Tuesday, May 19, 2009

Inflation, Deflation And Printing Money in the UK

Many of the readers from the UK may have been seeing news of the 'deflation' in the UK economy. A typical piece can be found in the Times as follows:

Deflation tightened its grip on the economy last month after a record fall in retail prices.

The retail prices index (RPI), the benchmark for pay deals, fell to -1.2 per cent, the lowest since records began in 1948, dragged down by a decline in energy and mortgage costs.

Economists expect that prices may fall farther as the recession takes its toll and unemployment rises. Some believe that the rate could fall to about -2.7 per cent, raising fears of prolonged deflation as consumers delay purchases and businesses withhold investment.

It becomes increasingly difficult to view such articles without a measure of irritation developing. In particular, the media seem to be subject to some confusion. As such, a quick introduction is given below to the two main measures of inflation, taken from National Statistics (emphasis added):
Consumer Prices Index (CPI)

The Consumer Prices Index (CPI) has been designed as a macro-economic measure of consumer price inflation and forms the basis for the Government's inflation target that the Bank of England's Monetary Policy Committee is required to achieve. It has been developed according to internationally agreed rules and internationally is known as the HICP. The HICP is the preferred measure for international comparisons of inflation.
Like the RPI, the CPI measures the average change from month to month in the prices of consumer goods and services. However it differs in the particular households it represents, the range of goods and services included, and the way the index is constructed.
Retail Prices Index (RPI)

The Retail Prices Index is the most familiar general purpose domestic measure of inflation in the United Kingdom and is continuously available from June 1947. It measures the average change from month to month in the prices of goods and services purchased by most households in the United Kingdom. The RPI or its derivatives are used by the Government for the uprating of pensions and benefits and index-linked gilts.
The important point to note here is the key difference between the two measures, which is in the cost of housing, as follows:
For example, the RPI basket includes a number of items chosen to represent owner-occupier housing costs, including mortgage interest payments and depreciation costs, all of which are excluded from the CPI. These differences are described in greater detail in Roe, D. and Fenwick, D. (2004), ‘The New Inflation target: the Statistical Perspective’. Beyond these specific areas, the contents of the CPI and RPI baskets are very similar, although the precise weights attached to the individual items in each index differ [the Roe and Fenwick article can be found here]
It is very easy to get these measures confused, but the important point to take forward is this:

The government and Bank of England use the CPI for inflation targets, and the CPI does not include housing costs.

By contrast, the RPI includes housing costs as follows, taken from the ONS guide here:
Private furnished rent Private unfurnished rent
Local authority rent Registered Social Landlord (RSL) rent
Mortgage interest payments
Average interest payments on a typical repayment mortgage (estimated/modelled)
Back in December, I wrote a post on what I thought the prospects were for deflation, and pointed out that currency weaknesses and therefore higher import prices would likely offset the deflationary factors within the UK economy. At the time of writing, food prices were already starting to climb. As it is, much as predicted, the CPI has continued to be inflationary. The chart below shows the different measures of inflation.

[Chart from the ONS here]

Having introduced these measures, the astute reader will immediately see that there is a circularity to the measures. Mortgage interest payments are linked to the interest rate, and the interest rate is determined in part by the interest rate targeted by the central bank. As such, during the boom years, the RPI would have been held down due to the low level of measured inflation of the CPI. In other words, even though there was rampant inflation in the economy (in house prices), it was hidden in part by the way in which the statistics were used and measured.

It is here that we come to the source of irritation. At present, the Bank of England have reduced interest rates to record lows. As such, the cost of servicing mortgages and indirectly rental costs are falling. Furthermore, as house prices fall, there will be a combination of lower interest rates on smaller mortgages. In this scenario, the problem is that what we are seeing is a case of deflation being measured as a result of an asset price bubble popping, and central bank intervention.

It is hard to imagine that the asset price bubble bursting should be seen as a bad thing, as it is an inevitable correction in the market. As for the other element, the central bank intervention, this is where the circularity starts to kick in - sort of.....If we remember, the bank targets CPI, not RPI. However, in the Bank of England inflation report from February, it might be noted that the RPI is discussed in the report, even though the CPI is the target for inflation. You will note how the measures are blurred in this passage.
Deflation is sometimes used to describe any fall in the general level of prices (as measured in the United Kingdom by the CPI, RPI or the GDP deflator), however short-lived. A more economically significant phenomenon, however, would be a sustained period of negative inflation.

The RPI is likely to fall temporarily over the coming months (Section 4.1). This period of negative retail price inflation would be unusual (Chart A) and predominantly reflects the much lower contribution from mortgage interest payments, following the recent large falls in Bank Rate. The MPC’s central projection is for its target measure, annual CPI inflation, to remain above zero throughout the forecast horizon. (p33)
Whilst there is no direct statement of targeting of RPI, the way in which the whole passage is put is somewhat grey. The same section of the report then goes on to warn of the dangers of deflation......it appears that the Bank of England is subtly conflating the two measures, and they even use a chart which is designated as the 'ONS composite index'. (p33) One of the interesting points is that an argument for printing money directly follows this discussion of RPI and deflation:
Periods of low inflation, associated with weak demand, may limit a central bank’s ability to use conventional monetary policy to stabilise the economy. But if reductions in official interest rates do not prove sufficient to meet the inflation target, policymakers still have other options available to them to stimulate the economy, if necessary (see the box on pages 44–45 in this Report). (p33)
Page 44-45 are discussions of unconventional monetary tools, otherwise known as quantitative easing (QE- or printing money). The problem that we are now seeing is best expressed by Liam Halligan from the Telegraph:

Over the last few months, we've printed money on an unprecedented scale and run up enormous extra liabilities. When sensible people have protested, pointing out the clear dangers, we've been told such "bold" measures were necessary for the UK to avoid getting sucked into a deflationary spiral.

But now, just three months later, this looming threat has apparently passed. It warrants not a mention in the Bank's Inflation Report. Has deflation really gone away? Or did we never actually face such dangers? Was the spectre of deflation conjured up, instead, for other reasons – as an excuse for this ghastly Government to yank monetary policy back off the Bank and nail interest rates to the floor, while junking fiscal caution and borrowing in a fashion more akin to a banana republic?

Liam Halligan is quite correct that the latest report passes by the deflationary scare stories, and rightly identifies that there was no real prospect of CPI deflation. As can be seen from the chart earlier in the post, it is still relatively high. However, he misses the way in which the RPI was introduced as a means of pulling deflation into the picture in the February report. As you will see from the above text, it is done in a very subtle way, and this has been broadly absorbed by most of the media. The elements of the report that considered CPI were very nuanced, and were not firmly deflationary.

The February report was actually a very subtle and nuanced document overall. The spectre of deflation was primarily raised against the RPI, but the way that the report reads does not reflect this. Crucially, acceptance of the deflation argument was the reason for why quantitative easing (QE - printing money) was accepted in the media. Now that the controversy over QE has died down, the RPI issue is now quietly dropped, along with the talk of deflation.

Here is the central problem for the Bank of England. The only way to justify QE is through the fear of deflation, but the only measure that is showing deflation is the RPI. The bank's remit does not extend to RPI so that it can not use the RPI as an excuse to print money. As such, they subtly conflated the measures, planted the idea of deflation in the mind of the media, and 'lo and behold', deflation has appeared. It now looks like, post hoc, that the Bank of England can justify the deflationary scare. Through smoke and mirrors, the media have accepted the deflationary argument and continue to accept QE.

However, if the media were paying attention, they would note that the deflation is on RPI and, in part, due to the very policies that the Bank of England is actually pursuing. In particular, the Bank of England is fighting to reduce interest rates on consumer debt and mortgages through QE and historically low interest rate policies. Furthermore, the deflation of the housing bubble, in which asset prices are returning to sustainable levels, would be an extremely difficult reason to use to justify the policy of QE - if not impossible. Such an argument would be that the policy is aimed at reflating house prices, and I am not sure that anyone in their right mind might accept such a policy.

The fundamental problem in this whole picture is that the Bank of England has a problem with justifying QE if deflation is identified in the RPI. Over and above the problem that the remit is to target the CPI, the problem arises that targeting of the RPI would be to reverse a bubble deflating and would also preclude any further monetary easing. In particular, the monetary easing would serve to reduce interest rates, and thereby be deflationary through reduced costs in housing.....

I am hoping that, at this stage, it is apparent that there is a significant problem with the policy of QE. The remit of the bank is to target the CPI, the justification for QE is deflation, the index showing deflation is the RPI, and the bank is actually contributing to deflation in the RPI.

In other words, even if the principle of QE is accepted (which is not the case for this blog), there is currently no justification for the policy which can withstand scrutiny. Under such circumstances, it is only possible to return to the long standing argument/theory of the blog, and conclude that QE is simply a way of printing money to buy bonds and support the bond market. The policy is therefore really about printing money to support profligate government spending through printing money.

The trouble is that, excepting a few commentators like Liam Halligan, the media are still buying the lie that QE is to fight deflation.....

Note 1:

I did not want to make the main article too long, so I have not discussed the problems with deflation theory. I discussed this in a very long post previously, and have quoted from the post below [the most relevant bit]:

[Quote starts.....]

Economists say that deflation is a terrible thing. They say that it wrecks economies. If you have deflation, then people stop consuming, and stop investing.....

Let's start with the case of consumers stopping consuming. In this case, we have a good example of deflation to illustrate that deflation does not stop people buying things that they want. The example is computers which, as every year has gone by, have become ever cheaper in relation to their performance and sophistication. We all know that if we wait until next year, we will get a much better computer for our money. This is real deflation, but during a period of real deflation, the sales of computers has expanded, and expanded, and expanded.

If we think of a more mundane example, we might come up with something like a bottle of shampoo. Let's imagine that every year there are ongoing productivity gains in manufacturing shampoo such that the price falls by 3% per year. Does this mean that we will defer our buying of shampoo? Does that mean that, in order to benefit from the price reduction of shampoo, we will walk around with greasy hair.

Alternatively, we can take the case of a discretionary spend on something like a holiday. As some people will be aware, the low cost airlines have seen huge reductions in the cost of overseas travel, and the costs continued to go down over a period of years. Did this mean that people stopped overseas travel while they waited for the flight prices to drop even lower? What we actually saw in places like the UK was a massive expansion in overseas travel, as it became ever more affordable. However, this occurred despite deflating prices. This is like the example of the wine glasses....

The idea that people will not spend money during deflation is simply not true. However, if we knew that there was an unusual deflation about to take place, such that we expected the price of something to drop dramatically at some future point, we might defer our spending. For example, if the newspapers were to announce that in April of this year that there will be a new type of computer which will cost half the price of a computer today, then we would likely wait until April before buying a new computer. Moreover, when the new computers were released in April, then the sales of computers would increase as more people could afford them, and we would all potentially be richer by a factor of half a computer (if that makes sense).

However, such events would always be exceptions, and we readily buy computers despite the steady price deflation.

In short, steady deflation does not stop people from consuming.

[Quote ends]

I have since seen a book review, on the Mises institute website, that uses similar arguments and examples. I was hoping to link to it, but could not find the article (apologies).

The other nasty element proposed for deflation is discussed in the Economist:
Real debt burdens therefore rise, causing borrowers to cut spending to service their debts or to default. That undermines the financial system and deepens the recession.
However, this does not account for the savers. People who save see the value of their money grow, and this means that they have greater spending power. The problem is, of course, that there are too many debtors rather than savers....but this is perverse way of looking at the problem. A more balanced economy would not see such a situation, and it is lax monetary policy that caused the problem in the first place.

However, I do not want to go into the full argument here. I detail far more in the original post, and (bear with it) this can be found here. The issue of inflation versus deflation is very complex, and I am not sure that even my long article does the subject full justice.

Note 2:

I have long been grumbling about the use of inflation statistics. It has been a regular feature of the blog. Two quotes are given below, but these are only a limited selection.

This is from a post I wrote in January.
Now the expression measured is very important, because asset price inflation did not count in official inflation. In particular, as fast as new money was produced, asset prices such as houses inflated. Greenspan, in his wisdom, allowed one bubble after another to soak up the expansion in money. However, we have now gone one bubble too far, and there is no new bubble on the horizon to soak up the money being dropped into the market (which would in any case just be a delay, not something that would be a 'good' thing). As such, one of the sources of money absorption has been bubbles in assets, which stopped the prices of other goods going up. Mainstream economists seem to think inflation was conquered, but it was just displaced into something that was not measured.
This is from a post in February:
It should be recognised that arguments against including house prices might be put forward, such as the idea that the cost of owning a house is in part dependent on the interest rates charged on mortgages, and that is a valid measure. However, this becomes a circular argument as, if house prices are inflating and are not measured in inflation, interest rates will remain low despite the actual inflation, thereby keeping the cost of the mortgage repayments relatively low whilst the asset price inflates. However you look at it, having to borrow £200,000 this year to by a house, and having to borrow £300,000 next year is inflation. The day to day cost of servicing the loan may change, but the cost of the good has still inflated.

You will find the UK Office of National Statistics personal inflation calculator here. You will note that they do not calculate the rate of inflation by the interest rate paid on borrowing when buying, for example, household goods. They measure it against the price of the good itself. It seems that they have not noticed that a house is a 'good', or more likely they have decided that the inflation of house prices is something they would rather not measure.
Note 3:

For US readers, you may be interested in an article here. It details how the inflation statistics have been manipulated in the US. It is not happy reading. I have yet to find a similar discussion of UK statistics, and would ideally like to look into this. I did consider it, but will admit to being 'outfaced' by the scale of the problem of digging through the various papers, and studying the methodology in enough depth. Any links to such articles would be appreciated.....

Note 4:

I hope the above article makes sense still. I had to chop it around to shorten it, and hope that this has not led to any errors. Comment if you spot any, and any other readers can then see any errors.

Note 5:

Sorry to not respond to any of the comments, but this post was rather demanding of time. The final article does not reflect all of the articles I have recently read on the subject...as there are just too many out there....

Note 6:

I have long been (against the grain of the same conventional economists that failed to predict the recession) arguing that regulation of the banking system was a major part of the crisis. I have been heartened to see a very similar argument from Niall Ferguson, which can be found in the New York Times here....

Note 7:

Regular readers will know that I have long been discussing the idea that China has been positioning the RMB as the new reserve currency. Arguably, progress in that direction can be seen in Brazil, and more and more people are picking up on it:

Brazilian President Lula is the latest world leader (after Wen Jiabao and Vladimir Putin) to call for moving away from the US dollar in trade and and for a new monetary and financial order. On the eve of his trip to China this week, Lula suggested in an interview with Caijing (and other news sources) that the two countries should conduct more of their trade in their own currencies rather than the US dollar.

“Between Brazil and China, we need to establish a trade that is paid for in our own currencies. We don't need dollars. Why do two important countries like China and Brazil have to use the dollar as a reference, instead of our own currencies? We've already started doing this with Argentina. Our trade is taking place in our own currencies. Otherwise, we'll be in an absurd situation, where the country that caused this crisis will be the country that gets the most dollars. It's crazy that the dollar is the reference, and that you give a single country the power to print that currency. We need to give greater value to the Chinese and Brazilian currencies.”

Early this year, China supplanted the U.S. to become Brazil’s largest trading partner, as its commodity demands resumed and Brazil’s trade with the U.S. slumped. At the moment, Brazil is one of the few countries with which China runs a significant deficit which rose to $11 billion for all of 2008. Chinese imports are almost all raw materials.

Greater use of the RMB in trade with Brazil would be yet another step China has recently taken to increase the use of the RMB outside of China. China has been signing 3-yr RMB/local currency swaps with a range of emerging and frontier markets including Argentina, Brazil’s neighbor. As Nouriel Roubini notes in a recent oped, these swaps are small steps towards a possible greater international role of the RMB – pilot projects to use RMB as a settlement currency in Hong Kong Macau and Asean are other such steps. These deals are also another way to provide a bit of trade finance to key trading partners. The swap with Argentina might help finance China’s extensive trade with the country. As a result, even if US dollars are not used, it could well be the RMB and not the BRL that is used, especially if China wanted to avoid bearing the exchange rate risk.

In addition to the Petrobras-CDB deal the Brazilian development bank BNDES is reportedly seeking a credit line from China. BNDES, like other trade credit providers globally, has taken on a higher profile in the face of the withdrawal of private trade finance. Such a loan could be conducted in RMB/BRL. While that would be major, there are significant preconditions before the RMB internationalization progresses further. In particular, the more the RMB is used outside of China’s border the less control the central bank has. In this way China’s shorter-term goals of economic stabilization and longer term goal of more sustainable consumption driven growth may conflict.

The really interesting step will be any move towards pricing oil in RMB. My guess is that we are on the cusp of such a move, though initially it will be small scale (i.e. not the Gulf states). However, it is possible to see the progression forwards of the RMb with each passing week.....


  1. Your post argues that reasons for QE are not to combat deflation, question that comes to mind is why pursue QE?

    Perhap a post on this subject - Disenfranchising the Chinese of their holding in Gov bonds through high inflation

  2. Sorry to be the devil's advocate but I've been getting the feeling over the last few weeks that the economy in the UK is on the road to recovery. The banks shares have really rallied and so has £GB.

    Am I missing something?

  3. Anon82:

    A very, very quick reply. You have heard that the economy is recovering, but the big question is to ask where is the evidence of the recovery. The bank shares? But the banks are still on life support....take away the life support, and see how long they would last....

    You may have seen articles that appear to be positive. In each case, if you look at the details, you will find that the most optimistic amount to rates of decline slowing. In other words, the economy is still sinking, just not as fast.

    As yet, aside from the silliness of the stock market, there are no real positive signs. As for the £GB, this is improving in relation to other basket cases. What is it being measured against? The long term trajectory of the £GB is still down, it is just that other OECD currencies might fall faster for a while.....

    The winners...they will be the emerging economies, but that is a process that will take time. The simple fact is that we are watching a process of wealth distribution - or recognition of where wealth is generated.

    We still have a long, long way to reach the bottom....

    Sorry, a very quick reply....

  4. The fundamental problem in this whole picture is that the Bank of England has a problem with justifying QE if deflation is identified in the RPI. Over and above the problem that the remit is to target the CPI, the problem arises that targeting of the RPI would be to reverse a bubble deflating and would also preclude any further monetary easing. In particular, the monetary easing would serve to reduce interest rates, and thereby be deflationary through reduced costs in housing.....

    Hi CE,

    I have not commented for quite a awhile but have still be reading just taken a back seat.

    I cannot quite get my head around how HMG is causing deflation through QE.

    From the article:
    "The remit of the bank is to target the CPI,"
    "the justification for QE is deflation,"
    "the index showing deflation is the RPI,"
    "and the bank is actually contributing to deflation in the RPI."

    Keep up the good work.

  5. I have to resist the temptation to throw things at the TV and radio when I hear talk of 'deflation' in the media. I don't recall the RPI being mentioned much when it was higher than CPI, and if one was tracking it, justified higher interest rates.

    Anyway, by the end of this year the effects of the rate cuts will start to fall out of that index, and RPI will start to return to its more realistic level - ie well above zero. What will the BoE do then? Raise rates and reverse QE just as the economy MIGHT be returning to positive economic growth? I don't think so.

    Double digit inflation by 2011 is my prediction.

  6. Asset price inflation and green shoots. Bloomberg published the following article stating that the average cost of a home climbed 2.4 percent from April.


    I then checked the original report from "Rightmove"


    There you will see that it is only a few optimistic, ambitious and needy NEW sellers that have pushed up ASKING prices.

    But read a few lines down and then you will come across the following

    "Prospective buyers with nothing to sell are increasingly active, encouraged by 59,072 properties reducing asking prices by 2% or more in the last 4 weeks, with an average reduction of 6.8%"

    So how about THAT for the real headline?

    "UK Home Sellers reduced average price by 6.8% in four weeks to encourage buyers"

    This is more than slightly different to the nonsense 2.4% increase. Green shoots, I don't think so.

    I am convinced that the current government is determined to fire up another debt driven housing mini-boom before the next general election. That is all they care about. With QE and ZIRP they have abandoned any attempt at a long term solution, but are condemning the UK to penury and modern day serfdom, the debt slaves.

  7. Found on mises.org

    An Austrian Taxonomy of Deflation by Joseph T. Salerno

    From my notes:

    'There are four basic causes of deflation—two operating on the demand side and two on the supply side of the “money relation.” The economic processes associated with these factors may be categorized as:

    #Growth Deflation (Price Deflation). Demand-side. Benign. Falling prices due to technological improvement and using capital more productively.

    #Cash-building Deflation. Demand-side. Benign. Savings and underconsumption. (So-called "Hoarding")

    #Bank Credit Deflation. Supply-side. Benign. Lack of confidence in fractional reserve banks, purgative bank runs, eventual collapse, reduced lending in the short run.

    #Confiscatory Deflation. Supply-side. Malign. Government "austerity measures" resulting in severe restrictions on bank withdrawls and the expatriation of money.'

  8. Oi. Parabéns por seu excelente blog. Gostaria de lhe convidar para visitar meu blog e conhecer alguma coisa sobre o Brasil e nossa luta contra o comunismo. Abração

  9. On the subject of inflation, the reason why we haven't yet had hyper inflation in the UK is explained in a fascinating article from Global Research here that looks at what triggered German hyperinflation and how it was cured.

  10. and here we go:


    it gives me no satisfaction to say you were right Cynicus, but you were. This is the start.

  11. CynicusEconomicus,

    It's slightly puzzling that on the day Britain gets an outlook downgrade by S&P, the Gilt auction succeeds well and £GB still ends the day strongly.

    Anyway, just in case you hadn't seen this 17 minute interview with the DMO, here it is:



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