Wednesday, October 13, 2010


Given yesterday's once again eye-watering inflation numbers out of the UK, TMM decided it was time for another look at UK policymaking, and it seems to us that the UK is undergoing a serious bout of Mervynflation. As far as TMM can tell, policymakers just haven't learned arguably the most important lesson of the crisis which is that groupthink amongst economic policymakers is very dangerous. And seeing the steady stream of calls for renewed monetary easing from such policymakers around the World post-Jackson Hole, gives TMM cause for concern. In particular, Adam Posen's recent eloquence making the case for a second round of QE in the UK. While Dr Posen can claim significant expertise with respect to the Japanese experience, TMM are now convinced that his line of argument ignores the most important considerations, those he clearly knows least about... THE UK. It is easy to see the attractiveness of the Depressionary view of the World post-crisis where deflationary forces caused by exceptionally large output gaps mean that the downside risk is very real and the evidence in the US is indeed worrying in this respect when we look at measures of resource utilisation. But this just isn't the case in the UK, as we will attempt to argue in this piece. TMM is concerned that this deflationary tunnel-vision by the Bank of England, and economic policymakers in general, as a result of the Jackson Hole consensus is causing a serious policy error in the UK.

Team BoE have been at pains to argue that the reason for the consistent upside surprises in UK inflation have been as a result of "one off factors" such as the large currency depreciation and the VAT hikes. Given we are now two years on from the collapse of Sterling, it is hard to argue that there is any remaining pass-through from this effect. As for the other "one off factor", TMM have attempted to strip out the VAT effects from core-CPI (see chart below: headline CPI - white, CPI ex-indirect tax - pink, core CPI - brown, core-CPI ex-VAT - green), and while this measure of inflation sits a lot lower than the headline, at 1.5%, it is still around the average level that core-CPI has been at since the BoE was given independent control of monetary policy. Since the emergence of China et al, a wedge between the headline and core-CPIs has opened up, something that policymakers regard as being a "one off", as energy and raw material prices are pushed higher. As regular readers will know, TMM believe this is unlikely to stop as the economies of these countries grow, and thus it is very hard to get sustained deflation in headline CPI. But the point here is that ex-everything-the-BoE-thinks-are-one-offs, inflation is pretty much where it has been for the past 13yrs. As some wags have commented in the past, inflation ex-everything is zero.... we're not fooled.

OK, so what about the relative picture? The below chart shows UK core-CPI (white line), UK core-CPI ex-VAT (yellow line), Eurozone core-HICP (green line) and US core-CPI (brown line). It is pretty clear that both US and EU core-CPI have been gradually trending lower, and to the lows of their historical ranges, but the UK measure is nowhere near the negative levels it fell to in 2000. As far as this chart goes, it is possible to construct a deflationary argument in the US & Eurozone, but laughable as far as the UK is concerned.

"Ah," you say, "but what about the output gap? That chart only tells you what has happened, not what is going to happen. Growth is going to be very slow, unemployment is going to rise when the public sector spending cuts start, and we will have a double dip". Well, the trouble with this argument is that the UK is not the US, the output gap is a lot smaller as unemployment didn't rise anything like as much as economists expected, and has begun to fall (see chart below -white line, inverted), while manufacturing capacity utilisation (yellow line) and the CBI's capacity utilisation survey (orange line) have both retraced a large amount of their fall and are either at or approaching the levels of the past 15yrs. As a wise colleague once said to TMM, the trouble with measuring the output gap is that you're trying to fit a line using past data that is going to be revised, using present data that will also be revised in order to predict where you think future potential output will be (that will also be revised). TMM is thus of the view that making policy based upon something so transient is somewhat short-sighted.

In terms of the public spending cuts, as Ben Broadbent (TMM's favourite UK economist) at GS keeps pointing out, the public sector job losses are equivalent to 0.4% negative job growth, while the private sector is adding jobs at a rate of 1.6%, which will comfortably offset the loss of those public sector jobs. A recent OECD study also finds that in the UK the fiscal multiplier is something like zero, plus or minus 0.1 (!). As we've pointed out before, the two periods of strongest growth in the past 30yrs were during periods of fiscal retrenchments... now, that may or may not be due to FX rate falls or monetary policy, but that is a subject for another day.

The other argument the BoE put forward is that wage growth is tepid. But this misses the point. Once inflation shows up in wages, it is too late... Anyone remember the wage-price spirals of the 1970s??? Today's wage data seems to suggest that the rate of pay increases (see chart below) is beginning to turn back up again...

...And Nominal GDP (chart below, white line) has reached a new peak, even as Real GDP (brown line) is still well-below its peak. The answer here is inflation, and as far as the guy on the street is concerned, the economy is nominal GDP - the money illusion is real (excuse the pun).

But back to the BoE... TMM have updated their UK Taylor Rule (see chart below) which is based upon the unemployment gap and consensus economic forecasts. The brown line is using straight core-CPI, while the purple line uses core-CPI adjusted for the VAT effects, and both suggest that policy is too loose, and that rates should be around 2%. To be talking about doing more QE when policy is already too loose seems somewhat loopy to TMM.

The extent to which the BoE have allowed inflation to rise and continue to set policy too loose has begun to have a material impact upon inflation expectations, and TMM are surprised that the BoE have allowed these to begin to de-anchor, something they put down to the economic groupthink of Jackson Hole. The Fed, for example, usually respond either with rhetoric or action when two of the following measures of inflation expectations begin to de-anchor: (i) professional forecasters, (ii) market-based and (iii) survey-based. Well, the charts below seem to suggest all of those have in the UK. Professional forecasters have raised their long-term inflation expectations from around 2% to 2.5% (chart below, blue dots):

The market-based measure implied by 5y5y fwd breakevens has settled into a higher range of 3-3.5% vs. pre-2007 range 2.5-3.1% (see chart below, white line), and have stayed high, even as the equivalent measures in the US (orange line) and EU (yellow line) have moved lower as deflation fears have grown:

And the BoE's own inflation expectations survey shows a clear de-anchoring:

TMM's question for the BoE is "At what point do you accept you have got this wrong?". While conspiracy theories have grown that this is all part of a grand plan to inflate and reduce the real debt burden for both households and the government, TMM think it is more to do with groupthink than anything sinister. The trouble is, we have no idea at what point the BoE will finally respond... 4% CPI? For the time being, both Sterling and Gilts have to be a sell on rallies given the inflation tail risk.


Leftback said...

Agreed with most of your reasoning, which fits the data and my anecdotal observations of a recent trip to London ("HOW much for a pint?"). The potential flaw in your argument, and what the BoE is presumably thinking about, is that there are still parts of the UK where the housing bubble hasn't burst properly, or really hasn't burst at all (London). Nor will it, until the twenty year bull market in banker bonuses finally ends.

While they should, indeed, leave UK real estate market well enough alone to find levels that are affordable by everyday humans, they may be looking at UK real estate as a source of deflationary input for some time to come and be preparing some props to hold it up as it falls.

Deniz said...

great post. thank you.

it seems uncertainty around impact of fiscal consolidation on growth is enormous. while fiscal multiplier should be zero for open small economies, the imf study on weo was suggesting in a situation where the zero interest rate
floor applies and the rest of the world conducts fiscal consolidation at the same time -prime example is UK-, multiplier becomes 2x. wide range indeed.

Second thing is that in his speech Posen was pointing out roughly equal number of jobs are forecast to
be lost over the next four years in the private sector companies that serve the public sector as in
the public sector directly. a higher bar to clear.

Third worrying point was it seems that PSFB in Q2 fell sharply due to fall in personal savings rate -correct me if i am wrong. depending on the outlook for wage growth, one can argue that private sector is not in a great shape to withstand cuts in public spending.

love to hear your thoughts.

cpmppi said...


Yes, it certainly feels anecdotally that inflation is here.

First, in terms of the housing market, yes, there is clearly the argument that keeping real rates very low will help cushion the blow, but to be honest, I'm not even convinced that there actually *was* a housing bubble... you'll remember our post several months ago on this point. Secondly, from what I can tell, wages have taken something like 11% of the adjustment in the sustainability ratio (house price-to-earnings ratio) since the peak, such that we now sit around 3.7x. It's not obvious that there is much further to go in terms of adjustment given that the construction boom was primarily in apartment complexes rather than where demand exists ( houses not apartments)... the supply problem still exists over here, unlike in the US. That's a post for another day I think...

cpmppi said...


Glad you liked it.

Yes, I appreciate that there is a lot of uncertainty here, but the UK's prior experiences with fiscal consolidation give grounds for optimism here... at least relative to market and commentariat opinion. I think a lot of a myths have just become accepted wisdom in this respect - e.g. opinion polls with respect to "Thatcher's Cuts"... again, this is a post for another day...

With regards to the private sector service company job losses, sure, that is a higher bar, but vs private sector hiring that is still net +0.8% employment growth per year. And that doesn't even take into account private firms' hiring intentions on the back of business investment - this is something we've talked about a few times before, but largely falls on deaf ears because no-one can remember the early-80s or 90s as trading desks are generally staffed with those that earned their stripes in the late90s/early00s. Post the spending review, firms will have a lot of clarity here, and judging by the CBI's capex intentions surveys, this looks likely to ramp significantly. In the early 80s/90s both recoveries were driven in this way (unlike 2001-3).

As regards personal savings rate... TMM learned a long time ago never to underestimate the stupidity of the UK consumer. I guess if anything they are following Mr Bean's advice to spend, spend, spend! And if there has been one thing that the crunch has shown, it is that you are better looked after if you are the indebted spender rather than the cautious saver. I don't think this has been lost on people.

But in all seriousness, the "lucky" scenario is that in which consumer spending and clarity on spending cuts encourage businesses to fill the gap left by the state, and accelerate their hiring plans. I think that scenario is at least as likely as the Japanese one. After all, the UK recovery so far doesn't look much different from all the other ones of the past 50yrs.


Stan123 said...

You guys are absolutely right! The bank of England are negligent to the UK inflation problem. I however think that they know that if they do the right thing and raise rates it will bring the property price bubble back to earth. For the long term good of the country this needs to happen, but the BoE are too beholdent to banks and over leveraged homeowners and their politicians to do the right thing. I just can't work out why the gilt market is not collapsing? What morons are buying 5yr gilts at 1.5%???!!!!! Not my pension fund I hope!!!

Nic said...

Excellent post.
It is our patriotic duty to help Mervyn and sell the pound, no? We are in a currency war after all.

Voldemort is exporting like crazy. FX reserves rose $194bn in Sept to $2.65 trillion, way more than forecast.

I am not sure about deflation everywhere else. Grains +48% YoY av, Energy +23%, Meats +39%, Sugar +36% etc. but Ben still wants more. At some point food riots in poor countries will surely kick off again.

Tim said...

Can't help wondering if the BOE wouldn't actually like quite high CPI combined with tepid house prices as a way of defusing the real debt while avoiding bad debt (screwing savers inc gilt holders)

FX said...

PoLEMIC, Is"nt economics more an art than science? if it is'nt , then I'm in big trouble.

My pretty sports-horse rating graphs display past performances of standard variables,and if anyone just deduced from the top rated down they'd end up on a park bench and I can asure you, these ratings are'nt park bench material. strips, are they those color thingyme bob things that are on a yield chart.

RebelEconomist said...

Followed the link from FTAV.

A really useful post, that I hope that is read by someone at the BoE.

I doubt though that the BoE internally have ever really been committed to the inflation mandate. It was primarily a piece of "commitment technology" designed to gain some credibility for nothing (like the ERM), and now that the constraint has become binding, it is an embarrassment to be played down by any plausible argument. Their priorities are to keep face, ideally to be liked, and to avoid doing anything that might later be seen as a mistake.

Thank heavens for Andrew Sentance.

OF Connoisseur said...

Good post - more of this standard please.
I think the output gap in the UK is exaggerated. With much tighter bank credit, most businesses just cannot hold as much stock as before, or utilise as much capital. Much less capacity and competition in the UK tallies with the great margins we are seeing in UK business.

maynardGkeynes said...

Just wondering, how much UK debt is inflation linked; how has the existence of indexed debt affected UK policy; how well or poorly have indexed bondholders fared during this bout of inflation; if the answer is "pretty well" why would anyone buy nominal bonds at this point, when the UK has telegraphed a pro-inflation policy? One might ask the latter question about US debt after QE2 has been announced.