The inflation report made for gloomy reading, the bank has adjusted the forecasts for growth this year to around 2% and inflation is heading the wrong way towards 5%. Not to worry, in the medium term, inflation will revert to target 2% because that is the way the Bank of England model works. The Governor is creating a new law of inflation, it is the “homing pigeon” model. Buffeted by the strong winds of commodity prices, imported inflation and energy costs, sooner or later inflation will revert to target, the pigeons will come home to roost to join the doves in the MPC coop.
The Bank of England model is fundamentally flawed in three dimensions. Firstly, an over dependence on gapology, the belief that an output gap will inhibit price rises. Note, that manufacturing prices increased by 4.8% in January against an estimated output gap of 4% to 6%. There is some correlation between earnings and the output gap but not enough to hold the theory, given the challenge of weaker sterling and rising commodity prices.
Secondly, the failure to recognise the step change in the world economy, China has passed the critical tipping point. It is the second largest economy in the world but still ranks just within the top one hundred in terms of GDP per capita. Think of it now as a vast hoover, sucking in a disproportionate share of food, energy, and raw materials particularly hot metals. In turn this enhances the earnings and incomes of commodity blessed emergent nations, enriching the appetite for basic foodstuffs, pushing up pressure on world prices. The Bank of England achieved target despite the fact that service sector inflation has averaged over 3.6% for the past twenty years. Cheap manufactures from China flattered the target rate as manufacturing prices hit a zero rate. This pigeon has flown the roost.
Thirdly, the Governor still believes the economy will rebalance towards exports “although we are still waiting for the boost to net trade”. This is very concerning. The graph shows the continuing deterioration in net trade in goods. It is getting worse not better as has been explained in earlier posts.
“Rebalancing the economy, “waiting for the day the boats no longer come in” will be as probable as Miss Haversham’s trip to the registry office. It is time for the Old Lady to take off the cobwebbed wedding dress, dust off the cake and get out more.”
The Governor said it takes one year or even as much as three years for reliable trade stats to emerge. This is even more concerning. The data state clearly there is no rebalancing in trade in goods. The Governor cites tourism as a way in which devaluation is benefitting the economy. OK, tourism is modelled as a function of domestic wealth and does have a high price elasticity with a short lead time. Manufacturing is relatively price inelastic with a limited “pass through” ratio. Consider the twenty per cent devaluation in 1992 produced a muted eight per cent change in relative export prices.
The Governor cracked a joke, suggesting a rate rise from such a low floor would be a futile gesture to manage the economy. For savers in the "unhappy economy" whose earnings have been severely damaged, this would be a positive gesture to reward the prudent and far from futile. JKA
Sign up today and "subscribe" for e-mail notification of updates.
Relying on Keynes is about as useful as switching off Sky News and reading Nostradamus. The views expressed are my own and in no way reflect pro.manchester policy. In no way should the comments be considered as investment advice or guidelines or reflect political bias. UK Economics news and analysis : no politics, no dogma, no polemics, just facts. JKA is a visiting professor at MMU Business School, an economist and specialist in Corporate Strategy, educated at LSE, London Business School with a PhD from Manchester Metropolitan University
Comments