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No matter how we measure inflation, politics will forever trump economics

No matter how we measure inflation, politics will forever trump economics

THE ECONOMIC Affairs Committee of the House of Lords has got its bovver boots on. Last week, the government was given a sound kicking.

The issue was the seemingly esoteric one of how to measure inflation. Inflation tells us how much the prices of goods and services are going up. The question is: what do we put into the basket when we are working this out?

The most general measure is the consumer price index (CPI). This takes into account literally everything which individuals in the UK buy. Something which is widely purchased, such as rail journeys, will carry more weight than, say, spending on parts for model railways. But they all count. The percentage change in the CPI is one measure of inflation.

Gathering all this information obviously takes time. In contrast, the retail price index (RPI) is quick and easy to calculate. It is, quite literally, based on a basket of products available in shops. The basket gets changed from time to time to reflect changes in spending patterns. The disadvantage of the RPI is that it is much more focused on goods than on services.

In recent years, inflation as measured by the RPI has been higher than the CPI. Between 2014 and 2018, the respective rises were 9.7 and 5.9 per cent.

These differences have important practical consequences. All sorts of things get increased each year by the “rate of inflation”.

The Lords accused the government of using the RPI for uprating stuff like rail fares and student loans, where directly or indirectly the government rakes in money. But it uses the CPI when it comes to paying out on pensions and benefits. “Index shopping” was their Lordships’ neat description of this practice.

But in top academic circles, much more fundamental attacks have been made on both these traditional metrics.

Measuring inflation faces a very difficult problem. How do you take into account changes in the quality of goods and services?

A simple example is a car. A particular model may cost exactly the same as the identical model last year. But suppose that, unlike last year’s model, this car has heated seats and parking sensors. The measured price has not changed, so inflation is zero. But you are getting more for your money.

The problem becomes acute in any area of new technology. Smart phones did not exist 30 years ago, and the internet was not yet developed for general use. How much have their prices changed since then? We have only to ask the question to see the problem that the vast advances in technology pose.

Even back in 2003, the top MIT econometrician Jerry Hausman estimated that the CPI was systematically overstating inflation by as much as two per cent each year, because of this quality issue.

Measured correctly, inflation could well have been negative in the current decade. But it will be hard to get politicians to take an interest in this. Imagine having to tell people that their pensions would be reduced because prices were falling.

Even if we could improve the measurement inflation, as the Lords demand, politics is forever likely to trump science here.

As published in City AM Wednesday 23rd January 2019
Image: Maths Equation by World Bank Photo Collection under CC BY-NC-ND 2.0
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It’s time to question the macroeconomic orthodoxy on interest rates and inflation

It’s time to question the macroeconomic orthodoxy on interest rates and inflation

Mark Carney, governor of the Bank of England, is getting his retaliation in early.

Faced yet again with the Bank failing to deliver its designated target of a two per cent inflation rate, in a speech last week he suggested that his remit was broader.

“We face a tradeoff between having inflation above target and the need to support, or the desirability of supporting, jobs and activity”, the governor stated.

In other words, he claimed that the Monetary Policy Committee (MPC) of the Bank should be concerned not just with inflation, but with what economists describe as the “real” economy, output and jobs.

The Federal Reserve in the US is explicitly mandated to take account both inflation and the real economy when it sets interest rates. This is definitely not the case with the Bank of England. When Gordon Brown made it independent in 1997, its remit was unequivocal. It was to ensure that inflation was two per cent a year.

This time round, inflation is above the Bank’s target. The current level of some three per cent may even rise in the short term because the weakness of sterling is pushing up the cost of imports.

But in recent years, inflation has been below the two per cent desired rate, even falling to zero in 2015.

All this time, Bank rate has been essentially flat. The MPC cut it to just 0.5 per cent in March 2009, where it remained until the reduction to 0.25 per cent in August 2016.

To put this into perspective, when the rate fell to 1.5 per cent in January 2009, this was the first time it had been below two per cent since the Bank was created in 1694, well over 300 years ago.

So here is a puzzle for mainstream macroeconomists, whether in central banks or universities. Central banks are meant in theory to be able to control inflation by setting short term interest rates. Inflation has been low since 2009. But at the same time, the Bank rate has been at all-time record lows.

Perhaps more pertinently, inflation has fluctuated from year to year, even though interest rates have to all intents and purposes not changed. It was 4.5 per cent in 2011, and 0.7 per cent in 2016.

In short, inflation seems to lead a life of its own, independently of what the experts on the MPC either say or do.

Inflation really is a naughty boy all round. A central concept in orthodox economic thinking, encapsulated in the quote from Carney above, is that there is a tradeoff between inflation and jobs and output. The faster the economy grows and unemployment falls, the higher inflation will be.

But starting in the early 1990s, for around 15 years across the entire Western world, both inflation and unemployment experienced prolonged falls.

The idea that a central bank can control inflation by adjusting interest rates is shown by the evidence to be absurd.

It is yet another example of the limits to knowledge in orthodox macroeconomics.

As published in City AM Wednesday 25th October 2017

Image: Mark Carney by Bank of England is licensed under CC by 2.0
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It’s fanciful to think China’s economy will overtake the US’s anytime soon

It’s fanciful to think China’s economy will overtake the US’s anytime soon

Possibly the single most important of the tensions stoked up by President Trump is the rivalry between the United States and China. Economic strength will be the ultimate determinant of this struggle for the position of Top Nation.

Comparisons of the size of economies, particularly ones at very different levels of income per head, are fraught with difficulties. Taking a deep breath, annual output in China is currently around $10 trillion a year, compared to $17 trillion in America.

Over the past 30 years, the US has grown at an annual average rate, after allowing for inflation, of 2.4 per cent, and China by 9.3 per cent. If we project these rates forward, the Chinese economy will be as big as the American by 2024. By 2037, it will be more than twice the size.

We can allow for some slowdown in China’s growth, to, say, 7 per cent a year, and a bit faster expansion in the US, to take account of the fact that the average over recent decades is influenced by the impact of the financial crisis. Even so, we soon reach a situation where the two are of comparable size.

But a paper in the latest issue of the world-class Journal of Economic Perspectives argues persuasively that the sustainable Chinese growth rate in the medium and longer term is much lower, in the range of 3 to 4 per cent a year.

Hongbin Li and colleagues, based both in Stanford and top universities in China, note that Chinese growth since the start of the economic reforms in 1978 has been the fastest that any large country has sustained for such a long period of time. But much of this is due to the rapid transition from a centrally planned to a market oriented economy. Forty years ago, virtually no-one operated in the private sector. Now, well over 80 per cent of workers do so. This shift obviously cannot be repeated.


Closely intermingled with this has been the massive move of population from the countryside to the cities – or more precisely, from low productivity agriculture to higher productivity urban economic activities. But the annual growth rate of rural-to-urban migration has fallen from over 11 per cent in the 15 years before 2000 to only 3 per cent since. And the authors argue that the growth of migration almost certainly will decline further given that “rural-based surveys are finding that less than 10 per cent of young able-bodied rural individuals are now living (and working on farms) in rural areas”.

Until 2011, the authors point out that China enjoyed what they call a “demographic dividend”. The age group of the working population was unusually high as a share of the population as a whole. But because of what the authors tactfully refer to as “the fall in fertility” since the early 1980s, this is now declining fast. The One Child Policy was mainly responsible, but higher incomes also reduce birth rates.

China remains a huge and growing economy. But projections that it will overtake the US within readers’ lifetimes seem fanciful.

Image: Chinese Lanterns by Suloke Mathal is licensed under CC by 2.0
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Forward guidance is just another delusion foisted on us by mainstream macro

Forward guidance is just another delusion foisted on us by mainstream macro

The governor of the Bank of EnglandMark Carney, was on good form last week when he appeared at the Treasury Committee of the House of Commons.

Asked what “forward guidance” meant, he answered smoothly: “The thing about forward guidance is that it is guidance that is forward. Which is not to say it is meant to be in any way accurate. Indeed, it would be surprising if it were. The most important thing about forward guidance is that the underlying economic determinants should be correct, not that it should be helpful.” Cue collective bafflement of the assembled MPs!

But the statement actually tells us a great deal about how mainstream macroeconomists believe the economy operates.

“Forward guidance” has been the key element in policy-making by the Bank since Carney himself introduced it in the summer of 2013. It is meant to give guidance about the economic circumstances in which the Monetary Policy Committee (MPC) will start to raise interest rates.

The first attempt was certainly not in any way accurate. The governor stated that the MPC would not consider raising interest rates until unemployment fell to 7 per cent, which he predicted would take about three years. It took less than six months. By January 2014, the rate of unemployment had fallen to 6.9 per cent.

This just seems to have been a piece of poor analysis by the Bank. But it does not detract from the more fundamental reason economists think that forward guidance will not usually turn out to be accurate.

The forward guidance is deliberately based on the assumption that behaviour will not change. Yet the mere fact that the central bank makes a pronouncement about the future might induce people to alter their behaviour. And if behaviour changes, the forward guidance might very well prove to be inaccurate.

It is actually a sensible addition to the Bank’s armoury of policy levers. Properly managed, it might enable the Bank to nudge behaviour in directions which it believes will give a better outcome than would otherwise be the case.

The final part of Carney’s statement appears the most gnomic: “The most important thing about forward guidance is that the underlying economic determinants should be correct, not that it should be helpful”.

The governor meant that forward guidance should be given on the basis of a model of the economy which is correct.

In each of the various different macroeconomic models which exist, the assumption is made that consumers and firms form expectations about the future as if their particular model, and no-one else’s, were correct. Yet despite many years of intensive research, macroeconomists still do not agree on what constitutes the model of how the economy works.

There is a challenging academic literature on the theory of how people go about learning the correct model of the economy. But in practice economists are unable to apply it to themselves. We might reasonably conclude that it is the theory which is wrong. Forward guidance is just the latest technocratic delusion foisted on us by mainstream macroeconomics.

As Published in City AM on Wednesday 23rd November

Image: Mark Carney by The Financial Stability Board is licensed under CC BY 2.0

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Thank competition – not magical central bankers – for years of low inflation

Thank competition – not magical central bankers – for years of low inflation

Tempers are fraying at the highest levels of economic policy-making in the UK.

Theresa May, at the Conservative Party conference, emphasised the “bad side effects” for savers of the Bank of England’s policy of near-zero interest rates, a position reinforced by former Tory leader William Hague in the Telegraph this week. A few days ago, Mark Carney, the governor of the Bank, hit back by saying he would not take instructions from politicians.

He went on to discuss inflation. The fall in sterling puts up the price of imports, and some economists predict that inflation will hit 3 per cent next year, up from its current (still low) level of 1 per cent. The Bank’s Monetary Policy Committee (MPC) has an official remit of maintaining inflation at 2 per cent. Carney stated that he would allow inflation to run “a bit” above this to protect growth and employment.

Just how much power does the MPC have to control inflation in such a precise way? At first glance, the work of the MPC has been brilliant. Some years the inflation rate has been higher than the 2 per cent target, like in 2011 when it was above 4 per cent, and some years lower, as last year when it was zero. But over the past 15 years, inflation in the UK has averaged 2 per cent a year, almost exactly in line with the target.

But the average inflation rate has been very close to 2 per cent averaged across the 28 member states of the European Union. And the United States also registered the same average of around 2 per cent over the past 15 years.

The fact that inflation has averaged more or less the same rate across the major economies for well over a decade – only in Japan has it been substantially different – strongly suggests that there is a common factor at work. It could be the collective skills of central bankers, or it could be the effect of plain, old fashioned competition.

Competition in markets for goods and services means that it is hard to make price rises stick, and competition for labour means it is difficult to secure substantial wage increases. Competition in the global economy is the main reason inflation has both been low and very similar across the developed world.

The MPC controls the short-term rate of interest, and the theory is that a rate increase, say, reduces demand in the economy as a whole. This in turn has a stable and predictable impact on inflation, with lower demand leading to lower inflation. The trouble is that the facts do not fit the theory. Inflation dropped to zero after peaking in 2011, but unemployment has effectively halved and the economy has grown at a decent rate.

We do owe central bankers in the UK and the US a massive vote of thanks for preventing the crisis of the late 2000s from becoming a repeat of the Great Depression of the 1930s. But even they do not have magic powers. Inflation is low because of competition, not central bankers.

Paul Ormerod 

As published in CITY AM on Wednesday 18th October 2016

Image: FSB Chair Mark Carney at pre-Brisbane press briefing in Basel by Finance Stability Board is licensed under  CC BY 2.0

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Why the economic picture tends to be rosier than initial estimates suggest

Why the economic picture tends to be rosier than initial estimates suggest

One of the surprises of last week was the Office for National Statistics (ONS) estimate of economic growth in the second quarter of 2016, the period from April to the end of June. In the run up to Brexit, the economy expanded by 0.6 per cent on the first quarter of the year. This was an acceleration, with the first quarter of 2016 only being up 0.4 per cent on the previous one.

The situation in the third quarter is currently confused. The GFK consumer confidence survey for July showed the biggest monthly drop since 1990. But the weakness of the pound means that exports are due for a boost. Certainly, judging from the sheer numbers of foreign tourists crowding London in the last few weeks, we are raking in the euros and the dollars.

But the ONS view on what happened in the second quarter of 2016 is by no means the last word. Quite rightly, our national statisticians are keen to provide information on what has been happening in the economy as fast as they can. So they publish what is known as the “first estimate” of GDP growth for a quarter just a few weeks later. It is this estimate which grabbed the headlines.

Most economic data published by the ONS are estimates, produced with information gathered from a wide variety of sources. But as time goes by, more of it comes in for any particular quarter. Self-employment income, for example, is quite important these days. But an accurate picture is not available until after the end of the tax year, when all the returns are submitted. So the initial estimate might very well change over time.

Looking back over the past 20 years, the average of all the first estimates of growth made over this period is a bit lower than the average of the latest estimates. So, on balance, first estimates get revised upwards, showing that the economy has been more buoyant. But statistically speaking, we cannot say with real confidence that they are significantly different.

Certainly, the averages can conceal some large inaccuracies in the first estimate data. The ONS now thinks we entered the recession of the late 2000s in the second quarter of 2008, with the economy shrinking by 0.7 per cent compared to the first quarter. But the first estimate which was made showed modest growth of 0.2 per cent. The first estimates did indicate a recession in the second half of 2008, but underestimated how much the economy was contracting. In contrast, during 2009, the first estimates failed to register the speed of the economic recovery. In the winter of 2011-12, the first estimates notoriously suggested we had entered a new recession, which is not borne out by the latest data.

It is a hard life being a policy-maker. One of the problems is reading the runes about where the economy is now and where it has been in the recent past. The first estimates of GDP are better than nothing, but can on occasion be quite wrong.


As published in CITY AM on Wednesday 3rd August 

Image: Scale by Thomas Leuthard licensed under CC BY 2.0

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