Last week UK inflation fell below the Bank of England’s target for the first time since September 2007, meaning it has taken almost two years of financial crisis to bring inflation back below 2 per cent. Sticky meet UK inflation. UK inflation meet sticky.
UK inflation is a bit sticky relative to its CPI peers as well. To wit, this chart from RBC Capital Markets:
In fact, RBC analyst Richard McGuire is positing that the UK’s sticky inflation may be caused by an underestimation of the output gap, which is a measurement of how far an economy is from its full potential, and is a prime component of how central banks gauge future inflation. ‘Slack ‘ occurs when there’s a negative value for the output gap — when the economy is not operating at its full potential — and implies deflationary pressures. A positive output gap takes place when actual ouput is more than full-capacity, implying future inflation. Ideally there would be no output gap — the value would be zero.
In gauging the degree of slack, and hence the level of inflationary pressure, in the economy a vital input for policy makers is the level of actual output relative to potential. The latter is, however, notoriously difficult to gauge. The problem with the former, meanwhile, is that the true level of output is often not fully appreciated until some considerable time after the event. It will come as no surprise, then, that the scope for policy error when judging the output gap is high.
As an example, here’s RBC’s chart of GDP growth between 1986 to 1988, when an underestimation of the actual level of output was instrumental in pushing inflation into double-digit territory at the beginning of the 1990s (The Lawson Boom). The X-axis shows how the UK’s Office for National Statistics (ONS) estimates of growth during the period changed in the ensuing years. So for instance the 1986 estimate was revised up 0.84 percentage points between 1990 and 1993. While 1988 was revised a full percentage point over the same period. Clearly gauging GDP is not that easy.
Errors or inconsistencies in measuring the output gap mean errors in policy too. In fact, a 2001 paper from the Bank of England estimated that output gap measurement mistakes contributed between two and seven percentage points to the high inflation rates of the 1970s and one to five and a half points to that of the 1980s. If the ONS were underestimating recent GDP numbers, it would mean the BoE is possibly underestimating the risk of inflation.
Back to McGuire:
Of course, there is no way of proving the ONS underestimated the true level of output in the years leading up to the current crisis although it does provide an intuitively appealing explanation as to why inflation has been so slow to fall back below target. Interestingly, meanwhile, in his appointment testimony to the Treasury this week, Adam Posen noted one of his first projects would be to understand “why the UK did not show greater productivity growth during the NICE years…”. Our suspicions on the growth front would certainly also square this circle. . . Aside from supply side issues, the likely underestimation of the output gap also stands to see inflation pick up more quickly than anticipated once some form of recovery finally gets underway – this raising the risk of the Bank falling behind the curve.