At the beginning of last year, there were many who were
predicting a rise in UK interest rates in 2014. By then UK unemployment had
been falling for many months, and we had had four quarters of solid growth.
However I said that if rates did rise in 2014 it would
be extraordinary. One of the reasons I gave was that there was absolutely no
sign of any increase in nominal wage inflation. I thought it would be
particularly odd if UK rates rose before US rates, given that the UK’s recovery
was lagging a few years.
Unemployment continued to fall rapidly. By June 2014 even the
Bank’s governor, Mark Carney, was giving indications that rates might rise
sooner than some were expecting. US monetary policymakers showed no signs that
they were about to raise rates, and I still thought they should be the first to move, but
I was worried that the MPC was sounding too itchy. Sure enough in August two
MPC members voted to raise rates. But wage inflation showed no signs of
increasing.
Move forward to March 2015, and the prospect of rate increases
seem to be receding on both sides of the Atlantic. On Wednesday the FOMC revised down their forecasts for inflation,
and also revised down their estimate for the natural rate of unemployment. The
reason is straightforward: despite continuing falls in unemployment, wage
inflation refuses to budge. John Komlos argues that this state of affairs is unlikely
to change anytime soon.
Much the same seems to be true in the UK, as this excellent account from Andy Haldane makes
clear. In the UK there is an additional twist. To quote Haldane: “Back in 2009,
the MPC’s judgement was that the benefits of cutting rates below 0.5% were
probably outweighed by their costs, in terms of the negative impact on
financial sector resilience and lending. With the financial sector now
stronger, the MPC judges there may be greater scope to cut rates below 0.5%.”
It now looks like the Zero Lower Bound (ZLB) may actually be zero.
Haldane goes through in great detail the possible reasons why wage inflation
seems so sticky. Moving to the monetary policy implications, he
talks about asymmetries, and many of the issues that I raised here he also raises. However he ends with
something that I think is even more telling. The chart below shows an optimal
interest rate path, using the Bank’s COMPASS model, and assuming a ZLB of zero.
What it does is confirm a suspicion that both Tony Yates and I
had about the MPC’s current stance. The policy of doing nothing, and waiting
for the inflation rate to gradually converge towards 2%, does not look optimal
even if the Bank’s forecast is completely correct.
'Doing nothing does not look optimal'. To me it looks like Haldane is clearing the path to base rate cut, but if this is more clearly signalled won't it become self defeating as inflation expectations fall even further?
ReplyDeleteForgive my elementary level question, but if the large part of the current cause of lower inflation/deflation is external ie the fall in the price of oil, why is there a need to do something internally? If inflation is a comparison with the situation of 12 months ago, surely waiting 12 months will then mean the comparison for oil prices will not show a fall, but an equilibrium, with a consequent removal of that downward pressure on the composite inflation number? And since other elements in the inflation index were described as currently showing rises, not falls, surely Carney's argument has some merit? From your explanation above I can't follow your logic...
ReplyDeleteWhile lower oil prices account for most of the fall in inflation below target, inflation would still be below target without (the direct and indirect effect of) lower oil prices. Haldane has the details.
DeleteAs I have pointed out since at least 2009/10 the labour market and the economy/GDP have been decoupled.
ReplyDeleteSo, just by concentrating on the supply side of the labour market it was possible to suggest that the recession and the recovery would be job rich - because of a 'light and even' employment protection system and labour supply boosting welfare to work policies and an efficient job-matching system in Jobcentre Plus. And if GDP does not grow as fast as employment it will be 'productivity poor'.
But the decoupling of the GDP (nominal or real) and the labour market applies even more to nominal wage growth. There are long period where nominal wage growth are fairly constant. 71/2%-8% in the 1980s 3-5% in the 1990s until the Crash and 1-3% since. And with the relatively small increase in wage growth associated with the Lawson boom the last time nominal wage growth picked up was in the late 1970s. Given this constancy movements in real wages have largely been determined by the movements in price inflation and the recent falls in real wages has been largely down to the high inflation in the UK.
And if nominal wage growth is now largely unaffected by the economy as a whole or price inflation but tends to be shocked down by recessions I think that this is implies two things.
Firstly, with a decentralised and competitive labour/product markets there is no real incentive for any business to raise the rate of nominal wage growth in their business. Which may mean that the next move in nominal wage growth is down - triggered by the next recession.
Secondly, the recent fad for central bankers to use the labour market as an indication of the state of the economy as a whole is likely to be dangerous and by focusing on (say) unemployment, employment or wages there is a danger that problems will arise elsewhere - and perhaps miss the signs of frictions elsewhere - and making the likelihood of a recession greater and perhaps closer. Whether the model of how the overall economy looks like - Keynesianism or monetarist (although are there any monetarists left?) - applying it to movements in the labour market seems to me to be misjudged.
Bill Wells
Prof SWL Sir I urge you to consult your physician.
ReplyDeleteSince I last looked at your blog around the 12th March you appear to have aged about 20 years. Either that or your Grandfather has taken over your blog.
Has GO's budget had such a profound effect on at least one person.