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? 

Deflation, inflation, oil prices and asymmetries

When both headline and core inflation rose above target after the financial crisis, helped by rising oil prices, the Fed and Bank of England kept their nerve and did not raise interest rates. They saw through what was a temporary episode. The ECB’s judgement was not as good. Even in the UK it was close, with three out of nine MPC members voting for a rate increase for a few months. But it was the outcome that mattered - excess inflation was ignored because it was temporary. To what extent is what we are seeing right now just the mirror image of this period?

In terms of where inflation is and the monetary policy response, the situation today does indeed look like a mirror image. Headline inflation is or is about to be negative, and core inflation has fallen below target. As Tim Duy points out for the US, core inflation seems to be heading lower rather than returning to target. However I think that is where the symmetry ends. While the dangers of letting inflation rise above target because of temporary shocks are small, the dangers in the opposite direction are more serious. 

One of the arguments used by the inflation hawks when oil prices were high is that even if the impact of higher oil prices on inflation was itself temporary, there was a danger that inflation expectations would increase, and the central bank would lose its anti-inflation credibility. My response at the time was three-fold: first, the private sector can see the reason that rates are not being raised (the continuing recession), so credibility should not be in danger; second, the best indication that the expectations that matter have shifted is when nominal wage inflation starts to pick up (which it did not), and third when that happens it will be easy to restore credibility and reduce expectations by raising rates. [1]

None of these arguments apply with deflation today. Then unemployment was clearly too high. Today unemployment is not clearly too low. How far we are from the natural rate is unclear, but no one would argue that we are in a boom that is the mirror image of the recession a few years ago. The second argument is that we could use changes in nominal wages as a clear indicator that the inflation expectations that mattered had shifted. That argument is not symmetrical because of the well known resistance to nominal wage cuts. Finally if credibility does seem about to be lost, the central bank will find it very difficult to take action to restore it because of the Zero Lower Bound (ZLB).

Please allow me to get technical for just one paragraph, which can be safely skipped. As has often been pointed out, the ZLB means that there are two steady states in the economy associated with a given real interest rate: the ‘intended’ equilibrium with target inflation, and the ‘ZLB equilibrium’ when inflation is negative. I recently discussed a paper that treated agents views about which equilibrium was appropriate as a ‘belief’ and that perhaps the liquidity trap could be a manifestation that agents believed we were heading for the ZLB steady state. The controversial aspect of this analysis is the suggestion that this belief could be shifted by the monetary authorities raising rates. I find that very unconvincing, but it would be a mistake to dismiss the exercise completely on that account. In that post I did suggest an alternative rationalisation for why we might be heading for the ZLB equilibrium: agents no longer believed that the monetary authority had the means to stop it happening.

This last asymmetry is the one that troubles me the most, and why I am not as relaxed as monetary policy makers appear to be about deflation. There are three interpretations of this relaxed attitude to negative headline inflation. The first is the one I suspect monetary policy makers actually hold, which is that the beneficial impact of lower prices on demand will with a year or so push inflation back to target, so there is no reason for concern. [2] I think the probability is that they are correct, but good policy does not just think about the most likely outcome, but should also be robust to risks, particularly risks with large consequences.

The second interpretation that the private sector could give for the relaxed attitude by central banks in the US and UK is that deviations above and below 2% are not treated symmetrically. In theory this should be more of a concern in the US than the UK, because in the UK asymmetry is against the central bank’s mandate. However I’m not sure the private sector thinks that is as important as MPC members do. There is one obvious additional asymmetry between now and a few years ago: many of those calling for higher rates back then are still pushing for higher rates today.

The third interpretation about why central banks are doing nothing is there is nothing they can do. Quantitative Easing seems to have come to a permanent halt either because it has stopped having a useful effect, or because policy makers fear it is having undesirable consequences. Under this interpretation the inflation target loses credibility not because the private sector no longer believes policy makers’ stated objectives, but because they no longer believe they have the means to achieve them. 

This possibility is the one that should really be worrying central banks right now. It is a scenario that is quite consistent with what is currently happening, and it puts at risk central bank credibility in a most fundamental way. Quite simply, central bank credibility is destroyed because people believe they have lost the ability (rather than the will) to do their job, and there is very little central banks can do to get it back because of the ZLB. This is what should be giving central banks nightmares. Strangely, however, they seem to be sleeping just fine.

[1] A footnote for macroeconomists: this is why I have never been convinced by Cochrane’s worries about using the inflation target as a transversality condition.

[2] Resistance to nominal wage cuts may also dampen any the deflationary path, giving time for these positive effects to come through. However resistance to nominal wage cuts does not mean the ZLB equilibrium will never occur – in the paper I discuss in this post, it is the reason why that equilibrium is associated with high unemployment.