CPI inflation is expected here to fall further through early 2014, undershooting the MPC’s forecast significantly, before rebounding later next year and in 2015 in lagged response to recent monetary buoyancy and associated economic strength. The near-term decline may allow the MPC to claim that the “inflation-growth trade-off” (a questionable concept) is more favourable than it had assumed, implying that Bank rate can be held at 0.5% even if the unemployment rate falls well below its (current) 7% threshold.

CPI inflation eased from 2.8% in July to 2.7% in August, while the core measure monitored here – which excludes energy and unprocessed food and adjusts for changes in VAT and undergraduate tuition fees – was stable at 2.0%. The core rate has trended lower since early 2012 in lagged response to a slowdown in monetary growth in 2010-2011 – see previous post for details.

The core downtrend is scheduled to continue into the autumn and may be reinforced by recent sterling strength. Coupled with smaller rises in energy and unprocessed food prices than a year before, this may result in CPI inflation falling to 2.25-2.5% in early 2014 versus a current MPC central projection of 2.89% for the first quarter of next year.

Core inflation, however, is forecast here to embark on another upswing from late 2013 in lagged response to a sustained pick-up in monetary growth from late 2011. Incorporating assumptions about energy and food prices detailed in the prior post, this implies that CPI inflation will move significantly higher from spring 2014, probably exceeding 3.0% during the second half of next year. The first chart below shows projections for headline and core inflation while the second compares the former with the MPC’s forecast.

The suggestion is that the MPC’s policy stance will be exposed as having been much too accommodative in mid-2014, with the unemployment rate at or close to the 7.0% threshold and inflation rebounding strongly. Monetary conditions may then be tightening in response to higher market yields and as faster inflation squeezes real money supply growth. Belated hikes in Bank rate would not prevent a further rise in core inflation in 2015 – already baked into the cake by recent monetary trends – but would increase the probability of another economic downswing in 2015-16.

Such a scenario would imply that, by failing to respond in a timely fashion to monetary signals, the MPC has once again served to magnify rather than moderate underlying economic volatility. Such mismanagement, in turn, deters businesses from making the investment commitments needed to boost long-run potential growth.

UK productivity – output per hour worked – is currently 15% below an extrapolation of its trend over 1998-2008. Productivity rose at a trend rate of 2.3% per annum (pa) over this period; since 2008, by contrast, it has fallen by 1.0% pa – see following chart.


The Bank of England’s Monetary Policy Committee (MPC) forecasts that productivity will recover by 1.8% pa over the next three years. Many commentators regard this as unduly pessimistic, since it implies that 1) the 15% loss relative to the prior trend is permanent and 2) future trend growth will be below the historical average.

The judgement here, by contrast, is that the MPC's forecast is optimistic. This is based partly on an analysis, summarised below, of the last major productivity slowdown, in the 1970s. The weaker productivity performance expected here informs the view that unemployment will fall more rapidly than the MPC expects while “core” inflation will pick up in 2014-15.

The 1970s analysis is based on output per worker rather than output per hour because the former has a longer data history. Inspection of the data reveals a strong productivity trend in the decade to 1973, much slower growth between 1973 and 1980 and a return to faster expansion in the 1980s – next chart.


The change in trend in 1973 coincided with the onset of the “first oil shock” recession, which had similarities to the 2008-09 downturn – it was preceded by extreme monetary / credit laxity and precipitated a financial crisis; a spike in energy costs, moreover, contributed significantly to the 2008-09 recession.

A key difference from the recent past is that productivity continued to grow in the mid to late 1970s. The divergence from the prior trend, however, was substantial. Trend productivity growth slumped from 3.3% pa over 1963-1973 to 1.4% over 1973-1980, a reduction of 1.9 percentage points (pp). This compares with the recent decline of 3.3 pp (i.e. from 2.3% to -1.0%). By 1980, productivity was 16% below the prior trend – similar to the current 15% shortfall.

Several features of the 1970s experience are discouraging to current productivity optimists. First, the period of weakness lasted seven years, which, if repeated now, implies no recovery until 2015. The optimists, presumably, would argue that the larger deterioration in recent years increases the likelihood of an earlier revival.

Secondly, while productivity recovered after 1980, growth was permanently lower than before 1973. There was no catch-up relative to the prior trend. Trend growth over 1980-1990 was 2.5% pa, 0.8 pp below that in the decade to 1973. A similar step down now would imply future expansion of 1.5% pa (i.e. the 1998-2008 trend of 2.3% pa minus 0.8 pp).

The 1980s productivity revival, moreover, occurred only after another – deeper – recession and was at least partly due to economic liberalisation under the Thatcher government. The 1980-1981 downturn forced companies to shed low-productivity workers, whose jobs had been shielded by the loose monetary / fiscal policies of the 1970s. The Thatcher reforms, meanwhile, resulted in a more efficient allocation of capital and labour.

Current and prospective faster economic expansion should allow productivity to recover but the working assumption here is that growth will be 1.0-1.25% pa in the absence of policy changes to improve economic efficiency. If GDP rises by 2.5-2.75% pa, and the labour force expands in line with the MPC’s projection, this would imply a decline in the unemployment rate of about 0.75 pp pa – consistent with it reaching 7.0% in mid-2014.

The optimists believe that productivity growth will “mean revert” without any policy intervention, resulting in unemployment staying high. The 1970s-1980s experience suggests that causation is the other way round – a normalisation of productivity expansion may occur only as a result of policy changes that promote a reallocation of resources and push unemployment higher in the short term.

A scenario regarded as plausible here is that, with productivity performance remaining weak, faster growth will run into capacity and inflation constraints in 2014-2015; an associated tightening of monetary conditions – probably market-led rather than due to the MPC – could then produce another economic downswing in 2015-2016. Depending on its extent and policy choices, this downswing – like the 1980-1981 recession – could act as a catalyst for a more significant and durable improvement in productivity growth.