The UK inflation conundrum
Economists like to use rule books to work out what is happening. Sometimes, these rule books work well. Once in a while, though, the rules get jumbled up. The various bits of an economy do not gel. Previously trustworthy relationships falter.A cursory...
Economists like to use rule books to work out what is happening. Sometimes, these rule books work well. Once in a while, though, the rules get jumbled up. The various bits of an economy do not gel. Previously trustworthy relationships falter.
A cursory glance at the data coming from some of the world's major economies backs up this assertion. The US economy is on the brink of recession. Output rose only 0.6 per cent in the first quarter of the year, a continuation of a slowdown that began a year ago. Then again, the US economy is booming. Consumer spending rose by more than four per cent per cent during the same period, and unemployment remains low, despite concerns about the housing market.
China's economy is overheating, with first quarter growth up 11 per cent. It has often been heard that this rate of growth cannot be sustained. On the other hand, maybe China's economy has plenty of spare capacity because, despite strong growth, inflation remains well-behaved.
Germany's economy is booming, with annual growth running at about three per cent, the strongest since the late-1990s. Exports are surging and investment is running at a brisk rate. German consumers, though, are refusing to dip deeper into their purses and wallets, even though consumer confidence has shot up.
All of this is very odd. How can the US grow so slowly when consumption is booming? How can China grow so quickly without a rise in inflation? And why are German consumers so unwilling to spend when they are happy to tell anyone who cares to listen that their economic prospects are the best in years? The answers are not obvious. They stress, however, that economics is never that simple. Data is revised. Relationships change. Economies evolve. Nothing stays the same. It is this sense of change that is disturbing policymakers.
Mervyn King, the Governor of the Bank of England, used to talk about the "Nice" decade - 10 years of Non-Inflationary, Consistently Expansionary economic performance. All of a sudden, however, inflation in the UK has picked up. Why?
One possibility is simply the effect of higher energy prices. If so, the outlook for UK inflation should improve relatively quickly. Oil prices may still be high, but they are not persistently rising anymore. On this interpretation, there has been a one-off rise in the UK's price level relative to the level of wages. This leads to a squeeze in real spending power, an appropriate response given that higher energy prices make most of us worse off.
To reach the appropriate policy decision, policymakers need to think about a variety of different hypotheses. While the UK's higher inflation rate may have been triggered by rising energy prices, higher energy prices might, themselves, be a reflection of strong global demand and loose global monetary conditions. Rising energy prices might then simply be a symptom of a broader inflationary impetus. Under those circumstances, it is possible that underlying inflationary pressures continue to rise, even when energy prices start to behave a little better.
This argument suggests that at least some of the UK's recent inflation difficulties stem from developments beyond the control of the Bank of England. Maybe, for a given UK growth rate, inflation might be a little higher than in the past, reflecting booming economic conditions elsewhere in the world.
Even here, though, there are competing hypotheses. One possibility is that inflation is more elevated because demand either in the UK or globally is high relative to available supply. Another possibility is that people, collectively, are losing faith in the Bank of England's ability to control price pressures. As a result, their own, subjective, expectations of inflation are beginning to rise. Neither of these hypotheses is particularly encouraging because both imply a period of slower growth ahead.
The pick-up in UK inflation so far has been an unusual mix. Other than the increase in energy prices, cost pressures have been rather muted. In particular, the feared increase in wage demands has failed to transpire. Nevertheless, companies have managed to push through price increases. The Confederation of British Industry conducts regular surveys of pricing power and it appears that in the industry and the retail sector pricing power is on the rise. However, it is anticipated that in response to interest rate rises, demand will slow and pricing power will fade.
If so, the key question is not so much whether demand growth slows but, rather, by how much it needs to slow to bring inflationary pressures under control. That is the great unknown. The old rule book provided easy answers: A gentle deceleration in economic growth would be enough to remove any incipient inflationary pressures. That was the characteristic of the "Nice" decade. Perhaps the rules have changed!
• This report was compiled by Peter Calleya, manager corporate strategy and research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.
A cursory glance at the data coming from some of the world's major economies backs up this assertion. The US economy is on the brink of recession. Output rose only 0.6 per cent in the first quarter of the year, a continuation of a slowdown that began a year ago. Then again, the US economy is booming. Consumer spending rose by more than four per cent per cent during the same period, and unemployment remains low, despite concerns about the housing market.
China's economy is overheating, with first quarter growth up 11 per cent. It has often been heard that this rate of growth cannot be sustained. On the other hand, maybe China's economy has plenty of spare capacity because, despite strong growth, inflation remains well-behaved.
Germany's economy is booming, with annual growth running at about three per cent, the strongest since the late-1990s. Exports are surging and investment is running at a brisk rate. German consumers, though, are refusing to dip deeper into their purses and wallets, even though consumer confidence has shot up.
All of this is very odd. How can the US grow so slowly when consumption is booming? How can China grow so quickly without a rise in inflation? And why are German consumers so unwilling to spend when they are happy to tell anyone who cares to listen that their economic prospects are the best in years? The answers are not obvious. They stress, however, that economics is never that simple. Data is revised. Relationships change. Economies evolve. Nothing stays the same. It is this sense of change that is disturbing policymakers.
Mervyn King, the Governor of the Bank of England, used to talk about the "Nice" decade - 10 years of Non-Inflationary, Consistently Expansionary economic performance. All of a sudden, however, inflation in the UK has picked up. Why?
One possibility is simply the effect of higher energy prices. If so, the outlook for UK inflation should improve relatively quickly. Oil prices may still be high, but they are not persistently rising anymore. On this interpretation, there has been a one-off rise in the UK's price level relative to the level of wages. This leads to a squeeze in real spending power, an appropriate response given that higher energy prices make most of us worse off.
To reach the appropriate policy decision, policymakers need to think about a variety of different hypotheses. While the UK's higher inflation rate may have been triggered by rising energy prices, higher energy prices might, themselves, be a reflection of strong global demand and loose global monetary conditions. Rising energy prices might then simply be a symptom of a broader inflationary impetus. Under those circumstances, it is possible that underlying inflationary pressures continue to rise, even when energy prices start to behave a little better.
This argument suggests that at least some of the UK's recent inflation difficulties stem from developments beyond the control of the Bank of England. Maybe, for a given UK growth rate, inflation might be a little higher than in the past, reflecting booming economic conditions elsewhere in the world.
Even here, though, there are competing hypotheses. One possibility is that inflation is more elevated because demand either in the UK or globally is high relative to available supply. Another possibility is that people, collectively, are losing faith in the Bank of England's ability to control price pressures. As a result, their own, subjective, expectations of inflation are beginning to rise. Neither of these hypotheses is particularly encouraging because both imply a period of slower growth ahead.
The pick-up in UK inflation so far has been an unusual mix. Other than the increase in energy prices, cost pressures have been rather muted. In particular, the feared increase in wage demands has failed to transpire. Nevertheless, companies have managed to push through price increases. The Confederation of British Industry conducts regular surveys of pricing power and it appears that in the industry and the retail sector pricing power is on the rise. However, it is anticipated that in response to interest rate rises, demand will slow and pricing power will fade.
If so, the key question is not so much whether demand growth slows but, rather, by how much it needs to slow to bring inflationary pressures under control. That is the great unknown. The old rule book provided easy answers: A gentle deceleration in economic growth would be enough to remove any incipient inflationary pressures. That was the characteristic of the "Nice" decade. Perhaps the rules have changed!
• This report was compiled by Peter Calleya, manager corporate strategy and research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.