Bank of England Governor Mark Carney. Photo: Bloomberg (under Creative Commons Licence)
Mark Carney’s letter to George Osborne: What might it say?
When the British economy misses the inflation targets set by the Chancellor by more than one percentage point, the Governor of the Bank of England has to write him a letter explaining the reasons. It looks like we’re on course to miss tomorrow – for the first time below rather than above target. Here’s what I’ve imagined (rather, fantasised) Mark Carney might be drafting to send…
With inflation once more outside one percentage point of the target of two per cent, I am required to write to you explaining how this came about and how a return to the target will be ensured.
As you know CPI inflation fell to [0.7 per cent in December; DN: based on consensus forecast], somewhat below the 1.0 per cent forecast in our November Inflation Report (our forecasting team continue to have difficulties nailing this!).
Below is a chart of RPIX and CPI inflation against target since the start of the MPC in 1997.
Consumer inflation, annual growth, per cent
While my predecessor has written on several (14!!) occasions to explain inflation above three per cent, this is the first time since inflation targeting began that there has been a breach on the downside. Even through the financial crisis of 2008-09, inflation did not fall below 1 per cent. I should stress too the wider global context of increasingly low inflation (disinflation), and now the negative inflation (deflation) figure in the euroarea. With further reductions in CPI inflation likely in coming months as energy effects unwind, we are dangerously close to deflationary territory in the UK.
As we have approached this pivotal moment, I have noticed your ministers celebrating the inflation figures (for example the Chief Secretary’s “welcome early Christmas present to millions of families across the country”). The same is true of the response to apparently slightly positive real wage figures, which are driven more by the fall in inflation than a recovery of nominal wages to anything like normal levels. After the euroarea figure last week City people were also in on the ‘good deflation’ act, notably Bilal Hafeez of Deutsche Bank in the Financial Times (8 Jan).
While you might think this plays well with the voters, we should not kid ourselves that low inflation is some kind of beneficial external shock. Disinflation and deflation are symptoms of the contraction of spending and incomes across the world (which includes the UK) that have been underway really since the monetary and fiscal stimulus of 2008-09 was withdrawn, and (modest) fiscal stimulus replaced with contraction. For my speech last September to the TUC Congress, we calculated that in the UK real wages had fallen by ten per cent. These are not conditions conducive to expansion, let alone inflation.
The feed of oil prices to the petrol pump may be an important factor behind recent falls in inflation, but it is increasingly recognised that this follows from a wider failure of demand on a global basis. I note that ‘core’ inflation (excluding food, beverages, tobacco and petroleum) has fallen alongside headline figures. Others have appealed to the distortions arising from the recent strength in the sterling exchange. Obviously these can reduce the prices of imports, but the strength of sterling surely follows our being one of the better horses in the glue factory that is the EU.
This leads me to how inflation can be restored to target. As you know, forecasting oil prices and exchange rates is a mug’s game. My analysis above suggests that there are material economic factors behind recent movements, and the best I can offer is that it is not clear that these factors are going to unwind even on the two-year horizon to which we are always looking when we set policy.
Then there are wages. Really recent outcomes only move wage growth from rock bottom back to the bottom, and none of us had expected rock bottom. It is too early to call the start of any normalisation. Indeed, my Chief Economist Andy Haldane is pleased with his chart that shows how forecasts of a revival in real wages have been repeatedly dashed year after year without fail since 2008.
All our forecast technology amounts to nothing more than a fervent hope that relations according to orthodox theory will be restored. Yet deep down we know – and we have been more up front than others in admitting this – that this theory fails to describe the reality of a monetary economy. We perpetuate the fiction of a near-zero output gap and hide behind low productivity growth, but the deficiency is – and always has been – in demand rather than in supply.
Now obviously we have seen some momentum recently which has been welcome, but you will recall this involved a rather significant change of course (not least the arrival of yours truly!). Wisely, as your party’s ex-chancellor Kenneth Clarke has recently conceded, you chose not to intensify austerity in 2012 (and on the basis of the ONS’s latest figures it looks like you really gave spending a go in 2014, while still pretending to do otherwise – you sly dog!). And of course you asked us to throw the monetary ‘kitchen sink’ at the economy. Like our fellows in the Federal Reserve, we were willing to give forward guidance a shot. But we did warn about stoking the housing market when it was already unaffordable, and we have been trying to deal with the consequences ever since. Hopefully we have put a lid on it now.
More generally there is a very real danger that monetary stimulus has served to inflate assets in general; likewise, instead of a revival in domestic production and income, there has been a severe deterioration in our current account position and private indebtedness appears to be back on the rise. As the Monetary Policy Committee warned: “the prospect of a continued reduction in private sector saving and a persistent current account deficit should be carefully monitored” (November2014 minutes, paragraph 18). But fundamentally, and getting back to our remit, over the past five years the economy has never been far from stagnation and vast resources (i.e. workers) remain idle or only partially deployed. That is why inflation is so low and I am writing to you today.
To be frank, Chancellor, we kind of feel that we have done our bit. We have reached a point where some shared responsibility for the recovery and for meeting the inflation target would not just be welcome but is essential, unless of course you are retreating from our central objective. In the meantime, with the recovery hardly in rude health, we are faced with the likelihood of four years of cuts in public spending (as the TUC has pointed out, the only precedent for this – rather terrifyingly – is the Geddes Axe of the 1920s). The election is hardly serving the interests of clarity on the outlook here, which we absolutely need to make a genuine assessment of prospects and policy. While this nonsense continues in public, I should remind you that the OECD, IMF and even the Economist newspaper are lining up behind public works in the face of deflation. Were you to go ahead with these cuts, I do not believe there is anything sensible that the Bank of England could do to bring inflation back to target.
All this said, I stand ready to discuss how we might operate monetary and fiscal policy in a more complementary and constructive manner.
I look forward to your response.
PS on a lighter note, I wonder if you have had the chance to enjoy the very amusing Christmas card by the Daily Telegraph’s Matt. You can see it on this link to a certain on-line retailer; hopefully they will have some back in stock by next year, because without a change of course they will certainly still be applicable.