Economics

Economics

UK inflation: lessons from 300 years of history Key macro reports

Chart 1: Stellar economic growth during the deflationary 19th century 130

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Euro crisis: The role of the ECB

29 July 2011 Saving the euro: the case for an ECB yield cap

26 June 2012 The lessons of the crisis: what Europe needs

27 June 2014 90

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Brexit: assessing assessing the domestic policy options

2 November 2016 After Trump: notes on the perils of populism

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14 November 2016

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Reforming Europe: which ideas make sense?

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We analyse trends in inflation and economic performance using over 300 years of UK economic data. We then outline the major forces shaping current and expected trends in UK inflation before considering the policy implications for the Bank of England (BoE). ● What is the problem with deflation? On its own, deflation or very low inflation need not be a sign of a deteriorating economy. Using BoE data going back to 1700, we show that the UK economy has often performed well during lengthy periods of deflation (Chart 1). ● The underlying cause matters: We find no clear link between deflation and economic growth when the fall in the general price level reflects improvements in the supply-side of the economy – ie rising trade or gains in productivity. Instead, we find clear examples of multi-decade deflations that coincide with strong real GDP growth, rising trade, per capita income, productivity and share prices, and a falling public sector debt ratio. Critically, while we find little evidence of strong negative effects from lengthy deflations, we can easily identify periods where high inflation damaged the economy – such as the 1970s and 1980s. ● The future could be disinflationary: Two major supply-side trends are likely to shape future inflation dynamics in the UK: 1) global supply chains and other aspects of globalisation enhance productive efficiency through a deeper division of labour across regions; and 2) technological change dampens rises in wages and prices by increasing competition. Automation, robots and the ability to shift production abroad more easily than before can constrain wage gains even in labour markets such as the UK’s that are close to full employment. ● Policy implications: In a likely future disinflationary environment, the BoE’s rigid 2% mandate could encourage it to pursue a monetary policy that is persistently too easy. This would be risky. If the BoE returned to something resembling its old mandate (2% or less), it would have the freedom to allow positive supply trends to reduce inflation or even lower the price level without having to encourage excesses in order to raise inflation.

The Fed and the shortfall of inflation

15 September 2017 Notes on the inflation puzzle

5 October 2017 Beyond inflation: spotting the signs of excess

3 November 2017 2017 Euro Plus Monitor: Into a higher gear

30 November 2017 Brexit scenarios: now for the hard part

15 December 2017 Global outlook 2018: coping with the boom

4 January 2018 Can Can productivity growth keep inflation at bay?

5 February 2018 Global update: Narrowing the transatlantic gap

3 July 2018

22 August 2018

Kallum Pickering Senior economist [email protected] +44 20 3465 2672

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Economics

Costs and benefits of deflation Not all deflation is created equal: whether it is good or bad largely depends on what the cause is. This view is not universally accepted. Financial market participants often react negatively whenever there is a so-called deflation “scare”. The most recent such example occurred in 2015/16 when the oil price declined sharply. As Chart 2 shows, the falling price of oil in 2014 coincided with a loss of upward momentum in global stock prices. Several key factors at the time, including worries about China and some other emerging markets, and risks linked to populism in Europe, had underpinned the fall in market confidence. But the falling oil price and associated weakness in oil-orientated industrial producers exacerbated the sell-off. Global stock markets sank in 2015 as the fall in the oil price worsened. Critically, global equity prices resumed their upward trend in 2016 when the price of oil started to rise again. The market panic in late 2015 over the fall in the price of oil did not make much sense. The decline in oil prices was mainly due to the positive supply-side development of a sharp increase in global oil supplies (mainly from US shale). It did not reflect an underlying weakness in global demand. The rise in the global supply of oil first caused a drop in the price of oil before dampening inflation across the range of goods and services linked to oil. The boost to real household incomes from cheap oil caused consumption growth to accelerate sharply in 2015 (Chart 3). The ongoing healthy expansion in global demand partly originated from the drop in oil prices three years ago. Chart 2: Oil prices versus global equities

Chart 3: Oil prices versus real private consumption (yoy %)

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It is somewhat surprising that the market sell-off was reinforced by a trend – cheap oil – that predictably boosted global GDP growth down the line. However, the episode highlights the generally reflexive negative response that deflation, lowflation and disinflation triggers among market and economic participants. Although markets rallied afterwards as the benefits to demand from the lowflation started to materialise, the initially negative reaction to slowing inflation is telling. Markets tend to focus on the demand side when it comes to inflation while ignoring the supply side. Low inflation or deflation caused by weak demand usually signals problems in the economy. In the case of the 2015 deflation scare, weak demand was not the main reason for the fall in the oil price.

Demand versus supply For the most part, the economic cycle is driven by short- and medium-term shifts in demand. As a result, many standard macroeconomic models – most notably Keynesian-style models – place more emphasis on demand than supply when describing the economic cycle. Major central banks rely on such models to produce forecasts for growth and inflation. In these models, estimates of supply growth are held constant over time and throughout the economic cycle. Supply estimates are seldom revised, and often only on a somewhat ex-post basis after initial estimates are proved inaccurate. As a result, central banks and markets can

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be late to incorporate features of supply than can be critical for determining long-term inflation trends. The BoE estimates that the UK’s potential growth is 1.5%. Like other major central banks, it sets its monetary policy in relation to its projections of demand versus its estimate of underlying supply growth. Persistent expected deviations in growth above and below the fixed estimate of supply potential usually lead it to raise or lower its policy rate respectively. This demand-focused approach to policy reinforces the market’s habit of explaining economic trends – including fluctuations in inflation – through changes in demand while often underestimating or ignoring the role of supply. As we highlight above, this habit led the market to initially misread the benefits that eventually arose from the drop in the oil price in 2015. Sometimes, of course, concerns arising from deflation are legitimate. Beyond the obvious signal that the economy is weakening, deflation caused by weak demand can trigger and reinforce at least three other serious problems. ● Because nominal wages are stickier than prices, deflation can push up real labour costs and lead to rising unemployment. ● If deflationary expectations become entrenched, households and firms can delay consumption in anticipation of lower prices in the future – thereby lowering demand and prices even further. ● Finally, deflation can constrain central banks’ ability to stimulate demand through lowering real interest rates – when the general price level is falling, central banks struggle to reduce their nominal lending rates to below zero – the “zero lower bound” problem. The widely held negative perception of deflation has deep roots that have been reinforced by a handful of bad economic experiences. Notable examples include: Hong Kong after the Asian crisis in 1997, Japan during the 1990s, and major parts of the western world during the Great Depression in the 1930s. However, during all of these key events, something else was going on that had damaging effects on the wider economy. Usually, it was a deflation of another sort – falling asset prices.

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What does history tell us about deflation? In the first two industrial centuries, the 18th and 19th, the UK government sector was small as a percentage of GDP, and the BoE largely stood back from trends in the business cycle. Deflation was common. Unlike today, policy makers made little effort to “smooth” economic cycles using fiscal and monetary policies. We identify key trends and features that were present in the economy during these regular bouts of deflation. Two observations are striking: (1) periods of deflation were often protracted – up to 50 years, with persistent entrenched deflationary expectations; and (2) apart from the Great Depression, the economy improved throughout all such periods, especially in the 19th century.

Deflation in the 18th century Chart 4 shows inflation measured by CPI and real GDP during the 18th century. Despite the prolonged periods of deflation (highlighted in grey), real GDP increased steadily over the century (c125% overall). We identify three lengthy deflations in the 18th century: 1) from 1700 1 to 1707 (eight years); 2) from 1713 to 1749 (36 years); and 3) from 1772 to 1788 (17 years) . ● From 1700 to 1707, the CPI declined by 23.5%. This was the shortest but most severe drop in the general price level during the 18th century. Long-term inflation expectations were negative for six out of the eight years – averaging -0.7% over the period – that the general 2 price level declined . Prices measured by the GDP deflator declined by 10%. Real wages (35.9%), real GDP per capita (3.2%) and real GDP (6.8%) all increased substantially. Annual real GDP growth averaged 1.6%, or 0.7ppt higher than the century average. ● The UK entered a long deflationary phase again in 1713. While prices fell by less than in the earlier period – CPI declined by 10.9% and the GDP deflator by 3.2% – it lasted much longer, some 36 years, until 1749. Long-term inflation expectations were negative for 21 of those years (average of -0.1%). Nevertheless, as in the previous deflationary period, general economic conditions improved. Real GDP increased by 33.9% (0.9% annual average). Real GDP per capita advanced by 22.7%, while real wages increased by 22.5%. Chart 4: Annual change in real GDP and inflation (1700=100)

Chart 5: Comparison of average annual change in CPI and GDP (%)

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● Finally, between 1772 and 1788, the UK experienced a long period of lowflation. Although the consumer price index declined by 3.5%, the GDP deflator rose by 8.3%. Average longterm inflation expectations remained modestly positive over the period at 0.3%. Annual real GDP growth averaged just 0.6% between 1772 and 1788. Real GDP increased by 13.9%

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Throughout this report we define a “deflationary” periods as multi-year trends of regular years of falling prices and persistent inflation expectations that are below 1%. 2 The inflation expectations series is available in version 3.1 of the Bank of England’s “Millennium of macroeconomic data” dataset. The series is based on the work of Chadha and Dimsdale – “A view of real rates” (Oxford Review of Economic Policy, vol. 15, no. 2).

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and real wages by 14.3%. However, real GDP per capita declined by 1.9%, partly due to the 16.1% rise in the size of the population. A clear picture emerges: deflation/low inflation was common during the 18th century. However, we find no link between changes in the general price level, measured by either the consumer price index or the GDP deflator, and the performance of GDP (Chart 5). But before history can provide any guide, we need to consider the differences between the world then and now. Looked at through modern eyes, the UK’s pre-industrial economy in the years 1700 to 1799 would hardly be recognisable. A modern market economy did not exist in major parts of the UK for most of its first industrial century. Virtually none of the capital stock (ie machines and tools) and transport systems (ie railways and canals) which came as part and parcel of industrialisation existed. International trade occurred only on a very small scale. The combined ratio of exports and th imports averaged just 5% of GDP in the 18 century, compared to c60% today. th

The localised and primitive nature of the 18 century economy meant that the foundations necessary for price discovery and efficient resource allocation – a high degree of choice and competition – did not exist. It is unlikely that inflation expectations played a major part in economic decision-making. Therefore, we should not draw overly strong lessons from this period.

Deflation in the 19th century th

By the 19 century, industrialisation was in full swing. Despite an increase in the population from c12m in 1800 to 38m by 1900 and two lengthy periods of deflation – from 1812 to 1851 and from 1857 to 1906 – per capita living standards improved significantly over the century. Before describing the broad trends in growth and inflation, it is worth outlining a few key th events and trends that occurred during the 19 century to provide a context. ● The UK experienced a major banking crisis in 1825-6 – comparable to the 2007-08 crisis – in addition to minor crises in 1847, 1857-8, 1866-7, and 1878-9. John D Turner’s book 3 “Banking in Crisis” provides a nice historical overview of these and other events in the UK financial sector. There notable conflicts including the Napoleonic Wars, the Opium Wars, the Boer Wars and the Crimean War. Chart 6: Output by sector (1750=100)

Chart 7: BoE begins to intervene more in the 18th century

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● The UK started the century with a mercantilist trade policy which was aimed at boosting trade within the British Empire to increase wealth and profits at home, while damaging trade in rival empires. But over time, the UK shifted away from mercantilism in favour of free trade. This policy accelerated after the UK lost some of its largest and most developed colonies during and after the American War of Independence (1875-83).

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Turner, J (2014). Banking in Crisis: The Rise and Fall of British Banking Stability, 1800 to the Present (Cambridge Studies in Economic History – Second Series). Cambridge: Cambridge University Press.

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● The UK abandoned mercantilism by the mid-19th century. Most notably, the repeal of the Corn Laws in 1846 led to a fall in the prices of imported grains which underpinned the shift in the UK domestic economy from agriculture toward production and services (Chart 6). ● The BoE had acted as financier to the government and issuer of banknotes since it was founded in 1694. In the 19th century, it began to intervene in the economy more with changes in its short-term rate. The BoE became the lender of last resort for the first time during the panic of 1866. Chart 7 shows the bank rate versus the annual change in real GDP from 1750 to 1900. Note that the bank rate was unchanged at 5% for the entire second half of the 18th century. During the 19th century, the BoE started to alter its bank rate in line with fluctuations in output. th

There were two major deflations in the UK during the 19 century. The first lasted from 1812 to 1851, a period of 40 years. The second lasted from 1857 until 1906 – an impressive 50-year stretch. Both occurred as a result of positive supply trends, namely dramatic rises in productivity linked to international trade. Across all key metrics, the UK economy improved in major ways. Four key points bring this out clearly.

Consumer prices declined linked to falling import prices (Charts 8 and 9) ● Between 1812 and 1851, the UK import price index declined by almost 60%. Consumer prices fell by c43%. The GDP deflator receded by c46%. ● Between 1857 and 1906, the import price index declined by c40%. Consumer prices cheapened by c14% over the period. The GDP deflator remained broadly unchanged after a period in which it increased, offset by a similar decline thereafter. Chart 8: Measures of inflation (domestic versus imported)

Chart 9: Measures of inflation (domestic versus imported)

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Real GDP and trade doubled (Charts 10 and 11) ● A trade ratio is the sum of imports and exports as a percentage of GDP. During the first deflationary period of the 19th century, the trade ratio roughly doubled from 8% of GDP to nearly 17% of GDP. During the second deflationary period, the trade ratio increased substantially again, from c19% of GDP to 33%. ● The fall in import prices described above caused demand for imports to rise. The substitution of domestic products for imports freed up domestic factors of production for other uses. ● In line with the rise in trade, real GDP more than doubled during each of the two periods. By becoming more open in the 19th century, the UK and its trading partners reaped the benefits of higher productivity and specialisation that increased along with trade.

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Chart 10: UK trade ratio versus real GDP


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Solid gains in real earnings, per capita GDP and productivity (Charts 12 and 13) ● Total factor productivity increased by more than 25% from 1812 to 1851 and by c50% from 1857 to 1906 as trade increased. ● Lower consumer prices and gains from specialisation through trade supported major gains in real GDP per capita and real incomes. Per capita real GDP rose nearly 40% and real wages by almost 50% in the 40 years from 1812. In the 50 years from 1857, per capita real GDP and real wages increased by c60% and c80% respectively. Chart 12: Real earnings, real GDP per capita, and productivity

Chart 13: Real earnings, real GDP per capita, and productivity

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Share prices increased, public debt ratios declined (Chart 14 and 15) ● After peaking at 214% of GDP in the 1810s, public debt as a percentage of GDP had declined to 130% of GDP by 1851. Share prices increased by c350% over the same period despite a near-20% correction in share prices during the banking crisis of 1847. ● The government’s balance sheet and share prices enjoyed similarly large improvements between 1857 and 1906. Share prices increased nearly sevenfold, while government debt declined from c100% of GDP to below 40% by 1906.

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Chart 14: Share price index versus public debt (% of GDP)

Chart 15: Share price index versus public debt (% of GDP)

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The lesson of the 19 century is clear: if deflation is caused by positive supply-side factors, it does not inhibit improvement in the economy but promotes it instead. Total real GDP and per capita GDP can grow at healthy rates and productivity can rise (indeed, the fall in prices reflects the improvements in productivity). Share prices can rise amid rising productivity gains while strong growth can lower debt ratios.

Inflation trends in the 20th century th

The first half of the 20 century was defined by three major crises: the First World War (1914-18), the Great Depression (1929-39), and the Second World War (1939-45). Few periods in history provide greater insight than these crisis decades. To some extent, the success th during the second half of the 20 century is the consequence of the failures during the first half of it. However, for our analysis, which focuses on inflation during normal times, this th period is best skipped. We begin our analysis on the 20 century analysis in 1950. th

There is no major period of deflation in the second half of the 20 century. However, the period still warrants analysis in light of its own unique inflation trends. On the one hand, th th much like the 19 century, during the 20 century the UK enjoyed rapid growth in living standards, supported by rising trade and technological progress (supply-side improvements). Equity markets performed well and public debt dynamics improved. On the other hand, inflation during the last century was like nothing seen before in modern history. In contrast th to the 19 century where major improvements in the supply-side of the economy led to th higher output and lower prices, the 20 brought higher output and higher prices. Real earnings and real GDP per capita increased fourfold between 1950 and 2000, supported by a nearly 150% rise in total factor productivity (Chart 16). This was underpinned by a sharp rise in the UK trade ratio from 20% of GDP to nearly 55% of GDP by the end of the century. Real GDP quadrupled (Chart 17). Chart 16: Real earnings, real GDP per capita, and productivity


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The rise in UK trade mirrored ongoing trends in global trade after the Second World War. The mostly developed nations of the western world sought to reverse the protectionism that had worsened the Great Depression – think General Agreement on Tariffs and Trade (GATT). Then, another spurt in trade growth occurred from the 1980s onwards as the closed-off eastern economies that had previously orbited the command-and-control economy of Soviet Russia began to open up and join the European community. Thanks to solid gains in real output, productivity and trade, equities rose nearly 80-fold, while public debt as a percentage of GDP declined from 200% to less than 40%. Although the rise in share prices and fall in the public debt ratio look impressive, such trends ought to be considered in the context of inflation trends. Chart 18: Share price index versus public debt (% of GDP)

Chart 19: Measures of inflation (domestic versus imported) 200

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Unlike during the deflationary periods of the 19th century, when share prices rose and public debt dynamics improved as prices fell, the high inflation is partly responsible for these th developments in the 20 century. The consumer price index rose over 15-fold between 1950 and 2000, while the GDP deflator rose by more than 20-fold. Despite the rise in global trade, import prices rose almost tenfold over the period. This stands in contrast to past experience where rising trade had gone along with falling import prices. But as relative prices determine demand, the slower rate of import price growth relative to domestic price growth (Chart 19) will have encouraged UK households and firms to gradually switch to the relatively cheaper imported goods.

What caused the high inflation of the 20th century? During the 1950s, disciples of British economist John Maynard Keynes concluded that western economies had escaped the Great Depression because of the demand-side boost from high government spending during the Second World War. They decided that, through big government and interventionist policymaking, demand-side management (monetary and fiscal policies) could steer economies out of the boom/bust cycles that had been a feature of the pre-war economy towards a more stable employment and growth path. UK government spending was less than 10% of GDP in the early 1900s. It gradually rose to a peace-time high of c45% in the mid-1970s when the annual growth rate in nominal public spending growth peaked at c35% as growth in the monetary base hit 15% and inflation broke 20%.

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Chart 20: Government spending, monetary base and inflation 40

Chart 21: Measures of inflation (yoy %) 25

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Governments and central bankers thought they need not worry about high inflation during periods of rising unemployment. During the 1950s, 1960s and 1970s, western governments were firmly committed to Phillips curve logic – they believed one could simply trade off inflation and unemployment. This proved to be a mistake. By the late 1960s, unemployment had started to rise. This continued through the 1970s despite accelerating government spending and growth in the money supply. By the mid-1970s, government spending and inflation were surging (Chart 20). Eventually, the evidence that misguided policies were not achieving the desirable outcomes curbed the public’s enthusiasm for demand-side management, mostly notably with the election of Prime Minister Margaret Thatcher in 1979. Mrs Thatcher’s initially painful medicine of tight monetary policy and smaller government had tamed inflation by the late 1980s. th

As Chart 21 shows, from 1934 until the end of the 20 century, the UK did not experience a single year where the general price level declined – measured either via the GDP deflator or the consumer price index. But things have changed since the financial crisis. Rather than battling inflation, central banks now face the challenges posed by disinflationary pressures. That is, not quite deflation, but a persistent weight of factors weighing on inflation.

The bottom line On its own, deflation or lowflation need not be a sign of a deteriorating economy. Using BoE data going back to 1700, we show that the UK economy has often performed well during lengthy periods of deflation throughout its modern history. We find no obvious negative correlation between deflation and growth when the fall in the price level is due to improvements in the supply-side of the economy – ie rising trade or gains in productivity. Instead, we find examples of multi-decade deflations – which we define not just as periods when measured prices fall but when there are persistent deflationary or lowflation expectations – that go hand in hand with strong real GDP growth, rising trade, per capita incomes, productivity, and share prices and a falling public sector 4 debt ratio . Critically, while we find little evidence of strong negative effects from lengthy deflations, we can easily identify periods where high inflation damaged the economy – such as during the 1970s and 1980s.

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The long-term data we use in this report can be found in the BoE’s long-term dataset “A millennium of macroeconomic data” https://www.bankofengland.co.uk/statistics/research-datasets

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Factors driving current and expected inflation trends In October 2017, we published Notes on the inflation puzzle. In this report, we discussed the trends in inflation since the financial crisis, and outlined four major factors that are likely to drive future inflation trends. ● The age of caution: So far, the moderate economic recovery in advanced economies since 2009 has not resulted in any significant exuberance, let alone any genuine spending excesses. As Chart 22 shows, nominal domestic demand growth in major parts of the advanced world has been much lower in the post-Lehman period than in the decade before the crisis. Chart 23 shows that aggregated domestic debt levels have stabilised or fallen. Chastised by the 2000s boom/bust experience, households and firms operate with more caution than before. As a result, we find very little evidence yet of a significant demand-driven increase in inflationary pressures in advanced countries. ● Globalisation: The integration of China and other formerly closed countries, such as those of the erstwhile Soviet bloc, into the global economy since the late 1980s has increased the pool of labour and resources available to the broader global economy. This constitutes a positive supply shock drawn out over a period of at least two decades. A deeper division of labour and supply across regions enhances the efficiency of production. As a result, excess demand in one region can be distributed across the supply chain, causing a small rise in prices in many countries rather than a surge in prices in one region. A rising share of imports in real GDP has the same impact: it makes supply more responsive to changes in demand for tradable goods and services. ● Technological change: Rapid technological change helps augment supply relative to demand. By reducing search costs and increasing transparency for consumers, the internet has made markets more competitive. Fiercer competition puts downward pressure on prices as firms fight for market share. As this is an ongoing process rather than a one-off effect, it reduces the rates of inflation instead of showing up merely as a one-off drop in prices. It is difficult to distinguish between price increases and genuine quality improvements. If statistical agencies have underestimated the contribution to growth of these new technologies it would imply they have overestimated the deflators used to turn nominal output into a measure of real output and therefore that inflation rates have been overestimated. ● Labour market: In the US, the UK, Germany and some other countries, unemployment has fallen back to levels consistent with market and central bank estimates of “full employment”. Contrary to perceived “Phillips curve” wisdom of a clear inverse relationship between unemployment and wage growth, the tightening of the labour market has not gone along with a pronounced acceleration in wage inflation yet. The “age of caution” workers seem ready to accept lower wage increases than in the past in return for a higher degree of job security. Because wage inflation is more subdued than before, demand growth is weaker too, thus lowering the demand pull impulse on inflation. Inflation rates will likely continue to edge up much more slowly in the current post-Lehman economic upturn than in previous cyclical recoveries. This may last for a long time. If so, it is possibly that we will go through a period where deflation becomes a potential reality. Even as economic conditions improve, central banks may struggle to meet their 2% inflation targets as positive supply trends create disinflationary pressure.

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Chart 22: Average annual change in nominal domestic demand

Chart 23: Domestic debt outstanding (% of GDP) 600

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2017

-1

Quarterly data. Source: Eurostat, Cabinet office of Japan, Office of National Statistics, Bureau of Economic Analysis

Quarterly data. Source: Eurostat, Bank of Japan, Office of National Statistics, Federal Reserve Board

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Economics

Straining for 2% inflation – practical consequences Major central banks, including the BoE, the Federal Reserve, the European Central Bank (ECB), and the Bank of Japan (BoJ), all target 2% inflation as measured by a version of the consumer price index. For the BoE, the Fed and the BoJ, this target is symmetric, while the ECB targets inflation of close to but below 2% (an asymmetric target). The architects of inflation targeting typically argue that a small amount of inflation is beneficial, to help avoid zero lower bound problems, and to help overcome the problem that nominal wages are sticky – they adjust downward slowly to rising unemployment. They argue, as US economist James Tobin once put it, that a little inflation helps to “grease the wheels of the economy”. But the 2% target is largely arbitrary. Some economist favour slightly higher targets, some lower. At any rate, consistently achieving 2% inflationary requires considerable effort. By committing to 2% inflation under all circumstances, sometimes central banks are forced to artificially steer the economy away from its natural path. Suppose, for instance, the BoE had th tried to hit 2% inflation during the 19 century. Just how much extra borrowing and demand growth would have it required to reach 2% inflation amid the powerful deflationary forces at play? One might argue that, as wages are now less flexible to the downside than they may have th been in the 19 century, deflation could be much more dangerous now. However, we are only referring to price deflation as a result of positive supply-side trends. This would not require wage deflation, because, as prices fall because of a positive supply shock, productivity would increase and mitigate any impact on unit labour costs from falling prices. The BoE was made independent in 1997. From then until 2003, its mandate was to target 2.5% annual inflation as measured by the retail price index excluding mortgage interest payment (RPIX). During this period, RPIX inflation averaged c2.4%. In 2003, then-Chancellor Gordon Brown switched the BoE’s targets to 2% yoy change in the consumer price index. When the target changed, CPI inflation was trending below 1.5%. CPI inflation averaged just 1.3% between 1997 and 2003 – all the time the BoE had achieved its RPIX target, implying that monetary policy was too tight during those years. To hit the new inflation target, the BoE lowered the bank rate from a peak of 7.5% in 1998 to 3.5% in 2003 despite a backdrop of solid demand growth (Chart 24). Not all excesses show up in prices. As the BoE lowered the policy rate between 1998 and 2003, the growth rate in debt as a percentage of GDP started to accelerate. As Chart 25 shows, had the pre-1997 trend continued, total domestic debt would have been c325% of GDP on the eve of the financial crisis. Instead, it was over 450% of GDP. There is no doubt that the balance sheet recession that occurred in 2008/09 would have been far less severe if liabilities as a percentage of GDP would have been almost a quarter lower. Chart 24: Real GDP growth, inflation and BoE policy rate

Chart 25: UK domestic debt as a percentage of GDP compared to 1987-96 trend

14

500

Real GDP (yoy %)

Domestic debt as a % of GDP

12

1987-96 trend

450

Consumer price index (yoy %) 10

400

BoE policy rate (%) 8

350

6 300

4 250

2

200

0

150

-2 1991

1993

1995

Quarterly data. Source: BoE

1997

1999

2001

2003

2005

2007

1991

1993

1995

1997

1999

2001

2003

2005

2007

Quarterly data. Source: ONS

Between 1997 and 2007, CPI inflation averaged just 1.6% pa. Although this seemed low at the time, especially in context of the double-digit rates of inflation in the 1970s and 1980s,

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considering the backdrop of rising trade and technological improvements from computerisation and other digital technologies – very similar trends to the 19th century – such inflation rates seem decidedly high. In other words, had the BoE not been required by its mandate to pursue a fixed inflation target, its monetary policy might not have been as expansionary, and in turn, it might not have engendered the excesses that led to crash. As our historical analysis shows, lengthy deflations caused by positive supply trends have not harmed the UK economy in the past. Instead, the BoE’s blind pursuit of its inflation target caused problems of its own. As future inflation trends will be shaped by two positive supplyside factors – robotics and continued rising global trade – UK governments might consider if legislating the BoE to strive to meet the symmetric 2% inflation targets is worth the risks. The BoE could, for instance, simply revert back to its original mandate before the fixed inflation target was introduced in 1997. When UK monetary policy first started to target inflation in October 1992, decided by then-Chancellor Norman Lamont – to replace the framework of the exchange rate mechanism, Mr Lamont wrote in a letter to the Treasury Select Committee:

“I believe we should set ourselves the specific aim of bringing underlying inflation in the UK, measured by the change in retail prices excluding mortgage interest payments, down to levels that match the best in Europe. To achieve this, I believe we need to aim at a rate of inflation in the long term of 2% or less.” Note that the original framework for inflation targeting would not prevent the BoE from allowing the general price level to decline in the way that the current symmetrical 2% target does. During the current upswing, the BoE has pursued an unnecessarily slow policy normalisation, hiking the bank rate just twice in November 2017 despite record employment and eight years of unbroken economic growth. Why? Because inflation has remained stubbornly low. But then again, so has wage growth. If wage growth is set to rise at no more than, say, 3% yoy – close to the current rate – for the foreseeable future, would not households be better off in terms of real income growth if inflation ran at 1% rather than 2%? When wage growth is weak, inflation does more harm than good. Generally speaking, economists treat money as neutral in the long run. In other words, while monetary policy can affect short-term demand, changes in the stock of money only affect nominal variables over the long term (they do not raise real output). On this basis, the inflation target is largely irrelevant. However, this view mostly ignores the role of debt and finance. Suppose a central bank engenders a large build-up of debt over a period, in order to raise demand growth by enough to meet its inflation target. Real output growth may not be higher during this period if the extra debt simply leads to more inflation. However, after a while a stock of debt can begin to weigh on real output growth. Potential growth post-crisis would have been much stronger in the UK and elsewhere if central banks had controlled the precrisis build-up in debt better. Instead, the large debt overhang and related balance sheet recession has had far-reaching consequences, including lowering potential growth. Had the BoE followed its original mandate prior to and after the financial crisis, its policy would likely have been tighter both before and after the crisis. For instance, it could have easily justified beginning its normalisation as early as 2014 when real GDP growth was touching 3%, as well as during the 2015 and 2016 when the fall in the oil price boosted real incomes. In a likely future disinflationary environment, the BoE’s rigid 2% mandate could encourage it to pursue a monetary policy that is persistently too easy. If the BoE returned to its old mandate, it would have the freedom to allow positive supply trends to reduce inflation or even lower the price level – this would boost real output and wages. Maybe the best next step forward may actually be a step back.

14

Economics

Disclaimer This document was compiled by the above mentioned authors of the economics department of Joh. Berenberg, Gossler & Co. KG (hereinafter referred to as “the Bank”). The Bank has made any effort to carefully research and process all information. The information has been obtained from sources which we believe to be reliable such as, for example, Thomson Reuters, Bloomberg and the relevant specialised press. However, we do not assume liability for the correctness and completeness of all information given. The provided information has not been checked by a third party, especially an independent auditing firm. We explicitly point to the stated date of preparation. The information given can become incorrect due to passage of time and/or as a result of legal, political, economic or other changes. We do not assume responsibility to indicate such changes and/or to publish an updated document. The forecasts contained in this document or other statements on rates of return, capital gains or other accession are the personal opinion of the author and we do not assume liability for the realisation of these. This document is only for information purposes. It does not constitute a financial analysis within the meaning of § 34b or § 31 Subs. 2 of the German Securities Trading Act (Wertpapierhandelsgesetz), no investment advice or recommendation to buy financial instruments. It does not replace consulting regarding legal, tax or financial matters. Remarks regarding foreign investors The preparation of this document is subject to regulation by German law. The distribution of this document in other jurisdictions may be restricted by law, and persons, into whose possession this document comes, should inform themselves about, and observe, any such restrictions. United Kingdom This document is meant exclusively for institutional investors and market professionals, but not for private customers. It is not for distribution to or the use of private investors or private customers. United States of America This document has been prepared exclusively by Joh. Berenberg, Gossler & Co. KG. Although Berenberg Capital Markets LLC, an affiliate of the Bank and registered US broker-dealer, distributes this document to certain customers. This document does not constitute research of Berenberg Capital Markets LLC. In addition, this document is meant exclusively for institutional investors and market professionals, but not for private customers. It is not for distribution to or the use of private investors or private customers. This document is classified as objective for the purposes of FINRA rules. Please contact Berenberg Capital Markets LLC (+1 617.292.8200), if you require additional information. Copyright The Bank reserves all the rights in this document. No part of the document or its content may be rewritten, copied, photocopied or duplicated in any form by any means or redistributed without the Bank’s prior written consent. © 2018 Joh. Berenberg, Gossler & Co. KG

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17