The Brexit interest rate increases and misunderstanding inflation

The Brexit interest rate increases and misunderstanding inflation

Last week’s rise
in UK rates has been extensively analysed (see for example Tony Yates
so I will be very selective. First, the justification for the title
of this post is provided by an extract from the inflation report:

“The overshoot of
inflation throughout the forecast predominantly reflects the effects
on import prices of the referendum-related fall in sterling.
Uncertainties associated with Brexit are weighing on domestic
activity, which has slowed even as global growth has risen
significantly. And Brexit-related constraints on investment and
labour supply appear to be reinforcing the marked slowdown that has
been increasingly evident in recent years in the rate at which the
economy can grow without generating inflationary pressures.”

The last sentence is
particularly important: in plain language it is saying that Brexit is
contributing to lower trend productivity growth, which the Bank now
put at 1.5% compared to a pre-recession level of 2.25%. The wording
is chosen carefully: they are not talking about uncertainty effects,
but permanent effects from a likely deal. So last year worries about
the demand side effects of Brexit led the Bank to reduce rates, and
now concerns about the supply side effects of Brexit are contributing
to higher rates.

Whether these modest
increases in interest rates continue, as the Bank are signalling,
should largely depend on whether the pickup in earnings growth they
anticipate actually happens. As Torsten Bell from the Resolution
Foundation argues here,
the set of information that might justify the Bank’s expectations
of an imminent recovery in earnings growth is not empty, but
nevertheless many economists regard it as a brave forecast.

However the labour
market is not the only reason the Bank is raising rates. Putting
labour market issues aside, they think that because firms are
operating with little ‘spare capacity’, any large increases in
demand will be met by firms raising prices. Ergo the Bank’s job is
to use higher interest rates to stop demand rising too fast. I think
this is conceptually wrong, because it underestimates the role that
demand and expectations about demand play in determining investment

A firm can meet
rising demand in three ways: by investing in more productive
processes, by raising prices or by using more of its spare capacity.
In a traditional economic upswing firms first use spare capacity,
then invest, and when capacity utilisation is at a peak and there
are no profitable investments to make
it raises prices. At that
point it is right for a central bank to step in to moderate demand

This has not been a
typical recovery from a recession. Firms have used up spare capacity,
but have not invested in more efficient processes. This is what
measures of capacity utilisation suggest (taken from an earlier Bank of England
Inflation Report).

If you just take
these surveys as measuring the state of the cycle (and if we ignore
the Bank Agents) since 2013 the economy has been experiencing an
economic boom. Yet from 2013 core inflation has been below target and
falling. You can resolve this paradox by thinking about firms acting
unusually, by failing to invest and meeting additional demand by
utilising capacity as if they are in a boom The result of that is
stagnant productivity growth.

The conceptual error
is to read these capacity utilisation numbers as indicating that
there are no profitable investments to make. We know these profitable
investments exist, because leading firms are improving their
productivity.* What we have is an innovations gap, where lagging firms
are not copying leading firms and are instead holding back on
investing. We do not know why they are holding back, but one obvious
reason is they have expectations of low future growth and/or high
uncertainty about this growth. Empirical evidence shows the strongest
determinant of investment is output growth, and the obvious
rationalisation for that ‘accelerator effect’ is that current
growth influences expectations about future growth.

If this is right,
increases in demand will be met by firms finally coming off the fence
and investing, rather than raising prices. But if the central bank
starts raising interest rates to choke off demand, even when it is
growing slowly by historical standards, it will validate the
pessimism that has been holding back investment and productivity will
continue to stagnate. There is a very real danger that the Bank may
be playing its part in a self-fulfilling low growth recovery.

*Postscript (8/11/17) Discussion here by Berlingieri et al shows this growing divergence between leading and lagging firms is a global phenomenon.

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