Today my topic is a subject which may seem like shuffling deck chairs on The Titanic but in fact turns out to be very important. This is because it affects workers, consumers and savers ever more because of the way that both wage growth and interest-rates head ever lower. For the latter we often see negative interest-rates and for the former the old text book concept of “sticky wages” has been in play but pretty much one way as rises are out of fashion but falls do happen. Indeed we have seen more than a few cases of wage cuts recently with the airline industry leading the way for obvious reasons. So we can afford inflation if I may put it like that much less than previously as it more quickly affects living-standards.
The Fantasy World
Central bankers have become wedded to the idea of inflation targeting but have not spotted that there is a world of difference between applying it when you are trying to reduce inflation and trying to raise it. In the former you are looking to raise living-standards via real wages and in the latter you end up trying to reduce them. Hoe does this happen? In spite of over a decade of evidence to the contrary they hang onto theories like this.
If the anchor for inflation is the inflation aim, the Phillips curve – the link between the real economy and inflation – plays a central role in allowing central banks to steer inflation towards that aim. But in the low inflation environment, prices appear to have become less responsive to the real economy. ECB research suggests that the empirical Phillips curve remains intact, but it may be rather flat. ( ECB President Christine Lagarde yesterday )
It can be any shape you like according to them which means it is useless. Accordingly it follows that they have been unable to steer inflation towards its target and for reasons I shall explain later they may well have been heading in the wrong direction. But let us move on with the Phillips curve being described by Lewis Carroll.
“When I use a word,’ Humpty Dumpty said in rather a scornful tone, ‘it means just what I choose it to mean — neither more nor less.’
’The question is,’ said Alice, ‘whether you can make words mean so many different things.’
The next issue is that they have got away with defining price stability as something else entirely. Back to Christine Lagarde of the ECB.
Since 2003, the ECB has used a double-key formulation to set our objective, defining price stability as a year-on-year increase in inflation of “below 2%”, while aiming for inflation of “below, but close to, 2%”.
This misrepresentation was exposed back around 2016 when measured inflation fell to approximately 0% but there were price shifts because the inflation fall was driven by a large fall in the price of crude oil. We saw it in another form as goods inflation fell to zero and sometimes negative where services inflation continued and in the case of my country was little affected. So the bedrock of the 2% inflation target crumbled away.
But they cannot stop clinging to the Phillips Curve.
The intuition behind the first factor is that the Phillips curve is alive and well, but the euro area faced a series of large shocks that made it harder to measure economic activity relative to potential. ( Lagarde)
Let me give you an example where this failed utterly in my home country the UK. Back in 2013 the then new Bank of England Governor Mark Carney established his Forward Guidance based on a 7% Unemployment Rate. Within six months that was crumbling and we went in terms of a “full employment” estimate 6%,5.5%,5%, 4.5% and lastly 4.25%. I would argue it was worse than useless as it was both actively misleading and an attempt to claim he was on the verge of raising interest-rates without having any real intention of doing so.
How much difference does it make?
Central bankers live in a world like this.
Broadly speaking, three factors might explain why inflation responded so weakly to improvements in the economy in the run-up to the pandemic.
One of the reasons is that the economy did not improve that much. The previous peak for Euro area GDP was 2.47 trillion Euros at the start of 2008 which rose to 2.68 trillion at the end of 2019 on 2010 prices. The increase of around 8.5% is not a lot and compares badly with the previous period.
Next comes the fact that central bankers inflate their own efforts and policies according to Chicago University. From Bloomberg.
However, they also find that, on average, papers written entirely by central bankers found an impact on growth at the peak of QE that was more than 0.7 percentage points higher than the effect estimated in papers written entirely by academics. (This is a sizable difference considering the effect found on average across all studies was 1.57% at the peak.) In the case of inflation, the difference in the effect of QE at its peak between the two sets of papers was more than 1.2 percentage points. Central bankers also tended to use more positive language in summarizing their results in abstracts.
They have discovered a point I have been making for some years now.
They suggest that career concerns may have played a role and provide some evidence that central bank researchers who found the largest impact of QE had a better chance of receiving a promotion.
An issue here is the way that official inflation indices have been designed to avoid measuring inflation. I noted this yesterday with reference to the Christine Lagarde speech.
We need to keep track of broad concepts of inflation that capture the costs people face in their everyday lives and reflect their perceptions, including measures of owner-occupied housing.
This continues a theme highlighted by Phillip Lane back in February.
I think we at the ECB would agree that there should be more weight on housing – but there is a difficulty and this has been looked at several times before.
Just for clarity they completely ignore owner-occupied housing which Mr,Lane admitted was up to 33% of people’s spending in a different speech. In other matters ignoring such a large and significant area would get you laughed out of town but as most are unaware it just means they do not believe the inflation numbers.
a lot of households think it is higher. ( Phillip Lane)
I wonder why they might think that? From UBS.
Use our interactive Global Real Estate Bubble Index to track and compare the risk of bubbles in 25 cities around the world over the last three years. Munich and Frankfurt top our list in 2020. Risk is also elevated in Toronto, Hong Kong, Paris, and Amsterdam. Zurich is a new addition to the bubble risk zone.
So the ECB has topped the charts and has four of the top seven. Makes them sound like The Beatles doesn’t it?
The situation here is an example of institutional failure. Central banks had a brief period of relative independence because politicians failed to get a grip on high inflation and so they sub-contracted the job. Whether they thought it would work or whether they wanted simply to shift the blame off themselves is a moot point? Either way it had its successes as inflation did fall as highlighted by the description of that phase as the NICE decade by the former Bank of England Governor Baron King of Lothbury.
The problems in the meantime are as follows
- Inflation is now below target partly due to the miss measurement of it. We are also in “I cannot eat an I-Pad” territory.
- They believe that 2% inflation is causal rather than something which was picked at random.
- They believe that they can influence it much more than the evidence suggests.
- Most breathtakingly of all they believe that raising the inflation target will make people better off via the wages fairy ( where wages growth will rise even faster).
Or you can take the view that this is all about keeping debt costs low for government’s and all of the above is simply a front.
Let me now address further the issue of how things have been made worse. Firstly there is the psychological impact of so-called emergency measures persisting and all the policy moves. Next has come the Zombification of many times of business as models which should have failed get bailed out. Also the use of negative interest-rates cripples much of the pensions and longer-term savings and insurance industry.
On the this road the 2% inflation which they cannot achieve and anyway would make you poorer seems likely to become 3% which is even worse….