Warning: Declaration of action_plugin_safefnrecode::register(Doku_Event_Handler &$controller) should be compatible with DokuWiki_Action_Plugin::register($controller) in /home/public/dw/lib/plugins/safefnrecode/action.php on line 14

Warning: Declaration of action_plugin_blog::register(&$contr) should be compatible with DokuWiki_Action_Plugin::register($controller) in /home/public/dw/lib/plugins/blog/action.php on line 0

Warning: Declaration of action_plugin_blockquote::register(&$controller) should be compatible with DokuWiki_Action_Plugin::register($controller) in /home/public/dw/lib/plugins/blockquote/action.php on line 0

Warning: Declaration of action_plugin_include::register(&$controller) should be compatible with DokuWiki_Action_Plugin::register($controller) in /home/public/dw/lib/plugins/include/action.php on line 0

Warning: Declaration of action_plugin_popularity::register(&$controller) should be compatible with DokuWiki_Action_Plugin::register($controller) in /home/public/dw/lib/plugins/popularity/action.php on line 0

Warning: Declaration of action_plugin_redirect::register(&$controller) should be compatible with DokuWiki_Action_Plugin::register($controller) in /home/public/dw/lib/plugins/redirect/action.php on line 0

Warning: Declaration of action_plugin_captcha::register(&$controller) should be compatible with DokuWiki_Action_Plugin::register($controller) in /home/public/dw/lib/plugins/captcha/action.php on line 0

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: Declaration of Doku_Renderer_metadata::table_open($maxcols = NULL, $numrows = NULL) should be compatible with Doku_Renderer::table_open($maxcols = NULL, $numrows = NULL, $pos = NULL) in /home/public/dw/inc/parser/metadata.php on line 24

Warning: Declaration of Doku_Renderer_metadata::table_close() should be compatible with Doku_Renderer::table_close($pos = NULL) in /home/public/dw/inc/parser/metadata.php on line 24
Spare capacity did not prevent UK inflation from rising to 4.4% [ClearOnMoney]
Top

Site

About
Contact

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656
Sitemap

Profile

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656
Trace:
Spare capacity did not prevent UK inflation from rising to 4.4%

Reference

Main
Updates
Schedule

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656
Commentary

Spare capacity did not prevent UK inflation from rising to 4.4%

22 Mar 2011 by Jim Fickett.

It is commonly thought that significant inflation is incompatible with a large amount of slack in the economy. A year ago this argument was being made in the UK; both the official Inflation Report of the Bank of England and a research report at the Treasury projected that inflation would likely be under 2% in 2011. It now stands at 4.4%. The main lesson is that investors should take all projections with a grain of salt, and remain vigilant.

In the US most people think there cannot be any danger of near-term inflation because unemployment is currently high and capacity utilization low. In recent posts I have challenged the reasoning involved (for unemployment here and for capacity utilization here), but of course the real outcome remains in the future, and unknown.

However the UK allows us to look at the reasoning and the outcome jointly since, though the spare capacity argument was being made last year, inflation has risen considerably, and now stands at 4.4% year-over-year:

U.K. inflation accelerated more than economists forecast in February to the fastest pace in more than two years, adding pressure on the Bank of England to increase its benchmark interest rate.

Consumer prices rose 4.4 percent from a year earlier after a 4 percent increase in January, the Office for National Statistics said today in London. That’s the most since October 2008.

4.4% is not terrible, but it is high enough to make life more difficult for investors. It is certainly high enough to be worrisome.

The Bank of England's inflation report from about a year ago (February 2010) projected that inflation in 2011 would probably be below 2%:

Note that, although they were honest enough to include a wide spread of possible outcome, 4.4% in early 2011 is higher than the whole range of possibilities projected.

Part of the central bank's reasoning was that spare capacity in the system would prevent inflation from rising:

CPI inflation rose sharply to well above the 2% target in December and is likely to have risen further in January. The pickup in inflation largely reflects the impact of one-off adjustments to the level of prices which should have only a temporary effect on inflation. Downward pressure from the persistent margin of spare capacity is likely to cause inflation to fall back to below the target for a period as these temporary effects wane.

We can get a little more detail on the reasoning typical in policy circles from a careful and well-written Treasury research report, entitled Inflation and the output gap in the UK, from March of 2010. The authors concluded that the output gap – the difference between actual and potential GDP, and a close relative of capacity utilization – is, in fact, useful in predicting inflation. They constructed a model partly built on this relationship, and projected that inflation would be well under 2% in 2011. It is worth looking in a little more detail at their methods and conclusions.

The main work in the paper has to do with the output gap. However they do consider unemployment as well, and provide quite an interesting scatter plot:

Note the very different behavior in different periods. In the 1970s unemployment varied little while inflation went to extreme levels; in the period 1992Q4 to 2007Q4 inflation stayed very low while unemployment varied considerably. Although there is obviously some correlation between unemployment and inflation, it is not very strong or consistent.

An a priori difficulty with the output gap is that you cannot measure it (and the same goes for capacity utilization). As the report says, “the unobservable nature of potential output makes the output gap susceptible to possible, and perhaps sometimes very large, degrees of measurement error”. Nevertheless, people do estimate the output gap and attempt to predict inflation. Here is one calculation of the UK output gap, compared to inflation:

The authors admit that the correlation is not terribly consistent or clear:

Restricting the analysis to the post-1997 period, the results lack clear interpretation. Up until the recent global crisis, inflation and the output gap had moved within a narrow range since 1997, which makes it difficult to identify a strong effect from the output gap to inflation. It may also be the case that the delegation of operational independence over monetary policy to the Bank of England in 1997 has reduced the effect of the output gap on inflation by anchoring inflation expectations more tightly to the inflation target, and this should also be considered in interpreting the results.

Nevertheless, there is a positive correlation, and they build a model in which inflation at any given period depends on inflation (both overall and for imports specifically) in previous periods, the output gap in previous periods, recent changes in the tax law, and the rate at which the output gap has recently changed. Here are the results:

What's the lesson here? Despite the fact that the projections were far too low, I am not willing to say that the authors' model was completely useless, or that the output gap is irrelevant. There has been, indeed, some historical correlation between the variables used by these authors, including the output gap, and later inflation. But it is hard to ignore that the projection was badly off.

I think the main conclusion is that inflation is very hard to predict. If someone tells you that slack in the economy means inflation must stay low, you have every right to doubt. Just as much, if someone tells you that the Fed's policies are sure to result in inflation, doubt that as well. And do not give in to your own prejudices. We just do not know.

In the bigger picture, over many posts on this site, the main message I am trying to convey is that there is significant danger of high inflation in the US, probably longer-term, but perhaps sooner. And given that danger, one should try to understand as well as possible what works and what does not to preserve capital in the face of inflation, and so to be prepared.