Yesterday saw another leg up in the rally which has continued in the American equity market for several months now. The US Dow Jones equity index made a triple-digit gain of 108 points to 11,980 but could not quite gain the 12,000 level. There was some possible support from the International Monetary Fund for such an improvement as it raised its forecast for economic growth in the United States in 2011 from 2.3% to 3%. It is also true that equity markets often perform well after the State of the Union Address which is tonight,so maybe markets were anticipating this. Moving back to the IMF it raised it forecasts for world economic growth too in 2011 from 4.2% to 4.4% and also raised its forecast for the year just ended from 4.8% to 5%. So good news and a little fuel to the fire which has been affecting one type of economic theory which I discuss below.
Andrew Sentance challenges a key theory of the Bank of England by debunking the “output gap”
For those unaware of the situation Andrew Sentance is the member of the United Kingdom’s Monetary Policy Committee who has recently been voting for an interest-rate rise. Yesterday he gave a speech challenging the orthodoxies of his colleagues and agreeing with points I have been making pretty much since I began this blog.
So let us start with his reason for having the views that he has.
Whereas the Governor wrote only one open letter to the Chancellor (in April 2007) in the first decade of the MPC, he has written a further eight letters in the past three years. This run of letter-writing appears set to continue throughout this year, with inflation soon expected to rise to around 4% and possibly go even higher.
So he is worried about the UK’s inflation trajectory and goes on to explain the “output gap” which I put in for newer readers who may not have followed it.
The second challenge is to the notion of a simple trade-off between growth and inflation, which seems to underpin much thinking about economic stabilisation in policy-making circles. This approach leans heavily on the idea of the path of inflation being driven by an “output gap” between the current level of activity in the domestic economy and the amount that it could produce if it was operating at capacity.
Having identified what the output gap is Mr.Sentance then debunks it as being appropriate for these times.
In the analysis I have set out I have made relatively little mention of the domestic “output gap”, because I find this a rather narrow way of thinking about how the demand climate affects inflation in an open economy like the UK. The margin of spare capacity in the domestic economy, which output gap measures seek to capture, can have a bearing on inflation processes. But it is only one element of the way in which the demand climate affects inflation. The growth of domestic demand, global demand and the global capacity gap are also significant for an open economy like the UK. And looking beyond demand, the global inflation climate, the exchange rate and inflation expectations are also significant influences on our inflation rate, not just in the short-term but in the medium-term too.
In case the point might be missed then Mr.Sentance hits harder to emphasise his point.
The downward impact on inflation of spare capacity in the domestic economy is likely to be most noticeable in the recession or immediately after it. However, we have not seen much evidence so far that the margin of spare capacity is bearing down significantly on UK inflation………………..And many business surveys – such as the CBI Industrial Trends Survey – suggest
that the margin of spare capacity within firms is already back in line with historical norms.
And finally we get his policy prescription for the UK.
But when it is clear that global inflationary pressures, coupled with a substantial decline in the exchange rate and reasonably healthy growth of domestic demand are all contributing to a sustained period of above-target inflation, then the time has come to act. As I have argued in recent months, if we do not start to raise UK interest rates gradually soon, we risk having to do so more aggressively in the future.
The views expressed here are much more in line with mine than those expressed by the majority of the Monetary Policy Committee although I would add that Mr.Sentance trails me by a year and in monetary policy the timing of what you do can be as important as what you actually do. However. I wholeheartedly welcome his abandoning of the “output gap” mantra which has dominated the thinking of the MPC in spite of the fact that reality has plainly not followed the theory. I also welcome his attack on the use of the phrase one-off by saying “but it would be a mistake to label all the global factors affecting inflation as one-off short-term disturbances”. You see that is exactly what many of his colleagues on the MPC have been doing.
A little more of this and the MPC would be in danger of getting a grip on events.
Just to link this story there has been a recent change in “output gap” theory which goes as follows. Even some of its adherents can see that it is not working in the UK so they have moved onto the world as a whole. This links with my mention of the IMF growth figures above as the world overall is recovering well from the credit crunch. Accordingly some think that here the output gap theory gives an explanation for some of the commodity price rises we are seeing. In essence they are arguing that the world as a whole has seen its output gap decline and accordingly prices are rising. This leads me to two thoughts. Firstly this is a more realistic proposition than applying it to the UK alone. And secondly never underestimate economists ability to recycle (failing) economic theories!
UK Economic Growth or GDP Figures
This mornings figures were estimated a week or so ago by the National Institute for Economic and Social Research or NIESR and they forecast this.
Our monthly estimates of GDP suggest that output grew by 0.5 per cent in the three months ending in December after 0.6 per cent in the three months ending in November. These estimates suggest the economy expanded by 1.6 per cent in 2010.
Unfortunately for them they got the 0.5% bit right but forgot to put a minus sign in front of it as the official figures have shown this morning that UK GDP contracted by 0.5% in the last quarter of 2010 rather than grew! There is a small crumb of comfort in the fact that output was 1.7% higher than a year before. But according to the Office for National Statistics we saw this on the quarter.
Output in the construction sector decreased 3.3 per cent.Output in the service industries decreased 0.5 per cent.
Ouch! One factor that needs to be taken into account is the unusually cold weather and snow which disrupted the UK in 2010 and the ONS has some thoughts on the effect of this.
The change in GDP in Q4 was clearly affected by the extremely bad weather in December last year. The disruption caused by the bad weather in December is likely to have contributed to most of the 0.5 per cent decline, that is, if there had been no disruption, GDP would be showing a flattish picture rather than declining by 0.5 per cent. We should emphasise that this assessment of the effect of the bad weather is the best we can make it at this stage, but is still inevitably uncertain………..weather creates more uncertainty than usual and increases the chance that the GDP estimate will be revised.
We also see the fall in GDP due to the bad weather expressed in terms of the individual sectors of the economy which the ONS feels caused the drop.
Construction -0.1 Services -0.4
In terms of estimating the breakdown of the services sector the ONS estimates that the main areas affected were hotels and restaurants,transport and recreation.
These figures came this morning as pretty much a complete surprise. Yes 0.5% was expected perhaps but not the minus sign in front of them. I feel compelled to point out that I have often argued that these numbers can be unreliable and we never actually ever know that they are correct, so a dose of caution is required. After the bad weather of December this point is likely to be particularly true.
Another potentially ameliorating point is the fact that if we look further back into 2010 we saw “upward surprises” to growth in the second and third quarters. The numbers then were unexpectedly strong being initially reported at 1.2% and 0.8% respectively. I wonder if some of the growth unexpectedly reported then has dropped out of the figures in some way giving us a surprise in the reverse direction.
Also as there will no doubt be some shock headlines in the mainstream media we should remember that many of the other indicators for the UK economy have been recording more optimistic numbers than this which again suggests that there may be something of an aberration in these figures. An example of this was that the latest figures for manufacturing and industrial production which covered the period up to the end of November rose on a quarterly basis by 1.2% and 0.8% respectively. Also it is worth remembering the figures for world economic growth from the IMF which were revised upwards for both 2010 and 2011 only yesterday.
In the end, in my view, you also have to take the figures on face value to a degree as I do not feel you can pick and choose the ones you accept. Should they turn out to be accurate then the situation may be worse than the stagflation scenario I have feared and written about. So let us hope the weather had a big impact and roll-on the 25th of February when we get a revision of these figures!