Carney has poured cold water on the 3 rogue MPC hikers with this morning’s release of the delayed Mansion House speech. That’s not wholly surprising given that the rate cut last August was very much driven by the Carney “Brexit Disaster” purview, and hence wouldn’t be taken back in a hurry for fear of admitting the cut was an error. Indeed, Carney can breathe a little more easily now that one of the rogue hikers, Kristin Forbes, just voted in her last meeting, and will be replaced by Silvana Tenreyro who said in January: “My pessimism regarding Brexit has not moved much: I think it will have a negative impact on the UK economy and Europe more generally”.
Forbes has left a parting gift, however. A Discussion Paper, entitled “A trendy approach to UK inflation dynamics”, suggests that the volatility in inflation is not simply driven by short-term cyclical issues. It’s a trend. The recent rally in inflation is nowhere near as cyclical as that of the 1980s or the commodity-driven boom of 2008:
What is driving this trend? Well, the paper argues that the exchange rate may have a much larger impact on inflation than many think:
‘the one (and only) variable that consistently yields a coefficient estimate that is significant for both headline and core inflation and for the shorter and longer lag structures: the sterling exchange rate index. A sterling depreciation is significantly correlated with both higher subsequent headline and core inflation. Moreover, the magnitude of this effect is estimated to be material.’
They calculate that the 20% depreciation in trade-weighted GBP last year implied an increase in trend core CPI inflation of 0.86pp. As they put it, ‘these are large effects’.
They go on to look at other potential drivers of inflation such as the output gap and inflation expectations but conclude ‘these standard measures…are… rarely significant in explaining the dynamics of core inflation’, and when they are, it’s of a small magnitude. They point out that the UK, unlike the US, is a small open economy, so the exchange rate plays a much bigger part.
In other words, the BOE ignores Sterling at their peril. We can all understand why Carney is desperate to keep rates low as the UK economy faces an uncertain future. Even more so now that we have months if not years of political instability ahead. But they face a very unhappy trade-off between the somnolent wages of an apparently dead Phillips Curve, and rampant exchange-rate-driven inflation as capital flows out of the UK economy. The tight labour market is not (yet?) generating inflation; but the exchange rate is. So to which do they respond?
Meanwhile the Fed has the opposite problem. It wants to raise interest rates, with Janet Yellen mindful that she only has two more press conference FOMC meetings in which to stamp her legacy into history (if her term is not renewed). They also face an apparently dead Phillips Curve, but no signs of inflation despite the tight labour market. The downturn in inflation is causing the doves to flutter their wings. Evans was on the wires yesterday warning that “We could wait till December” for the next hike. He went on: ‘I think if we were to race to a higher funds rate too quickly without seeing improvements in inflation, that could be quite a concern. And it’s that part that I think where we need to stop and kind of go, you know — I just think the message out of the conservative central banking story was, we need to get inflation to 2 percent’.
Then Yellen, in last week’s press conference, says that she is open to raising the inflation target, after having previously dismissed it. She suggests: ‘this is one of our most critical decisions and one we are attentive to evidence and outside thinking. It’s one that we will be reconsidering at some future time…. But a reconsideration of that objective needs to take account not only of benefits of a higher potential benefits of a higher inflation target, but also the potential costs that could be associated with it… But I would say that this is one of the most important questions facing monetary policy around the world in the future. And we very much look forward to seeing research by economists that will help inform our future decisions on this’.
Is this Yellen the dove popping up again? Or more likely, Yellen who wants to make her legacy secure. She’s nervous now that she will exit with inflation never having reached target. So over to you the academics, you come up with some research that provides a Get Out of Jail Free card.
She, like Carney, is stuck between a rock and a hard place. She was handed the poisoned chalice of removing extraordinary stimulus without derailing the US economy. If she can just start to reduce the size of the balance sheet and get rates back to a neutral-ish level before her February exit, she will have done her job. But if inflation starts to dip? Oh dear… Charts like these will worry her:
So, Yellen has to balance tightening policy against lower inflation. Fortunately the rally in the stock market is loosening financial conditions even as she is hiking. How long can she rely on that?
Meanwhile Carney has to balance loosening policy against higher inflation. Fortunately value hunters are happy to buy GBP near its recent lows, despite the political instability. How long can he rely on that?
We would feel sorry for them, if only their persistent “lower for longer” narrative hadn’t been a prime contributor to driving the inequality that is now spilling out into electoral rage. But that’s a story for another day. For now, both GBP and the USD face significant risks ahead.