The difficulty of defining domestic inflation

Posted by Joe Rennison on Jun 22 12:51. 20 comments | Share

Have you heard? High inflation is OK. Or rather, increasing the Bank Rate wouldn’t do much to solve it at this time.

It’s not really news if you’ve been watching recent justifications for UK monetary policy, More…

Have you heard? High inflation is OK. Or rather, increasing the Bank Rate wouldn’t do much to solve it at this time.

It’s not really news if you’ve been watching recent justifications for UK monetary policy, true, except — Wednesday’s MPC minutes broached the idea that high UK inflation might not stop more QE, since domestic inflation is dying out.

Actually Mervyn King constantly emphasised how much UK inflation is imported during his Mansion House speech last week, so we should have seen this coming.

It’s worth reprising this chart from the latest BoE inflation report, published in May:

The chart handily shows that if you remove energy prices, import prices and VAT, which the BoE argue are key to imported inflation, then inflation hovers below the MPC target 2 per cent rate. Justifying QE even.

It seems that recent ONS employment data reinforces this view, showing wage growth in April at just 2 percent. If domestic inflation were higher, an increase in wage growth rates would be expected, so look, the people don’t believe that high inflation is ingrained either, see?

Err… let’s unpack that argument.

Simon Ward from Henderson Global Investors has argued that the wage growth rate is offset by increases in non-wage income and that domestic inflation is actually increasing:

The domestic contribution to prices is captured by the “ deflater for gross value added” – this excludes indirect taxes and import prices and measures the sum of employment income, profits and rents per unit of output. The GVA deflater rose by 2.4 per cent in the year to the first quarter of 2011, with slow growth in employee pay costs offset by a surge in non-wage income.

Using the GVA deflater, or even the GDP deflator as a measure of domestic inflation is perfectly reasonable. It’s just not what the BoE choose to use.

Ward was writing in response to Adam Posen, member of the MPC, who wrote:

No growth in broad money or credit, persistently high interest spreads for small businesses and households, flat or contracting private consumption and retail sales, a dearth of construction and declining real wages – all only partially offset by some expansion in exports. In such a situation, you should expect little domestically generated inflation, and that is also just what the UK has.

Raising interest rates to offset VAT hikes is counter-productive because a VAT increase contracts nominal demand, while its measured price impact is one-time only. Energy prices are volatile and can reverse with no notice, as they just did. Setting monetary policy in response to short-term commodity price gyrations would only destabilise the UK economy and create greater uncertainty about future inflation

Conspiracy theorists – those that believe the BoE’s insistance on keeping the Bank Rate low is to support growth, not target inflation – will remain unconvinced.

However, a recent note from Malcolm Barr at JP Morgan seems to stand with the BoE:

The MPC’s remit explicitly allows the committee to look through high inflation in the near term if it is expected to be temporary, as attempting to deliver 2% inflation continuously would generate undesirable volatility in output. MPC members have repeatedly reasserted their commitment to the 2% inflation target. Conspiracy theorists will remain unconvinced. But the design of the committee, with external members rotating on and off, works against any undisclosed shift in objectives.

Whether it is to stimulate growth, or to avoid reacting to temporary high inflation, the Bank Rate shows no sign of increasing and domestic inflation is the reason given for keeping it low.

Related links:
Buiter bashes BoE accountability, and other central banks – FT Alphaville
Reasons for a UK QE2 trade – FT Alphaville

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