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Inflation in recoveries

Created:

27 July 2010

Written by:

Chris Dillow

How different is this recovery from the previous two? This is one question the Bank of England's monetary policy committee should tackle at next week's meeting.

My table shows why. It shows that inflation fell sharply in the two years after the last two recessions. Economic recovery on its own, then, does not generate an inflation threat - quite the opposite.

There are three reasons for this. First, recessions create an 'output gap' - an excess of potential over actual production. In the first stage of recovery, this gap diminishes. But as this is quite consistent with there still being lots of spare capacity in the economy, inflation can fall. Secondly, it is often only as demand recovers that firms engage in price wars; it is only when there are customers out there that it makes sense to cut prices to win more demand. And, thirdly, the early stages of an upturn usually see companies able to increase output by working their existing employees harder. This means that productivity soars and unit wage costs fall.

All of which poses the question: why should this recovery be so different?

Of course, there are differences with the 1980s. Back then, unemployment continued to rise and oil prices fell. It's possible - but by no means certain - that neither will happen this time.

Instead, there might be two other differences.

1. This recession - more than its two predecessors - has seen our supply potential fall, so the output gap hasn't widened much.

This is undoubtedly true to some extent. But is it really the entire story of this recession? Is the 5.1 per cent fall in GDP since its peak really completely a reduction in supply potential, and none a fall in demand short of potential? This would be a big claim.

2. The path of government debt looks a lot worse now than it did in the 1980s and 1990s. This poses the threat that the debt will be monetised in future. And even if this doesn't happen for a while, the danger that it might do so even in the distant future is a reason for prices to rise soon.

You could claim that the biggest factor behind the second-quarter's rise in GDP - the 6.6 per cent surge in construction output - is consistent with this. Builders have been trying to get work done before costs rise, in the hope of benefiting from future inflation; it's often houses and offices that do especially well in inflationary times.

However, one big fact suggests that fiscal inflation isn't a big immediate threat. The gilt market's inflation expectations are low; the breakeven inflation rate for 25-year bonds is just 3.2 percentage points - less than it was in late May.

Personally, then, I'm not convinced that the differences between this and the last two recoveries are sufficiently great as to suggest that inflation is a pressing problem.

However, it doesn't follow from this that there is no case for a rate rise next week. There might be.

The thing is that Bank rate was cut to 0.5 per cent in part as insurance against a catastrophic meltdown in the economy. As that risk has receded, so there might be a case for paring back the insurance.

This is especially true because rates are very low, relative to what the Taylor rule predicts. With CPI inflation at 3.2 per cent, one reasonable interpretation of this rule says that a 0.5 per cent Bank rate is only warranted if the output gap is over 8 per cent of GDP. But few economists think it's that big.