The Brexit interest rate increases and misunderstanding inflation

Last week’s rise in UK rates has been extensively analysed (see for example Tony Yates here) so I will be very selective. First, the justification for the title of this post is provided by an extract from the inflation report:

“The overshoot of inflation throughout the forecast predominantly reflects the effects on import prices of the referendum-related fall in sterling. Uncertainties associated with Brexit are weighing on domestic activity, which has slowed even as global growth has risen significantly. And Brexit-related constraints on investment and labour supply appear to be reinforcing the marked slowdown that has been increasingly evident in recent years in the rate at which the economy can grow without generating inflationary pressures.”

The last sentence is particularly important: in plain language it is saying that Brexit is contributing to lower trend productivity growth, which the Bank now put at 1.5% compared to a pre-recession level of 2.25%. The wording is chosen carefully: they are not talking about uncertainty effects, but permanent effects from a likely deal. So last year worries about the demand side effects of Brexit led the Bank to reduce rates, and now concerns about the supply side effects of Brexit are contributing to higher rates.

Whether these modest increases in interest rates continue, as the Bank are signalling, should largely depend on whether the pickup in earnings growth they anticipate actually happens. As Torsten Bell from the Resolution Foundation argues here, the set of information that might justify the Bank’s expectations of an imminent recovery in earnings growth is not empty, but nevertheless many economists regard it as a brave forecast.

However the labour market is not the only reason the Bank is raising rates. Putting labour market issues aside, they think that because firms are operating with little ‘spare capacity’, any large increases in demand will be met by firms raising prices. Ergo the Bank’s job is to use higher interest rates to stop demand rising too fast. I think this is conceptually wrong, because it underestimates the role that demand and expectations about demand play in determining investment decisions.

A firm can meet rising demand in three ways: by investing in more productive processes, by raising prices or by using more of its spare capacity. In a traditional economic upswing firms first use spare capacity, then invest, and when capacity utilisation is at a peak and there are no profitable investments to make it raises prices. At that point it is right for a central bank to step in to moderate demand growth.

This has not been a typical recovery from a recession. Firms have used up spare capacity, but have not invested in more efficient processes. This is what measures of capacity utilisation suggest (taken from an earlier Bank of England Inflation Report).

If you just take these surveys as measuring the state of the cycle (and if we ignore the Bank Agents) since 2013 the economy has been experiencing an economic boom. Yet from 2013 core inflation has been below target and falling. You can resolve this paradox by thinking about firms acting unusually, by failing to invest and meeting additional demand by utilising capacity as if they are in a boom The result of that is stagnant productivity growth.

The conceptual error is to read these capacity utilisation numbers as indicating that there are no profitable investments to make. We know these profitable investments exist, because leading firms are improving their productivity.* What we have is an innovations gap, where lagging firms are not copying leading firms and are instead holding back on investing. We do not know why they are holding back, but one obvious reason is they have expectations of low future growth and/or high uncertainty about this growth. Empirical evidence shows the strongest determinant of investment is output growth, and the obvious rationalisation for that ‘accelerator effect’ is that current growth influences expectations about future growth.

If this is right, increases in demand will be met by firms finally coming off the fence and investing, rather than raising prices. But if the central bank starts raising interest rates to choke off demand, even when it is growing slowly by historical standards, it will validate the pessimism that has been holding back investment and productivity will continue to stagnate. There is a very real danger that the Bank may be playing its part in a self-fulfilling low growth recovery.

*Postscript (8/11/17) Discussion here by Berlingieri et al shows this growing divergence between leading and lagging firms is a global phenomenon.

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?