The high cost of keeping inflation in check
"Economies take time to react to policy changes. So we can never be certain if policy has been tightened too much or too little "
Monday 21 August 1995
Memories are still sore, and egos are still bruised, from a time when hopes of avoiding a significant pick- up in inflation and a lengthy recession were crushed by remorselessly rising inflation and by output falling for two long years between 1990 and 1992.
Last week we learned that unemployment rose in July for the first time in two years and that retail price inflation, though unchanged in July, remains at its highest level since the summer of 1992. Is it all going wrong again, with unemployment and inflation rising in tandem? Have those who talk of a soft landing for the real economy and a blip in both unemployment and inflation once again taken leave of their senses?
Before we answer these questions we should start with economic policy. What is the Government trying to do? The chart provides a schematic answer. The trough of the recession occurred in the second quarter of 1992. Since then GDP has been rising steadily, the output gap has narrowed and unemployment has fallen.
In order to avoid the booms and busts of previous economic cycles the Government has moved to tighten policy, fiscal and monetary, at a relatively early stage, when output is still well below trend. Its aim is to ensure that GDP decelerates and approaches potential from below. Thus the output gap narrows, though ever more slowly, and only closes when GDP eventually reaches trend. What the Government, with its ambitious medium-term inflation targets, is keen to avoid is an overshoot: GDP rising above trend by definition strains resources, creates bottlenecks and sets up inflationary pressures.
This is easier said than done. Economics is an imprecise science, the economy is like an oil tanker, difficult to manoeuvre and slow to turn. Judgement is necessary, and judgement is fallible. Economies take time to react to policy changes. So we can never be certain whether policy has been tightened too much or too little. It would be more by luck than judgement if the degree of policy tightening had been judged exactly right.
That is the logic: where are we in the present cycle? The policy tightening is there for all to see. Taxes have been raised by around 2 per cent of GDP and interest rates by 150 basis points in the last year. As a result GDP, which was growing at a four per cent-plus rate a year ago, has decelerated sharply. Underlying growth is now running at around 2.6-2.7 per cent, in line with trend. (The Bank of England's caution may reflect a more pessimistic view of trend growth.)
This means that the output gap is no longer closing, that since the middle of last year GDP and trend have been rising at the same rate - as illustrated in the chart where the lines are now parallel. It also explains why unemployment has stopped falling - when GDP is rising in line with potential, natural increases in productivity can cope with the extra output, and higher employment is not needed. If this is correct, the logic is that the Treasury has over-tightened. It has brought output back to trend growth too early, ahead of when it intended. Worse, there is an obvious possibility that the deceleration in output has not yet run its course.
The CSO will publish data for output and demand in the second quarter later today. But ahead of this, it appears that some of the growth in output (provisionally estimated at 0.6 per cent in the quarter) may be because of unplanned stockbuilding. If this is confirmed, it means that demand was weaker than expected. So, without a spontaneous rebound in demand - especially consumer spending, in the second half of the year - output itself will fall back as manufacturers and retailers alike try to run off their excess stocks. There is some evidence that this is already happening. Retail sales volumes in this sector rose 1.6 per cent in July helped by record-breaking price reductions in the summer sales. This is good for inflation but, until the excess stocks have been worked off, it is bad for output.
It is the reference to inflation in the previous paragraph that adds the extra insight on Government policy. The Government does not have an explicit target for output and unemployment; its only commitment is to get underlying inflation below 2.5 per cent in the medium term.
For the past nine months the inflation trend has been upwards, although last week's data, especially the surprise drop in earnings growth, suggest that we may not be far from the peak. The main problem is the weakness of the pound this year which has pushed producer input price inflation into double figures and allowed output prices to rise at a near-five per cent rate. Most recently the pound has been dragged back up, as it fell earlier, by movements in the dollar.
But the effect on costs is clear and explains why the Governor of the Bank of England continues to argue for more monetary tightening. In terms of our analysis it explains why the Chancellor is no longer prepared to see the output gap narrowing - it gives him more leeway to ensure that the pick-up in inflation does not set up a damaging inflationary spiral.
We are at the stage in the economic cycle where the needs of the real economy and inflation conflict. Cost pressures are the main driving force behind the pick-up in inflation. To ensure that inflation does not get out of control, demand has been tightened by more than would otherwise have been necessary so that output remains below trend and unemployment is no longer falling. There is a danger that the output gap may widen in the coming months and unemployment may start rising again.
But unless the economy tips over into a sharper downturn than currently looks likely, we may still be in for a rare double. Whether by luck or judgement the tightening of monetary policy, though guilty of overkill in terms of the output gap analysis, has been judged well in terms of holding back the inflationary impetus from the fall in sterling.
So inflationary pressures should be contained (the blip),while the deceleration in the real economy prevents output from overshooting its trend level (the soft landing). Put this way, the connection is obvious. The 1990- 92 bust was the obverse of the late 1980s boom: avoid the boom and you avoid the bust. What is more the costs of the bust outweigh the benefits of the boom - the hangover lasts a lot longer than the party.
Higher unemployment is never welcome, but if it keeps inflation under control, the rise can be temporary. Once the peak in inflation is in sight, faster growth and falling unemployment can resume. In this case a temporary pick-up in unemployment (the emphasis is on the word temporary) would be a price worth paying for lower inflation - but that too is a phrase that no one in his right mind would ever use again.
Geoffrey Dicks is director, UK economics, at NatWest Markets, London
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