Repressed Memories


If there is one thing that central banks should have learned over the past few decades, it is this: leaving policy changes to the moment that all the macro-economic signposts are pointing in the same direction, means you are turning the wheel too late.

It is unfortunate, perhaps, that the transparency of our policy-setting processes (and the ease with which committee members can be called to immediate account), particularly in the UK, results in policy makers always wanting to justify their actions on the basis of hard data, rather than using their experience and intuition to determine what the appropriate course for interest rates should be. Almost by definition, this makes policy backward facing, and akin to driving a car using only the rear view mirror. The same can be said of rules-based policy regimes favoured by some central banks – if only it were that easy, that when a certain constraint was breached it necessitated a policy change. But these regimes are also essentially backward facing. The bottom line is that whenever policy makers lapse into either retrospectively justified or rules-based policy setting modes, they make mistakes.

And it is not as if central banks around the world have not made mistakes. Huge policy errors were made in both the US and the UK during the years prior to the financial crisis, with interest rate levels maintained at unusually low levels, despite rapidly rising debt ratios and increasing excess demand. The justification? – low inflation. But inflation was not low because price pressures generated within these economies were well contained. It was because of disinflationary pressure resulting from lower prices of imported goods.

Does this ring any bells? Well, let’s move the story on to the current time, and the developing story in the UK. To be sure, the recent cycle has not been without its challenges – and many media commentators would have you believe that the economy is, even now, only just emerging from recession. But this is far from the truth. The recovery started in the third quarter of 2009, six years ago, and annual growth in the period since the start of 2010 has averaged 2.0%. This is more than respectable and is in line with the UK’s long-term sustainable growth rate. The recent period has seen rather stronger growth – averaging, since the start of 2014, some 2.8%. One aspect of the post-recession period is that reasonable growth has been accompanied by exceptional job creation, to the extent that the employment rate is at an all-time high. And demand for labour remains strong, with job vacancies currently at higher levels than before the recession. The more recent tightening in labour market conditions has been reflected in faster growth in labour costs. A little over a year ago, in the second quarter of 2014, the basic pay of people working in the private sector was showing a year-on-year increase of just 1.0%. In the three months to August this year, however, the rate was 3.2% – a very significant escalation.

This rapid rise in labour costs should ring alarm bells in the Monetary Policy Committee meeting room in the Bank of England (BoE). For them to ring louder, we have to find evidence that labour cost inflation is feeding through to consumer prices. In fact, we do not have to dig too deep for this evidence. We know that a zero headline inflation rate is substantially due to falling energy and food prices. This is what is showing through in goods prices within the Consumer Price Index (CPI), which in September were down 2.4%, year on year. Goods account for 53% of the CPI. The remaining 47% represents services. Prices in this area are by no means as subdued. Indeed, in the 12 months to September they were up some 2.5%.

Whereas prices of goods are largely set in the international marketplace, most of the services we buy are domestically produced and are not so heavily influenced by developments overseas. In a sense, therefore, services prices can be used as a proxy to measure domestically generated inflation. As such, and in conjunction with faster growth in labour costs, they indicate that the UK economy is becoming more inflationary than might be implied by headline CPI numbers.

These numbers ought to be causing real worry behind the heavy doors of the BoE – and similar trends in the US ought to be of equal concern within the Federal Reserve. But both sets of policy makers seem more worried by the potential impact of weakening growth in China. My view is that this is a potentially dangerous distraction. China is a big economy, but because of the role it plays in the world economy, its difficulties are unlikely to have a major impact on growth in the West – just as the slowdown in the Japanese economy over two decades ago did not damage growth in the US or Europe.

My view is that in both the UK and the US, policy makers should have started tightening monetary policy – not aggressively, but by enough to ensure that tightening labour markets do not cause an inflationary shock further ahead. The longer the start of this process is delayed, the greater the extent of the policy error, and the rougher both central banks will have to be later in the cycle.

Source: Richard Jeffrey, Chief Investment Officer


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