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Economics Weekly

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How real is the inflation threat?

Mon, Jun 22 2009, 11:19 GMT
by Lloyds TSB Financial Markets Economic Research Team

Lloyds TSB Financial Markets

Recent developments have raised concerns that the UK could be facing an upsurge in price inflation over the coming years. Since early March, oil prices have doubled; the economy has found a firmer footing; and broad measures of inflation expectations have shifted higher. The rise in some of the forward-looking inflation indicators has occurred as the Bank of England has embarked on an unprecedented loosening in UK monetary policy. Having cut interest rates to a record low, the Bank has turned to the unorthodox policy of quantitative easing (QE) in an effort to stimulate lending and demand through expanding money supply.

Inflation expectations have turned upwards
The concern about future potential inflation has started to unsettle bond markets. Medium and long-dated gilt yields have backed up sharply since early March (see chart a). Part of this upward adjustment reflects rising concerns over the current and prospective level of public sector debt issuance. Part of it reflects rising real interest rates and a more general reassessment of risk premia as equity markets have improved. But the rise also reflects a noticeable shift higher in the market’s perception of inflation risk.

Since the Bank unveiled its quantitative easing programme in early March, long-dated breakeven inflation rates have risen by around 1 percentage point, to 3.7%. RPI inflation swaps tell a similar story. Since last November, the annual RPI two years forward has risen from less than 1% to 3% (see chart b). Adjusting for differences in methodology and definition, the increase in inflation expectations suggests financial markets doubt the ability of the Monetary Policy Committee (MPC) to meet the government’s 2% inflation target over the medium term. But it is not just the markets that have started to exhibit some scepticism. The latest Bank of England/NOP Inflation Attitudes Survey shows that the public’s perception of the inflation outlook over the next twelve months picked up slightly in May, to 2.4% from 2.1% in February, despite slower actual inflation (see chart c).

But medium-term inflation concerns are overdone
While there may be justifiable concerns about the inflation outlook over the longer term, the creeping pessimism about the medium-term prospects looks misplaced. With the economy still in recession and unemployment continuing to rise sharply, the current economic environment is more consistent with deflationary, rather than inflationary conditions. Although ‘green shoots’ have started to emerge, the prevailing level of space capacity indicates that businesses are operating well below potential – hardly a recipe for a significant demand or supply induced rise in prices. We estimate that the UK is currently operating with a negative output gap of around 6% - i.e. the level of actual output is about 6% below the level that could potentially be produced given the current pool of available labour, labour productivity and capital stock (see chart d).

Not surprisingly, inflation and the output gap are reasonably closely correlated. As demand weakens, unemployment tends to rise, putting downward pressure on wage and, with a lag, consumer price inflation.

Indeed, this describes what has occurred over the past year or so. Since February 2008, claimant count unemployment has risen by 760,000 and underlying average earnings growth has slowed from 3.7% to 2.7% (see chart e); since last September, consumer price inflation has dropped from 5.2% to 2.2%. With unemployment almost certain to continue rising over the remainder of this year and into 2010, we expect CPI inflation to fall further – to below 1% by the end of this year, (see chart f). Over the coming months, the fall in inflation also is likely to be accentuated by favourable base effects, as last summer’s sharp rise in food and energy prices drop out of the annual comparison. Although unemployment is still expected to be increasing for much of next year, headline inflation is expected to gravitate slightly higher, as the temporary cut in VAT expires in January and demand conditions gradually improve.

Even if GDP bounces strongly, the output gap will remain negative for some time..
Nonetheless, it is difficult to make a strong case for a fundamental shift higher in inflation until the output gap closes. Such an outcome requires a sustained period of above-trend growth. While recent indicators suggest the inventory adjustment may now be largely complete, this points to a stabilisation in output, not necessarily a resumption of growth. Moreover, even if the economy were to exhibit a sharp rebound, it would take time for the level of spare capacity to erode to the point where inflation pressures started to build again. Broadly speaking, for the current output gap to close, GDP would have to rise by 2% above trend over the next three years. While low interest rates and quantitative easing may pose longer term risks, the degree of spare capacity poses a formidable obstacle to a pick-up in inflation in the short term.

...trend growth may have fallen, but not by enough to induce price pressures
Admittedly, there is a caveat to this. Estimates of the output gap are almost impossible to derive with precision as the growth potential of the economy changes over time in response to changes in the capital stock, productivity, and the available pool of labour. Since the credit crisis erupted, the capital stock has clearly been depleted as a result of the decline in business investment and rising corporate bankruptcies. This represents a permanent loss of output. Moreover, reports suggest that migrant workers are increasingly leaving the country. Proponents of rising inflation argue that these developments leave the UK more exposed to inflation pressures when demand picks up. While this may be true over the longer term, we believe it is highly implausible that the UK’s trend rate of growth has fallen to such a degree that the UK is exposed to supply-side price pressures. Although the capital stock has been depleted, the proportion of the UK population that is economically active has actually risen slightly, as the downturn has obliged some individuals to re-enter the labour market.

Finally, demand conditions pose little threat to inflation
Moreover, from a demand perspective, there appears little threat of inflation. Unemployment continues to rise sharply, credit availability remains constrained and household indebtedness is close to a record high. None of these seem consistent with an imminent improvement in corporate pricing power. Inflation looks set to stay low for a while longer. Consequently, fears of an early rise in interest rates seem premature.

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Published on  Mon, Jun 22 2009, 11:35 GMT