Monday, Sep 06, 2010
Does this negative number re capacity utlisation explain IR policy?
H.M. Treasury: Inflation and the output gap in the UK: march 2010
this was part of a discussion with easybet man re tightness in cap utilisation. i think it goes some way to explaining uk ir policy:
".. this paper demonstrates that the level of the output gap has an important role in
explaining inflation and suggests that the lagged effect of the large negative output gap will generate
significant downward pressure on inflation over the next few years. The analysis also finds
strong empirical evidence of the influence of import prices on inflation, with a one-off shock to
import prices taking around 1 year to fully feed through to inflation. .. The analysis has informed the
Treasury’s view on recent inflation developments and underpins judgements on the prospects
for inflation."
Posted by techieman @ 11:56 AM (1148 views) Add Comment
16 Comments
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1. techieman said...
page 20 of the report (26 of the pdf) has a nice chart.
What Does Output Gap Mean?
An economic measure of the difference between the actual output of an economy and the output it could achieve when it is most efficient, or at full capacity. There are two types of output gaps: positive and negative. A positive output gap occurs when actual output is more than the full-capacity output. Negative output gap occurs when actual output is less than full-capacity output.
2. Crunchy said...
Does this negative number re capacity utlisation explain IR policy?
I think the negative number re capacity was -9/11 when Greenspan set his IR policy.
Carry on by all means.....
3. alan_540 said...
techie, this is my understanding of the above :
i) So low demand is keeping prices down basically (with regard to domestic production)
ii) And imported goods haven't caught up (yet) with a devalued pound
iii) A low interest rate will help stimulate the economy and will not lead to high inflation in the short term because of the above and will more importantly help prevent deflation
seems to me to be supply-demand pure and simple, but i'm probably missing the finer points!
4. mark wadsworth said...
Techie, keep up the good work. On the earlier thread the score is Deflation 3: Inflation 0.
5. paul said...
This of course completely and ignores the fact that the Bank created the import inflation by lowering rates when inflation was rising.
Convenient omission.
6. easybetman said...
Thanks techieman for the paper. The same chart is interesting though, in 1975 - 85, the output gap was up to -8% and they managed to have double digit inflation - so that was 'output gap' that never was - more money were created than the ability of the economy to produce (perhaps due to labour factors etc) and the lot were happy to run -ve interest rates for years until Paul Volker lead the charge to stop it.
7. techieman said...
"This of course completely and ignores the fact that the Bank created the import inflation by lowering rates when inflation was rising.
Convenient omission." eh? i think you miss the point of the document and the post paul.
the posting is to try to explain why the treasury (and not the BoE) are looking at the output gap to explain why they believe there is or isnt underlying in(de)flationary pressures in the economy. I suppose i am making a leap that the mpc will use this information in the same way, and predicate monetary policy on it.
Well spotted easybetman - i think though this addresses the point you made before about tight capacity in the economy. I am no expert on all this, i just thought its something that "we" may have overlooked. if you like your comment on capacity utilisation got me thinking, as i thought i had seen this somewhere before. of copurse things may have changed since march - i would like to see an update of this graph.
As part of the budget (FWIW) they give some forecasts of this - see http://www.hm-treasury.gov.uk/d/junebudget_supplementary_material.pdf - page 3 (7 pdf)
Re the 75-85 period i think we had the oil price shock and a wage / price inflationary spiral in part contributed too by the unions. Then i think IRs were ratched up to squeeze the inflation out, and perhaps thats why there was the gap then with little disinflation let alone deflation. However i could stand corrected on my short summary of historical movements.
the fact remains that if the treasury look at this and have correlated it currently to IR policy, then i think its one thing (but perhaps not the only thing) we need to be aware of when trying to determine the risks - both inflationary and deflationary - to the economy.or at least to determine the likely policy response to the perception of either.
of course these are all aggregate numbers and the devil is in the detail. one issue is the same as always that IRs are a pretty blunt instrument - in that respect we are like the Eurozone in minature. Just as some countries needed higher IRs to squeeze the inflation some didnt, some sectors probably need a IR stimulus and others dont.
i have read the summary a couple of times and its not the easiest thing in the world to get your head round... but perhaps like tesco - every little helps!
8. techieman said...
easybetman:
summary @ 1.2 "There has also been a big fall in output as a result of the recession and, while there are significant uncertainties surrounding current estimates of the output gap, it is likely that a large degree of spare capacity has opened up."
9. techieman said...
paul the paper deals with many issues you raise. for example it explains the effect of the trade weighted index fall in sterling and the extent and likely ongoing effect this will have offseting deflationary pressures caused by the output gap.
it is an interesting - albeit difficult read. it seems like you are one of those people who have ingrained ideas. all i am doing is leading you to the water - its up to you whether you drink it. remember this is explaining WHY they are doing what they are doing. Of course people can have their own views as to whether what they are doing is right or wrong. i dont say they are 100% right in doing what they are doing or their conclusions, i am however interested in anything that helps explain why they are doing it. imo this paper deserves more than a cursory look for that reason.
10. Crunchy said...
9. techieman
They do what they want to do, regardless of numbers, past form being considered here. Save your time and energy is my view.
There is a much bigger picture and getting distracted is very easily done.
Have a cup of tea and think about where we are heading and how they are going to get us there.
This is about management through economics, not managing economics.
11. easybetman said...
@techieman,
Thanks for your feedback and I think such quality discussions allow all of us to learn and to find the truth.
Totally agree with you that it is not an easy piece of literature to read and I too spotted that interesting graph on first glance thorugh.
1. Contrary to HMT guesses in section 1.2 (yap, we are all guessing), in private moments, those BOE chaps thought differently:
"It was also noted that the level of spare capacity might be lower than many currently judged."
Source : http://www.bankofengland.co.uk/publications/other/monetary/roundtable/100823.pdf
2. If one look closely into CPI components:
http://www.statistics.gov.uk/pdfdir/cpibrief0810.pdf
Actually, those 'imported' items are not contributing to inflation (though imported oil etc may indirectly do so). At least the sterling devaluation excuse cannot reasonably explain most of the effects. There are quite a bit of 'home brew' inflation here (so, those with pricing power are taking advantage of that power)
3. Agree IR is a pretty blunt instrument. It always is. My believe is that it is better for BoE to ensure price stability and that the commercial banks are safe AND HMT does the stimulus/economic policies bits.
4. Re 1975 - 85, inflation is always a monetary phenomena and while unemployment was high, the money creation ran even faster and hence the double digit inflation (until Paul Volcker etc stopped it). While 2010 M4 increase is small (+2% ish) year on year, the M4 growth between 2000 - 2010 (mainly 2000-2007) had been phenomenal. The 'extra' money are now coming home to roost. When there is more money around (mostly in the wrong hand, perhaps) than real economic productive capacity, I don't feel that 'spare capacity' is a reasonable word to use. Also, a good chuck of the 75-85 spare capacities are in the wrong place (coal mining etc) which weren't exactly spare capacities at all (if there is no plan to resume coal mining, surely calling those unemployed miners spare capacities is bordering cheating).
As we are now, those businesses who have closed down so far tend to be those who are over leveraged and perhaps those locked in expensive leases. The demand haven't 'collapsed' but these 'weak' capacities gone because they are weak (e.g. need 100 shoppers a week, and if that drops to 95, it was enough to cause them to go belly up. In absolute term, the demand had just been reduced slightly). Credit crunch prevent those capacities from coming back on line (plenty of empty offices, shops and factories but few people can / willing to bring them on-line - perhaps prices aren't right and landlords are hoarding those properties and demanding unrealistic rent/prices.) So is it fair to call spare capacities that cannot be bring back on line quickly spare capacities?
Then we have areas like rail transport which to bring on new capacities are immensely costly and oh yes, the train companies have been merrily raising prices. I think National Statistic haven't hedonically adjusted these rail prices, given how awful it is to travel now in trains, the hedonically adjusted price inflation must have been shocking. (Of course, NS happily does the hedonic things when it suits them).
12. easybetman said...
Just thought of something - is it reasonable to call unemployed mortgage advisors, CDO creators "spare capacities" as they are now? Or these people are not really spare capacities until they are retrained ? (In 1975-85 these were the 'coal miners').
13. techieman said...
easybetman - interesting comments, what is your background / job if you dont mind me asking?
just an observation - you seem to be arguing with yourself a bit about the 75-85 era, i.e. explaining away why there is a negative rate then. whereas before you seemed to be saying that like now there was a negative rate but we had double digit inflation then.
my basic thoughts on this are that we just need to understand what they are doing and the reasons for it. you have shown examples where this chart may just be plain wrong, but overall - as we have both alluded to - nobody really knows (even HMT) - i.e. i think it probably lags and anecdotal evidence is probably as good as anything else. we cant really say - oh yes they are completely wrong because we dont have the data they have.
having said all that yes m4 is still positive, but my point on it is that despite the stimulus it is still trending down and the main volatile component - i.e. m4 lending is contracting y-o-y. i have no problem with the inflationist or even hyper inflationist point - which yes is probably a matter of timing, but for it to be right we need to see the trend reverse imo. i know you are saying look where we were as well, but i dont agree with that - again you could be right and i wrong.
overall i am pleased you have engaged on this because its interesting to hear well reasoned views rather than "boE bad" "huge inflation round the corner" etc.
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15. easybetman said...
Hi techieman,
Send me a PM and we can chat more. I can see a techieman on the main forum with just a few post - so not sure if it is you.
Re: 75-85, oh yes, the main reason of negative rates was fast monetary growth and probably velocity growth as well. Everything is relative you see - if MV (over a period) down, capacity down faster, inflation. If MV (over a period) up, productivity up even faster, then deflation.
I don't see double digit inflation now but probably 5% or so based on real index, not those in statistician wonderland. For the hyperinflationist, first they got to define hyper, if they are talking about 1E10^6%, I don't see that. There is only 1 cause of hyperinflation - velocity, which is directly affected by confidence. So, if Zimbabwe had printed 10 trillion but being nice to its people and its people were happy to use the money, then it probably would have settled at1e10^3% rather than 1E10^10.
As for M4 - I think we need to look at this over a period. These sort of things does not have effects immediately (even if there are 2-3 quarters of -ve M4, it doesn't means deflation. But 10 years of -ve M4 is of course deflation)
Finally thanks - nice discussions with you too. We are here to be student of the truth (and allocate portfolios accordingly).
16. easybetman said...
Just remember, when Volcker turned off the inflation pump at 1980, my guess ( I don't have data) is that M4 lending must have grown negative for several quarters and yet inflation raged on (though less furiously). I think we are just going to pay for the past 10 years of monetary inflation - no free lunch... The questions is of course who pays, and the answer tend to be the innocent...