Central bankers have been on a wild ride in the years since the financial crisis. In 2010-11 the Bank of England was explaining why, despite inflation near 5 per cent, it was expanding the money supply and keeping rates at historic lows. Now, the Bank expects deflation in the near term and aims to raise rates in early 2016. What is going on? Chris Martin explains.
Currently, the UK economy is like an optical illusion. Looked at in one way, things are going very well. Output has made up the ground lost in the financial crisis and is growing at the fastest rate in the G8, while unemployment is falling faster than anyone expected. But a slight shift in perspective reveals a very different picture. Output per capita is still below the 2008 level, real wages are 8 per cent lower than they were, there is no sign of a recovery in productivity and investment remains stubbornly low. The truth may be out there, but it is hard for the unbiased observer to make sense of it all.
And then there is inflation. This was touching 5 per cent in 2010-11, despite the financial crisis and the Eurozone crisis. The Governor of the Bank of England had to explain why the Bank was not raising interest rates and was instead using quantitative easing to increase demand when inflation was so far above the 2 per cent target. But in early 2015 inflation is 0.5 per cent and has a better than even chance of going negative. The Governor is now explaining why the Bank is not cutting interest rates, unlike the Eurozone, Sweden and Denmark and is not embarking on a fresh round of QE.
What is going on? The oil price is a major factor. The price of oil rose by over 50 per cent in 2010. Over the past year it has fallen by nearly 200 per cent. This fall in price is driving down inflation. But this is likely to be temporary. Oil prices will only keep on supressing inflation so long as the price keeps falling. A stable oil price, no matter how low the level, will not directly affect inflation. This is why the Bank of England did not raise interest rates in 2010 and why they are unlikely to reduce them in 2015.
But the oil price has an indirect effect on inflation. A lower oil price is associated with higher output and more employment. This puts upward pressure on wages, pushes up costs and leads to higher prices. Once the impact of falling prices has unwound, the impact of lower prices should increase inflation. The recent Bank of England Inflation Report reflects this view, although it does not expect this to happen before 2016 and sees a relatively small effect when it does come. Surveys and the usual leading indicators are suggesting that deflation, if it happens at all, will be small and temporary.
Nonetheless, the Bank is pushing back the date of the much anticipated increase in interest rates, now not expected until early 2016 (although a cynic might point out that the Bank has been predicting an interest rate rise in 12 months time at least since early 2010). This is despite an expected increase in the US interest rate, often the bellwether for changes in UK interest rates) as early as June this year. This probably reflects the deterioration in the outlook for the Eurozone that has meant that even Germany has reluctantly agreed to the ECB launching (a limited and timid version of) QE and increased uncertainty as the standard bearers of popular resistance to austerity begin to gain power.
Central bankers often say they want to be boring and predictable, cautious drivers who keep inflation on track by slightly nudging the economy up or down. At times over the past 8 years, central bankers have been more like white water rafters, clinging on an unstable economy and pulling hard on every policy lever they have to steer the global economy through treacherous rapids. Things are calmer now, but there is still a lot of uncertainty. We should continue to expect the unexpected.
Note: This article gives the views of the author, and not the position of the British Politics and Policy blog, nor of the London School of Economics. Please read our comments policy before posting. Featured image credit: Michael Button CC BY 2.0
About the Author
Chris Martin is Professor of Economics at the University of Bath. He is a specialist in macroeconomics and monetary economics, especially models of interest rate setting, the Phillips Curve relationship between inflation and output and non-linear macroeconomic models.