Growth, real terms growth, and inflation

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In this figure I show you three things. The red line is the standard rate of annual inflation in the cost of living – the all-items retail prices index. The green line tells us how the real value of quarterly output of the economy compared with the real value of output in the same quarter a year earlier (so, for example, real output in the second three months of 2011 is 0.8 percent higher than real output was in the second three months of 2010). I’ll call this “yearly real GDP growth”. The blue line tells us what happened to quarterly output in cash terms – when there is inflation, a rise in cash terms will be greater than the rise in real terms. I’ll call this “yearly money GDP growth”.

We can see that during most of the period 2000-2006, yearly money GDP growth was usually around 5 per cent, real GDP growth around 2.5 percent, and inflation around 2.5 percent. The first major departure comes in 2006, when money GDP growth goes well above 6 percent. Then inflation goes well above 4 percent (reaching 5 percent). Then we see all three series plummet during the 2008-9 recession. But then look at what happens after the recession. Money GDP growth returns to 5 percent, back to its pre-recession norm. There have been those (most notably Sir Samuel Brittan for many years, and more recently Giles Wilkes) who have argued that monetary policy should target money GDP growth instead of inflation. Indeed, some implicit variant of this is very probably an element in the Monetary Policy Committee’s thinking for 2009 onwards (it certainly was in mine). Well, the period after the recession should make Sir Samuel and the MPC happy – since the year following the commencement of quantitative easing (i.e. in our data, since the second quarter of 2010), yearly money GDP growth has been remarkably stable.

Now, if inflation had been around 2.5 percent, then 5 percent yearly money GDP growth would have meant about 2.5 percent real growth – as many hoped. But, in fact, inflation has been much higher than forecast, so real growth has been correspondingly lower. That extra cash the economy has produced just isn’t worth as much stuff. I suspect that is partly because the capacity for the economy to grow isn’t as high as we’d previously thought.

But now ponder this: what will happen if the economy does start to accelerate? If even the paltry growth of the past nine months has been associated with a rise in inflation, what might be the impact on inflation if the economy really starts to motor? The happy path would be if money GDP growth stayed pretty much where it is, but inflation fell back, so real growth accelerated. That is what the Bank of England hopes will happen. The other possibility is that when real growth accelerates, we will see a larger rise in money GDP growth, so inflation will accelerate even further. That’s what I expect.