Fundamental Macro

Andy Haldane, the BoE’s Chief Economist, gave a rather extraordinary speech yesterday (here). What was so extraordinary about it was just how off-message it was compared to the recent Inflation Report (which he oversees), MPC minutes and comments from Governor Carney at TSC. The MPC set-up not only allows for, but through the parliamentary process requires, individuals to explain their own views and how those views led them to vote in a particular way. So there is no reason for the Chief Economist to line up behind the Governor (indeed there have been plenty of examples when they have dissented in the vote), but what is more odd is that the speech didn’t line up with the various (recent) opportunities Haldane had to put forward these views. So the markets were once again surprised (short sterling rallied and the pound fell) when he concluded that:

“The risks to inflation at that horizon are plainly two-sided. But my personal view is that these risks are skewed to the downside. In my view, that means policy needs to stand ready to move off either foot in the period ahead to meet the symmetric inflation target.”

He thinks that the odds of the next move in Bank Rate being a cut are the same as a hike.

That compares with Governor Carney’s view at TSC last week that:

“The thing that would be extremely foolish would be to try to lean against this oil price fall today. (That’s) because the impact of that extra stimulus …. would happen well after the oil price fall had moved through the economy and we would just add unnecessary volatility.”

And in the minutes for the March MPC meeting, which was just two weeks ago, there was no mention of this view from any members of the Committee. Indeed, the minutes said that:

“There was a range of views over the most likely path of Bank Rate in future, but all members agreed that it was more likely than not that Bank Rate would increase over the next three years.”

While one could argue that Haldane can square that circle by saying that he could envisage a cut(s), followed by subsequent hikes, such that the statement remains true. But I would say that was somewhat disingenuous.

But what about the substance of the speech. Is he right that the odds should be evenly split between a hike or cut next? And will he be able to convince the others on the MPC of that?

Haldane breaks the argument down into two parts:

1. The impact of the drop in energy and food prices
2. The drag from the slack that remains in the economy following the crisis

Consistent with the Governor’s recent letter to the Chancellor, he says that around two-thirds of the fall in CPI inflation is due to (1). That leaves one-third to explain via (2).

Haldane argues that you can break (2) down into three catagories:

1. The amount of slack
2. The relationship between slack and inflation (slope of the Phillips curve)
3. Inflation expectations

He says that based on the current specification of their model(s) and the Committee’s agreed view on the amount of slack (which I might add he has signed up to as well), that wages have grown much more slowly than expected. So a logical conclusion is that either there is: more slack than they thought; the slope of the Phillips Curve has flattened; and/or inflation expectations have fallen. Taking each of those in turn:

On slack, Haldane doesn’t provide any new insights or analysis, but instead does a thought experiment of simply increasing it in order to bring down the model estimate of wage growth.

While there is undoubtedly lots of empirical evidence to suggest that the Phillips Curve has flattened (across many countries) that evidence is looking over long periods, and I would argue is much less convincing when looking at the most recent period. Again, the thought experiment he does is pretty arbitrary, rather than based in evidence.

Finally, on inflation expectations, he shows that longer-run expectations have fallen below their pre-crisis average. However, the pre-crisis history is very short (just 2 years) and may not be a good guide for the true mean of the series. Moreover, the decline is highly correlated with shorter-term measures and actual inflation. Therefore, one would expect them to rise again as the deflationary impact of lower energy prices drops out next year. And in his analysis of market-based measures of inflation compensation, it is a shame he does not consider the impact of a change in the inflation risk premium (something the Fed have highlighted).

So I don’t find his argument/thought experiments particularly compelling. At the end of the day, there is a puzzle around wage growth, he offers up some possible ways of explaining the puzzle away, which if true would pose downside risks to the outlook for inflation and hence Bank Rate. Unfortunately I don’t think that the evidence around any of these explanations is very strong (indeed, I think it is weak).

If I can’t be convinced, I’m not sure that other members of the MPC will be easily convinced either.