Has America been mis-led? Does she have an inflation problem like the UK?

2nd July 2010 by Shaun Richards

Yesterday again saw more equity market falls with European markets hit hard. The Dax,Cac 40 and FTSE 100 all had triple digit falls. Rather ironically BP was up so the FTSE 99 had a particularly bad day. In the event US markets rallied a little towards the close to stop a triple-digit fall there and the Dow Jones ended up 43 points down. Interestingly European markets are trying to rally this morning but so far it looks weak and feeble, perhaps they are waiting to see the US jobs report this afternoon. As one of the commenters on here pointed out there were strong currency moves yesterday with the Euro rising  nearly 2.5% against the US dollar and the volatility continued in other currencies with UK £ rising by 2 cents against the US dollar as well. If you take a look at a chart of this it was an extraordinary move from 1.22 to 1.25 for the Euro/$ after some days of relative stability. In the world of machismo and political grandstanding it may well get forgotten that the fall in the Euros exchange rate was a market mechanism likely to help her problems as one of them was an over-valued exchange rate. One factor that has been ignored recently has been the slow improvement (and yesterday not so slow) improvement in the UK £’s exchange rate which on a trade-weighted basis has risen from 76.6 to 82.

American inflation figures, are they for real?

I have seen some interesting new research done on this subject by Simon Ward which questions the methods of calculation of US inflation figures. These are figures which commenters on here have raised issues about before but the answers from this analysis are intriguing as we shall see later. On the face of it America does not have much of an inflation problem with her Consumer Price Index being at 2% and the trend for this appearing to be down. This compares with the UK’s official inflation index which is was at 3.3% in May.

However this analysis looks at things differently and asks the question what would American inflation be if she calculated her inflation in the same way as the UK and the Euro zone do? So what we need is an American measure of inflation which is the same as the harmonized index of consumer prices” (HICP) which is the full name of the euro zone measure. Fortunately the US Bureau of Labor Statistics does calculate such a number and it was 3.2% in April and its calculation for the UK was at 3.3%. Looked at like this US inflation has been over 3% since December 2009 which is a worse performance that the UK. Makes you wonder does it not?

The Technical Difference

The main difference between the two inflation indices ( the official US consumer price index (CPI) and the European HICP) is that the latter excludes owner-occupied housing costs, of which the most important component is what is called “owners’ equivalent rent”  or OER which is a notional payment by homeowners to themselves for accommodation.  It is a sizeable factor because OER has a 25% weight in the American CPI basket and is estimated  based on market rents  to have fallen over the last year, and accordingly it has exerted a major drag on official inflation measures.

I find this OER intriguing on several counts. Firstly it is a notional artificial concept and it does not really do the job to my mind which should be measuring house price inflation. Rents may move with house prices but they may not. I am not going to forget that I believe that inflation indices should measure house price inflation as well as other asset prices but if you argue not unreasonably that OER is not a good measure of this then you are left with the bare figures. US and UK inflation are very similar and Euro zone inflation is considerably lower at 1.4% for the latest “flash” estimate.

The clear implication

There is something very important which follows on from this. American is scared of deflation and possibly disinflation at this time and some of this is based on her Consumer Price Index. Indeed some economists (not me) prefer measures of what they call core inflation which is at 0.9% and is dipping. However using this new methodology it rises to 2% which does not raise deflation spectres so much.

So there is a very clear danger of policy being inappropriate and a mistake being made. We have been here before, for example I believe that the Bank of England gave itself such deflation scares due to its output gap theories that it “over-responded” to the credit crunch in my view leading us to where we are now. This new theory suggests America may have made a similar error.

Now consider the US government bond market and look at the yields on there.  Her ten-year Treasury Note yield of 2.94% did not look a lot before if you remove some of the deflation scares it looks much too low, and as for two-year yields at 0.63%? If this markets came round to this new inflation methodology there would be quite an impact.

The Bank of England

Recently members of the Monetary Policy Committee have been giving speeches which are not quite in the same form as before. I think that they feel that they are losing or have even lost the debate over inflation in the UK and wish to publically try to counter-act this. If they are trying to reduce inflationary expectations then of course they have a theoretical problem as so few people probably actually read their speeches we would have to be incredibly influential on public views to impact on inflationary expectations! I thank them for the implied compliment.

Of the speeches the most interesting was given by Adam Posen on Wednesday as it was about as honest as a member of the MPC is likely to get but it was also quite extraordinary in its (ill)logical gyrations. First let us have some welcome honesty.

Sometimes the simplest explanation is the best. It appears that actual inflation outcomes,
which have predominantly been overshoots of the Bank’s target for the last four years, are
contributing to a slow upwards creep in inflation trend.

I think this is as near as we are going to get to a mea culpa from the MPC. You may notice that the four-year period mentioned goes back to before the credit crunch so there is an implied admission for that period too. However then the logical contortions begin.

It is difficult to attribute the rise in inflation in the UK solely or even primarily to ‘one-off’ factors like VAT, past sterling depreciation, or energy prices

The issue I have with this is the “past sterling depreciation” which I believe has been a considerable factor in the UK’s inflation problems and can only think that this is being ruled out because it came mostly before the Quantitative Easing experiment and was therefore known and should have been allowed for. So I feel that this is an ex-post justification or put more simply an attempt to re-write history. In the past the Bank of England has expressed the view that changes in our exchange rate are a strong influence on inflation. However we do also get some more implied honesty.

The shorter the private actor’s perspective, the more consistently off target the Bank seems to have been – inflation has been above target 23 of the last 29 months since January 2008, and increasingly so on average. The MPC’s inflation forecasts in the Inflation Reports have seemed unduly sanguine ex post as well:

I like the phrase “seemed unduly sanguine ex post” which is a very formal and nice way of saying turned out to be mistaken and very wrong isn’t it? These (wrong) forecasts are important because the MPC sets its policy based on them so if the forecasts turn out to be wrong then the policy is likely to be too. However some more honesty is in the speech.

It is naïve or disingenuous for us on the MPC to pretend that such a sustained series of above target outcomes and forecast errors would have no impact

This section of the speech is quite welcome and in some ways refreshing. Unfortunately the speech loses its way as a piece of logic as having rejected sterling depreciation as a cause of inflation it ends up blaming private sector inflationary expectations as the cause of the inflation we have seen. So readers in the UK it was your fault. I hope that you all feel suitably admonished. The audience were not quite so convinced however and I am not surprised.

Tucked away in the speech was an interesting new view on QE ( I lost count of the new views on this from the MPC somewhere in the mid-20s) calling it “intentionally visibly aggressive” and thereby implying that it was at least partly enacted to influence expectations .


I do not wish to be too critical about this speech as I feel that there is more honesty in it than many others given by MPC members but there are clear failings in it which I have pointed out above. Perhaps an insight into his feelings is the talk of the recent inflation rise as “modest”. However towards the end of the speech we get the following disturbing statement.

……. in that state of affairs I would be only too happy to vote for an interest rate increase. If a majority of the MPC agrees at that time to tighten policy, I am fully confident that any inflation creep would be reversed, and that British inflation expectations would be totally reanchored

I have been following the UK inflation experience for 25 years now and have studied it back into previous periods and therefore cannot share his confidence as reanchoring inflation expectations has often proven painful,difficult and taken some years.

UK Money Supply

This week has seen some new figures for UK money supply and on first reading they appear to show that broad money growth is improving. There is an irony here possibly as the speech I quoted above has the MPC moving away from this as a main impact of QE! However one needs to be slightly careful with the figures as we are in a time of extraordinary moves in money markets around the world with serious issues for interbank lending particularly in the euro zone which can easily distort other figures.

 The Bank of England’s favoured broad money measure which is M4 (excluding deposits held by non-bank financial intermediaries) has risen by a 9.2% annualised rate over the last three months. But breaking the numbers down M4 held by households and non-financial corporations only rose by 1.5% annualised over tha same period. In other words in an echo of what was called disintermediation back in the 1980s there may well be issues with the numbers as there is a lot going on the financial sector. Only time will tell.

19 thoughts on “Has America been mis-led? Does she have an inflation problem like the UK?”

  1. Mac says:

    How can you measure something real by using something imaginary, yet that seems to be the preferred way? Course that in itself opens up whole avenues of opportunity to corrupt the figures! In my town there is an overabundance of ‘for rental’ properties, probably as people try to make some sort of return on cash, with agents sticking unrealistic headline rents onto them. They are not being taken up so what would the real rental figures be and which is being used?

  2. Shireblogger says:

    Thank you Notayesmaneconomics. First point, only Andrew Sentance on the MPC currently feels a need to tighten policy. Notwithstanding their candour neither Paul Fisher nor Adam Posen are advocating a tightening of monetary policy. I wonder whether this has more to do with the huge levels of debt. Second, the US comparison is very interesting as Mr Posen’s figures indicated a differing lower level of what he calls ‘core’ US inflation – is this an apples and pears situation? Third, what really worries me about this episode of reliance on theories is : the MPC will soon have a very powerful sister committee independent of government, the FPC ( financial policy). It will have very powerful tools at its disposal to manipulate lending policies and balance sheet structures of banks – it will interplay with the MPC at a point where the MPC is owner of substantial sovereign debt. Erroneous theories could cause havoc across the board. Who will account for them?

  3. Dave says:

    The US include hedonics, substitution, and weighting in deriving CPI inflation numbers. Are the same assumptions used both for the US and Europe?

    “What would happen if you were to strip out all the fuzzy statistical manipulations and calculate inflation like we used to do it? Luckily, John Williams of shadowstats.com has done exactly that, painstakingly following each statistical modification over time and reversing their effects.

    If inflation were calculated today, the exact same way it was in the early 1980’s, Mr. Williams finds that it would be running at closer to 13% than the currently reported 5%.”

    1. Drf says:

      Good link Dave. I came across this guy a couple of years ago. He really aims below the belt and hits them where it hurts! If most intelligent people read these modules and as a result understood how the politicians and statisticians have deliberately deceived them for so long, their reaction would change markedly.

      It is interesting that the step change took place when the gold standard was abolished. Once they were unfettered politicians instructed statisticians to use every trick in the book to conceal what they were doing, and most people did not understand how successive western governments were using inflation as a big ongoing stealth tax in addition to all the other increasing taxes which they levy. Socialism is very costly and destructive luxury?. Someone has to pay for it all.

  4. johnspoone says:

    This is off topic, but the tune is slowly, ever so slowly, changing in Europe regarding the orderly default of eurozone members.


    I very much liked the “I didn’t say that” in the following:
    Asked pointedly whether he was opposed in principle to an orderly insolvency procedure, Rehn replied: “I didn’t say that. But I am now focused on reforms that are possible without amending the treaty. We need rapid ways to counter excessive government debt and economic imbalances in the Eurozone effectively.”

    On a serious note, I do think (contrary to Shaun perhaps) that the eurozone politicians are doing a rather decent job given the challenges, the impact of decisions on people’s lives, and the multiple conflicting interests involved. On a less serious note, Sir Humphrey would have been proud!


  5. Rob says:

    Hi Shaun,
    I have been reading your blog for a while and as a non economist have found it very informative so thank you for taking the time to wite it.
    As today’s blog was on inflation there was something I have wondered about since the budget. Assuming all other things remain constant, how much of an impact does the upcoming riser in VAT have on the CPI, RPI and RPI-X?
    We will basically have two years of2.5% increases in VAT (15-17.5% this year).

    1. Hi Rob
      Welcome to my corner of the blogosphere and thank you for the compliment. As to your question it depends on how much of the increase is passed on by retailers. If we assume all of it is then one would see the Consumer Prices Index rise by 1.5% in that month assuming nothing else changes and the Retail Prices Index by up to 1.3/1.4%. The reason for the difference is that slightly more articles are subject to VAT in the CPI basket of goods than the RPI one.

      So the move is inflationary but to the extent that money is spent on these goods it also takes money out of the economy it is also deflationary (reduces aggregate demand)…

      1. Drf says:

        Hi Shaun,
        I find it difficult to believe that a change in any economic parameter may be both inflationary and deflationary at the same time, since that generates an algebraic conflict. Surely this is an example of the error in deciding to state inflation by monitoring only selected retail prices, since that is not in reality a measure of inflation at all in the classical concept, but only an effect. So the reality is that increasing taxes is deflationary in classical economic terms, but in terms of retail prices only this causes an increase in “tax-paid price inflation” which is what I seem to remember it was termed when the change was first made to at to stating inflation as measured by selected prices only.

        1. Hi Drf
          Whilst they make somewhat uncomfotable bedfellows we are likely to be seeing it. In the UK much of the effect may be hidden by other acts/moves but if you look at Greece with her more severe austerity programme and VAT rises….
          As to errors in measuring inflation I think we agree that they are not in short supply!

  6. Graeme B says:

    The MPC and Fed can always find some statistic to justify a position – the Fed’s current focus on core inflation is just another example of monetary policy being hostage to politics – in this case, the imperative to keep banks solvent.

    However, I find myself agreeing with Hugh Hendry that we in for another deflationary episode before we get serious inflation. For the trigger, take your pick from anaemic US demand recovery (you can lead a horse to water…), european tightening/default, chinese slowdown, japanese retrenchment etc.

    Because little of the new QE money has been finding its way to households (rather, it has increased living costs by devaluing their fixed wages), demand has not recovered and inflation will therefore be temporary. Also, don’t forget that if rates start going up soon in the UK in response to anger over the rising cost of living, there will be a temporary increase in inflation measures that include mortgage costs, even though this will lead to more asset price deflation in the medium term (rates always seem to change at just the wrong time – makes you wonder if they should just leave them at 3 or 4% and stop tinkering). Any renewed deflation would of course be self-reinforcing because banks are still stuffed full of loans backed by over-valued assets, which is also the reason increasing the monetary base hasn’t really led to M3 growth. Banks are being told to hold greater reserves and lend more at the same time 😮 The masses cannot spend if their wages are cut and the banks won’t lend them the money either!

    In answer to your question though, of course America is being misled. I am less sure that the likes of Bernanke don’t understand what is happening.

  7. seanbroseley says:

    Luckily we don’t have to look far to see our own future:


    1. Drf says:

      Good link, sean. The observation – “It now pays a hefty three percentage points more than Germany on its benchmark bonds, in part because investors fear that the austerity program, by retarding growth and so far failing to reduce borrowing, will make it harder for Dublin to pay its bills rather than easier.” shows what is likely to occur in the UK too. This is the key problem for such over-stretched economies; although cutting public expenditure seems to be the way forward, it never really works, and public borrowing costs continue to increase, as the economy continues its descent. On the other hand, increases in taxes depress economic activity and the GNP. Where is the light at the end of the tunnel?

    2. DanielC says:

      This is the key problem … cutting public expenditure … never really works … On the other hand, increases in taxes depress economic activity and the GNP. Where is the light at the end of the tunnel?

      Perhaps an answer to this that might not be very pleasant to hear is that leverage (or multipliers) works both ways?

      An overly simplistic illustration to illustrate the point – just as adding a new $100K job to the civil service payroll might seem to only really cost a government’s fiscal position a net $60K because it’s going to get back $40K of this new spending in new taxes arising from this new economic activity from this new job, when it turns out a government has actually overspent and needs to do some trimming, then in order to shed $100K from the government’s deficit requires not a $100K trim via pay cuts or job cuts or tax hikes but rather a $167K trim.

      1. seanbroseley says:

        And the biggest leverage is in the private sector.

        I don’t see light at the end of the tunnel. I don’t see the mechanism for getting out of depression.

    3. Shireblogger says:

      Very interesting article, thanks. On a different tack the Bank for International Settlements recent figures for bank exposures to foreign borrowers indicated that UK headquartered banks had very large exposures to private Irish bank and non bank customers to a value of $230 billions. The Irish predicament could be contagious.

      1. seanbroseley says:

        Oh yes I saw that first one , and commented on it somewhere.

      2. seanbroseley says:

        Monopolisation – priavte or public ends the free market.

        Then there was Martin Wolf in the FT recently:


        It’s free to look at that if you register.

        All grist to the mill. But I’m still a pessimist.

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