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Do Central Banks know what they’re doing?

I’m going to go out on a limb and suggest that Mark Carney and his friends at the Bank of England know more about what makes the economy tick than I do.

Yet with Carney under the spotlight to increase interest rates in November, there’s an argument that traditional economic relationships have broken down – leaving the highly revered Central Banks with little idea of how inflation really works.

UK inflation reaches 3%

Before I dig into the macroeconomic theory, let’s flip through the latest health chart for the UK economy.

Inflation jumped to a five-year high of 3% in September, with the latest surge driven by an increase in transport and food prices.

September signalled a tightening of consumer purse strings, with retail sales falling 0.8% – worse than the 0.1% pencilled in by City analysts. A look at volumes shows that the number of units sold rose just 1.5% in the third quarter, the slowest rate of annual growth since sales started to recover from the financial crisis in 2013.

Why are retail sales falling?

Underpinned by sterling’s post-referendum fall, inflation has accelerated ahead of subdued wage growth, which has tightened UK household budgets.

Brits have either been eating into their savings or borrowing to maintain their spending habits.

The Bank of England is expected to increase interest rates by 0.25% in November, which will make it more expensive to borrow. This may explain the sudden and more exaggerated fall in retail sales.

What’s this got to do with Central Banks?

It’s the Central Bank’s job to adjust interest rates to keep inflation in line with targets set by the government. In the UK, this target is 2%.

After nearly a decade of low interest rates, Central Banks want to return to a normal monetary policy – but all eyes are on these economic stalwarts as they plan their route.

To stop an economy from overheating, Central Banks will raise interest rates to make borrowing more expensive and curtail spending. Less demand for goods and services will cause prices to fall, which means inflation should begin to ease.

To stimulate an economy, Central Banks cut interest rates to make saving less attractive and encourage spending with cheap money. With cash to spend, demand for goods and services increase, pushing up prices.

What’s the Bank of England waiting for?

Before Carney increases the bank rate to 0.5%, he would ideally want to see evidence of wage growth in the UK labour market.

Globally, the economy is enjoying its strongest upsurge since 2010, but some of the trends that would traditionally underpin this momentum are absent. Essentially, inflation isn’t performing as the economic models say it should.

The big question is whether Central Banks actually understand the effects on inflation anymore.

If they don’t, current attempts to control the economy might not just prove futile, but could affect growth rates going forward.

Phillips wage curve

Traditional macroeconomic theory by AW Phillips looks at the link between the economic cycle and inflation. The Wage Phillips Curve suggests that a strong labour market should underpin wage growth.

In theory, a smaller supply of workers should mean employers hike their wages to attract them.

A crucial factor of this theory is slack – the amount of unused capacity in an economy.

It used to be that falling slack would push up wage growth, but this relationship seems to have weakened since the global financial crisis, and many experts are questioning the relevance of the model today.

Previously, the Bank of England thought unemployment had to reach 7% before wages and inflation bounced – now they’ve cut this measure to 4.5%. Which suggests there might be more slack in the economy than they thought, and could explain some of this shift.

Where’s the wage growth?

In the UK, unemployment has almost halved since 2010 and is now at a record low, but wage growth hasn’t budged off its 2% annual growth.

It’s unclear why. Perhaps it’s because inflation expectations influence worker’s demand for wage increases. Central Banks have kept inflation in line with its target, so there’s been less of an urgency for higher income.

Although stagnant wage growth could also be down to falling levels of productivity, the gig economy could also have a lot to answer for.

With half of all jobs created in the UK over the last few years said to be in the gig economy, the UK relies on thousands of zero-hour contract workers who get no guaranteed minimum hours at work1. Temporary workers have significantly weakened bargaining power when it comes to negotiating a pay rise.

A future shift in the composition of the workforce may breathe new life into the Phillips wage curve. If these factors are cyclical, the flattening of the wage Phillips curve may be temporary.

What are Central Banks doing?

Acutely aware the economic backdrop is shifting, Central Banks aren’t sitting on their laurels. The ECB, for example, now focuses on “super-core inflation”, which strips down the number of items it reflects and is performing better than its headline measure.

The Bank of England has a juggling act ahead of it as it negotiates a path to normal monetary policy. Carney has assured the UK that any process will be gradual, which will temporarily easy any concerns from those that have relied on cheap debt over the last decade.

With all pundits suggesting a rate rise in November, take the time now to go over your family finances and prepare a more realistic budget if you haven’t already.

It won’t be catastrophic if rates rise next month, but it will signal a change to tighter monetary policy. Being more careful today could prevent unnecessary pain later down the line.

1 Business Insider, One of Milton Friedman’s central assumptions about economics appears to be broken

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