We come today to that time of the month when the indices for inflation in the UK are due. They are particularly significant over this period of time because we have several issues at play. Firstly inflation as measured by the Consumer Price Index (CPI) is not only over its target it is more than 1% over its target. Secondly our body for controlling inflation the Monetary Policy Committee made a mistake when assessing what inflation would be now. I wrote in my article of the 13th May about what the MPC was forecasting in its May 2009 quarterly inflation report for what it felt inflation would be now. In case you are wondering it was approximately 1%, so they were out by some margin. Thirdly our previous targeted index of inflation RPI-X (the all items RPI excluding mortgage interest payments) is even more over its target than the current one. Thus if you were to look at the situation in terms of this you would be even more worried about inflationary trends in the UK.
Bank of England Monetary Policy Committee Forecasting Record
In my article of the 13th May I concluded the following
You see they set their monetary policy based on this and in May 2009 they were expecting an inflation undershoot when in fact we have an inflation overshoot. So policy has been set inappropriately.
Thus one might reasonably conclude that current policy which involves a base rate of 0.5% and a stock of some £200 billion of Quantitative Easing has been too accommodative. We have an extraordinary amount of monetary relaxation in our economy and it has been too much. The MPC’ s apparent terror of the possibility of any disinflation led it too a succession of unprecedented base rate cuts followed by an equally unprecedented experiment in Quantitative Easing.The problem is that their policy response of panic and terror when faced with the possibility of disinflation is not matched even remotely by their response to inflation over target. Indeed according to their latest quarterly inflation report published this month they say (without apparent irony or embarrassment).
Inflation has already been above the target for all but six out of the past 30 months for which data have been released
Looked at like that I think that it is not unreasonable to conclude that either they are not worried about inflation and are aiming for a target they are not telling or that they are worried but that their record involves policy mistakes. Or of course some combination of the two.
Did anybody else do better?
I cannot help in data back to early 2009 as I had not started this blog at that time but I have found and interesting and I think revealing source. The Member of Parliament Frank Field,someone I have respect for because of his work in and commitment to the issues around poverty, wrote the following on the 29th March 2009.
A month ago, the experts were predicting an era of deflation (disinflation) once the retail price index (RPI) was published. I cast doubt then, and do so now, on this analysis. The danger for the British economy is inflation, not deflation.
The British economy is in a big enough mess without policymakers fighting the deflation dragon, which shows not much sign of yet appearing on the scene. The 30% collapse in sterling has still to be fully registered as an upward movement in these measurements. And the government has embarked on a printing money policy, which can only lead to enormous inflationary pressures.
It is inflation, not deflation, that is still the public enemy.
Rather on the ball wasn’t he? Frank Field for Governor of the Bank of England?
Well if he had stuck to those views he would have done a better job than the current incumbent Mervyn King. You see my argument with current policy revolves around things which were known back when interest rates were being slashed and the QE experiment began. For example as Frank Field states there had been a 30% reduction in sterling’s exchange rate which has predictable effects on inflation and there had been reports on other countries experiences (mostly Japan) which predicted how QE was likely to turn out. I do not expect Frank to have known this but I do expect the MPC to have done so. Yet they still persisted in a set of policy mistakes which have led us here.
Today’s figures for inflation
These are rather shocking and somewhat disturbing. According to the Office for National Statistics Consumer Price Inflation is now 3.7% and has risen 0.6% on a month on month basis. Ordinary RPI has risen by 1% on a month on month basis and is now 5.3%. RPI-X (our old targeted measure) has also risen by 1% on a month on month basis and is now 5.4%. Things are going from bad to worse.
What has caused this?
This months rises in inflation have several factors behind them. Clothing and footwear,food and beverages and tobacco and alcohol were the main factors at play here. The RPI figures were also affected by a rise in their housing component mainly because they were compared with (falling) mortgage costs from a year ago. However we do not get a breakdown for RPI-X which of course does not include the mortgage component as if you do the maths and compare differences the changes do not quite add up! You might consider that to be a metaphor for UK inflation policy.
What will happen now?
The Governor of the Bank of England will have to write a new explanatory letter to the new Chancellor George Osbourne as the one from February has a 3 month lifespan. Let us remind ourselves of what was written in February.
“This is the third episode when inflation has moved above the target by more than one percentage point. As was the case on previous occasions, the Committee expects this to be a temporary deviation of inflation from the target”
If I was Chancellor I would write back and request a definition of the word temporary….
I do not expect much to have been learnt because in this months inflation report we got
As these temporary effects on inflation wane, downward pressure from the persistent margin of spare capacity is likely to cause inflation to fall below the target for much of the forecast period. But the pace and extent of that moderation in inflation are highly uncertain.
The MPC’s faith in output gap theory appears to remain regardless of the evidence that it is not working.
Our old inflation target is telling us something
If you take what was our inflation target RPI-X I would like to point out that it is now 5.4% and also that its targeted level was 2.5%. So it is 2.9% over its target (my emphasis). This is really quite shocking on two counts. Firstly as I wrote in my technical point of the 20th April there was a clear relaxation of inflation targeting when we switched from this to CPI as a target. But secondly we are seeing how much our guardians are willing to let this measure run over target. Just think of 5.4% inflation and compare it with the (bad enough) 3.7% that the newspaper headlines will be full of.
Our current inflation measure is 1.7% over target and our previous measure is 2.9% over target. Seeing as they are supposed to be measuring the same concept this is quite a difference!
What can we expect going forwards?
There are several factors at play here.
1. Our producer price figures are unfortunately even worse than our consumer price indices. Out put prices for April rose by 5.7% on a year on year basis and input prices rose by 13.1%. So there is more pressure in the system.
2. Our exchange rate has fallen against the US dollar recently and this is likely to add to inflationary pressures. For example our effective exchange rate closed at just under 78 on the 14th May which is where it was on the 19th April but over that period we fell against the US dollar from 1.53 to 1.455. We started 2010 at 1.61 versus the US dollar.This is important as many commodities including oil are priced in US dollars.The corollary of this is also that our exports will be less competitive as we must have risen against other currencies. This is the nightmare combination of exchange rate moves for the UK.
3. Against this there may be some relief from the recent fall in the oil price. This is hard to be precise about because the two measures Brent crude and WTI crude appear to have decoupled which is odd! But there has been a fall.
To my mind we have two problems. The first is that we have a clear inflation overshoot. The second is that our supposed guardian against such things the Monetary Policy Committee has not done its job and is failing in its task. I have given it some leeway because we went through difficult times but it has now used that up and some. But in terms of inflation its credibility is at best somewhat damaged and at worst gone. There has been a clear asymmetry between their moves when inflation is expected by them to be below target (panic) and when they expect it to be above target (complacency) in my view.
If one mentally takes a step back the overshoot recorded above is even more extraordinary when you consider that we have just gone through a year where economic output dropped by almost 5%. I am afraid this makes the policy mistake by the MPC even worse. I wrote at the time of the election debate the following as questions for the candidates.
1. How do you plan to make the MPC independent again?
2. What reforms do you intend to make to the MPC to help prevent it making more policy errors in future?
I would now add that as we are likely to get criteria for circumstances of gross neglect when a Member of Parliament can be deselected I feel that we need something similar as a check against the power of the MPC. All good systems need checks and balances and their erformance has exhausted any goodwill they deserve.
Looking further forwards there is another danger to inflation and that is a rise in Value Added Tax to 20%. Should it happen (and it looks very likely) then inflation will get another boost…