Markets are assuming that interest rates will remain at unusually low levels for a sustained period. Forward rates extracted from the government yield curve imply a Bank rate of about 3.5% in five years’ time – well below its 5.1% average since the MPC’s inception in 1997. These expectations reflect the consensus view that the current deep recession will result in very low inflation, and possibly deflation, over the medium to long term. Yet this consensus may be questioned on several grounds.
One important uncertainty is the longer-term inflationary impact of the huge exchange rate decline since 2007. Many commentators argue that sterling was significantly overvalued in 2007, implying reduced inflationary repercussions from its subsequent plunge. The claim, however, is dubious: a real trade-weighted exchange rate index calculated by JP Morgan was only 7% above its 1985-2006 average at its peak in January 2007 but has since fallen 19% below it. Such a large undershoot is unlikely to be sustained and can be corrected either by a recovery in sterling or higher UK relative inflation. Suppose the real exchange rate returns to its 1985-2006 average over 10 years. If inflation were to bear the full burden of adjustment, UK manufacturing prices would have to rise by 2.2% per annum more than prices elsewhere.
A second possible weakness in the consensus view is the assumption that the recession will produce a large decline in “core” inflation. There are two issues: the prospective size of the negative “output gap” – the difference between actual and “potential” GDP – and the sensitivity of core price trends to this gap. Actual GDP is falling substantially but the credit crunch is also likely to have damaged supply potential, reflecting business failures, investment cut-backs and a possible rise in “structural” unemployment (if workers displaced from bubble sectors prove ill-equipped for employment in other activities). Meanwhile, core inflation could prove less responsive to a widening output gap than suggested by econometric models estimated on data including the inflationary 1970s and 1980s. Core price trends showed limited acceleration when actual GDP was above potential over 2006-08, raising the possibility of a similarly modest response to economic slack.
Medium-term inflation prospects will depend critically on monetary trends. The broad money supply, M4, adjusted for distortions due to the financial crisis, probably needs to grow by 6-7% per annum to be consistent with the 2% inflation target. (This assumes potential GDP growth of 2% and a decline in velocity of 2.5% per annum, in line with the average over 1992-2004, when inflation averaged close to 2%.) The Bank of England’s adjusted M4 measure rose by an annual 3.8% in December – the latest available published figure – but growth should be pushed up to the required level, or higher, by the Bank’s securities purchase programme: planned buying of £75 billion by the end of June is the equivalent of 4.5% adjusted M4 and the MPC has authority to expand the scheme by a further £75 billion. Monetary expansion should also be supported by gilt purchases by commercial banks, partly reflecting regulatory pressure to increase liquidity reserves. Bank buying totalled £26 billion between November and January, up from just £4 billion in the prior 12 months.
International influences on UK inflation will reflect global monetary trends. The Swiss National Bank has also embraced quantitative easing over the last month, while the US Federal Reserve and Bank of Japan are further expanding securities purchase operations. The Fed’s latest plans are particularly notable, involving potential buying of $1.46 trillion over the remainder of 2009 – equivalent to 18% of the M2 money supply. Annual M2 growth has accelerated from 5.5% in August last year to 9.8% by February and could reach 20% later in 2009 if these plans are implemented in full. A similar pick-up is under way in China, with annual M2 expansion rising from 14.8% in November to 20.5% in February. Based on the Friedmanite view that money leads prices by about two years, these trends suggest rising global inflation from late 2010. Friedman emphasised the variability of lags, however, and a faster transmission is possible if monetary acceleration fuels renewed commodity market speculation.
A more esoteric reason for thinking that inflation, rather than deflation, is the greater longer-term risk is historical evidence of a long cycle in prices – the Kondratyev cycle. There have been four major peaks in world prices or inflation since 1800, spaced an average of 54 years apart – see chart. With the last climax occurring in 1974, this cycle suggests inflation should have reached a major trough 27 years later in 2001, to be followed by an upswing to a new peak in 2028-29. Historically, there have been significant shorter-term variations around the long-run trend so the current inflation decline does not invalidate the hypothesis that a secular upswing is under way. The theoretical basis of the long cycle is unclear but the notion that the balance of pressures is shifting gradually to the upside is plausible, based on factors such as faster global money growth since the 1990s, rising resource demand from giant emerging economies and a prospective surge in government debt, which may weaken political support for low-inflation targeting.
