BOE Update: Domestic Inflation Peripheral For Post-Forbes BOE

--Former MPC Forbes Made Heavy Use of DGI Measures To Justify Hike Vote

--Broadbent, Other MPC Seen As More Sceptical About DGI Measures

By David Robinson

     Domestically generated inflation measures were always cited as the reason

for higher rates by recently departed Bank of England Monetary Policy Committee

member Kirsten Forbes -- but there is no agreement among her former colleagues

about which DGI measure to use and there are doubts about how reliable they are

at all.

     Anecdotes from people familiar with the debate at the Bank, alongside

public comment from policymakers, reveal that MPC members are divided over what

weight to put on DGI measures and that there is scepticism about their

usefulness, with Deputy Governor for Monetary Policy Ben Broadbent believed to

be among the doubters.

     In her final policy speech and media interview in June Forbes, who voted

for a 25 basis point rate hike at her final three meetings, again put indicators

of domestic inflation centre stage. She said that DGI was already up around

levels compatible with the MPC's 2.0% CPI goal.

     "My preferred measure of domestic inflation ... is now at 2.2%. When

adjusting for trends in underlying core goods inflation, service inflation is

now at or above levels consistent with inflation sustainably at target," Forbes

said.

     Forbes' favoured way of looking at domestic inflation was to take a

weighted average of DGI measures which places less weight on the more volatile

inflation components. One obvious problem with taking any weighted average

across various measures is that this leaves how much weight to place on each

measure wide open to debate, with no agreement on the MPC over this.

     The Bank's August Inflation Report had a section on DGI, but acknowledged

the lack of agreement over weighting these measures.

     "There are a range of views among MPC members about the relative importance

of various measures of DGI ... and some members also consider other measures,"

the Report said.

     In the Bank's own language, the phrase "range of views" is the stock one to

cover disharmony.

     In theory, splitting out DGI should be a key part of monetary policy, as it

allows policymakers to avoid the trap of moving rates in response to the price

impact of currency movements. 

     The August Inflation Report stated that "DGI ... will determine where CPI

inflation settles once transitory effects, such as from the recent fall in

sterling, have passed through."

     Nomura economist George Buckley said in a note that with a lot of the rise

in CPI from just 0.2% a year ago to 2.6% apparently due to the fall in sterling

policymakers would want to avoid responding "to a rise in inflation that was

solely the result of a fall in the currency which in turn was due to weaker

growth expectations thanks to Brexit."

     As the Bank's August Inflation Report noted, every single measure of DGI

comes with caveats. Import prices tend to seep into supposedly domestic

measures. UK manufacturers, for example, may use imported parts and even service

companies' costs will be impacted by the rising price of overseas goods, such as

computers, and overseas services.

     One proxy for domestic inflation is core inflation, but as the Inflation

Report noted many goods and services in the core basket are sensitive to import

price changes.

     Another way of monitoring DGI is to focus on cleaned up measures of

services inflation: using the services producer price index (PPI) and stripping

out regulated prices such as education. This way of measuring DGI, aside from

excluding goods, has the drawback that services prices are impacted to some

degree by external costs.

     Yet another way of trying to get a fix on domestic inflation is to use

gross value added deflators, but these too are influenced by export and import

price movements. 

     A more traditional way is to rely on unit labour, or wage, costs (ULC/ULW),

though the drawback here is that this takes no account of shifts in firms'

margins. ULC comprises whole-economy labour costs divided by real GDP, entailing

that it is driven by productivity growth as well as wage and other employee cost

growth.

     When Broadbent, following his speech at Imperial College in March, was

asked about domestic inflation pressures he replied by talking about subdued

ULC. Low wage growth, accompanied by weak productivity growth, has kept ULC in

check.

     Looking forward the MPC does expect wage growth to pick-up, which would put

upward pressure on labour costs unless productivity also accelerates.

     At the August Inflation Report press conference Broadbent drew attention to

the prolonged weakness of productivity growth compared to the more ephemeral

impact of sterling weakness.

     "The big influence on real wages over the last year ... has been rising

import prices. Over the last ten years, it's been weak productivity growth," he

said.

     Alternative DGI measures, with spuriously precise figures attached, look

likely to be a sideshow for policy, with the focus still on such long-running

issues as whether, and when, wages and productivity growth will finally pick-up.

--MNI London Bureau; tel: +44 203-586-2223; email: david.robinson@marketnews.com

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