Such low inflation looks especially surprising given that the economy has been stronger than expected. For example, two years ago the Bank of England expected the economy to grow by 3.9 per cent between the third quarters of 2012 and 2014. It now looks as if it grew by around five per cent. And yet CPI inflation is on course to slightly undershoot the Bank’s forecast then of 1.7 per cent.
This poses the question: why has inflation been surprisingly low, given the strength of activity?
One possibility is that there is more spare capacity than thought. The clearest indicator of this comes from labour market figures. Whilst these show that unemployment is below 2.1 million on the official measure, they also show that there are a further 2.27 million people not in the labour market who would like to work, and another 1.3 million working part-time who’d like a full-time job. This huge excess supply of labour is holding down wages.
There’s a second reason. Inflation is not as responsive to economic activity as it used to be. Booms don’t trigger big rises in it, nor slumps big falls. The Phillips curve is flatter than it used to be.
One indicator of this is that the variance of inflation has fallen. There are several ways to measure this. One is to look at the average annual change in the inflation rate (regardless of sign) over a ten year period. Doing this for RPI inflation (which has a longer history than the CPI) shows that the average change in the inflation rate in the last ten years has been 1.7 percentage points. This is less than at any time between the 1950s and 1990s – despite us seeing the biggest economic shock since the 1930s.
This tells us that inflation doesn’t move as much as it used to.
It’s not just in the UK that this is the case. Policy-makers in Japan have found it difficult to push inflation up, and inflation in the US has stayed low despite a decent recovery since 2009.
There are two reasons for this.
One is that stronger economies don’t just create shortages which cause inflation to rise. They can also cause inflation to fall. The reason for this was pointed out back in 1986 by Julio Rotemberg and Garth Saloner. Their thinking is simple and powerful. Why would firms cut prices? To win more customers, obviously. But when are there more customers to be had? When the economy’s strong. It follows, they argued, that price wars are more likely in booms. This explains why we’re seeing supermarket price wars now rather than in 2009.
Secondly, inflation increasingly depends not just upon economic conditions here but also on the exchange rate and on inflation overseas. With firms in the euro area having raised prices by just 0.5 per cent in the last 12 months, many UK firms simply cannot raise prices much for fear of losing business to European competitors.
None of this means that inflation will stay low. But it does mean that – barring a shock to oil prices or sterling - any rise should be quite slow. Which is why there’s no rush to raise interest rates.
