There is growing acceptance that high UK inflation cannot be explained simply as the result of a series of adverse one-off factors, as claimed by Bank of England Governor Mervyn King in recent explanatory letters. External Monetary Policy Committee (MPC) member Andrew Sentance has linked the overshoot to a surprisingly strong recovery in nominal spending, while his colleague Adam Posen argues that inflationary expectations have become dislodged from the target. Is there a fundamental driver linking these views?
Previous posts have argued that the root cause of disappointing inflation performance has been an excess of the supply of money over the demand to hold it. An attempt by consumers and firms to eliminate this surplus has contributed to the pick-up in nominal spending; an environment of excess liquidity may also have made it easier for companies to pass on higher costs while increasing unease about inflation prospects.
Most economists with monetarist leanings have dismissed the possibility of such an imbalance because of the slow pace of broad money supply expansion in 2008-09. The surplus, however, is the result not of an excessive rise in supply but rather a fall in demand, as negative real deposit rates have encouraged investors to rebalance portfolios away from money into assets offering a higher yield and / or inflation protection.
To the extent that the possibility of a decline in money demand is acknowledged, the consensus is that this represents a one-off shift, implying no lasting economic implications. Such a view, however, is at odds with experience in the 1970s, when a fall in the ratio of money to national income was sustained for several years as the monetary authorities, as now, maintained official interest rates well below the rate of price increases.
A pick-up in money supply expansion, moreover, could now be taking over from declining demand as the key driver of surplus liquidity. The Bank's favoured broad money measure, M4 excluding holdings of non-bank financial intermediaries, rose at an annualised rate of the 9.2% in the three months to May, the fastest since the third quarter of 2007 – see chart.
The consensus is that this pick-up will, again, prove temporary because bank lending to the private sector remains weak. Money and lending, however, can, on occasions, diverge significantly. One possibility is that the combination of Eurozone stability worries, an undervalued exchange rate and the coalition’s early action to tackle the fiscal deficit will result in a sustained inflow of foreign capital into the UK. A combined surplus on the current and non-bank capital accounts of the balance of payments will, other things being equal, expand the money supply relative to private sector lending. Recent strong foreign buying of gilts and Treasury bills could be an early indication of such an inflow.
The risk, therefore, is that the supply of money will continue to run ahead of monetary demand, with the excess sustaining faster nominal spending growth and higher inflationary expectations. The neo-Keynesian MPC is relying on fiscal tightening to slow nominal income expansion but it may simply result in a less favourable real growth / inflation split, particularly in view of the VAT rise and other tax increases planned for next year.
On this analysis, there is little prospect, on current policies, of inflation returning sustainably to target. An early rise in official interest rates is warranted, not to choke off faster money supply expansion but rather to boost demand to eliminate surplus liquidity. Higher rates would further increase the UK’s attractions to foreign investors, with an increased capital inflow likely to put upward pressure on the exchange rate and partially offset the impact of a rise in the demand to hold money on the monetary imbalance. An appreciation of sterling, however, may be needed to reverse the recent upward drift in inflationary expectations and allow a more favourable real growth / inflation division of nominal income expansion.