I'm in the process of writing a guide to UK monetary policy, and thought I'd take a look at the material the Bank provide for participants of their Target 2.0 competition. In it's explanation of the cause of inflation, it says,
But what happens if there is an increase in demand for some reason, for example due to a reduction in income tax, or because consumers suddenly feel more optimistic and start spending more money rather than saving?
• Consumers’ expenditure – spending on goods and services by households in the United Kingdom;
• Capital expenditure – investment in buildings and new equipment;
• Expenditure on stocks of goods – spending by firms on increasing their inventories of goods and materials;
• Government expenditure – spending by central and local government on health, education and other public services;
• Expenditure on exports – spending by foreigners on UK goods and services; and
• Expenditure on imports – spending by UK residents on foreign goods and services.
The ultimate cause of inflation can really be said to be central banks, like the Bank of England. Their behaviour and actions determine whether inflation is allowed to rise or is kept low – in other words, whether they allow prices to rise unchecked by monetary policy, or whether the central bank seeks to influence the amount of money in the economy.
But what happens if there is an increase in demand because of an increase in the money supply
The recent update to the MA compilation method revealed a sudden reduction in the growth rate. However this was driven by a mysterious "improvements in reporting at one institution", which saw £85bn vanish in January 2014. I made a shadow M' series which added this back in, but that's not ideal.
I've just tried an alternative response, which is to strip MFI deposits from the measure. We can call this MAex, and here's the series from April 1991:
If you want to see a more recent look, here it is from January 2001:
I'm continuing efforts to improve the measure.
In my post on neutral interest rates I mentioned productivity figures. I wondered whether the reason the estimate of the (real) neutral interest rate of 1.8% (which is implausibly high) is a function of (i) using the wrong productivity measure; (ii) the problems with UK productivity measures. Labour market productivity is released each quarter, but ideally we want to use MFP.
The closest I've come is a January 2014 ONS estimate of MFP. It's labelled "experimental" but at least provides annual data from 1997-2012. It looks like this:
If anyone is aware of quarterly estimates, I'd be interested to know.
Having begun with such a confident headline, the rest of this post will involve a lot of backpeddling. For many economists (not just Austrians) the Wicksellian rate of interest (or "natural" or "neutral" rate) is of central importance for macroeconomic stability. In fact, one might argue that it isn't merely an indicator of the monetary stance - it is the stance.
Indeed David Beckworth and George Selgin argued this in a 2010 working paper. This morning I thought I'd attempt to make a very rough estimate of what interest rates would be in the UK - if they were at their natural rate. Their method is based on a Ramsey growth model that says that the neutral rate of interest is a function of productivity growth, population growth, and time preference. For simplicity, they focus on the component that is likely to be most volatile - productivity. Their equation for their estimate of the neutral rate is as follows:
In other words, the neutral rate today is equal to the long run steady real interest rate, plus the difference between expected Total Factor Productivity Growth, and the long run average TFP growth rate.
Following them, I assume that the long run steady real interest rate is 2%. For the productivity figures I used the quarter on quarter growth rate of output per worker (series code A4Y0). I then calculated expected TFP using the following approximation of an exponentially weighted moving average:
Again, following Beckworth and Selgin I set the coefficient at 0.7. The output is as follows:
Once I've had a think about possible errors I've made, and corrected them, I will add this to the data section of the Kaleidic website, and update it regularly. I think the chart broadly fits with intuition - fluctuation between 2%-3% prior to 2008, and then crashing into negative territory. Post crisis the rate is noticebly lower than before, with the latest estimate (Q4 2013) at 1.8%
We cannot observe the real neutral interest rate. But we do know that the long run average should roughly equal any actual long run value, and we do know something about the underlying determinants. I think Beckworth and Selgin have made an important contribution. A few discussion points to bear in mind:
- I've not factored any population changes in, but an increase in working age population should increase our estimate.
- I used quarter on quarter growth rates because they lead to less volatile results but Beckworth and Selgin use year on year rates
- This estimate is a real rate, so shouldn't be compared to a nominal policy rate without correcting the latter for inflation.
- Beckworth and Selgin are obviously comparing this to a real Federal funds rate in order to get a measure of the monetary stance. The Bank of England's Bank rate isn't the same thing as the Federal funds rate, however, so it might be better to compare the estimate of the natural rate with an overnight interbank measure for the UK.