Dorset Economy blog 54: The Inflation Story

BU's emeritus Professor Nigel Jump writes the latest in his series of blogs on the Dorset economy.

RGDP = real gross domestic product CPIH = consumer prices including housing
PMI = purchasing managers’ index- survey of regional activity. Sources ONS & SPGlobal

Mixed activity trends persisted through February, with production doing better and construction worse.  Activity surveys point to a small rise out of recession in Q1 2024, whilst the labour market loosened, and inflation continued to ease.

The Inflation Story

When the recent acceleration of inflation got underway, there were many analysts who thought it was more than a temporary phenomenon related to lax monetary policy and supply chain blockages.  The recovery from the Covid-19 pandemic was expected to boost demand whilst the Russo-Ukrainian war was expected to restrict supply.  The accommodative stance of money (negative real interest rates) and the accumulation of excess public debt were seen as contributing to an inflationary surge not seen for a few decades.  To an extent, these views were correct but, with inflation peaking at 11% and now down to about 3%, some now see them as short-term uncertainties which are already abating – helped by flexible labour markets that have not built a prolonged inflationary spiral.

Recent inflation was a shock after a long period of relatively successful central bank targeting.  “Mistakes” or at least “mistiming” boosted inflation and, importantly, inflationary expectations.  It is argued that the Bank of England has been 6-9 months behind the curve, reflecting 1) less focus on the link of money (too much M2/too long QE) to price changes, 2) over emphasis on deflation risks, and 3) the line from fiscal policy and public debt to prices.  In the MPC’s favour, there was a lot of noise in the data as well as policy makers’ tendency to “fight the last battle”.  The problem is that, at this moment, price expectations were difficult to measure or forecast, especially regarding the outer range possibilities at the turning points.

Market pricing of the public debt (the yield curve) suggests we are unlikely to return to pre-pandemic low interest rates for any prolonged timescale.  ‘Flights to safety’ are engrained in the new world of the 2020s and, over the longer term, base interest rates are likely to be floored at 3-4% (ECB-Fed) rather than zero.  For the UK that means about 4.25%.

Right now, at 5.25% for base rates, is monetary policy too tight?  Two things matter:  has the economy weakened to below trend growth?  (Is real GDP falling or unemployment rising?) and has inflation persistently declined (CPI at 3.2% year to March 2024).  Real GDP fell in the second half of 2023 and unemployment rose a little.  Inflation has decelerated too.  The policy question is also influenced by the slowing of M2 growth and the flattening of the yield curve.  In theory, interest rates, however, should be roughly equal to the underlying “nominal” GDP growth rate.  The latter is about 4-4.5% whilst base interest rates are 5.25%, suggesting money is a little tight right now.

There is another aspect, however, - incentives.  It might be argued that we need a period of tight money to wean us off the largesse of the last decade or so: to get investors and others back to where economic decisions are made against a realistic long-term expectation on financing rates for investment.  We need to shake out the ‘zombies’ and base the future on sensible real returns.  So, it would be wrong for the monetary authorities to push rates below sustainable nominal growth: 5.25% might be a current ceiling but the floor needs to be no lower than 4.25%.  This should mean inflation stays around target (2%) and investment decisions are better: i.e. realistic drivers of future productivity. 

The financial markets now look for a couple of quarter percentage cuts in base rates this year, starting in the Autumn.  The UK’s inflation problem is viewed to be worse than that of the EU or USA because of adverse terms of trade effects on goods, inputs and labour.  Lenders and borrowers, investors and savers probably need to get used to the idea of base rate norms between 4% and 5% for the years ahead, assuming the 2% policy target for inflation remains.

There are always risks of more inflation or a deflation, especially in a world of potentially impactful shocks.  Price expectations are volatile and uncertain, particularly now in this global year of elections.  The inflation story seems to be one of easing price increases and gradual policy slackening through 2024-25.  Without further shocks, UK base interest rates seem rooted at just above 4% if the right mix of incentives is to be maintained, underlying real growth is to climb above 2% per annum  and inflation is to stabilise around a 2% norm.