UK producer price inflation remains high and inflationary expectations are rising

Yesterday was a day for meetings of central banks with both the Bank of England and the European Central Banks (ECB) announcing the results of their latest meetings. Little was expected and little was provided with policy remaining unchanged. In addition the President of the ECB was quite tight-lipped when interviewed afterwards on questions such as government bond buying. There is the occasional rumour going round the markets that the ECB may cut rates further (in spite of the fact it has said it sees 1% as a floor) and this got some support from the comments of “Dr. Doom” Nouriel Roubini. He feels that the ECB should cut its official interest rate to zero and expand its government bond purchases. As to its latest financial backstop he feels that 750 billion Euros may not be enough so he may also have contributed to the words of European Union President Mr. Van Rompuy which were quoted in yesterdays comments section.

As to equity markets well we got another triple-digit day with the Dow Jones closing up an extraordinary 273 points on very little news.This is now 23 days out of the last 29 with triple-digit moves. It looked like a short squeeze to me but some attributed it to an improved export performance by China. The problem for their logic is that Chinese inflation figures out last night show signs of over-heating being above target at 3.1% for consumer prices, so shouldn’t we now retrace our steps?

UK Inflation and Inflationary Expectations

The UK has had a period this year where inflation has exceeded its official target for each month of this year, in fact it has been more than one per cent over each month. The Bank of England has several times said that inflationary expectations remain low as part of its campaign to persuade people that inflation is and will be only a temporary phenomenon. However Barclays Bank carry out their own measures of inflationary expectations which was published yesterday. It tells a different story.

Barclays Bank said its BASIX survey of inflation expectations, which it has been compiling since 1986 (giving it a reasonable track record), recorded an average expectation for inflation in May 2011 of 3.4 per cent and this is 0.6 % points higher than in the first three months of this year. Indeed their report also publishes figures for what people think inflation will be in two years time and this was 3.8%, which was also up 0.6% on the previous survey and the largest upward rise in expectations since the first quarter of 1995. At the five-year horizon, inflation expectations lifted to 4.1% from 3.8% in the previous quarter.So not only rising inflationary expectations but ones which are sustained going forwards. This is exactly what the Monetary Policy Committee will not want to hear. They will not be able to say in future that this index remains below its series averages as the did in their last Quarterly Inflation Report.

Also the Bank of England has today published the results of its quarterly survey on U.K. consumers’ expectations on price increases in the next 12 months which was compiled between May 13 and 18. It showed inflationary expectations rising to their highest level since August 2008  with predictions of inflation of 3.3 % in a year’s time. This compares with expectations for an increase of 2.5 % when the survey was last compiled in February

Today’s Producer Price Figures

Regular readers will know that one of the factors driving the poor UK Consumer inflation figures has been both input and output producer price figures. These are important because they give a signal for inflationary trends at the beginning of the price chain. They are also significant because the figures have been so high recently. For example input price inflation was in double figures (10.5% and 13.1%) in March and April 2010.

Today’s figures show output price or what is called ”factory gate” annual inflation for all manufactured products rose 5.7% in in May which was up 0.3% on a month on month basis. These price rises reflected price rises in most product groups especially petroleum, and alcohol products. These rises were partially offset by a fall in the price of other manufactured products.

The input price index for materials and fuels purchased by manufacturing industry rose 11.2 % in the year to May but fell 0.6 per cent on a month on month basis between April and May. The fall in the input index between April and May mainly reflected a fall in the price of crude oil, partially offset by price rises of chemical, and home produced food products.

 These are bad numbers and continue what is a very poor trend. There is a small glimmer of hope from the fall in month on month input inflation but even with the fall the rate of annual rate of inflation remains in double figures. Again we have a marginal fall in output inflation on an annual basis but we remain well above 5%. As these are signs of inflation in our economic system they present a considerable challenge to the economic policy of the Monetary Policy Committee.

Comment

These are a poor set of figures and survey results. For example input price inflation has been in double figures for three months now indicating that there is further inflationary pressure at the beginning of the UK price chain. This in itself poses a challenge to the MPC view that the current rise in inflation is a “blip”. Now we see inflationary expectations as measured by Barclays Bank and the Bank of England itself rising. I think that you have to ask now, what would make our supposed inflation watchdog actually raise interest rates?

Recently Adam Posen a member of the UK Monetary Policy Committee gave a lecture on the Japanese “lost decade” at the LSE. Regular readers will be aware  that this is an area I study and write about but I found a note to the speech to be potentially rather revealing as Mr.Posen refers to the UK experience.

No, I am not happy that UK CPI inflation is currently overshooting the Bank’s government given inflation target. As I have said in the press of late, if this proves to be other than temporary factors at work, the MPC should take action. But I’d certainly rather have us temporarily overshooting by around 1% than facing oncoming deflation.

As I have written many times asymmetry is very dangerous and one might also refer that such views and opinions blatantly contradict the stated policy aims of the Bank of England and the Monetary Policy Committee. Also I think it is time he and the other committee members are challenged on the meaning of the word “temporary”.

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18 thoughts on “UK producer price inflation remains high and inflationary expectations are rising

  1. Your analysis suggests to me that the MPC may have added a lexically prior objective to the inflation target: i.e. that there shall be zero-risk of deflation. If so, that would mean the MPC’s decision rule would go:
    (i) take policy actions to avoid any risk of deflation;
    (ii) without prejudice to objective (i), take policy actions to keep CPI inflation as close as possible to 2% in the medium term.
    Would that make sense of the MPC’s actions?
    Two follow-on questions would be: is it good policy? and is it legal?

    • Hi Ian, but the MPC’s remit does not make any reference to avoiding any risk of deflation! It defines their simple task as being to control inflation, to keep it at 2 % by adjusting base rate. This they have continuously failed to do, as Shaun has explained in detail on this blog previously.

      If anyone else fails in achieving such a simple type pf task they are called “incompetent”. There is no point in having a supposed independent committee to set base rate if the charade does not work.

    • Hi Ian
      I think that your theory works quite well as an explanation of how the MPC has behaved. As to it being good policy i do not think so as you should respond to inflation being 1% above target in the same manner as 1% below in my view.The increase in inflation seen so far this year has some of its roots in the way the MPC responded ( I think in a bit of a panic) to disinflation fears in 2008/09, after all our exchange rate had fallen by then enough to make outright sustained disinflation rather unlikely…

      As to legal that is harder for what court would be fit to judge them and how would you prove it? If you look at their policy objective and ask if they are trying to achieve that i.e inflation of 2% as measured by CPI some 18/24 months ahead then their recent performance has been poor and I believe that it is no longer their true objective.

  2. “So not only rising inflationary expectations but ones which are sustained going forwards. This is exactly what the Monetary Policy Committee will not want to hear.” The MPC place ear-plugs in their ears, just as Nelson placed the telescope to his blind eye, and as Brown could see only half of every economic problem. They do not want to listen to any evidence which contradicts what they want to continue believing.

    The longer the trend for rising inflation continues the more the MPC will refuse to believe the evidence; as much as anything this is because once they do acknowledge the truth it will condemn them and show them to have had no judgment or professional understanding of reality. Remember that the members of the MPC were hand-picked by Brown, and were chosen for having left wing leanings and neo-Keynesian persuasions.

    Until and unless the new government clears out all the deadwood from the MPC and BoE things will not change. The MPC will continue to ignore inflation and we will end up with very high inflation and very high interest rates to eventually attempt to get it back under control. That will cause a lot of suffering and pain which could have been avoided if the MPC had actually been “independent”, rather than loaded with poltical bias..

  3. Agree with all the above comments. Maybe the true objective is to inflate our way out of the debt mountain and this is the hidden agenda we are not told about.

    Whether or not this is so the result is that once again it is the prudent savers who will be suffering at the expense of sometimes reckless borrowers (on a personal and national level) while interest rates remain so low.

    • Absolutely right, Janet, it is looking increasingly as if this is the de facto policy. This is the British way of dealing with situations that are too uncomfortable on the social level to confront by any other than stealthy means. The first stage appears to be denial of any kind of problem, then another problem is found (in this case deflation) that would be so terrible that it has to be avoided at any cost and is certainly worse than the problem that is being denied. The truth, rather conveniently, gets lost in between these positions. The truth is that inflation is back, and accelerating.

  4. What befuddles me is every saver of modest means I encounter bemoans the paltry interest rate.My stock response is “National Savings Index Linked,RPI+1%,Tax free”. Yet the eyes glaze over.

  5. “On the downside, there is a risk that inflation will turn out to be weaker,
    perhaps because the influence of spare capacity in the economy could be more significant than assumed. On the upside, there is a risk that inflation may be raised by further commodity price increases or other price level surprises. And if the current period of above-target inflation causes inflation expectations to move up that may lead to some persistence in the current high level of inflation.”

    This is a quote from Mervyn King’s recent letter to Mr Osborne. The hat is being hung on 1) spare capacity will act to bring prices down ( output gap theory?) 2) the MPC remit allows it to ‘look through temporary effects. The acknowledged risk to their strategy is now persistent rising inflation expectations. To what extent do you criticise them having regard to 1) and 2)?

    • Hi Shireblogger
      The thoughts behind the sentences that you have quoted from Mervyn King have become rather familiar as time has gone by. However my issue with them is not particularly with “output gap” theory which is clear enough. It is the reality they apply it to where it goes wrong….. For example if you used it from the beginning of the credit crunch (which they have) as a minimum you have to accept it has performed poorly. I would contend that when you look at the UK’s experience of the credit crunch it has been outright misleading as using it led to expectations of disinflation which never came to exist and worse than that policy set on incorrect expectations. If you are a believer in learning from experience then I feel that you have to put output gap theory to one side for now.
      As to temporary effects again if you look at the evidence it was disinflation which was temporary rather than inflation which already is more permanent.

      So my critique is simply to suggest a look at what has actually taken place in terms of the evidence.

      • I am similarly concerned about inflation. Given that the MPC are hanging their hat on the output gap theory you might find it interesting to read Treasury Economic Working Paper No 6 March 2010 suggesting that the lagged effect of a large negative output gap will generate significant downward pressure on uk inflation over the next few years. The MPC have friends in court here allowing them to ‘look through’ and predict,rather than act now, and I wonder what you think.

        • Hi Shireblogger
          I can reply but in another form which is very similar. I am a rugby fan and have just watched the first half of England versus Australia. England have deployed the same (failed) tactics that they have deployed under Martin Johnson (one of my heroes as our World Cup winning captain). Oddly Australia are waiting for our entirely predictable kick and hope tactics and we come to my point which is a theoretical question for you, when something is failing at what point do you abandon it? Einstein I believed defined insanity as doing the same thing and expecting a different result.
          So to my mind our rugby coach and our MPC have a similar problem whereby there seems to be no assessment process in any realistic time frame. As to the working paper I love the phrase “next few years” as it just emphasises that their timeframe is wrong doesn’t it? Anyway back for the second half although I realise that I might be suffering from Einstein’s definition in so doing…

          I just thought that I would add congratulations to Australia, you have some backs who are good at running the ball and cut through England. You must have thought it was nice of us to keep box-kicking it to you to give you the opportunity to display this skill.

  6. My grass needs cutting.However I am “looking through” this rapid expansion to winter when it may slow for a while and hide the grass.

    • Good one andy!

      Of course you cut the grass now and when it stops growing you put the mower away. If you wait to see whether it has stopped growing in the winter, by then it will be so tall that you will need much more than a mower to get it back to being a normal grass lawn.

  7. Shaun et al,

    how much fudging is there in the UK official inflation numbers? In the US, we are told that CPI (consumer price index) is very low, but this is not my experience at the grocery store or the cafeteria. Prices have been going up (and/or the package/portion sizes have gotten smaller) and checking with friends I am not the only one who thinks so. Government agencies appear to redefine inflation measures as it suits them (the Argentinian government has been another obvious example). For the US, the Shadow Government Statistics Group has calculations for the CPI that agree more with my everyday experience
    http://www.shadowstats.com/alternate_data
    Several years ago, Bill Fleckenstein gave an explanation of how the US government goes about manufacturing low inflation numbers
    http://moneycentral.msn.com/content/p72746.asp
    A penny (sorry, make it a dollar) for your thoughts?

    Regarding inflating away government debt, the dismally named British magazine had an article a week or so ago, arguing that this would not make much difference, as most of the liabilities of the governments of developed countries are in pension obligations, which are indexed to inflation. If the government underestimates inflation however, everyone would be happy, right?

    js

    • Hi John
      Debate on this subject in the UK has been slightly different and there isn’t really an equivalent of shadowstats here. However there have been concerns and issues.

      On the subject of the switch from the retail price index (RPI) to the Consumer Price one which took place in the UK in 2002 ostensibly for us to be harmonised with Europe there has been a clear issue I think. I have written about this many times on here but have found myself to be rather a lone voice on the subject. In a nutshell we exchanged a measure with some flaws for one with more flaws. The worst part of it was that some versions of the RPI at least cover housing costs whereas CPI ignores them. There is a British obsession with housing so it is a big subject here (and accordingly should be included) and of course it was one of the factors in the banking collapse. My suggestion going forward is that any inflation index has to have a section covering asset prices. Also to return to your specific question the numbers for our old target 5.4% compared to our new 3.7% do illustrate a reason for the change, although this is a lower difference than you have between shadow stats and the official ones.

      As to the issue of your msn article then let me just quote the relevant bit from it for other readers.
      “For those of you who don’t know, hedonics is the way the government transforms price declines into quality improvements. To wit, you buy a PC with twice as much power, so the government concludes that you really paid only half as much money for it. Hedonics is also the government’s way of taking quality improvements and converting them into price declines when calculating the CPI.”
      There were issue raised on this here but mostly in the past on Greenspans watch when some similar moves took place here although not I think on the same scale.

      So actually it was the change in inflation index here which has caused the main problem. Conveniently the new one on average will produce lower numbers and the targets were changed unfavourably ( I wrote on this on April 20th). We do not have the problem with our index-linked gilts that you have with your TIPS in the US as they have remained indexed to RPI.

      As to inflating away government debt I have read in many places that this cannot happen because many future liabilities are index-linked. I have always thought this to be a weak argument as for a start it requires (usually weak) politicians to bankroll the promises of past politicians. When push comes to shove I expect definitions to be changed. For example the rules on the state pension in the UK are about to be changed again (with a link to earnings). Whilst this in itself is a good move it establishes the point that governments can change the rules as should funds get squeezed in the future then they can change definitions unfavourably too.

      Moving to your final sentence actually in the UK most pension schemes operate to RPI except quite a few definitions have been changed unfavourably for people already. There has been almost no debate about this because the general population do not understand the rules. I only know about them because it is another area of mine so to speak as I have passed the Chartered Insurance Institutes exams on the subject and had to learn all the rules! So far this has mostly impacted on the private sector but I expect it to hit the state one too over the next 5/10 years.

      So a few (maybe jumbled) thoughts on the subject. But in general there has been a trend towards what you describe in under-reporting inflation and I feel there are still big gains for governments in inflating away debt…

      • Thank you so much Shaun for taking the time to answer and in depth. As always, very clear and informative.

        js

      • Hi Shaun; when you write “So actually it was the change in inflation index here which has caused the main problem.”, surely we in the UK are also much affected (deceived) by Hedonics? In the first place it is intensively subjective in any case. Whose opinion is it that a particular new PC has twice as much power? What does that actually mean in terms of product feature delivery? Why does that make it worth twice the previous price? When applied to features and supposed product “improvements” the whole concept (if it may be termed to be a “concept” at all) becomes even more nebulous, deceitful and suspect. It becomes increasingly that it was in fact devised to deceive.

        As applied by the ONS hedonics in pricing becomes a blatant device for hiding the real level of inflation. For example, the oft quoted example of the chocolate/confectionery bar: manufacturers like governments use devices as smoke and mirrors to conceal that they are in effect increasing the price of a product, so as to deceive their customers. Typically they will reduce the weight of a product and/or dilute the proportion of the most costly ingredient in it; at the same time they advertise it as, and print on it “New Improved”. The ONS then see the product labelled as “New Improved” and this triggers hedonics in their statistical gambits. They then apportion a supposed improvement in the product of twice the features or notional value; as a result they state in their statistics that the price of this product has actually halved, whereas we all know that the price has been increased significantly. All of these tricks are then aggregated to show inflation as having fallen significantly, whereas it has actually increased!

        One of the best books (written by a very experienced statistician) I have ever read concerning the way in which these tricks are used by statisticians to distort reality and to show the supposed statistical result which they want (or have been instructed to “get”) is “Facts from Figures”, by M. J. Moroney : Penguin Books. The first sentence of the first chapter is “There is a germ of truth in the suggestion that, in a society where statisticians thrive, liberty and individuality are likely to be emasculated.” Although this book was originally published in 1951 its message and substance remains just as true today. It has been republished many times.

        • Hi Drf
          I agree in principle with what you say. One of the reasons I have discussed on here the issue of what is a price is that I feel that these days with the power of supermarkets for example it is hard to know the price of certain products even if you buy them regularly as supermarkets deliberately vary prices of many products. My examination of this is limited to what I buy and know but feel it must be happening elsewhere to others. If you take this forward and confess that it is hard these days to establish a consistent price then any inflation measure (which must have consistent prices as an underlying tenet) is accordingly weakened…
          I intend to talk about this more on Tuesday as we are due the update for our CPI and RPI.

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