Analysis - UK haunted by the spectre of stagflation

[HEXUS]

Inflation is rising and so is unemployment so what, if anything, can policy-makers do about it?

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[aidanjt]

The economy needs a good deflating.

[Saracen]

Re: the last para of that article ....

But he's been using that argument for a while, and you have to wonder how long it will be before King admits the high inflation is due to interest rates being the lowest they've ever been for the past two years. When he does, especially if GDP is on the rise too, we wouldn't be surprised to see interest rates climbing rapidly.

I don't agree with the inference or the conclusion. A large part of our current inflation clearly is due to external factors, not least, commodity prices, including oil, food (like wheat, etc) and metals. And in turn, a large part of that is because growing demand from "3rd world" countries like China, India and Brazil are, through a basic supply/demand effect, driving up prices and I see no end to that basic pressure any time soon.

If you extract the impact of those from inflation, you're left wit an underlying trend of about 1.2%, and a chunk of that is caused by steady QE over the last year or two, with some heavy injections but a regular, steady trend, too. And that, inevitably, has an inflationary effect.

So the big question is whether, IF the BoE increases interest rates, will it be able to impact on inflation by doing it, and to what extent, because it WILL hit economic activity in other regards if they do that. For a start, it has an inflationary imperative of it's own - if they increase rates "rapidly", as you said, it will hit anyone with a mortgage in the wallet, right at the time when other "austerity measures" are coming in to effect, and not only will that dampen down domestic demand but the risk is that a combination of that pain and the austerity measure's pain will strengthen the union's case for wage rises to compensate. And if that starts to happen then we'll face something far worse than the current inflation, which is a slowly ingrained inflation expectation. And that is dangerous, because if we get started on that, it can be very hard indeed to get it out of people's psyche, and you'll get a perpetual cycle of wage demands based on that expectation, which directly feeds back into business costs, so prices up up because of the action people took to combat their expectations of inflation. In other words, a pernicious self-reinforcing inflationary cycle.

Interest rates are, in all probability, not the answer to our current problems, and instead, could well add to our woes. There may well be some pressure to increase them, but there will also be pressure not to.

Finally, the "stagflation" idea is not germane at he moment either. At about 2.7%, the worry is not stagnation, but rather, whether a relatively healthy growth level for a modern, Western economy is maintainable at that level, or whether the "austerity measures" could derail it. If you add rising interest rates to the austerity measures, that chance gets bigger.

[Noxvayl]

The problem is the principles which created the market. When economics was first proposed by Adam Smith the thought of natural resources running out was as far fetched as Alien invaders are today. Thus the infinite growth paradigm emerged which dominates the market.

It is impossible to maintain growth while resources continue to diminish and thus, through simple supply and demand, you get inflation. Essentially there is nothing that can be done to reduce it in our current system. A radical rethink of the way in which economies operate is required to achieve sustainable economics so we may manage our finite resources better instead of waste them in the infinite growth market currently in operation.

The system is it's own downfall.

[aidanjt]

...

Indeed, well said. The monopoly money in circulation doesn't help, either.

[Scott B]

Re: the last para of that article .... I don't agree with the inference or the conclusion. A large part of our current inflation clearly is due to external factors, not least, commodity prices, including oil, food (like wheat, etc) and metals. And in turn, a large part of that is because growing demand from "3rd world" countries like China, India and Brazil are, through a basic supply/demand effect, driving up prices and I see no end to that basic pressure any time soon.

Regardless of the relative contributions to inflation that come from internal and external factors, it is way over the target level at a time when interest rates, which are the primary tool at the disposal of the BoE to influence inflation, have been at a record low for years.

So I ask: is it no longer the remit of the BoE to aim for 2% inflation? If not then fine, but if it is then how long is it permissible for it to utterly fail in that regard.

The point I was trying to make in that final para, perhaps not very well, is to question how long we can keep calling an inflationary factor transient. Because as soon as we accept it's not transient, then surely it has to be addressed.

[nichomach]

Re: the last para of that article .... I don't agree with the inference or the conclusion. ....

This, very much - it isn't sufficient to say that inflation is high therefore interest rates must go up if what is pushing inflation isn't susceptible to interest rate variations to start with; that's economic Retrophrenology.

[Saracen]

Regardless of the relative contributions to inflation that come from internal and external factors, it is way over the target level at a time when interest rates, which are the primary tool at the disposal of the BoE to influence inflation, have been at a record low for years.

So I ask: is it no longer the remit of the BoE to aim for 2% inflation? If not then fine, but if it is then how long is it permissible for it to utterly fail in that regard.

The point I was trying to make in that final para, perhaps not very well, is to question how long we can keep calling an inflationary factor transient. Because as soon as we accept it's not transient, then surely it has to be addressed.

It is still the remit of the bank, though of course, that remit is set by Government and could be changed.

But the situation is that if they fail to meet the target, they have to write an open letter to the Chancellor explaining why they didn't. However, it has so far been possible to provide coherent, if not entirely unanimous support for, those reasons.

The real issues the MPC will be considering are not what the current rate of inflation, CPI in this case, happens to be, but what they consider the medium term inflation predictions to be, and the effect of various factors, clearly including BofE base rates and their current QE, and to consider the various risks to the economy of acting, and of not acting.

Bear in mind, in some ways, inflation = good. In others, inflation = bad. And for that matter, some inflation = good, and it's bad if it's too much, or not enough.

It is, all in all, a very fine balancing act, absent of any concrete, known results from changes they make. Changes have a way of taking a while to take effect. It's a bit like flying a plane. It's not like a car, when you turn the wheel and the car immediately changes direction, and you steer back to turn back. You have to expect a turn to be be less immediate than that, and you have to anticipate when you want to turn back and start a bit beforehand. In fact, maybe a supertanker would be a better analogy.

And the BofE's decision is vastly complicated by the fact that it's not just reported inflation figures, of necessity a view of what happened several months ago, but their view of what they think is going to happen, and a view of what people's expectation of what is going to happen are.

The minutes for the last MPC meeting aren't out yet, but the previous one made it clear that imported inflation, especially fuel and commodities, are believed to be a major factor, though a notoriously hard one to quantify, and that their decision not to raise rates was, by 8 to 1, supported because of that.

So yes, controlling inflation is still the banks responsibility and yes, inflation figures will be exerting some pressure, but it's a FAR more complex picture than just that. Inflation is not a simple thing. It comes from a variety of sources, some of which would be entirely unaffected by the BofE raising rates, so you have to ask, if they believe a rate rise would have minimal effect because much of the inflation is imported, then is what you gain from doing it enough to justify the damage that it would do in other ways?

Perhaps more likely than inflation figures directly pressuring for a rate rise will be if inflation expectations start to fuel a wage inflation demand, because that is a far more insidious problem for the medium and long term. It might not be actual inflation that ends up causing a rise, but dampening down expectations of, or even fear of inflation.

And critical to that will be how responsible the unions will be. Protecting members standards of living is one thing, but screwing up the economy over daft claims is positive vandalism.

[CAT-THE-FIFTH]

[nichomach]

Oh deer-y deer-y me...

[Scott B]

As ever, Saracen, thorough and insightful stuff.

As a dilettante I'm well aware of how imprecise and complex economics is. But I thought it was generally accepted that cheap money is inflationary, and that inflation of much above 2% is bad.

So while I feel for the poor old policy makers and their delicate balancing act, I'm just asking how long the BoE committee can continue to justify failing to deliver on its core responsibility. It's justification so far has been that mid-term inflation will sort itself out, but it's been saying this for a while and it's still going up.

At what point to be conclude we've reached that mid-term, and judge the BoE claims accordingly?

[Saracen]

As ever, Saracen, thorough and insightful stuff.

As a dilettante I'm well aware of how imprecise and complex economics is. But I thought it was generally accepted that cheap money is inflationary, and that inflation of much above 2% is bad.

So while I feel for the poor old policy makers and their delicate balancing act, I'm just asking how long the BoE committee can continue to justify failing to deliver on its core responsibility. It's justification so far has been that mid-term inflation will sort itself out, but it's been saying this for a while and it's still going up.

At what point to be conclude we've reached that mid-term, and judge the BoE claims accordingly?

All good questions. I guess if I had the answers, I'd be one of those City types currently expecting to pocket a 7-figure bonus, which I desperately need because the helicopter on my yacht needs to be upgraded - the ashtrays are full.

What you say about accepted views is broadly right (though perhaps that view is a tad simplistic for such a complex area), but I think we have to start challenging some accepted views.

For instance, it's an accepted view that bank retail rates (mortgages, etc) are tied to the base rate. Base rate goes down, mortgage rates go down, base rates go up, mortgage rates go up. Recently, that's been about as true as the accepted view that Lehman Brothers were gold-plated and couldn't fail, or that Icelandic banks were a good place to park all your spare money because interest rates were so good. Or, a lot of people seemed to hold the view (or certainly acted as if they held the view) that property prices could only go up and that buying property was a dead cert winner, despite very clear and relatively recent proof of how stupid that bland assumption actually was. And, if you're a bank, that lending to anyone and everyone, at daft levels and on stupid terms, was good business practice.

The world, in my opinion, has changed. It's been changing for a while, and that will continue to happen. And it's changed again because of the global banking and credit crisis. Some old assumptions have been proven to be flawed and not, as often believed, immutable laws of physics.

One of those assumptions has been the nature of inflation and the "solutions" to it.

When a lot of economic theory was evolved, the world was a very different place. Keynes, for instance, knew a world where things were radically different from where they are now, and the evolving economic power blocks are, quite likely, game changers.

If you have inflation where it's almost entirely domestic, one set of rules (and solutions) will apply. If it's not, you may just have to come to live with the fact that there's an inherent, underlying inflation level due to overseas demand and competition for resources that is entirely outside our ability to affect, and then you'd have to build that in to the assumption that the "correct" level for inflation is 2%. Or maybe, you have to evolve better analytical tools for assessing just what the components of inflation are, and set targets based on the bits that domestic policy will influence, and ignore the bits that it won't.

So yes, inflation is important, and persistent excessive inflation is very damaging indeed. But, the BofE needs to be careful not to kill the patient by trying to cure it. Inflation is a bit like cancer, and interest rates like chemotherapy. They're poison, and the art of setting interest rates, like the art of chemotherapy, is to get the magnitude and timing of the therapy right, so that you kill the cancer a bit faster than you kill the patient. And .... quite important this .... don't over do the therapy.

Inflation is important, but more so is growth. In the absence of that, we're really in the poop. And too much interest rates, or to early, or when unnecessary, threatens growth and could lead to more unemployment. We really need growth up, or at least not to drop much, and unemployment to come down, to reduce the structural deficit, in order for government finances to stand any chance of coming back under control in even the medium term, yet at the same time, deficit reduction has to start and that alone threatens temporary increases in unemployment. The very last thing we need is to make the finance that supports both consumer spending and business capital any more expensive unless it's absolutely required because the threat from inflation is too large.

So .... it's a balancing act, and one in a very different world from when that 2% (+ or - 1%) reporting rate was set. The underlying factors have changed. We're it not for the very dangerous signals it might send, I would be surprised to see the Chancellor changing the target rate to reflect underlying imported commodity inflation, but the psychology of that would be to unnerve the financial markets and that he won't do.

I'm a firm believer in back-channel communications between government and the Bank. I always have been. I just don't buy the notion that interest rates are quite as independent as politicians would have us believe. I would not be at all surprised if the "message" had been sent that yes, there's a 2% target, but no, we're not going to be hopping up and down with fury if you can't meet it.

We've now seen about a year of that target being missed, but has anyone seen much rhetoric from the Chancellor chastising the Bank for not meeting it, or calling for it to raise rates? And by Chancellor, I mean both Osborne and, pre-election, Darling.

Perhaps that back-channel message is, in this case, a lack of overt moaning from the Treasury. They might not want to overtly increase the target rate, but they don't seem to have been overly loud in moaning about missing it.

If you have a patient that's been in a car crash, broken his leg and then had a heart attack, you worry about the heart attack first. There's not a lot of point in doing a wonderful job repairing the bones, setting the leg and making the patient comfortable if, in the meantime, he's died of the heart attack.

That's kind of what I'm getting at with interest rates and inflation. Yes, it's a problem, and yes, you're right, pressure will grow. But .... at what point does it become so serious a problem that treating it becomes a priority over the damage that very treatment might do? Right now, protecting growth and not derailing the recovery we do have is more important than a longer-term inflation problem, especially if you believe there are still temporary factors underlying recent inflation figures that will work themselves out anyway.

For instance, the rise in VAT rates.

Putting VAT up to 20% will impact on inflation rates. That's inevitable. But .... when? The obvious answer is in this quarter and so the next quarterly inflation range will reflect it. But there is some evidence that many firms somewhat pre-empted it. There's a lot of "we're delaying implementing the VAT rate, so buy in our sale" advertising going on right now. But is it all it seems? A rise in VAT was signalled months ago, and firms are crafty enough to drift prices up before that, in order to be able to use the "no VAT rise" price advertising after rates go up,when in fact, they've already built it in. And, if they did do that, the last quarter's inflation figures is precisely where you'd expect to see it.

So .... the implication is that some of the impact of the VAT rise will be in this quarter's figures, and some was in last quarters. You'll probably see that drop out in the June quarter figures, so we'll see those in, what, late July?

I think the Bank will hold it's nerve for a while yet. I certainly would unless something much more drastic comes to light. By mid-year, the chances of inflation forcing rates up is higher, in my view, and by year end, if the figures are still as bad, I think it'll be hard to resits. But before that, I think it's much more finely balanced. The case for a rise can certainly be made, but so can the case for not doing it, and it's a fairly fine balance that, in my view, comes down on the side of not doing it. And that, personally, is a shame, since saving rates are in the toilet at the moment, and I don't have a mortgage worth taking about. I'd prefer to see rates go up. But I doubt they will. Not quite yet.

[Scott B]

I completely agree that the Bank and the government are far more complicit then they would have us believe. The longer King has to keep writing his public letters, and the longer the Chancellor keeps making it clear he's not that bothered about inflation, the clearer it will become that both the Bank's remit and independence are a sham.

Maybe that's for the best, but when the Bank was given supposed independence from politics I think the move was generally well received...