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Moneyweek say: ‘an interesting book that asks some provocative questions’. Pete Comley ‘ has a knack for making points that others have overlooked‘.
MoneyWeek subscribers can read the full review at: http://moneyweek.com/book-review-inflation-tax-expect-inflation-to-get-much-worse/
This week my academic journal article was published in Economic Affairs entitled “The Purpose of Inflation“. You can access it from Wiley here. In it, I highlight the ways in which the government can follow ‘inflation-friendly’ policies to ensure that we will continue to have inflation in the UK.
These are as follows:
1. More quantitative easing. The MPC has not ruled out further quantitative easing. It may well be considered should the economy falter before the 2015 election. Many commentators expected the injection of £375bn during 2009–12 to be highly inflationary. It was not, primarily because at the same time the money supply was contracting due to widespread deleveraging and the banks’ attempts to shore up their balance sheets. However, the money supply is now increasing (Bank of England 2013b) and any further round of quantitative easing could well be inflationary.
2. Increases in regulated prices. A large part of the inflation rate is under the direct control of the government through regulated prices of, for example utilities, train fares, and student loans. Indeed, Mervyn King, the previous Governor of the Bank, often pointed out that this was the largest factor behind current UK inflation (Bank of England 2013c). Despite the Labour Opposition’s threats to temporarily freeze some utility prices if elected, this tool is still going to be an important one for any government to foster inflation.
3. Government housing schemes. Schemes that assist home buyers (such as Help to Buy) have already helped revitalise the UK housing market and increase the amount of mortgage loans and consumer credit (Giles 2013) This has increased house prices, which have a direct impact on inflation measures such as RPI and indirect effects through increased money supply and enhanced consumer spending, which boost prices. While the banks are still recovering their financial positions, continued government support for housing in various ways is likely to remain (especially in the pre-election period) and this will enhance inflation.
4. Devaluation of the pound. It is quite easy for a few words from the Bank of England to the effect that it expects a decline in sterling to lead to dramatic changes in the exchange rate, as was witnessed in early 2013. Such a policy has also been very effective in Japan recently. Such devaluations lead directly to higher import prices, and, as Table 1 shows, these have the power to increase UK inflation.
5. Creating a wage–price spiral. Since 2008, wages have lagged significantly behind inflation (The Economist 2013). There will come a tipping point in the economic recovery when workers start to regain the upper hand. This could even be prompted by a government which allowed widespread public sector wage increases, for example. If that occurred at a time when inflation was already at a higher level, it would enhance the effect of the wage–price spiral.
6. Increasing bank credit. The government and the Bank are already doing a lot to bolster private bank finances to encourage lending. They will probably continue to do so for some time. There will come a point when balance sheets are sufficiently repaired that animal spirits return and banks are able to significantly expand the money supply and promote further inflation in the UK. Indeed, we have already witnessed a marked upswing in unsecured loans and consumer credit in 2013 (Bank of England 2013d).
7. Increased government spending. Despite the current era of austerity, the government can also increase the money supply by investing in large projects which may not appear in the national accounts. For example, the UK government has recently sanctioned the construction of many new nuclear power stations (with funding provided by the private sector). Another large project recently agreed is the proposed high-speed train between London and the north of England. It is unclear yet how it will be funded, but it will probably not be directly from tax revenue or further government debt (Oodit 2012). However, such large-scale projects will further add to inflationary pressure.
In addition to these seven published in the article, I forgot to add what is arguably the most important driver of UK inflation today:
8. The Bank of England’s target for 2% inflation. This provide a justification for governments to follow any of the above seven policies with impunity.
In addition to my detailed article on Save our Savers about the effects of the withdrawal of the Funding for Lending Scheme, the London Evening Standard also published a version of my letter to them on the subject too, ie.
Read Pete’s blog post on Save our Savers on the impact of the ending of the Funding for Lending Scheme. (Original text repeated in full below).
The announcement this morning by Bank of England to end the Funding for Lending scheme early for mortgage lending is the first bit of good news for savers in over a year. It heralds the possibility of a return to higher savings rates and ones that might approach that of the level of inflation.
In the weeks building up to the Olympics in July 2012, the government announced a scheme that was to inflict misery on millions of UK savers. Brought out in the wake of the euro crisis, it was a desperate attempt to stimulate bank lending and kick start the economy by helping to revive the housing market. To some extent, it has been very successful in its primary objective – in fact so successful that there is talk of the housing market overheating in some parts of the country. This was the reason for its premature withdrawal by Mark Carney today.
But the UK’s savers are still living with the effects of the ‘law of unintended consequences’. What Funding for Lending allowed banks and building societies to do was to borrow money directly from the Bank of England at near zero rates. They soon realised that there was no need to compete for savers money anymore. Therefore since summer 2012, savers rates have been continually declining.
As the chart below illustrates, average variable cash ISA rates have halved from 2.6% in July 2012 to 1.26% in September 2013. Even those prepared to lock up their savings for two years are only receiving rates just over 2%, which after tax is substantially below the rate of inflation.
Data source: Building Society Association – Variable cash ISA rates inc bonus
So now that the end of scheme has been announced, will rates soon return to previous levels? The likely answer is unfortunately no, as the effects of the scheme will be felt for a long time yet. Banks will still have funds on their books from the scheme that they have yet to allocate and so the need to tempt depositors back again will only gradually return.
However I suspect savings rates will start to increase over 2014. Moreover I may go so far as to predict that just before the election in May 2015, we’ll finally see inflation matching rates again. In order to win the next election, it is going to be key for the Collation that the savers of this nation return to a bit of that feel-good factor we had during the Olympics.
In a speech to the House of Commons Treasury Committee yesterday, Mark Carney, Governor of the Bank of England, admitted publicly something which many of us have suspected for a long time – see ‘Mark Carney criticises quality of ONS data’, Daily Telegraph, 27 November 2013. There are very serious problems with some of the data published by the UK Office for National Statistics (ONS). My blog post today on Save our Savers gives examples of how the GDP deflator produced by ONS is exaggerating the apparent size of the economy in the UK. A more detailed version of the article is presented below.
The latest revisions to the GDP figures today apparently confirm economic growth is now running at an equivalent annualised rate of over 3%. Moreover revisions to previous GDP figures now show the UK avoided any double dip recession and the economy is back to where it was in early 2007 (although still slightly below its peak in Q1 2008).
But should we believe these numbers? The Bank of England clearly has its doubts about the data produced from the ONS. Mark Carney’s said yesterday to Treasury Committee, he trusted them less than those produced by the Canadian statistical office – see Daily Telegraph ‘Mark Carney criticises quality of ONS data‘ (27 November 2013[i]). As we’ll see in this article, he should have good reason to doubt the official GDP growth story too.
When the initial Q3 GDP figures were released last month George Osborne tweeted that ‘we are firmly on the road to economic recovery‘. Does this make sense and stack up with the reality we all see around us?
We are still in a period of austerity. Savings income has been slashed as interest rates have been cut. Government expenditure has been reduced. Unemployment is more than 50% higher than in 2008. Disposable income has shrunk by 10% over the last 4 years, as average wages have risen just 7% whilst inflation (RPI) has increased 17%. Food prices alone are up over a quarter in the last five years since the recession started. So how can it be that the overall UK economy has managed to almost recover?
The official explanation for economy’s bounce is that consumer is borrowing and spending again and this is leading to businesses starting to invest again. There is some evidence for this. The government is pouring money into the housing market via schemes such as Help to Buy. However more importantly, unsecured lending is up by 4%[ii]. To meet the gap in their disposable incomes noted above, people are now having to borrow on their credit cards and from payday lenders. This led economist Ann Pettifor to describe it recently as more like an ‘Alice in Wongaland’ recovery[iii].
However there is an alternative explanation. Maybe the economy has not recovered. Maybe, like Mark Carney possibly fears, it is only the official statistics that appear to show a recovery, while the real economy has been languishing in a recession? Although this might sound far-fetched or Orwellian, there is unfortunately some evidence to support the view. To appreciate why, you need to understand a bit more about GDP first.
Calculating GDP is actually very complicated, not least because it is calculated in three completely different ways i.e. from income, expenditure and production statistics. These measures are combined (as they all approximately give the same answer), and one GDP figure is published.
One of the simplest ways to understand GDP is in terms of the countries’ expenditure. It is the total everything that people spend, everything that government spends and everything else that is spent by others (such as capital investments by companies)[iv].
However statisticians publish the change in spending each quarter to determine GDP growth, they first need to take inflation into account. Therefore two figures are calculated each quarter – the actual (nominal) amount spent and a (real) inflation adjusted amounts. If you look at the difference between these two, you can work out what is called the GDP deflator, i.e. the effective rate of inflation the government is assuming in the calculation.
Naively you might assume the deflator is pretty much the same as something like the Retail Prices Index (RPI). This makes sense as nearly two-thirds of GDP is household expenditure. RPI measures inflation for this group pretty well. Of the remainder, nearly a quarter of GDP is government spending, much of which involves purchasing many things that consumers buy, but on a bigger scale. The main other element is capital expenditures (usually building things), which are influenced by material prices – which also correlate with RPI.
That naïve logic held true for about half a century until the late 90s, as the graph below shows.
However that that historical relationship has now changed. The deflator is now consistently lower than RPI[v].
Moreover the divergence between them has grown even greater in the last three years to just under 2% on average.
This has major implications. If we were still calculating GDP as we used to (when it approximated to RPI), the stats would have shown the UK in recession for almost the whole period of the current government since 2010 – see table below. The countries’ real GDP would still be over 10% less than what it was in 2008.
|Year||Official GDP||GDP adjusted by RPI|
I would contend that the RPI adjusted figures accord much closer with the man in the street’s perception of the economy than the official statistics do.
As you’ll see below, I will argue that this is probably not a conspiracy but is mainly the effect of a succession of changes made to the way GDP is calculated. On the face of it, some of these appear well intentioned. Though as we’ll see, most were introduced for political reasons. However it is quite probable that those directly introducing them may not have fully anticipated what implications they would then have for GDP today.
One of the main reasons why GDP appears so high is related to the way government expenditure is now deflated.
If you look at the deflator stats for 2012 spilt by category, this highlights that something appears very odd with the inflation assumptions for government expenditure. The ONS is assuming there is outright deflation going on:
|Component of expenditure||
Deflator/ inflation rate
Source: ONS – Second Estimate of GDP, Q2 2013 at: http://www.ons.gov.uk/ons/dcp171778_322665.pdf – Annex D.
The reason for this goes back to a progression of changes that were made to the system after 1998.
Prior to then, government expenditure was deflated assuming that changes in outputs were the equivalent to changes in expenditure i.e. assuming productivity was constant. Other countries (i.e. the USA) had switched to a system where the quality of outputs were being taken into account and this had led to enhancements in their apparent GDP levels. As Tony Atkinson (key Government advisor in this) wrote[vii] retrospectively about it in 2005:
“In the report we pointed out between 1995 and 2003 the US economy grew ½% per year faster than that of the UK…But half of this difference is due simply to the difference in how we measure Government output. If we had used the same method as the USA, then the UK growth rate would have been 3% per annum [vs 2 ¾%]. These are not simply statistical conventions, but they materially affect how we view our performance.”
The report being referred to is Measurement of Government Output and Productivity for the National Accounts (2005). This highly influential government sponsored document resulted in the formation of the UK Centre for the Measurement of Government Activity (UKCeMGA) which then brought in further changes in the GDP calculation which we have seen the results of in the recent statistics.
The basic essence of all these changes is that we are no longer using inflation in government costs (like wages, fuel and catering bill rises) but instead deflating them by measures of quality (such as the number of children getting a GCSE grades A-C or the number of patients treated in A&E in four hours).
There is a big problem with this concept. Over recent years when spending has been capped, apparent productivity (as measured by blunt instruments like GCSE grades) has carried on improving. Therefore it looks like government is getting more productivity for each pound spent. This means they have to assume a negative deflator (-1.6% in 2012 for example), to make the books balance.
This change has significantly contributed to making GDP look a lot higher than it really is over the last 2-3 years.
The other major change to the GDP calculation recently was the decision in 2011 to stop using RPI to deflate certain expenditure measures and to switch to CPI (Consumer Prices Index). This matters because CPI is almost always lower than RPI. This is primarily due to the way prices are averaged in CPI using a so called ‘geometric mean’. This methodological change can trim a staggering 1% off CPI. Moreover as I have written elsewhere[viii], the justification for such statistical manipulation, is dubious at best.
However it does now have direct implications for GDP estimates, which will always be higher now as a result of it. Note though, the pattern of prices in the shops has not altered, nor has the amount of money we all spend altered. It is just the GDP growth statistic that has changed and will now appear to be up to 1% higher each and every year now.
If this were not bad enough, the ONS have taken the opportunity of this change to not just change the way we calculate GDP after 2011, but have used it to rewrite the whole GDP history back to the Second World War in a very Orwellian fashion. Even though CPI did not exist before 1996 in the UK, they have still used it to justify somehow enhancing all our historical growth figures. The effect was highlighted in a recent blog post on EconBrowser[ix]. and the chart below summarises the way our history has been rewritten:
Average GDP growth per year
Before CPI change
After CPI change
To make matters worse in my view, if you try and go back and find the old GDP data (e.g. in the 2010 Blue Book) you’ll find that all the spreadsheet numbers now have been replaced with ‘new numbers’ in what looks like an example of Orwell’s Ministry of Truth in action[x].
The answer as you can see from the above is very difficult to tell. However if you view the economy through a lens of a statistician living in the 1990s, the answer is most probably that we’ve been a recession for most of the last three years. On the other hand, according to the latest Newspeak of the ONS, the economy grew 0.8% last quarter. I wonder which opinion Mark Carney believes?
[iv]The GDP expenditure model also includes a measure of imports less exports.
[v] The only exception was in 2009 when house prices plummeted causing RPI to go negative. CPI, which excludes housing, did not go negative and remained above the deflator.
[vi] These 2012 figures are derived from the ONS report published in August 2013. In the latest report published on 27 November 2013, the deflator for government expenditure was changed to -0.5%. See: http://www.ons.gov.uk/ons/dcp171778_335900.pdf.
[vii] Atkinson, A.B.(2005), Editorial: Measurement of Government output and productivity, Journal of the Royal Statistical Society, 169, Part4, pp659-662.
[viii] Comley, P. (2013), Inflation Tax: The Plan To Deal With The Debts.
[x] Luckily the data still does exist from those who copied it before 2011 and in old ONS publications which are paper documents/PDFs e.g. http://www.ons.gov.uk/ons/rel/elmr/economic-trends–discontinued-/2005-edition/economic-trends-annual-supplement.pdf
In the Economist of 9th November 2013, the lead article is strongly advocating increasing world inflation, ie
‘The biggest problem facing the rich world’s central banks today is that inflation is too low.’
It even goes as far as suggesting that inflation targets should be set at 4%.
In response, Pete Comley has written the following response which the Economist published part of in the 23rd November edition. (Listen to audio version?)
I disagree strongly with your conclusion that the world’s biggest problem is low inflation (“The perils of falling inflation”, 9th November 2013). Low inflation, or even deflation, is not always depressing as you suggest. During the Victorian period from 1840-1900, prices declined by 17% in the UK. During that time, real GDP increased from £45bn to £147bn. The concept of always pursuing positive inflation was only enacted in major economies after World War II. Prior to that, prices went up and down. Since 1945 when central banks started to be tasked to create inflation, prices have always gone up – over thirty times in the UK for example.
Moreover the article doers not distinguish between good and bad deflation. Good deflation occurs when prices are declining because of productivity gains. In this case (for example, electrical goods like computers), declines in prices result in increasing sales.
The editorial also argues for inflation on the grounds that the effects of low inflation are damaging to governments and some consumers with high debts. What it fails to point out is that the debt relief gained by those groups is always at the cost of a counterparty who either does not anticipate inflation correctly or is unable to do so because of central bank’s financial repression policies. Cash savers with low interest rates, workers with below inflation pay rises, and pension funds holding government bonds are all paying for the central bank’s inflation policies.
The world’s biggest problem is not low inflation, but high debt.
Guest blog post published on SaveOurSavers.com on 13 November 2013.
Copy of full article:
Yesterday saw the publication of the October inflation figures. Most savers probably breathed a sigh of relief that RPI had declined to 2.6% (CPI=2.2%). However there are some statistical reasons for this decline and savers are still being squeezed as most prices are rising far faster than this. Moreover this decline in inflation will probably be a temporary one.
The latest figures from the Building Society Association show that interest rates are still declining and the average instant access account (even with a bonus) now pays just 0.75%. Even average two year bond rates are now below 2%. So even if you assume inflation has declined to 2.6%, none of these accounts are going to allow you to keep up purchasing power.
But the picture is worse that this because the headline rate is created by comparing the level of prices in October 2013 with October 2012. Last October not only saw massive rises in university tuition fees to £9000pa but petrol prices were also high that month. These price rises dropped out of the annual rate calculation this month, hence the apparent drop.
Indeed if you look at the rate of rises of almost every other category of goods you’ll see that prices are still rising generally by a rate over 3% – see below. The matter is made even worse by the figures published by ONS today which shows that the latest average wage increase for UK workers is only 0.7%. Inflation is still squeezing us from all sides, despite the claims of economic recovery.
|RPI Category||Oct 2013 annual increase|
|Alcohol and tobacco||4.2%|
|Food and catering||3.4%|
|Housing and household expenditure||2.5%|
|Travel and leisure||0.4%|
Today also saw the Bank of England publish its latest Inflation Report. In the press conference launching it, the Governor, Mark Carney, made it clear that interest rates were not going to rise anytime soon. Even if unemployment drops below its 7% threshold next year, that was not going to be an automatic trigger for rates to go up – in spite of his so called forward guidance on the matter. He’ll only increase them when the slack in the economy is eliminated (a vague term, allowing a lot of wriggle room). This probably translates as meaning ‘not until after the next general election’.
In the intervening period until May 2015, prices will probably have increased a further 4-5% and the average saver lost about 3% of the purchasing power of their money. Inflation tax is still being paid by the people of this country.
 Assuming: (1) 19 months of RPI inflation at the average rate of the last 12 months of 3% i.e. 4.5%. (2) The average saver is receiving about 1.25% interest gross i.e. 1% after tax, and 1.5% after 18 months. (3) Net loss of purchasing power is 4.5%-1.5%=3%.
Pete appeared on BBC Radio 4 on Friday 13th September talking to Tim Harford on More or Less about how the GDP deflator is a lot lower than CPI/RPI. Pete’s view is that it is because of the way that the government estimates inflation on its own expenditure. It does not use inflation in its costs (like wages) but uses measures of quality (such as the number of GCSE grades A-C) to calculate the deflator.
There is a big problem with this. Over recent years when spending has been capped, apparent productivity (as measured by blunt instruments like GCSEs) has carried on improving. Therefore it looks like government is getting more productivity for each pound spent. This means they have to assume a negative deflator (-1.6% in 2012 for example), to make the books balance.
There is a major impact of this quirk of statistics. It has made GDP look a lot higher than it really is over the last 2-3 years. Indeed, had ONS not used these hedonic adjustments, we’d probably been in recession for a large part of the time of the current government.
Moira O’Neill wrote a great article based on the book this week. See: http://www.investorschronicle.co.uk/2013/08/28/comment/smart-money/don-t-fall-for-the-money-illusion-CdSAf8uLO9vMHlNgazC1hN/article.html
Read Pete’s article at My Finances entitled: Forward Guidance: How will it affect savers and investors?