Winner of the New Statesman SPERI Prize in Political Economy 2016

Tuesday, 24 March 2015

Zero UK Inflation

Today it was announced that UK consumer price inflation hit zero in February. The ONS estimate that we have to go back to the 1960s for the last time this happened. More importantly, core inflation fell back 0.2% to 1.2%, after 0.1% increases in the previous two months. As Geoff Tily points out, if you take out the 0.2% contribution from the decision to raise student fees (which are hardly an indicator of excess demand), then the Governor could be writing a letter to the Chancellor based on core inflation, and not just the actual inflation rate.

The Chancellor is in election mode and so does not care: in fact he says zero inflation is good news, and he just hopes no one asks him why he chose to reaffirm a symmetrical 2% target. For the Bank of England it means the key question is now should they cut rates? As I noted here, optimal control exercises on the Bank’s model and forecast say they should, and I discussed here why there is an additional strong prudential case for doing so.

The point I want to make now is about survey evidence on capacity utilisation. I had a number of memorable meetings with various economists and officials at the Treasury, Bank and elsewhere when the Great Recession was at its height, but the one that left me most puzzled was with one of the more academic economists at the Bank of England. It was at about the time that core inflation started rising to above 2%, despite unemployment being very high and very little signs of a recovery. At much the same time survey measures of capacity utilisation were suggesting a strong recovery, completely at variance with the actual output data. The gist of our discussion was: what the hell is going on!? It was particularly puzzling for me, because I had many years before done a lot of work with survey data of this kind, and back then it seemed pretty reliable.

The problem with the 2010 period was that it was exceptional, and so in that sense it was not that surprising to see surprising things going on. My own pet theory at the time was that the financial crisis had made firms much more risk averse, which made them less likely to cut prices in an attempt to gain market share. Move on to today, and things are perhaps a bit less exceptional. What today’s figures emphasise is that the inflation ‘puzzle’ of 2010/11 has gone away. Levels of inflation are now much more consistent with substantial spare capacity in the economy. However the bizarre behaviour of the survey data has not disappeared.

Here is a nice chart from the ONS, comparing various different measures of spare capacity.

  
What it shows is that labour market indicators suggest an amount of spare capacity well outside the ‘normal’ range from the pre-recession years. In contrast, both hours worked and survey based indicators (the first six measures) suggest the output gap is quite small, and in one case actually positive. As this OBR paper shows, survey measures of capacity utilisation were suggesting a positive output gap as early as 2012.

Faced with this combination of spare capacity in the labour market and firms reporting its absence, a macroeconomist would suggest it could be a consequence of high real wages, encouraging substitution from labour to capital. Firms were fully utilising their capital – hence no spare capacity – but had hired less labour as a result. However a notable characteristic of this recession in the UK has been the high degree of labour market flexibility, with large falls in real wages. One of the more persuasive theories for the UK productivity puzzle, which I outlined here, is that we have seen factor substitution going in the other direction.

Back in 2010, I was reluctant to suggest the survey data were simply wrong, partly because of their past reliability but mainly because inflation was telling a similar story. On the day that inflation hits zero, I think the argument that these survey measures are not measuring what we used to think they measured has become much stronger. But that still leaves an unanswered question - why have they gone wrong, when they worked well in the past? 

27 comments:

  1. In 2010, people were blaming the high(ish) inflation on wholesale energy price shocks, a supply shock - hence it could not be used to indicate excessive demand led inflation, it was a cost led inflation that the central bank should ignore over the medium term as demand is still too low.

    You can argue that the current low inflation has the same cause, an enormous drop in wholesale energy prices - should this be ignored as well, since it's again arguably supply shock rather demand shock caused disinflation?

    ReplyDelete
    Replies
    1. The behaviour of inflation in 2010 was difficult to explain even when you made allowance for commodity prices and the earlier depreciation. I agree focusing on core inflation is a crude way of showing that, but my discussion at the Bank in 2010 was all about how something odd was going on even allowing for the supply shock.

      According to Haldane, low oil and other commodity prices can account for about two thirds of the fall in UK inflation. That leaves one third, that could be easily explained by spare capacity.

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    2. Or that residual one-third could be explained by rapid sterling appreciation

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    3. That is not something Haldane mentions, I suspect because it is too recent - implying that this will be reducing inflation in the months to come.

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    4. Hi Simon

      Do you think that the potential dangers of the seemingly imminent period of deflation the UK is entering are being understated by politicians and the media in general?
      I ask this given (as you also note above) the fall in core inflation, the continued and predicted low oil and commodity prices into the future, the strength of the £ coupled with low inflation/deflation with our major trading partners putting further significant downward pressure on import prices... and will this deflationary episode quickly dampen any significant wage rise deals (which many predict will still continue to remain robust despite economy-wide deflation)?
      Many thanks
      Simon

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    5. Probably yes. I certainly think that most of the media are not pressing the Bank enough on why they think a cut in interest rates is a bad idea.

      Delete
    6. Wasn't there a steep hike in VAT that had a very direct impact on inflation? I remember not being very surprised by inflation because of that, but I may have got my timing wrong.

      Delete
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  2. Whilst you point out the government's view that inflation falling to zero is seen as 'good news', have you read David Cameron's inferences that this 'milestone' is in fact part of their long-term economic plan? I must admit I had no idea he had control over the world price of oil, but credit where credit is due!
    "Step by step, milestone after milestone. Last week it was a record increase in the minimum wage, today it's the rate of inflation. This Government has a long-term plan – and we're determined to make it work for you."
    http://www.thisismoney.co.uk/money/news/article-3009228/DAVID-CAMERON-Zero-cent-inflation-figures-reminder-right-track.html
    (Maybe he was echoing George from January who according to ITV "Mr Osborne said the low inflation rate was proof that the Conservatives long term economic plan was working..."
    Is there anything these guys can't do? (Besides not misleading the general public).
    http://www.itv.com/news/update/2015-01-13/osborne-low-inflation-reflection-of-economic-recovery/

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  3. Pleased to see this point on capacity. It seems much neglected and can explain much in relation to stagnation.

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  4. I think that there are different explanations for the hours worked variables and the other, survey based measures, which show close to full capacity. The hours worked variables contrast with the employment measures suggests what used to be a standard story: in the recovery from a recession employers, who are uncertain whether the recovery will continue, initially do not want to take the risk of incurring the costs of hiring and training new workers (who may not be needed for very long if the recovery is short-lived), so instead increase the hours of existing workers (who may have even been under-utilised during the slump). They would definitely want to bring their existing employees back to full-time working before the expenses of hiring new workers The survey capacity variables are more puzzling. My tentative suggestion is that firms may have adapted their expectations of what is normal full capacity over the course of the long recession. Essentially they are looking at the increase in their output and thinking it must be bringing them close to normal levels of output. Almar.

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    Replies
    1. Also a standard (not good - but clearly explainable in an era where firms are run by accountants) response to a crisis it to stop spending on maintenance. So you can have an initial substitution of capital with labour, only to find 7 years later that you cannot substitute back. No idea whether this is what is at play here, though.

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  5. It's not clear if it is deliberate or not from your text, but the ONS "spare capacity" chart is from March 2014. Labour market measures of spare capacity have shrunk even further since then, for example the vacancy ratio has collapsed.

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  6. Superbly clear and well-written piece! But I worry that the apparently anomalous behaviour of many of these measures - inflation, the output gap, productivity, capacity utilisation surveys - is deceptive. There are significant independent factors likely to be affecting all of these factors - not least the competitive landscape in the case of core inflation. There may well be some pro-cyclicality in the degree of competition, which somewhat scuppers a simplistic output gap/inflation target approach! But the greatest likely source of confusion in all of this is mis-measurement. I'm not sure even a 1% change in core CPI is meaningful. Certainly anything much lower than than is little better than noise. If inflation is mis-measured, of course, lots of other things go awry. For that reason, I would put greatest weight on the data we have most confidence in, such as unemployment. Unemployment continues to trend lower, which suggests that economic growth is reasonably strong, and wage growth is low which implies there is little inflation risk or evidence of a shortage of capacity. As for interest rates, a rate cut here would similarly fall into the "noise" category. The substantive policy question (other than devising a contingency plan) is why is the government not funding more R&D, education and infrastructure given it can borrow for less than zero real for over 10 years.

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  7. What about pervasive scale economies? If e assume a downward sloping supply curve (with demand more inelastic than the supply - ie, demand crosses over the supply curve) due to input indivisibilities (ie, scale economies), a negative demand shock would lead to higher prices – ie, as firms struggle to recover their fixed costs with a smaller customer base. This would register as rising inflation, although there would basically be an over-supply – ie, the policy implications would be reverted. Admittedly, firms could refuse to raise prices to steal rivals' business, but that might lead to an unwelcomed war of attrition.

    This price increase would further squeezze disposable incomes, leading to a vicious cycle.

    Moreover, if you believe that under these circumstances, your payroll is mainly fixed - as it is made up mainly of knowledge economy people doing product developments - so that even in the downturn you cannot lay them off - given that continuous product innovation/improvement/personalisation is a key competitive dimension (ie, without it you are quickly obsolete, so better hang on to your market share with all your fixed costs in a sort of war of attrition) –you have an alternative explanation for lower productivity– ie, it is not about job-hoarding but about input indivisibilities (including payroll) in a knowledge economy.

    Overtime, as weaker firms exit the market, surviving firms will be able to broaden again their customer bases by lowering prices (ie, in order to regain lost scale economies), which would boost real disposable incomes and revert the cycle thereof. The cycle therefore revert to a virtous one with new firms entering over time.

    Is this total nonsense? As to whether it is plausible to think in term of downward sloping supply-curves, nowadays there is a lot of talk about the the fact that digitalisation has penetrated all sectors (ie, not just hi-tech ones), whereby firms’ cost curves becomes front-loaded (high first-copy fixed cost and low marginal reproduction cost).

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  8. The 3 indicators in the chart showing a continuing deterioration are all employment ones - is this the area to focus on?

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  9. I was literally laughing out loud as I read this article.

    One could distill the whole article down into one line:

    'We're economists, and we don't have a clue what's going on in the real world, and we never have done. But we think a cut of rates (from 0.5%) by the BoE is a jolly good idea'.

    Such pointless existences you must endure to be an economist.

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    Replies
    1. At least it fills the time so that we do not end up writing pointless blog comments.

      Delete
    2. Well, I might make a few people consider your irrelevance, so that would make the comment worthwhile.

      Reality will spoil the rest of your days, as you and your kind flail around struggling to make sense of everything that unfolds.

      Of course, the irony is that many non-economists can see what is happening as clear as day, as they are not fettered with orthodoxy that relies on theories that don't relate to the happenings in the real world.

      Good luck though, must be a frustrating life to lead.

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    3. 'irrelevance...reality spoiling your days...flailing aroundstruggling to make sense of everything that unfolds'
      - A classic case of psychological projection Gary.
      http://en.wikipedia.org/wiki/Psychological_projection

      Won't you share with us 'what is happening as clear as day' so you may enlighten us and make our existencies slightly less pointless?

      Delete
    4. Thanks for the incredible insights - You surely have a blog or webpage where people might read more of your views?
      I like the George Osborne-esque 'living beyond its means' expression with regard to debt - is that private debt, household debt or both though? Remember Gary that the economy is not like a household when its comes to debt and paying down debts. And you realise that prior to 1922 and the partial re-instatement of the gold standard the world never was in the habit of "settling its debts and living within its means" as you imply with the nonsense of a "huge misstep...by deciding to move away from settling its debts".
      Private and public debt has always risen and fallen substantially during the 18th and 19th and of course 20th centure to present. But you must have known that to have written so assuredly about the world's ills and historical/current debt problems? Sure the levels of private debt in particular are currently a great cause for concern as they are higher than previously and have long term implications for sustainable growth and economic performance.
      Perhaps it might be an idea to acquire even a tiny amount of knowledge/understanding of the most basic macro-econ before commenting and exuding delusions of possessing a superior knowledge.

      Delete
    5. Perhaps you feel you have nothing to learn, but it seems clear to me that you have not realised that the past 100 years are vastly different to anything that has gone before, and hence you don't have a hope of sensible analysis:

      http://screencast.com/t/SrTXoQ9ocX

      That's it from me, time will prove everything.
      Good luck.

      Delete
    6. Gary, try to focus on the questions and issues you raised, and explain:
      1. "a huge misstep in 1922 (in Genoa) by deciding to move away from settling its debts and living within its means."
      - which I showed was completely innacurate.
      2. With regard to the falsehood "settling its debts and living within its means" was that private debt, household debt or both?
      3. Regarding "it seems clear to me that you have not realised that the past 100 years are vastly different to anything that has gone before"...
      Did you miss the bit in my reply where I did indeed acknowledge that "levels of private debt in particular are currently a great cause for concern as they are higher than previously and have long term implications for sustainable growth and economic performance." (I didn't mention public debt as although high, they are not historically high for UK especially, despite the scaremongering by government and media).
      - But surely the question must be asked: Why are you accusing me of "not realising the past 100 years are different..." when you falsely claimed 1922 was a turning point when the world "moved away from settling its debts and living within its means", when in fact it wasn't and I am the one illuminating you on past historical debt patterns, showing you they have fluctuated greatly over time?
      PS. Interesting graphs, which show inflation. But remember you were talking about debt and in particular "settling its debts and living within its means".

      Delete
  10. " But that still leaves an unanswered question - why have they gone wrong...?"

    The GBP has strengthened against the euro, which is used by its main trading partners, therefore importing lower inflation. Euroland on the other hand is now importing higher inflation. The UK had a weak currency and was able to supply demand; now Euroland has a weak currency and will be able to supply demand.

    ReplyDelete
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