.1% (highest since 1991), many feel the Bank need to act to reduce inflation and maintain low inflation expectations.

For a long time, the Bank have dismissed the inflation as temporary inflation - due to short term, one-off factors such as tax rises, fuel prices, commodity prices e.t.c. However, this temporary inflation has lasted quite a long time. Therefore, inflation hawks argue, now is the time to act to reassure markets that the Bank are serious in keeping inflation close to the government's target.

However, if the Bank do raise interest rates by 1% in a few months, would it actually reduce inflation?

Higher interest rates increase the cost of borrowing, discouraging investment and consumer spending. Therefore, higher interest rates are effective for reducing demand pull inflation.

Higher interest rates increase the cost of mortgage payments giving people lower disposable income. Again this helps to reduce consumer spending. Higher interest rates can also act as a break on asset price inflation, (higher house prices can indirectly cause inflation through encouraging more consumer spending)

However, although the inflation rate is 2% above the government's target, it is hard to argue that the current inflation is due to excess demand. Wage growth is muted (annual growth of 2.2%). Unemployment is at its highest level since the early 1990s. After the deepest recession since the 1930s, the economy still has spare capacity.

Raising interest rates will probably reduce consumer spending growth. It will make the weak recovery weaker. But, will it tackle the commodity price inflation, we are currently seeing?

This graphs shows some of the different items within the CPI. This shows how rising fuel prices are one of the key factors in causing higher CPI.

Higher interest rates don't really effect fuel prices. Fuel prices are determined by international supply and demand. If UK interest rates rise, it will have an insignificant impact on the price of world gas and oil prices. (Gas and electricity inflation)

It may be that by the end of 2011, the Chinese and Indian economy will slow down. This would lead to lower demand for commodities and we could see the price growth stop. This would reduce UK CPI inflation. But, it would not be the result of higher UK interest rates. The UK economy is too small to significantly effect the price of world commodities. - Even a recession and slow growth in the US has failed to prevent rising commodity and fuel prices.

The MPC may feel obliged to raise interest rates but, the move would be largely symbolic having little effect on actually reducing cost push inflation.

The truth is that interest rates are not very effective in reducing cost push inflation. Just as cutting interest rates, in the liquidity trap of last recession was not very effective in causing a quick economic recovery.

In 2011, we *might* have a strong recovery. It is possible wage growth will pick up and economic growth exceed expectations. If this occurs, there would be a strong case for increasing interest rates. After all, the current interest rates (0.5%) are a response to the exceptional depth of the recent recession.

However, with falling house prices, cuts in government spending and higher taxes, it is difficult to see a return to a booming economy.

The MPC should continue to distinguish between core inflation and headline inflation. It is a lesson the ECB would be advised to follow too.

Related

• Difficult choices for Monetary Policy

Alarmist Financial Reports

"Figures released today by the Monetary Policy Committee of the Bank of England show that financial hyperbole is now at a record high, and could continue to climb until your children have left home.

Statistics have increased by up to 3.5% over the last quarter, and typical inflationary vocabulary, shared by economists, blogging worrywarts and financial reporters has broken its previous record – set in August ’09 – of 2,000 scary words per article.

‘The increased incidence of undefined TLAs in financial news reporting is a reflection of an underlying malaise designed to worry both savers and people with mortgages’, a well-meaning but actually uninformed financial expert, Jim McHugh, commented. ‘The rise in VAT, taken on its own is minimal, but when amplified by a lot of hysterical statistics and undefined references to petrol, RPI, CPI and the pound in your pocket it can scare the bezeesus out of 99.7% of the population...’"

- News just in from: News Biscuit

Related

• Economics of fear
  

Inflation and Pay Deals

In previous posts, I mentioned how the MPC faces a difficult period - essentially the conflict between sluggish recovery combined with high inflation.

It may start to sound a bit repetitive, but the inflation we are experiencing is essentially due to cost push factors (higher oil costs, raw material prices). This is leading to a rise in producer prices and CPI (rose to 4%), but underlying factors and measures of 'core inflation' still remain muted - though is starting to edge up.

Of great significance is the impact of higher CPI inflation on wage growth and inflation expectations.


Source: ONS | Real wages in UK

Evidence suggests that nominal wages are not keeping pace with CPI inflation. This strengthens the argument that the 4% inflation we are experiencing is temporary and is not leading to an increase in underlying inflation. The fact real wages are falling shows unions have little power in a climate of high unemployment, spare capacity and prospect of more job losses.

The MPC will be aware that if temporary inflation persists long enough, it can start to cause a rise in inflation expectations and a rise in underlying 'core' inflation. (see: does temporary inflation cause underlying inflation)

Despite all the complications of higher inflation, lower living standards and uncertain recovery, the MPC are doing the right thing in delaying interest rate increases. This will come as little comfort for those seeing a decline in the real value of their savings or workers who are experiencing a decline in living standards, but we face a testing situation where we will have to accept a worse trade off - at least in the short term.

Job Creation in the Private Sector

The government will be hoping that public spending cuts will make way for a larger private sector. There is an argument that shrinking the size of the public sector enables growth and job creation in the private sector. Furthermore the private sector is more efficient and should be able to create jobs faster than the public sector.

Since 2000, government spending as a % of GDP has increased from 35 % to 45%. Part of this is due to the recession, but it also part reflects increased government spending on the welfare budget and health care.

Arguments for Reducing Government Spending:

Crowding Out of Private Sector

Government borrowing can cause crowding out of the private sector. Firstly, if the government sell bonds to the private sector to finance its deficit, then the private sector are unable to use these savings for investing in private sector projects.

Secondly, if government borrowing appears to becoming unmanageable, markets will push up bond yields to compensate for the higher risk. These higher bond yields, push up interest rates in the rest of the economy and discourage private sector investment.

By reducing government spending, there may be a period of pain, but it also enables resources to be shifted from public to private sector. There is no reason why public sector jobs can't be replaced by new private sector enterprise.

Furthermore, some government spending can actually discourage productivity in the economy. If welfare benefits create a disincentive to work, then government spending could actually be encouraging a lower economic participation rate.

However, there are a few factors that need to be taken into account

Austerity creates climate of Pessimism.

I feel the government were over-enthusiastic in their scope and speed of cuts. By talking up how bad the economy was, they contributed to a decline in business and consumer confidence. This general pessimism does not create a climate conducive to private sector investment. If spending cuts had been less drastic and delayed for stronger growth, it would have been easier to absorb without adversely affecting general perceptions we face a double dip (or at least very slow growth). The private sector need stability, but the scale of spending cuts have created the opposite climate.

The enthusiasm for spending cuts, reminds me of the enthusiasm Mrs Thatcher had for tackling the money supply at all costs in 1980-1. At the Conservative party conference, she famously refused to do a U-Turn - great politics, perhaps, but you can't help feeling the 1981 recession was much deeper than necessary.

The irony is that 'bold' acts of public austerity, can prove much less helpful for reducing deficits than governments such as Ireland, Portugal and Spain are finding out.

Public Services.

There is a good argument to say that the private sector is more efficient for the majority of industry and business. However, this does not apply to public services with positive externalities. You may not agree with the necessity to subsidise rail, but private enterprise will generally fail to provide sufficient services such as education, training, infrastructure e.t.c. When councils fail to repair potholes in roads, it is the private sector who will face increased costs of car repair bills, slower journey times e.t.c. Spending cuts on vital public services lead to job losses, but the private sector will also suffer if the UK economy's infrastructure suffers lack of investment.

Crowding Out and Liquidity Trap.

Crowding out generally occurs when the economy is near full employment, but when the economy has spare capacity, crowding out is unlikely to occur - the government are essentially compensating for the fall in private sector spending.

Signs on the economic recovery are currently mixed. However, the low yields on UK government bonds suggests there is still reasonable demand for UK bonds. Private sector saving has increased since the recession. In this situation, of high private sector saving government borrowing doesn't cause crowding out because the private sector are preferring to save than invest.

Related

• Spending Cuts hurt

Economics of High Speed Rail Links

A recent report criticised a proposed new High Speed rail link between London and Birmingham (HS2) on the grounds that:

• Cost of building scheme (£17bn) is hard to justify given benefits would be limited to relatively small number of passengers.
• Benefits of reducing CO2 emissions are limited.
• There is a stronger argument for using government spending to improve existing rail infrastructure, e.g. longer trains and making better use of existing lines.

Supporters argue that demand for rail travel is continuing to grow. By 2020, projected rail use will have outstripped capacity. Investment is needed to provide more services and meet future demand. By providing extra capacity, it will relieve congestion on roads and improve the infrastructure of the UK economy. Also, by offering better quality, faster rail services, it will encourage more people to choose train. Like building new roads increased demand for car travel, building faster lines will create demand for train use.

Report calls for Rail scheme to be scrapped at Independent.

There may be a good case that investment funds may be better used on existing capacity. However, in this debate it is useful to take into account external benefits which are often ignored in public debate about the desirability of various transport schemes.

Death Rate by Mode of Transport

By comparing death rates by billion passenger KM, train travel is much safer than car use. A fatality rate of 1.9 per billion KM, compared to 0.3 billion KM for train.

Source: ONS - Social Trends 40

• Fatality rates of transport should be given a significant economic cost. If one form of transport is fives times safer than another, then this is a significant external benefit, which justifies government subsidy.
• The other issue is time. A new high speed train link helps save time for both rail users and car users who benefit from lower levels of congestion.
• The growth in train travel in the UK, is despite the fact that services are often overcrowded with a perception of being late and expensive. If train services are quicker, it will attract more people to choose train travel rather than drive.
• Related to the issue of time, is the fact that train travel offers opportunity to work. In the age of iPads and laptops, train travel can become an opportunity to work rather than get stressed driving through the streets of Birmingham.

This doesn't mean all high speed rail networks should automatically go ahead. But, when deciding, greater mention should be made of other externalities. Train travel does justify government subsidies, but often in the UK we have made decisions on the rail network based on simple profit and loss. This has left the UK, with a transport infrastructure which increases cost on business.

Related

• Growth of rail travel in UK
  
• Cost Benefit Analysis

European Inflation and Unemployment

Source: ECB Jan 31. 2011

Recent data suggest Euro inflation has increased from 2.2% in Dec 2010 to 2.4% in Jan 2010. This jump in inflation is primarily due to the cost push factors, which we are becoming quite familiar with.

If oil prices continue to spike, we may get a repeat of 2008, where ECB inflation rose to 4% before experiencing a brief period of deflation. Again, it would be useful if the ECB published a 'core inflation' measure which stripped out these volatile factors and helped us to understand the underlying inflationary trends.

Apart from the German exporting sector, which is doing very well, European growth is generally sluggish, with some peripheral members of the Euro experiencing a downturn. To prematurely raise rates, in the absence of strong recovery would be a mistake - at least for those countries in recession.

The graph shows the ECB do an admirable job of keeping inflation at 2%. But, unemployment remains at over 10%

European and Global Unemployment


click to enlarge. Source: Eurostat

Objectives of ECB.

Interesting to read objectives of ECB

"...The Treaty establishes a clear hierarchy of objectives for the Eurosystem. It assigns overriding importance to price stability. The Treaty makes clear that ensuring price stability is the most important contribution that monetary policy can make to achieve a favourable economic environment and a high level of employment..."

Related

• Benefits low inflation
  
• ECB vs Bank of England
• Criticisms of ECB