Merv has let the genie out of the bottle

Thursday, July 29, 2010

If there's on thing punters can rely on these days, it's for Mervyn King to sound as dovish as an albino pigeon trying to get into a "doves only" night at the disco. And yesterday was no different, with the Swerve downplaying the recent strong GDP print and bleating on about how spare capacity is likely to pull down inflation to target. Well, it's hasn't yet has it? Team Macro Man is sure it is not alone in questioning the Bank of England's credibility here in the context of consistent upside surprises both to its own and market-based inflation forecasts (see below chart of the UK inflation surprise index). The Bank repeatedly argues that the (supposedly) large output gap is likely to bring down inflation and that it should look through the "one-off" shocks of VAT and the currency depreciation of the past few years. The trouble with this line of argument is that it is utter bollocks - the effects of currency depreciation and VAT have been in their (and the economic consensus') models throughout all of these upside inflation surprises, yet we have *still* had them and there is no sign of disinflationary pressures (excepting those emanating from the US and Europe). Something else has to be afoot.

So first of all, the currency. The standard literature suggests that over the past decade or so, the pass-through of import inflation to domestic prices, more broadly, has fallen. But the evidence of the past few years seems to suggest the opposite - the below chart of the Broad Nominal GBP TWI YoY vs. lagged core-CPI YoY adjusted for VAT cuts/hike (more on VAT below) clearly shows CPI as being quite a bit higher than would have been expected purely as a result of the FX move. It seems to TMM that there has clearly been some pass-through into domestic prices, perhaps related to the gradual loss of credibility by the BoE...

...which brings us on to our next subject: inflation expectations. In contrast to just about everywhere else in the world, UK inflation expectations - both market-based and survey-based - have moved quite a bit higher in response to the consistent upside surprises in inflation. TMM does not view this as a coincidence given that since Mervyn King became Governor, he has had to write no fewer than 14 letters to the Chancellor explaining why inflation was above 3%, and precisely zero explaining why it has been below 1%. That's some skew. The BoE's own inflation expectations survey:

The market-based measure (see below chart of 5y5y breakevens) is similarly higher than the pre-Oil bubble average, though it has come down over the past month in line with the deflationary fears in the US and elsewhere, but there is not any room for comfort here:

So back to the BoE's other excuse, VAT. TMM has constructed a Taylor Rule (see first chart below) for the UK based upon core-CPI and the unemployment gap, and also one that attempts to account for the VAT cuts and hikes of the past couple of years by removing indirect taxes (of which VAT makes up the majority). First of all, purely based up core-CPI (brown line), the rule suggests that rates should be close to 3%, and core-CPI ex-VAT (purple) suggests they should be about 1%. The lines for 2010-2012 are based upon the median economist expectations, their high and low range and also taking the median expectations and adjusting them for the VAT changes introduced in the recent UK budget. From the median expectations, it's a little easier to see why Merv & the gang are so dovish, but TMM must refer the reader to the earlier chart for inflation surprises and the second chart for UK growth surprises. The consensus, and the BoE itself, have been much too pessimistic on growth and also much to optimistic with respect to inflation. TMM is of the opinion that given the above chart of FX pass-through and the rise in inflation expectations, the bet still has to be on inflation stubbornly refusing to come down, and the optimal policy setting being closer to the "high" end of the below forecasts, rather than the "low" end.

Now Team Macro Man may not have its facts straight (and is happy to be proved wrong), but they seem to remember that the Governor is sitting on a juicy £5m index-linked pension. Can anyone else see a problem with that...?! One bright punter pointed out to TMM yesterday that Merv has to top up his pension somehow now that the re-indexation from RPI to CPI has cost him dear. Perhaps TMM is being a bit unfair, but it seems to us that Merv is consistently behind the curve in terms of policy response, missing his lender of last resort responsibilities in August 2007 (and being jointly responsible for the run on Northern Rock), being hawkish in August 2008, then panicking in November, and now seemingly advocating an increase in QE. But we digress...

Given that the consensus forecasts above already include the expected drag from fiscal consolidation, it seems to TMM that the risk is for (dare we say) stronger-than-expected growth and worse than expected inflation surprises. The UK has an inflation problem and the Bank of England are asleep at the wheel...

Posted by cpmppi at 11:30 AM  

3 comments:

Isn't it usually better to observe what people 'do' rather than what they 'say'. To that end, the Bank of England Pension Fund is over 50pct invested in Index Linked Gilts. And has been for some time.

Matt said...
12:52 PM  

You just can't make this stuff up can you?! :-)

cpmppi said...
12:57 PM  

TMM,


You may have stated an leading indicator for USA at the very least,or not :)

FX said...
2:53 AM  

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