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.