The Bank of England seems determined to ignore the higher oil price

This morning has brought the policies of the Bank of England into focus as this from the BBC demonstrates.

Petrol prices rose by 6p a litre in May – the biggest monthly increase since the RAC began tracking prices 18 years ago.

Average petrol prices hit 129.4p a litre, while average diesel prices also rose by 6p to 132.3p a litre.

The RAC said a “punitive combination” of higher crude oil prices and a weaker pound was to blame for the increases.

It pointed out that oil prices broke through the $80-a-barrel mark twice in May – a three-and-a-half year high.

As well as the higher global market price of crude, the pound’s current weakness against the US dollar also makes petrol more expensive as oil is traded in dollars.

There is little or nothing that could have been done about the rising price of crude oil but there is something that could have been done about the “pound’s current weakness against the US dollar”. In fact it is worse than that if we look back to April 20th.

The governor of the Bank of England has said that an interest rate rise is “likely” this year, but any increases will be gradual.

This was quite an unreliable boyfriend style reversal on the previous forward guidance towards a Bank Rate rise in May that the Financial Times thought was something of a triumph. But the crucial point here is that the UK Pound £ was US $1.42 the day before Mark Carney spoke as opposed to US $1.33. Some of that is the result of what we call the King Dollar but Governor Carney gave things a shove. After all we used to move with the US Dollar much more than we have partly because our monetary policy was more aligned with its. Or to be precise only cuts in interest-rates seem likely to be aligned with the US under the stewardship of Governor Carney.

Just as a reminder UK inflation remains above target where it has been for a while.

The Consumer Prices Index (CPI) 12-month rate was 2.4% in April 2018, down from 2.5% in March 2018.

The welcome fall in inflation due to the rally in the UK Pound £ has been torpedoed by the unreliable boyfriend and a specific example of this is shown below.

Let us give the BBC some credit for releasing those although the analysis by its economics editor Kamal Ahmed ignores the role of the Bank of England.

Silvana Tenreyro

Silvana in case you are unaware is a member of the Monetary Policy Committee who gave a speech at the University of Surrey yesterday evening. As you can imagine at a time of rising inflation concerns she got straight to what she considers to be important.

Many critics have laid the blame on the tools that economists use – our models.So, in my speech today, I
will attempt to shed some light on how and why economists use models. Specifically, I will focus on how they
are useful to me as a practitioner on the MPC

Things do not start well because in my life whilst there has been a change from paper based maps to the era of Google Maps they have proved both useful and reliable unlike economic models.

An oft-used analogy is to think of models as maps

Perhaps Silvana gets regularly lost. She certainly seems lost at sea here.

Similarly, economic models have improved with greater
computing power, econometric techniques and data availability, but there is still significant uncertainty that
cannot be eliminated.

Let me add to this with an issue we have regularly looked at on here which is the Phillips Curve and associated “output gap” style analysis.

Many commentators have recently argued that the Phillips curve is no longer apparent in the data – the
observed correlation between inflation and slack is much weaker than it has been in the past. If the Phillips
curve truly has flattened or disappeared, then the current strength of the UK labour market may be less likely
to translate into a pick-up in domestic inflationary pressures. Given that the Phillips curve is one of the
building blocks of standard macroeconomic models, including those used by the MPC, a breakdown in the
relationship would also call for a reassessment.

Er no I have been arguing this since about 2010/11 as the evidence began that it was not working in the real world. However Silvana prefers the safe cosy world of her Ivory Tower.

My view is that these fears are largely misplaced. I expect that the narrowing in labour market slack we have
seen over the past year will lead to greater inflationary pressures, as in our standard models.

The fundamental problem is that the Bank of England has told us this for year after year now. One year they may even be right and no doubt there will be an attempt to redact the many years of errors and being wrong but we are now at a stage where the whole theory is flawed even if it now gets a year correct. As we stand with four months in a row of falling total pay in the UK the outlook for the Phillips Curve is yet again poor. Here is how Silvana tells us about this.

Although average weekly earnings (AWE) growth has now been strengthening since the middle of 2017,

Inflation

Fortunately on her way to the apparently important work of explaining to us of how up is the new down regarding economic models Silvana does refer to her views on inflation.

such as energy costs. And indeed, Chart 2 shows that the contribution of the purple bars to inflation
is correlated with the peaks and troughs of oil-price inflation over the past decade or so

It is probably because her mind is on other matters that she has given us a presumably unintentional rather devastating critique of the central bankers obsession with core inflation which of course ignores exactly that ( and food). Mind you it does not take her long to forget this.

Since the effects of oil-price swings are transitory, there is a good case for ‘looking through’ their impact on inflation.

Oh and those who recall my critique of the Bank of England models on the subject of the impact of the post EU leave vote will permit me a smile as I note this.

But in the past few quarters, we have seen some
building evidence that import prices have been rising slightly less than we had expected (only by around half
of the increase in foreign export prices – Chart 3). For me, this may be one reason why CPI inflation has
recently fallen back faster than we had expected.

I have no idea why they thought this and argued against it correctly as even they now admit. This is of course especially awkward in the middle of a speech designed to boost the economic models that have just been wrong yet again!

Comment

If we move to the policy prescription the outlook is not good for someone who has just dismissed the recent rise in the oil price as only likely to have a “transitory” effect. In fact as we move forwards we get the same vacuous waffle.

While I anticipate that a few rate rises will be needed, the timing of those rate rises is an open question

Okay but when?

With falling imported inflation offset by a gradual pick-up in domestic costs, I judge that conditional on the
outlook I have just described, a gradual tightening in monetary policy will be necessary over the next three
years to return inflation to target and keep demand growing broadly in line with supply.

So not anytime soon!

The flexibility is limited, however – waiting a few more
quarters increases the likelihood that inflation overshoots the target. In May, I felt that as in these scenarios, the costs of waiting a short period of time for more information were
small.

So more of the same although let me give Silvana a little credit as she was willing to point out that Forward Guidance is a farce.

Taken literally, the models suggest implausibly large economic effects from promises about interest rates many years in the future. There is ample empirical evidence that these strong assumptions do not hold in real-world data.

Also she does seem willing to accept that the world is a disaggregated place full of different impacts on different individuals.

Another unrealistic assumption in many macroeconomic models is that everyone is the same. Or more
accurately, that everyone can be characterised by a single, representative household or firm.

 

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27 thoughts on “The Bank of England seems determined to ignore the higher oil price

  1. Hi Shaun,
    So here we are almost 10 years of emergency rates and TBTF banks and the MPC is quite sure they haven’t got their “map” upside down and are confident they are on the right path —even if they don’t know how long it is — and HMG are quite sure it’s a good day to sell some bank shares.
    At this rate we will be lost for decades – or are my fears misplaced?

    • Hi Eric

      I spent a bit of time putting out some views on RBS which will be familiar to you as for example it should not have been bailed out like that. It provoked some aggression which I calmed by pointing out it has been a decade now when will it work? Also by agreeing that today’s decision was to some extent political.

      Anyway I then spotted that I was being trolled as several accounts making similar points were brand new. So I put out on twitter that I was being trolled and as if by magic they disappeared.

      RBS could easily be lost for decades.

      • They are another of these badly-run banks, which spend more time being Right-0on about diversity than getting the job done. I recently applied for a job with them and easily got through the basic entry tests (the standard of maths was around that of an 8-year old me. By the time I had got through the right-on bit, I had lost interest in their “culture” and any likely job prospects, but I still did the video interview (preset questions to which you record an answer) and deliberately bombed the one about changing work style by talking about getting rather aggressive over an oil tanker legal case I handled years ago. I was rejected about 10am the next day! They are just as rubbish as “minus 27%” Lloyd’s and Barclays.

  2. The BOE will not respond because it can’t; debt levels are far too high. The only way it would be forced to respond is if there were second round effects and there is no sign of that and there would have to be evidence of a wage/price spiral which, in the absence of unions, is much less likely than it was it was in the 70s.

    Furthermore we are overdue a recession and the “onwards and upwards” meme simply ignores the economic cycle at a point where the chances of a recession are much higher than say five years ago.

    The neutral rate of interest is that which allows sustainable growth and inflation at around 2% and, due to debt levels, this getting farther away, not closer as suggested so the ” gradual tightening in monetary policy will be necessary over the next three
    years” is a chimera; what would not make it so is a reduction in rates, not an increase.

    Which will come first; and increase in rates by the BOE or the monetary system blowing up completely? I bet the latter.

    • Hi Bob J

      In some areas to quote central bank speak we have become more resilient. For example many more people incept fixed-rate mortgages which personally I think is sensible. Of course there are danger zones such as the rise of unsecured credit and the car loan sector. But I think we could get up to 1.5% to 2% and that would be my plan.

      We need also to look at longer-term interest-rates and we are getting a test run of this from Italy. With bond yields pushing higher today ( for those who are unaware Italian bonds were sold off heavily) we may see more than one expensive auction of debt as it had to pay 3% for the ten-year last week. I recall one of the contributors on here saying that rate was a danger for the UK well considering its national debt burden it will be even more so for Italy.

      • The problem with fixed rate mortgages is that they are also fixed term.
        If someone has an unfortunate change of circumstances during their fixed-rate period, which persists until renewal time, there is a big risk that, even though the new payment rates will be far below svr levels, they will be refused on the grounds of “affordability”!!!
        This happened to me about ten years ago, my payments on svr were double what
        I’d have paid on a new fixed-rate deal, and probably was the single most decisive reason for me clearing my debts, to the point where I now have none, whatsoever, of any kind.
        There are approx. 3m households on svr mortgages, and I’d bet, that at 3 times fixed rate levels, most are trapped there.
        This is the second reason why interest rates won’t normalise: 3m more bad loans on banks’ balance sheets.

        • Or what I called “all the red ink” across Barclays’ balance sheet, but was assured wouldn’t cause problems as they were so “well regulated” now. Well, if it is not going to be a problem for the banks, why not raise rates? Oh ……

  3. So she’s saying they use an economic model that includes petrol prices, because it is the single largest determinant of future inflation, but then they ignore the petrol price when deciding whether to act on future inflation?! Sorry, I’m confused.

    • Perhaps she thinks Andrew Sentance is right and inflation is driven by global price pressures which are driven by exchange rates which are driven by Carney’s jawbone . After all, look at the last 10 years of inflation that’s been looked through while the base rate hasn’t moved- except for one temporary post referendum blip.
      On that basis the MPC should be disbanded, Carney can keep quiet, and bank rate locked to the price of oil…..
      That can’t be right, can it? I think I’m confused now..

  4. Shaun,
    Bill Mitchell’s MMT blog highlights ECB research (paper no:2058 May 2018) sources of business cycles – implications for DSGE models which in his words is a withering critique of mainstream economics. The relevant blog is dated 29 May 2018 and worth a read.

    • Hi Chris

      Thanks for the heads up and I think they are describing the model the Bank of England uses here.

      “To sum up, we argue that the current vintage of
      DSGE models lacks a dominant demand shock that would explain the business cycle dynamics. This
      is no ado about nothing—most models fail to coherently explain up to 80% of key macroeconomic
      variables. “

  5. So let me get this straight. By raising interest rates, the BoE is being inflationary. Geddit.

    But by not raising interest rates, the BoE is passively being inflationary, as the major input cost of oil become more expensive to producers, hence pushing up consumer prices. Inflationary policies yeah?

    • Inflation is directly linked to oil price but the oil price is not directly linked to the inflation rate (hopefully?).

  6. I can only assume the BoE has it’s own figures or it simply disbelieves the ones it receives from the ONS. This is why I’m an inflation dove even with the falling pound and rising oil price, or rather I’m a stagflation hawk. The BoE knows full well wages are going nowhere but stagnant/falling and any IR raise whatsoever will flatten our economy.

    In the real world people don’t use models, if housing costs increase (rents will rise with them) a combination of cuts to consumption and higher personal debt will result. That’s why the BoE keep saying they will raise rates now but as the Smiths once plaintively asked. “How Soon Is Now”?

  7. Steve is going to get the Governor’s job one day.

    Carney will obviously see through this “blip”, which is already getting the BBC comments page all irate, yet it just drains more money from ordinary and discretionary consumption. So even if Ahmed does not get the BoE angle, his readers do.
    The groundis being laid for sitting on hands, given the growing signs that house prices have stalled.

    • David, I too see that house prices are stalling despite the continued credit growth splurge and accomodating IRs. I wonder if the price levels have topped out irrespective of other policy and even creative policy measures which might be planned.

      Is it also possible that without further increases (i.e. staying roughly the same) the ponzi scheme could fail, since the scheme is now predicated on ever increasing asset values. I’m thinking maybe staying the same might not feed the debt monster…

      This could be an upset for a population of boomers and elderly who only perceive their lives through the lens of escalating value for same old bricks and mortar.

      • Paul,
        If house prices start to fall and continue falling(unlikely given the current policies) Carney will re-instate QE and may even go to negative interest rates.

        • Yes, interesting Kevin and I concur. It is fair to point out that some prices have been falling already though. I guess if they are reported tby the MSM media to be falling across the board then Carney will pull out the stops. Animal spirits being what they are though I am not sure that you can simply press those buttons anymore (Esp with 3% in the USA). The smart money will lead the way if they see 1) Assets Falling 2) Negative cost of holding Sterling and 3) Print-away to heaven. So I am not so sure Careny would pull it off without making a currency crisis when he only had an asset deflation.

        • It won’t matter. When house prices really start to fall, the game’s up, because it would need to be admitted that the original purpose of so much loose policy was to support banks, especially via house prices (loan books), and I really can’t see any central banker admitting that policy was set to keep a bubble inflated, not even this tosser, when it has already been claimed to be help for business, and the economy as a whole.

      • There comes appoint where people are so hopelessly indebted that they know it’s only a matter of time before the shit his the fan. That can have counter-intuitive consequences, like, eat, drink and be merry, for tomorrow we have our credit taken away.

  8. That ain’t working that’s the way you do it
    Money for nothing ….could have been written about the MPC

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