This was inflation week in both the UK and the US. So it´s not surprising that the inflation hawks were out in droves. So as not to burden the reader, just one reference to each country. After the release of yesterday´s US PPI Barrons had this to say:
The Producer Price Index report released by the Labor Department today is the latest sign of rising inflation pressures in the U.S. in early 2011.
In the UK “journalistic competition” drives opinions. This one cites Tolstoy!
The UK’s financial establishment is replete with officials, analysts and commentators who are superbly educated and, no doubt, have formidable IQs. But intelligence is useless, as Tolstoy explained, in the face of opinions which, for all kinds of self-serving reasons, are etched in stone. That is the situation Britain is now in. When it comes to inflation, the “authorities” are in denial.
Let´s take a look at pictures so as to have an idea of what has been going on. The first compares headline CPI inflation in both countries (UK is blue, US is red). Two “disconnects” are evident. The first between mid 2008 and mid 09 when the US headline CPI falls much more than the UK headline CPI. The second takes place over the past year, with UK headline remaining higher.
The following graph explains the second “disconnect” mentioned above. It plots the same headline US CPI but the British Headline CPI assumes taxes are constant (the moves in VAT that took place in December 08 (down), in January 09 (up) and the most recent increase last month are not “counted”).With that adjustment the more recent difference between headline inflation in the US and Britain disappears.
The following picture explains the first “disconnect”. The steep rise in oil and commodity prices in 2007/08 increased headline inflation in both countries equivalently. Nevertheless the fall in oil and commodity prices after mid 08 have a much stronger impact on the US headline inflation. That happened, as shown in the figure, because the drop in the (dollar) price of oil and commodities in Britain was offset by the depreciation of the pound. In early 2009, when the pound appreciated headline UK inflation came down quickly.
So I think Mervin King is right in not giving in to the “collective hysteria”:
There was something surreal about today’s Bank of England press conference to discuss its latest Inflation Report. The BOE says quite clearly in its executive summary – and Governor Mervyn King repeated it continually – that “the chances of inflation being above or below the 2% inflation target in the medium term are broadly equal”. But there was nothing broadly equal about the line of questioning from the assembled journalists: unless I blinked at the wrong moment, I don’t remember a single question about the risks to the downside. Instead, the Governor was subjected to a sustained and faintly hysterical assault, with almost all the questions a variant on the accusation that the BOE had either deliberately or incompetently lost control of inflation. Under the circumstances, I thought Mr. King handled it rather well.
Maybe we really shouldn´t expect things to be significantly different between the two countries. After all, the initial monetary policy mistake of letting nominal expenditure (nominal GDP) “drop like a stone” in “great depression fashion”, was common to both the US and Britain, as can be ascertained in the following (almost) identical graphs!
The “hole” to be filled is deep, even if one assumes that the crisis has reduced the “trend level” somewhat.
A note to those that speak only of “inflation expectations”: Expectations of future inflation will translate into higher future inflation only if economic actors can in fact act. Otherwise, you take the “hit” and accept that higher oil prices or VAT have made you “poorer”. This article from a few days ago is very clear and sober:
Hawkish discussions of inflation expectations today, and their potential effects on actual inflation in the future, remember the conclusion but seem to have forgotten the argument. Expectations of high future inflation lead to high actual inflation in the future only if workers and firms are able to pass that expected price rise through to their own contracts. If inflation is expected to be 4 per cent this year and this is expected to lead to a 4 per cent rise in nominal profits, then unions will reasonably demand a 4 per cent pay rise as a baseline, to avoid a fall in real wages. If firms then raise prices further in response to the higher wages then a wage-price spiral will result.
But today, high inflation is due not to a general rise in all nominal prices. It is driven primarily by the continuing effects of sterling’s devaluation, rising commodity prices, and rising VAT. So the recently-reported 3.7 per cent rate of UK inflation does not reflect a comparable rise in nominal profits. It implies a squeeze on both real profits and real wages because it reflects a deterioration in the UK’s terms of trade: imports have got more expensive relative to exports, so the country as a whole, both its firms and workers, are correspondingly poorer.