Could consumer price inflation be caused by higher rates?

Woody spends much of his time tutoring A-level students in economics and hence has to spend quite a lot of time pretending that standard theory about growth and inflation is adequate. However now that the exams are finished he can suspend belief for the time being and instead try to make sense of what is going on.

And the question that struck me was: could it be that the inflation in consumer prices that we are experiencing is the result of tighter credit conditions, rather than excessively loose ones as one would normally suppose?

My thought process went as follows.

When monetary conditions were loose, it didn't alter the demand for consumer goods very much because demand for them isn't that income elastic. (Richer people don't really spend that much more on petrol or food.) But loose monetary conditions reduced the costs for firms making and selling consumer goods, so that supply grew and prices therefore remained pretty low. Instead people spent more on housing which is highly income elastic. So loose monetary policy created house price inflation and consumer price disinflation / deflation. So far so good.

Now that monetary conditions have tightened substantially (a higher base rate + a higher risk premium demanded by lenders), this dynamic has reversed. People's demand for food, oil, and consumer goods hasn't altered all that much (because it's income inelastic). But the cost to firms of making and selling those products has risen sharply as borrowing costs have risen. Hence supply has fallen, but demand has stayed roughly the same - causing prices to rise. And the reverse has happened in housing. Higher borrowing costs have caused demand for housing to fall and supply to simultaneously rise - leading to falling prices.

So I tried to gather some data to check whether this might show up. I put together the chart at the top which shows how LIBOR and CPI have changed over the past few years. There is a pretty close correlation, but (and Woody might well be imagining this), the major trends appear to occur in LIBOR first, then some months later in the CPI. If so, then the current increase in CPI may have been caused by the spike in LIBOR caused by the credit crunch towards the end of 2007.

If this is right it suggests that the standard AS / AD approach to growth and prices fails to appreciate that in the modern economy - particularly for goods not usually financed through borrowing - the effect of higher borrowing costs may be more powerful on AS than it is on AD in the short run, hence having a perverse effect on prices.

Perhaps once the falling housing market hits demand in the wider economy, leading to unemployment, lower investment and lower consumer confidence, then but only then you get a fall in demand that outstrips the fall in supply caused by the higher borrowing costs. Then you get deflation / disinflation.

So maybe tighter monetary policy in the short-term leads to consumer price inflation, but in the medium-term to consumer price deflation. If this is right it suggests that CPI will indeed fall in the next year as a result of the fall-back in LIBOR, but won't fall substantially until LIBOR goes much lower.

Oh dear, what will Woody tell the kids?

Rising inflation to clobber profits, jobs

Yet another 'surprising' surge in inflation to 3.8% on the CPI (Completely Pointless Index). As usual the inflation is coming mostly from imported goods, particularly oil and food. Firms will try to pass on these increases to consumers, but will mostly fail because real wages are falling and consumer credit is drying up.

Instead they will mostly have to take the hit in their profit margins (which have been at all time highs over the past few years) as consumers cut back and find alternatives.

This means lower investment and higher unemployment, exacerbating the forthcoming recession. This is already happening. Confidence in the service industries has plummeted to an all-time low (see chart). Meanwhile, unemployment has jumped at its fastest rate for 15 years.

In an economy where growth is entirely reliant on the service sector this spells disaster. Anyone suggesting a rate increase at this stage might possibly help matters is barking.

The debate over rates is pointless - we're in trouble either way

While there is growing consensus that the global economy is in big trouble, there is an ongoing and very confusing debate about the cause of the trouble, and therefore what central banks should be doing about it.

Broadly there appear to be two schools of thought. In one corner stand the Inflationists which point to the take-off in inflation in China, India and much of the developing world. They see this as leading to higher inflation in the West, perhaps leading to an inflationary spiral which destroys the value of our currency (see e.g. Eric Janzen). These people are often the types to be burying bars of gold in the ground.

In the other corner stand the Deflationists which see the destruction of credit, and mounting bank losses as potentially bringing about a deflationary spiral which could ultimately lead to something like the Great Depression. See e.g. Mish. They think that banks should be vigorously cutting rates in an attempt to prevent this. These guys are buying bonds and waiting for the dust to settle.

These two camps are currently engaged in a lively debate over whether banks should be lowering or raising rates.

The fact is that the debate is pointless. It doesn't really matter whether central banks raise or lower rates. Either way the global economy is going to face a painful period of readjustment which will probably mean a period of recession and lower living standards in both the West and most emerging economies.

If we slash rates, our currencies will fall, imports will get much more expensive, eroding spending power, leading to a consumer recession, falling profits and rising unemployment. On the other hand we can raise rates, which will clobber the housing market further, depress consumer spending and lead to falling growth and unemployment.

Either way the result is basically the same. Central banks can't fight the economic fundamentals.

For the past 10 years the West and China have been stuck in a Faustian pact in which the yuan has been kept artificially low, allowing the Chinese to grow fast, while Western consumers could buy more goods than they could really afford. The large-scale sale of yuan and purchase of dollars by the Chinese allowed this to persist while keeping interest rates low in the West.

It seemed to be the best of all worlds. Continuous growth, low inflation, low interest rates, low unemployment, fast growth in the developing world. But it couldn’t go on forever, for it was built on a lie – the fiction embodied in the artificially low value of the yuan against other major currencies.

This lie allowed the Chinese to expand production and exports without having to worry about bothersome things like productivity or efficiency. And it allowed Western consumers to increase their spending while their wages stagnated.

But of course it couldn’t go on forever. Either the Chinese would be unable to buy dollars as fast as the rest of the World was selling them, or American consumers would be unable to spend as fast as China wanted to produce. In the end it was a bit of both. By 2007 US consumers were maxed out, and could spend no more, while servicing their huge debts. At the same time investors started to dump dollars en masse, sensing an economic downturn.

What we are seeing is the beginning of a gradual and inevitable reversal in the terms of trade. Chinese goods aren’t really getting more expensive, it’s just that they are no longer able to subsidise them as much as they have been. They’ve kept the exchange rate down but inflation is now making that effort pointless. The same goes for oil exporting nations. The lie is finally being exposed, and we are all facing the consequences.

In the longer term the result of this will be lower consumption (but possibly more production) in the West and lower production (but possibly more consumption) in the East. But that shift is going to be neither swift nor painless.

What central bankers and policy makers should be discussing is not how to prevent, or slow down the necessary rebalancing of the global economy, but rather how it can best be effected with the minimum of lost growth and welfare.

Unfortunately, like many things in life, big changes usually only happen as a result of an extended period of suffering. It's going to be unpleasant.

No consumption, no growth

Been feeling poorer recently? That's because probably you are.

The chart shows what has happened to the level of real wages (growth in earnings adjusted for RPI) since Dec 06.

That's right over the course of a year the average worker has got about 10% worse off as a result of wage growth falling below RPI.

In the past few weeks the commentariat have gradually come round to the idea that the UK economy may be in trouble. Most economists now predict a slowdown in the UK economy with a few foreseeing a recession in 2009.

Now Woody likes nothing better than to violently disagree with a growing consensus. And in a manner of speaking he does.

The consensus is still ridiculously over-optimistic on growth.

In our economy the primary driver of growth is the consumer. Real wages are falling. For the past few months the UK consumer has been raiding the remainder of its meagre savings and slapping the rest on plastic in a desperate struggle just to maintain living standards.

Meanwhile borrowing costs are rising, as is unemployment. House prices are falling, and mortgage equity withdrawl is drying up.

So how on earth can consumption grow in this environment? It can't, it's going to fall sharply, and stay lower for a long time while household balance sheets are repaired. And with falling consumption will come recession.