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Getting inflation wrong

The Bank of England's longstanding idea of what causes inflation might be plain wrong
Getting inflation wrong

Has the Bank of England been consistently wrong about inflation? This is the question I hope next week’s Inflation Report answers.

For years, the Bank has believed that inflation rises when the level of output reaches its “potential” level – that spare capacity (the output gap) holds prices down while a lack thereof pushes it up.

Recent developments, however, are inconsistent with this. Unemployment is now at a 42-year low, and the Confederation of British Industry (CBI) estimates that capacity utilisation is at a 29-year high. But inflation has been high recently only because sterling slumped in 2016, and economists expect it to fall this year. A lack of spare capacity, then, is not raising inflation. Why?

In the labour market, we have a plausible explanation, suggested by Andy Haldane, the Bank’s chief economist. It’s that wage bargaining has become more atomised – in part because of the decline of trades unions – which means workers are less able to convert low unemployment into pay rises than they used to be.

This, though, isn’t the whole story. Manufacturing output price inflation fell last year despite rising input prices, higher unit wage costs (thanks to stagnant productivity), less intense foreign competition as a result of sterling’s fall, and higher capacity utilisation. Why?

One possibility is that it is not the domestic output gap that matters but the global one. An inability to produce more at home need not raise inflation if the extra goods can be imported from a country that does have idle capacity. On this view, inflation is being held down by spare capacity in China and the eurozone (although the latter is growing well it is doing so from a low base: 8.7 per cent of the region’s labourforce is still unemployed, which points to still-unused resources).

There is, though, another possibility. Perhaps the very notion of full capacity and hence of a zero output gap is nonsensical. A nice study of a US steel mill by Igal Hendel and Yossi Spiegel has shown why. They showed that the mill doubled production over 12 years even with the same plant and workforce. This was because every time the mill seemed to be at “full capacity”, its managers found ways of tweaking production methods to eke out more output. “Capacity is not well defined,” they conclude.

If this is true of an old-fashioned steel mill, it’s likely to be more so of more modern intangibles-intensive firms of the sort described by Stian Westlake and Jonathan Haskel in Capitalism without Capital, which are often more scalable than old-style factories. What is Amazon’s capacity? Or Facebook’s?

This suggests that what looks like full capacity might lead not to inflation, but to productivity improvements. This is consistent with the fact that productivity in both the UK and US has jumped recently after a decade-long stagnation.

If this is true, it means conventional economic thinking is wrong. It has for years separated the study of long-run growth from that of short-term fluctuations and macroeconomic management. The separation is, however, a modern one: mid-20th century economists such as Joan Robinson and Nicholas Kaldor rejected it. And if full capacity generates not inflation but productivity gains, they were right and their successors wrong.

This wrong turning – if such it was - has been catastrophically expensive. It means tight macroeconomic policy has not so much had the benefit of holding down inflation, but the cost of lower innovation and productivity and hence sustainable growth. In this sense, we might all be much poorer because economists failed to learn from both the 20th century greats and from how real firms actually work.