Monetary policy revolution: Conditional Volatility, Standardized Inflation, and Output Gap Dynamics

Summary

In this episode of OIKONOMIKA, the focus is on the UK economy's economic forecast and monetary policy. The discussion revolves around using a Vector Error Correction Model (VCM) to interpret macroeconomic forecasts, showcasing its precision and depth in analyzing economic variables like CPI, GDP, and unemployment rates. The role of inflation and its persistent deviation from the 2% target is highlighted, revealing challenges in stabilizing the UK economy. Moreover, there's an exploration of the Taylor Rule's adaptation using conditional volatility and standardized deviations to manage monetary policy more effectively.

Highlights

• Discussed the UK's economic landscape, examining GDP and CPI forecasts with a weather-like unpredictability. 🌦️
• Introduced the Vector Error Correction Model (VCM) for a detailed and accurate economic analysis. 🛠️
• Highlighted the challenge of maintaining inflation at the targeted 2% amid consistent economic volatility. 📉
• Explored a refined Taylor Rule that accounts for conditional volatility, aiming for effective monetary policy. 🎯
• Addressed the issue of stagflation, emphasizing the problematic combination of stagnation and inflation. ⚠️

Key Takeaways

• The UK economic forecast is as uncertain as predicting the weather, with variables like GDP and CPI being particularly unpredictable. 🌦️
• The Vector Error Correction Model (VCM) offers a comprehensive analysis of macroeconomic variables, highlighting their interrelation and precision. 🧠
• Persistently high inflation in the UK defies the targeted 2%, challenging central bank policies. 🚫📈
• A fresh approach to the Taylor Rule incorporates conditional volatility to better address economic disparities and inflation gaps. 🔄
• Stagflation is a pressing concern, with stagnant growth and rising inflation posing challenges to economic stability. ⚠️

Overview

This episode dives into the murky waters of the UK's economic forecast, comparing it to the unpredictability of the weather. With the sun shining on hopeful projections, there's still a shadow cast by inconsistent GDP and CPI figures that leave economists scratching their heads. It's not just about numbers—it's about capturing the real essence of an unpredictable economic climate.

The Vector Error Correction Model (VCM) emerges as a hero in the story, providing a structured and precise view of how macroeconomic variables like CPI, GDP, and unemployment interrelate. This model allows for better comprehension and foresight, drawing back the curtains on the economy's intricate dance of numbers and projections.

Inflation stands as a formidable opponent against the UK's economic stability, with its refusal to comply with the genteel 2% target set by policymakers. This disparity fuels the discourse on how the Taylor Rule can be modernized—using conditional volatility and standardizing measures to offer a new, dynamic way of handling monetary policy. Meanwhile, the specter of stagflation looms large, with its dual threat of stagnation and rising prices challenging the very structure of economic recovery.

Chapters

• 00:00 - 00:30: Welcome and Introduction The chapter welcomes viewers back to the Economica channel, with a focus on economics. It introduces a special episode specifically discussing the UK economy, building upon concepts related to the Taylor rule explained in a previous video.
• 00:30 - 01:30: Discussion on Taylor Rule Formula The chapter discusses the Taylor Rule formula, focusing on the variables involved. The speaker shares their thoughts on setting up the Taylor Rule formula, selecting variables, and deriving parameters necessary for calculations.
• 01:30 - 13:00: Forecast for the UK Economy This chapter discusses the Forecast for the UK Economy. It begins by referencing a previously mentioned arithmetic formula, the Taylor rule, and notes that the speaker has refined their thinking since then. The chapter will continue with a new episode in light of an upcoming spring statement. The speaker aims to provide a perspective on the economic forecast.
• 13:00 - 25:00: Detailed Analysis of VCM Model The chapter provides a detailed analysis of the VCM model in the context of the UK's economic forecast. It highlights the uncertainty inherent in economic forecasting, drawing a parallel to the unpredictability of weather forecasts. Despite the uncertainties, the chapter adopts an optimistic tone, suggesting a bright and prosperous future, filled with joy, peace, and calm within the UK and globally.
• 25:00 - 37:00: Inflation and Output Gap Discussion This chapter delves into the relationship between inflation and output gaps, with a focus on peaceful conditions unaffected by wars or major global disruptions. The speaker emphasizes the importance of a stable geopolitical environment for accurate microeconomic forecasting. They reflect on their past studies and expertise in microeconomic variables, suggesting a foundation for the discussion on how inflation and output gaps interact.
• 37:00 - 47:00: Critique of Central Bank Inflation Targeting The chapter discusses the critique of central bank inflation targeting. It introduces the Vector Error Correction Model (VCM), which is crucial for understanding macroeconomic variables. The discussion suggests a connection between vectors and matrices when analyzing sets of economic variables.
• 47:00 - 57:00: Stagnation and Monetary Policy In this chapter, the concept of a vector in economic models is examined, particularly within the context of the vector error correction model (VECM). The VECM uses matrices to analyze economic variables, treating each variable as a column vector. The discussion explores the mathematical operation of matrices, emphasizing the conditions under which a matrix is considered to have full rank, its determinant properties, and its invertibility. Through this process, eigenvalues are determined, which are critical to understanding the dynamic relationships between economic variables within the model.
• 57:00 - 63:00: Conclusion and Personal Insights The Conclusion and Personal Insights chapter discusses the stability of the VAR (Vector AutoRegressive) model. It highlights that when the model is stable, all values fall within a certain range, akin to an ARMA (AutoRegressive Moving Average) model, emphasizing the autoregressive nature of these statistical models.

Monetary policy revolution: Conditional Volatility, Standardized Inflation, and Output Gap Dynamics Transcription

• 00:00 - 00:30 hello chams welcome back welcome back to Economica all about economics and uh yes today um we have a special episode uh about uh the UK economy and um because back in my previous video I was trying to explain uh the um the nuances of the uh Taylor rule
• 00:30 - 01:00 formula and uh how I was thinking around the tailor formula and all its variables um according to my knowledge and how I would um set the tailor root formula which variables I would use and uh which sort of how I would um derive the uh parameters that um uh I would uh utilize to calculate the
• 01:00 - 01:30 arithmetic formula which is the Taylor rule and um as I said back in my previous video that I I had to refine my thinking and uh um I've done a little bit more work um so let's get on CHS with today's episode and uh because also the uh I believe the spring statement it's uh coming and u um so I'll try to give you a perspective of the
• 01:30 - 02:00 um possible forecast uh of the UK economy which is which is not it's uh it's as uncertain as a weather forecast uh the sun is shining and spring is coming and uh we will all have a beautiful uh spring and summer plentiful of joy and peace and humanity and the world will be calm
• 02:00 - 02:30 and without any sorts of uh diabolic issues as wars and stuff like that so let's hope for the good for everybody involved in the peace of the planet so as I said I can provide you with a a better informing um microeconomic forecast of the variables that I studied in back in my previous
• 02:30 - 03:00 video which is a VCM uh model so it's a um vector error correction model so as you you are all wellvered uh when we talk about vectors then we have to think about matrices and how so when we take a a bunch of uh macroeconomic variables so we basically each of these
• 03:00 - 03:30 um variable is treated as a vector and then the interpolation or the the uh mathematical workings of the vector error correction model it's works through matrices okay because a a series of column vectors they define a matrix with the matrices with full rank and if it's determinant if it's invertible and you find the values the vectors and so when you find the AM values you can do
• 03:30 - 04:00 for example you can ask the machine what is v stable and it will tell you okay all the values of of the of the var model they all are within the AEN um values of uh so they are all within a certain range so the the VAR model it's a vector auto reggressive model so it basically works as an ARMA model it does auto reggression with with its L
• 04:00 - 04:30 terms the the the the method I'm showing you today is the VCM is the vector error corre correcting or correction model so still works with matrices and with vectors but uh it's um I believe is more precise than uh a bar model uh because it's it works um it interpolates the variables and it tries to find uh how the variables they
• 04:30 - 05:00 um correct their um overshoot or undershoot uh in relation to the other macroonic variables that you have injected into the models and I found that the the forecast charts that we will see now together they are much more precise and um the the VCM model carries also a a a wealth of additional um information
• 05:00 - 05:30 which are very useful to understand the parameters the forecast and it it it shows you also the uh the the theoretical not the theoretical what are the resulting error when implementing all the model so okay first thing first um we have here some sort of uh 19 variables uh we will count it now together and uh okay what do we have here it's uh the CPI
• 05:30 - 06:00 um which is the consumer price index including um households and owners occupiers equivalent rent so like households or uh people who are renting the property so it's a CPI it's an inflation basket that includes also the cost of shelter okay and uh the forecast is for a slight decline and uh stabilizing around uh three three and a half%
• 06:00 - 06:30 uh the GDP um real GDP forecast is a bit choppy but we see that the the long run uh average growth quarter on quarter of UK of UK real GDP and I want to emphasize is quarter on quarter it's not year on year GDP it's always been around 0.5% okay and before you start with all comments it's oh it's good it's bad it's flatlining oh I am compared it with
• 06:30 - 07:00 other countries in the world so I don't work with this assumption of uh prejudging stuff i'm I'm telling you what is the data since 1950 up to now the average growth per quarter it's 0.5% more than half a more than half a point less than half a point but on average we are around that stuff so we have to be realistic when it's useful it's very very useful when we see the data so that we have a a cold shower of reality of what actually it's the
• 07:00 - 07:30 potential and uh what is the size of the engine and how fast the the economy can grow because like plucking walls out of the air superpower we will have the fast growth in the world it means that you are it's a pipe dream I think it's much better to be more realistic and see what is the data if you actually uh have have wasted a bit of time to actually look at the real data yeah historical time series and did you have
• 07:30 - 08:00 a theoretical and empirical framework which is consistent and based on real facts okay not like a superpower of I don't know pie in the sky so as I'm as I as you all can see the forecast of the GDP just only on a percentage variance this is not by no means the all the inflows and outflows of capitals the accounts that's another stuff but anyway it's very flat and some
• 08:00 - 08:30 quarters they are projected to be negative okay so not great net debt to GDP is projected to increase you can see here the forecast net debt to GDP including banks it's projected to increase to 100 110% like 2020 levels Employment rate is projected to be steady and a bit little bit less than the steady rate now which is 75% maybe
• 08:30 - 09:00 it will be 74 and change 74 and six 74.5 we are around small decimals the budget deficit is projected to increase and its budget deficit are very cyclical the unemployment rate this is very crucial is projected to uh also to Go higher to 4 and a half 4.7 4.8%
• 09:00 - 09:30 right seems that the machine got some
• 09:30 - 10:00 sort of uh seizure or some sort of panic uh so what happens uh okay let's go on uh I will uh make sure that the video won't come out with this panic uh okay anyway I was saying the unemployment rate is as you all can see is projected to go
• 10:00 - 10:30 up um okay and it's consistent with the decline in employment rate output per worker it's follows more or less the long-term trend which is more or less sometimes is negative sometimes is positive but it's we are around small percentages around flat zero RPI uh it's projected to decline which is strange enough for me but nevertheless it would be converging to
• 10:30 - 11:00 2% uh to end something but anyway productivity the jobs also seems to decline in the first period and then be a bit choppy to stabilize around 0.5 but you can see all the the range here is between zero and 0.5 so we are talking about very small percentages CPIcl tobacco I will don't don't that this this one is the data in the is not
• 11:00 - 11:30 good so don't bother with that business investments also follow the historical trend of the um what is the historical trend of the in the UK economy so it should be a bit higher business investment quarter on quarter and then just stabilizing with a sort of cyclicality total assets seem to be a bit negative percentage starting and then some sort of um positive back up still with
• 11:30 - 12:00 cyclicality because the creation of productive assets in the economy takes a bit of time to build anything that is productive but we are in a narrow range nothing spectacular same is for the general government the government spending and the creation of assets uh we are in a small contraction in the first periods of 2025 and then around the long term uh trend business
• 12:00 - 12:30 investment seems strange not strange but very uh good forecast like I think because these are out of sample forecast so the forecast is a an out out of sample projection because the sample is the historical data this is the sample of data which are which already have happened so the machine projects an out of sample forecast and the historical data they are business investment is zero and maybe you would think okay
• 12:30 - 13:00 maybe it will be negative the forecast of the machine it's here the line plugs up here but then follows you see follows more or less what is the historical trend so uh we will see in a moment the table with the numbers so there will be more precision uh okay i believe yeah this is another uh example of the uh government spending and um this will be all retail sales um on a
• 13:00 - 13:30 weekly basis including uh fuel uh on a yearon year uh percentage change and they will be more or less uh in line with the historical trends uh asset here on here like a sort of decline and then stabilization around historical trends or cyclicality same for retail sales and uh yes here we have at current prices we have a more uh narrow range of
• 13:30 - 14:00 uh retail sales forecast nevertheless it's positive would be around two three% or something like that and crucially the Bank of England the past week kept the um the sterling overnight um rate uh um unchanged and uh the m the out of sample forecast is for a decline in long-term 4% so nothing spectacular or a decline like a a a a cutting of uh
• 14:00 - 14:30 interest rates so a lessening of the pressure of borrowing cost to 4% and uh so still will be somewhat of high uh interest rate uh it's not like the machine doesn't go to two to three or to two and a half so I do expect that the Bank of England have imposed now at the best it would it
• 14:30 - 15:00 can do two um two interest rates base [Music] um cuts of uh 0.25 basis points so from 4 and a half it will move to 4% if I have to follow exactly what the out of sample uh machine forecasts give me and these are the results okay so to show you the uh actual
• 15:00 - 15:30 um because you have I have a lot of interesting uh data a lot of interesting things and uh I can uh uh help you all understand some very important things for those that uh are more averse into the nitty-gritty of uh economics uh for those who are less um familiar with the uh terminology and the language of macroeconomics don't
• 15:30 - 16:00 worry i'll try to be as uh explicative and concise as possible so you can now see we have the um forecast results and uh allow me to uh set the the characters to 16 so we will have a larger without doing any disaster bear with me chs bear with bear bear with me
• 16:00 - 16:30 bear with bear with chumps bear with bear with bear bear with okay so you can see the forecast goes well into 2027 the second quarter of 2027 that's why I appreciate a lot the VCM model and uh as for the chart the out of sample forecast uh is for the CPIH annual rate to be um around 3% in the by the end of Q1 2.9% by the end of Q2 uh yeah 2.6% 6% uh
• 16:30 - 17:00 I'm sorry 2.9% at the beginning of Q2 that would be 2.6% 2.7% at the beginning of Q3 and by the end of 2025 CPIH should be around 2 and a half% to then you see that there is an upward trend for CPI to just basically um drift back up to to 2.67 67 2.72 287 and so the machine
• 17:00 - 17:30 sees CPI back to 3% in 2026 2027 so the the trajectory it's a a very steady and uh uh gradual sweet decline decreasing of the inflation rate for 2025 and then the curve will bottom at two and a half and then will steepen up again as I was saying the real GDP is projected to be negative
• 17:30 - 18:00 minus0.87% in the first quarter positive for the second quarter slightly positive for the third quarter and minus 1% in um the fourth quarter now if we take a uh later uh and uh we try to help the uh people which are less intelligible with the use of
• 18:00 - 18:30 uh scientific calculators and we try to see what is the sum of the quarter on quarter to have an idea + 0.33 - 1 so it's negative uh 0.17 if I divide by four yeah it's basically still it would
• 18:30 - 19:00 be negative GDP um on a yearly basis um so the macroeconomic projection quarter on quarter for 2025 still it's of more or less a flat to a marginally uh negative uh growth like a shrinking of real GDP although nominal GDP can still be growing like uh so not everything is so
• 19:00 - 19:30 uh doomy gloomy and doomy and uh 2026 also the machine some sort of uh ecap in the second quarter but the projection are for a moderate growth of 0.2 0.6 0.4% 4% which are in line with the average quarter on quarter historical average quarteron quarter growth of real GDP for the UK economy crucially net public debt is projected to uh rise and we see that it's it's
• 19:30 - 20:00 projected to be 104% for the first quarter of 2025 even 110% and then gradually stabilize around 107 108% um so this is very important and we see why we can appreciate why net debt to GDP is projected to increase because the budget deficit projected for Q1 it's 1.5%
• 20:00 - 20:30 so the economy the deficit will be growing 1.5% at the same time you the machine projects out of sample that real GDP would not even be positive but negative so this would be a double whammy you will have a net uh deficit on top of negative growth so that's adds a lot of uh net debt to the to the overall
• 20:30 - 21:00 stock of debt but if you if we all confront the two columns we can see that the machine uh after analyzing what is the cyclical historical data of the budget deficit quarter on quarter it projects a steady one and a half 1.1 0.70 0.76 70 or 0.8 uh you can see here 0.97 so in aggregate
• 21:00 - 21:30 uh the average uh budget deficit it's of 1% or or a little bit more while if we confront with the GDP column we see that the on average the growth is of 0 something so net net budget deficit will the machine projects that budget deficit is always growing more than real GDP
• 21:30 - 22:00 then what is the difference of growth between the deficit and GDP then it's accumulated it adds up to the stock of debt okay it accrrews into that you can use the ratio between what is the deficit to GDP but um that's the ratio is debt to GDP uh then to see what is the the difference between the deficit and GDP uh it's just doing a subtraction and you find out if the debt has grown
• 22:00 - 22:30 if deficit has grown more than GDP or or real GDP has grown more than budget deficit in that case you have acrewing you have deficit which is growing faster than GDP and that figure then goes to um into the numerator of the ratio debt GDP ratio okay if the numerator is growing and the and denominator is
• 22:30 - 23:00 growing less than the numerator then you have a higher debt to GDP ratio and so that's why uh the machine is very precise in this uh instance output per worker it's very um it would be 0.35 in the first quarter negative in the second quarter negative in the third quarter of 2025 negative in the fourth quarter so um I don't have a particular or precise uh explanation all I can see is the
• 23:00 - 23:30 forecast and you it also tells me that on going on the on after the machine going through all the historical data what is the projection the output output out output per worker first of all it's not um uh it doesn't seem to me to have a clear trend but it's chop it's somewhat volatile you don't you don't have a steady positive output per worker and the forecast of many quarters with
• 23:30 - 24:00 negative output it seems to me that it's related if you go and check my previous video then it's related to the lack of productivity or the low productivity which is intrinsic in it's a structural feature of the UK economy if I would summarize on an historical basis from 1950 up to now what are the two idiosyncratic factors of the UK economy is persistent and structural uh high
• 24:00 - 24:30 inflation which is uh structurally higher than the 2% holy grail uh threshold and some sort of uh volatile productivity that depends on business cycles and what is the overall um structure of the economy for example in the 1950s,60s7s up to the 1980s the output per worker of the product productivity per jobs was much higher you add
• 24:30 - 25:00 um the productivity per worker which was 1% or more than 1% per quarter then after the 1980s you have the the transformation of the economy into a mostly services u um driven uh economy and so the output per worker tends to decrease and after the financial crisis or with the after the year 2000 you have negative output per worker so you have
• 25:00 - 25:30 uh less and less a trend of decreasing uh productivity or decreasing uh workforce or labor productivity that is due to many factors but one important factor it's inflation which is inflation it's a cost for business and the cost for the worker that has then with the disposable income it has to be able to uh pro provide for uh himself and for uh for the family so uh
• 25:30 - 26:00 nevertheless uh employment rate as I said the the graph shows as a marginal from 74.8 to 74.7 so a slow decline and at the same time you have an uptick in the unemployment rate that is from 4.4 base going up to 4 and a half 4.6% so very marginal um variance in in the forecast
• 26:00 - 26:30 for the unemployment rate which nevertheless will go up and this also justifies somewhat of lower productivity so the output per worker it's sadly um negative in the first year and uh it's volatile also in for the other quarters in uh 2026 and 2027 so we have um we have four quarters here 2025 and uh 2026 uh first quarter will
• 26:30 - 27:00 be strong should be strongly positive second quarter as well then a sort of ecap in the third quarter and then strong quarter of productivity in Q4 2026 and then again the cycle reverse and you have a marginally lower output per worker in the first quarter of 2027 and then back on average some sort so the machine does a good work per se and it tells me that there is volatility in the output per worker while instead you
• 27:00 - 27:30 can see here you can confront with productivity per jobs in the whole economy and you see that there is an average which is steady it's 0.3 or 0.4 0.2.4 0 and a half% so we are in an average range which goes between 0 three or four to yeah 0.5% we'll have to uh do a quick [Music] um
• 27:30 - 28:00 um average so that you can see how to work with the uh calculator if you are such a big mouse and then you cannot use a calculator um K plus I say plus 0 uh
• 28:00 - 28:30 475 we got it 0 444 plus 0 49 bear with me somes we will see I want to see exactly what is the average and we divide by one two three four five six seven eight nine 10 Okay yeah 0.425 0.42 and a half so we see here we
• 28:30 - 29:00 confirm without work we see the productivity all jobs per jobs in the whole economy it the machine has a forecast of average 0.42% and a half okay 0 42 okay 0.4 the output per worker seems to be on average a bit skewed to the negative side but it's very volatile so it depends of how these statistics uh these data are measured and they are compiled nevertheless going forward RPI
• 29:00 - 29:30 also is projected to decrease but then to go back up again to the same average level 2.5 declining to even one and a half 1.8 8 and then drifting back up in 2026 and 2027 to 2.3 2.4% uh this CPI we cannot consider it so business investment we see the volatility of business investment plus 5 and a half% in Q1 minus 5.7% Q2 plus
• 29:30 - 30:00 1.4% Q3 minus 0.93 minus one so these are all projections minus one it's um Q1 2026 so the machine goes a bit forward in time but nevertheless you can see there is plus or minus and this reflects the uh cyclicality and the volatility in the business cycle okay and so the volatility of business cycle it depends from also from structural higher
• 30:00 - 30:30 inflation and structural volatility in the product productivity of inputs in the economy which can be businesses which can be uh infrastructure which can be the workforce so general government quarter on quarter it seems to be mostly um this general government creation of assets of new assets seems to be quite negative in the first quarters so we have some mixed uh
• 30:30 - 31:00 projection which reflects the the the volatility and the cyclicality of the business cycle uh total sector uh assets are negative for all four quarters of 2025 and um I can uh confirm you that there are some tables from the Bank of England with the which have showed me that actually in terms of gross fixed capital formation
• 31:00 - 31:30 in the economy uh whether is um um according to um the economic sector the the sector of the economy which can be I don't know transport restaurants industries manufacturing services uh there is a table in the bank of England latest table that uh um bear with mess I will show you now
• 31:30 - 32:00 it shows me that capital formation there is there is no issuance of um commercial paper and um yeah you can see it now okay I will uh so I do so numbers are very tiny okay let's try to do a better job with this oh dear I
• 32:00 - 32:30 pretended too much no okay let's keep it for what is the supposed to be okay so now I've done a disaster but it was better the the original thing so you can see a net capitalissions by UK residence by industry and it's not seasonally adjusted so it's not discounted for um inflation and you see here that uh 2023 and 2024 you have negative issuance whether it's mining electricity gas and water
• 32:30 - 33:00 supplies so the total issuance but you see many months which is negative issuance of um capital of money so additions of money it can be commercial paper it can it can be uh corporate bonds it can be some sort of uh line of credits for businesses uh senior I don't know all sorts of things um but I mean I I hope you understand you see the data it's construction we have it's a contraction of credit in the economy of
• 33:00 - 33:30 private credit in the economy wholesale trades so negative totally negative uh the total is positive here But many months of negative credit creation other restaurants minus three uh million but you can see here this is the aggregate the total the end sum but you see many months of -30 million minus - 200 - 300 mill like in September 2023 you have minus 300 million of issuance so uh it's
• 33:30 - 34:00 probably I don't know I mean it seems to me a negative number it seems to me that there is no issuance of um of money there is no private credit so all the real estate a billion negative figure here and there is minus two and a half uh I hope I'm not wrong and I'm not reading wrongly the data like business activities we have a positive but the total for all these um for all the this industrial sector it's minus
• 34:00 - 34:30 1 19 or minus 1 2 billion a billion and 200 million 1.2 to be negative so it seems to me a contraction of private credit in the economy that has been going on in 2023 2024 because that's the only thing that we can see now while it's a monetary financial institution they have a positive balance other financial corporation they have a positive balance so the total overall it's
• 34:30 - 35:00 11.7 billion of net capital issuance but the bulk of credit creation it's either monetary financial institution which is banks or other financial corporation so I understand this is a table from the bank of England so it's related to the issuance of corporate bonds from banks or this sort of uh it's more skewed to the banking sector but nevertheless He shows a picture that the other parts of the economy the overall aggregate of the
• 35:00 - 35:30 economy which basically works on real things on producing uh I don't know meals order and restaurants contraction utilities electricity water gas supply money agriculture all the there is no credit creation it's uh there is some sort of contraction in private credit and this is that's a consequence or it's an outcome of a bad economic environment and also the cost of borrowing which is
• 35:30 - 36:00 a a which is correlated with inflation okay so a big issue of UK economy like the the the baba in the room not the elephant what is the baba the submarine in the room it's inflation i come to the conclusion that inflation is a huge problem for the UK economy so business investment total sectors that's why the machine projects all negative percentages quarter on quarter because if we account for the
• 36:00 - 36:30 total se for all the sectors in the economy and we confront it with the negative of private credits there is no issuance of new capital of new money even in the private sector for all the all the parts of the economy then of course there is no creation of assets business investments seems to be very positive in Q1 plus 14 and a half% I don't know from where this number comes and uh it's mostly positive uh not for
• 36:30 - 37:00 Q1 2026 but although the machine has a positive picture of business investment this is an alternate another iteration of uh general government creation of asset and it's slightly different a posit on average seems to me a positive that I should do the the exact calculation but it's mixed let's say it reflects the cyclicality uh this assets other iteration it's less
• 37:00 - 37:30 gloomy than uh also because it's a different time series and because this is quarter on quarter on yearly basis this is quarter on quarter so it's a two it's different frequencies of uh data and nevertheless it's for 2025 still it's a mixed picture this first quarter very positive in line with business investment I don't know the machine projects a strong Q1 investment I don't know and then
• 37:30 - 38:00 negative for the Q2 Q3 Q4 2025 and then on average 1.2 2.7 between 1.2 and 2 and a half 2.7% so then uh for what regards retail sales we see that we have strong numbers three between two and 3% for each quarters uh these are excluding fuel so still on average between 1 and 2% uh projected quarters 2025 26 up to Q2 2027 and all
• 38:00 - 38:30 retail says uh figures seem to be positive and last but not least we have the sterling overnight which is projected to decline by 50 basis point from four and a half to 4% so what is um um interesting for the um the um VCM model is that we can uh measure oh where we are now here
• 38:30 - 39:00 uh we are far and away from so let's uh stick with the code we can measure I I we will not I will not go through the lags because it's going to take too long time and I have to I want to you to focus on the next topic which is the work that I've I have worked on the tailor rule so do you see here the alpha coefficient so this tells you basically uh for first variable the CPI it tells
• 39:00 - 39:30 you okay this is the coefficient you have a p value which is statistically uh relevant what tells me that CPI tends to uh adjust to correct its overshoot by this co coefficient which is minus010% okay and so does for all the variables that you inject into the model so GDP it does not have a uh nevertheless it tends to adjust by this small coefficient uh p value of uh
• 39:30 - 40:00 okay net debt tends to adjust by this coefficient so uh net debt when it it deviates from its um long-term trend or there is a shock in net debt it tends to adjust positively so upward with a 0.17% okay so that's what does also the VCM it tells you what is the coefficients of adjustment reach variables uh as
• 40:00 - 40:30 um as short during its historical uh time series data um okay banks so you see that the coefficients of adjustment they are all very small percentages but nevertheless this helps you to understand how the variables how they adjust into the economy when they overshoot or they undershoot uh where they drift higher or lower from the long-term trend and how they adjust how the variable adjusts within each other
• 40:30 - 41:00 in the economy all the moving parts uh like this p value is very relevant and it's output per worker and tells me the output per worker tends to adjust by minus 1.15% to the negative side so output per worker this uh statistic which is collected by the ONS it tends to adjust negatively it it has a negative skew and it tells me the output per worker tends to be negative I don't know why RPI also
• 41:00 - 41:30 tends to adjust negatively if there is an inflationary shock so um general government creation of asset tends to adjust also to the downside by minus one uh 12% and um this is the uh business investment instead is a positive adjustment by 4.3% so this is the alpha coefficient which tells the adjustment
• 41:30 - 42:00 of each variable and then you have the beta integration factors which is the integration relation between variables beta 1 is CPI beta 2 etc etc etc and then you have a coefficient of adjustment uh which is uh worked out from the in interpolation of the variables and if we uh check the p value column only beta 9 it's um too large of a uh p value so all the all the variables that we have
• 42:00 - 42:30 considered into the vcm model they have a relevant beta factor so they their co- integration shows a very strong relation between these variables and then they adjust by some small or very large coefficients within each other so if inflation is moving then GDP will adjust by a a coefficient within the co-int integration uh matrices which is also very interesting and at the end of the
• 42:30 - 43:00 uh the proa we have also the uh uh root mean square mean square error and this v this the RMSC shows you what is the square mean square error for each variable the smaller is the error the more accurate is the um forecast okay so some like CPI has a
• 43:00 - 43:30 somewhat of large uh root mean square error also net that uh goes as a some sort of cyclicality or things like that some RPI small values to show you a smaller error okay also this one you see how large is the error here so of course we have to be um attentive and um careful in what we uh see from the data so back to us again to the tailor
• 43:30 - 44:00 rule so as I said in in my previous video I have been wondering about the Taylor rule and um I've explained the other day that um I'll flip around with this one so I can write something on the uh on the free paper here okay I've explained the Tor explain I repeated that the tailor rule is a neutral level of interest rate plus a actual level of inflation
• 44:00 - 44:30 uh plus alpha and inflation at time t minus the uh 2% target uh plus beta and uh the uh GDP now minus the um potential GDP and this this whole arithmetic equation will give you an IR which is the interest the optimal interest rate for the economy and if there is an inflation gap so inflation it's higher than 2% you have a positive inflation
• 44:30 - 45:00 gap that means that you need to arithmetically by the formula you need to raise interest rate so my changes to the formula are that uh so alpha and beta usually are equal to 0.5 although for example um John Taylor said that alpha parameter because it's related to the inflation gap it should be one what that means is that for every percentage point of positive inflation gap I will
• 45:00 - 45:30 jack up the one to one the interest rate okay because it's very natural if here instead of one I persist in having 0.5 when I multiply one which is the positive inflation gap with 0.5 I end up with 0.5 in the final result of the interest rate but because I want to be um in line with what is the inflation the the deviation of of the inflation gap then I
• 45:30 - 46:00 want to be sure for example that I move the interest rate up one to one with inflation gap and then for example beta you can leave it per let's say at 0.5 so you want to be more gentle with the output gap which is more normally distributed so the work that I performed is to refine the formality of detail rule uh by doing what by doing a lot of work a lot of research and refining still I
• 46:00 - 46:30 have unanswered question uh that uh oh this doesn't want to cancel anyway come on okay you need to say come on so first first thing first I substitute alpha and beta with the conditional volatility of inflation the average conditional volatility of inflation according what fits what Garch model fits the most among these four Garch model plus the conditional the historical conditional volat the average
• 46:30 - 47:00 historical conditional volatility of the output gap then I've studied in isolation the inflation and the output gap with the CLT the central limit theorem and I have uh standardized the inflation gap and the output gap by standardizing the inflation gap and the output gap i have empirically uh proved to myself and I will show it to you i will prove it to you that inflation is
• 47:00 - 47:30 not normally distributed and um it's not symmetric to zero uh the row number I mean the inflation data they are not symmetric to zero it's not a standard normal distribution it deviates it depends from country to country so I say it again I use the CLT the central limit theorem to standardize inflation because inflation is not
• 47:30 - 48:00 normally distributed and I want to achieve a uh theoretical and empirical framework of the tailor rule which gives me more certainty and injects into the equation the long-term variability of the conditional volatility of inflation instead of a fixed parameter like a 1:1 uh 1% inflation 1% up interest rate central limit theorem I work this formula and I use pi bar so I
• 48:00 - 48:30 take the time series of inflation and I find the average then I set mu pi which is the um the um sample mean sorry about that and then I standardize by doing this square root of n okay or sigma square root of n and n it's for example 144 um for the quarterly inflation data time
• 48:30 - 49:00 time series that I have for the UK inflation data and the same method I used it for I have y t bar minus mu y of t and then I have sigma square root of n okay sort of um central limit theorem so uh why do we do this because I want to have a distribution a
• 49:00 - 49:30 standardized distribution of outcomes or or standardized distribution um that shows me the range of the inflation output and the inflation gap and the uh potential output gap so that I work out all the historical time series and by using CLT I can standardize the gap mind the gap I can standardize the inflation gap and the output gap and see what is their
• 49:30 - 50:00 distribution and because it's standardized it's skewed around zero it's skewed it's centered around zero I don't know if it's visible yeah okay so you see here the distribution of the out output gap with CLT you see it's centered around zero so it's a standard normal distribution if I take the raw data of inflation and I don't standardize the data inflation data then I have a bit of a problem because inflation is not symmetric to percent
• 50:00 - 50:30 and and I will show you now here okay if I take the Excel you see here observation date Q1 1989 and there is two frequencies quarter and month okay and the other column it's uh inflation gap okay I'll make it larger so that you can all read it observation date CPI monthly month inflation gap quarter on quarter inflation gap most of inflation
• 50:30 - 51:00 gap they're all positive so there are two important things to know at this point as you can see the the bars of this uh CPIH quarter on quarter so these are the these two charts okay they reflect with the bar chart histogram chart they reflect the inflation data that that have been recorded quarter on quarter since 1989
• 51:00 - 51:30 Q1 or since January 1989 month on month so a standard normal distribution it has is this one you see here it's centered around zero and is a standard normal it's symmetric 5 minus 5 okay and the textbook standard normal it's n approximately 01 so it's centered around zero and it's + one minus one standard deviation okay so remember the shape of this it's a
• 51:30 - 52:00 bell curve yeah it's it's it's a bell curve right it's symmetric if we see the bar we see that we have a lot of values going up to 0.7 8 10 which means 10% 9% 8% 7% so the distribution of the inflation data it's not symmetric to zero you see here so only the model inflation is more or less symmetric to zero more or less but it's still it's positively skewed the quarter on quarter is symmetric it's symmetric or it's uh
• 52:00 - 52:30 sended around 2% just to to to pleasure all the central bankers which they have the they work with the wrong assumption the the wrong empirical model but because all the bars they they go higher and higher and higher here you don't have a bell curve but you have a kai square distribution it's a totally different ball game it's another thing it's a kai square distribution which is long tail that extends in positive
• 52:30 - 53:00 values in a positive tail the Kai distribution is continuous and accounts for all real numbers positive and negative but you see that the distribution is not symmetric inflation it's skewed to the positive side you have a lot of data which is four 5 6 7 8 9 10 inflation 10% inflation quarter on quarter month on month so this shows you that the assumption that inflation is symmetric 2% it's wrong it's
• 53:00 - 53:30 empirically pract practically factually wrong okay and these are the uh foundation also to prove the fact that inflation is volatile and volatility of inflation is not constant it varies and so we cannot presume by in any way that we can uh
• 53:30 - 54:00 um balance monetary policy with a fixed inflation target because you constantly miss the inflation target because inflation moves around and inflation in UK has never ever ever been at 2% has always been on average four four and a half% so what comes out of the Bank of England now and in the past decades it's bollocks okay but I I'm not picking up on the Bank of England because what is
• 54:00 - 54:30 worse is the Federal Reserve or what is worse is the ECB they all talk about price stability the only mandate that DCBS is price stability and I haven't worked with the Euro zone data but I'm sure for example that the inflation data and the Euro zone they will be a lot skewed to the negative side and deflation so you have a distribution which accounts for a lot of negative inflation or very low inflation so you're not at 2% inflation target and
• 54:30 - 55:00 okay I have lower inflation no problem i have higher real GDP that's great but this um proves wrong again that you can have some sort of price stability and a fixed target of 2% on which you calibrate you balance or you decide the level of interest rate in the economy this is that's um completely float and the the
• 55:00 - 55:30 foundation of monetary policy they are really on sandy and shaky grounds here because you see the bars they extend as a kai square distribution to 10% okay and when you sum up all this data the average is not 2% but it's between four and 5% so the UK economy has worked persistently for many many many years with the inflation which was higher than 2% well above the target and the central
• 55:30 - 56:00 bank has calibrated interest rate some it's outcomes okay what is the judgment or what is the I don't know how they did it but in by no means in the bank of England has managed to keep inflation at 2% and So I'm not saying that the bank of England is bad i'm saying you another thing which is very very clear and I hope somebody who works in uh monetary policy will listen to me
• 56:00 - 56:30 you cannot target 2% inflation because it has proved that it it has never been achieved and so the framework it has to be theoretically improved and empirically it has to change it it has to be improved not changed it has to be improved in you you I mean I I've done a lot of work don't take my model but you cannot start from the assumption that
• 56:30 - 57:00 inflation stays at 2% is symmetric 2% and volatility is constant it doesn't work like that and then you come up in the press conference say oh we have the oil shock the exogenous supply chain shock okay you have exactly because there are shocks exogenous shock in the economy it's for the birds to say that the job of the central bank is to keep inflation at 2% okay it's something that cannot be achieved it cannot be achieved and it it
• 57:00 - 57:30 doesn't matter if you say "Oh maybe inflation it's 2 and a half% or 3%." No it's the the theoretical framework it has to approach the whole thing in a different manner it's important to consider the conditional volatility of inflation because because it's a kai square distribution when you go and see the standard deviation that comes out it's 10 20 standard deviations and so you cannot plug in the standard deviation that you that you get out from the uh from using the the CLT because it blows
• 57:30 - 58:00 up the the tailor rule formula so you need to use the conditional volatility with the GACH model which gives you a 0 something or 1.2 into 1.5 standard deviations and then you can use that parameter and then you can you start to be proactive and you account for the conditional volatility historical conditional volatility of inflation and so that you cannot say okay no you cannot say you're not taken out of the blue
• 58:00 - 58:30 uh then [Music] um there is some exogenous shock and then oh we didn't see this coming and no because inflation has been struck actually higher let's do let's do it now cuz I'm not I'm not saying and I understood things that you human beings cannot understand is I take the average of CBI quarter on quarter from
• 58:30 - 59:00 1989 to 2024 let's see the average it's 2 88 2.88% 88% or 2.9% so the average it's well above the 2% target so it's not symmetric to 2% so in uh from 1989 to 2024 we never achieved 2% target or very rarely or we can go below 2% or we blow up and we go to 10% inflation but it's
• 59:00 - 59:30 never been steady at 2% because inflation is volatile how on earth you can um make an entire monetary policy framework to work on a fixed target which is not fixed by definition in statistical term i'm bewildered i'm totally bewildered because we are talking about the basic of statistics which is standard deviation central limit theorem and I don't know I may be wrong and I'm
• 59:30 - 60:00 getting upset for no reason but don't tell me that inflation is symmetric to the percent because it's not a standard normal distribution it's a k square distribution and if I plot the the histogram of the inflation gap it's another k square distribution so I have to standardize the inflation gap with the central limit theorem to have a normal standard normal distribution and then I have a range of outcomes so that I know within this
• 60:00 - 60:30 range of outcomes how I have to move around just about only the interest rate tool in the toolbox okay and this is my work and I keep it for me nobody will ever know that I exist i don't mind but if you are listening to me please like the video subscribe but be aware that central banks they've got it totally
• 60:30 - 61:00 wrong with their um monetary policy framework they are getting it totally wrong totally totally totally wrong so we can explore the the graph here okay let's work with these tables and uh we will we will go step by step on the process with the process so we first thing first I ask the machine to work for me and give me the garch
• 61:00 - 61:30 model so I take the GACH one the EGACH constant mean T garch a bar model and the machine fits the conditional the uh generalized auto reggressive um conditional heteroscalasticity model because it's heteroscasticity on the inflation data which is the montomon data and it gives me all the um the data of the are for
• 61:30 - 62:00 each and every GH model from the start of the time series to the end 1989 up to 2025 so the last data for example in January 2025 the conditional volatility was 1.22 which is 1.22 and 22 standard deion so it's somewhat volatile inflation and we have the same parameter for the other for all the other GACH model garch ech a bar the garch model is the
• 62:00 - 62:30 most simple the earchch and aar model they calculate the asymmetry of volatility and they calculate also the the the the size of the asymmetry of the volatility shock in the past data okay so at the end of the of the thing I have the average historical volatility for CPI and it's between 1.16 to 1.24 standard deviations
• 62:30 - 63:00 okay so I have my first data which is the the the that's for the alpha parameter in the tailor rule in the tailor formula which is not nothing to do with tailor expansion which is a bit more difficult to do okay so okay that's the same code that's so I have here if I have to choose which fits the most I'll probably use the a parch model
• 63:00 - 63:30 and so I know that my parameter here it's 1.24 and this is very relevant because if I go blind on the tail of formula and I and I follow the generic uh theory that I have to increase inflation the interest rate 1% for every 1 percentage point of uh positive inflation gap then I would miss the 1.24 standard deviation i would miss the volatility of inflation
• 63:30 - 64:00 so I would risk not to be proactive and to know how volatile is inflation and the persistency of volatility in inflation because this beta parameter tells me of that from all the data when I have an inflationary shock then there is persistency and the persistency is explain explains 70% of inflationary shock and the alpha parame tells me that
• 64:00 - 64:30 past shock explain 22% of present shock so these are parameters which are very very important to have okay so if I go blind and I go one to one then I don't account for the volatility of inflation so this parameter is more precise okay it tells you that for example you have to increase interest rate by 1.25% for every 1%age positive inflation gap tells me no
• 64:30 - 65:00 it tells you it tells me so this one is the quarter on quarter and the output the standard deviation are two and so I don't consider that then I asked the machine I coded with the machine and I said okay the this is that's the chart with the trend historical trend of potential GDP quarter on quarter and you see that we are between 0.4 0.8 date starting from 1950 and the forecast potential it's around here and the historical potential
• 65:00 - 65:30 is around here between 0.2 0.4% okay and that's the projected potential GDP for the next quarter it's around 0.36 0.37% so it's not quarter on quarter okay it's not year on year and then you have the charts the green line is the potential GDP growth calculated with a a Nordic Prescott filter and then the the blue line it's the the real data the
• 65:30 - 66:00 historical data that have been recorded since 1950 so you see that the green line is a smoothed trend which removes basically all the volatility of the of the data and it and you see here business cycle component so the business cycle component it's the the uh actual GDP okay so recent data growth rate these are the real data okay we have 0% in Q3 0.1% in Q4 potential GDP
• 66:00 - 66:30 it's that one so the business cycle tells me that there is a ne is marginally negative output gap so the GDP quarter on quarter is growing less of is its theoretical potential okay so when there is a negative output gap the central bank the bank of England needs to cut interest rate because by cutting interest rate then you can make private credit cheaper
• 66:30 - 67:00 and then you can start to have credit creation in the economy and business cycle starts to pick up again but the Bank of England is not cutting interest rate why because uh um inflation it's a 3 and a half% so they cannot cut interest rate that's why I told you that the big issue of the UK economy it's high inflation which basically hinders the possibility of
• 67:00 - 67:30 having um normalized yield curve affordable rate of borrowing which is uh proactive enough it's uh yeah it's I mean an affordable I'm sorry I'm I'm crashing on my uh train of thought so having a lower stable interest rate borrowing cost predict predictable
• 67:30 - 68:00 borrowing cost which is not um derailed by the volatility of higher inflation it makes the business cycle um better it makes it stable and it can basically lift up real GDP growth towards its potential GDP it can even lift up potential GDP it generates growth higher growth because you have lower rate of borrowing you still have to discount the your business investment
• 68:00 - 68:30 by internal rate of return you need to have a rate of borrowing to do this kind of the internal rate of return or to forecast what is the return of on equity or an investment you need to have a a a borrowing cost but instead of having a four or five% or even higher borrowing cost if you manage to have a um average borrowing cost around two two and a half% 3% okay then it's easier to
• 68:30 - 69:00 stimulate the economy it's affordable to do a business but the problem comes from the exogenous fact that inflation in the UK economy tends to be always very high above 2% and so this creates a problem for the central bank it it has always been a problem because the Bank of England has never achieved 2% inflation target you have inflation goes 1.8 1.7 1% but in in 144 quarters I will show
• 69:00 - 69:30 you now one thing if I do a test of um inflation volatility okay so here we have the Aric Prescott filter for inflation this is CPH quarter on quarter you see that the green line is the potential trend and it's well above the potential of inflation it's well near 5% closer to 6%
• 69:30 - 70:00 and now inflation is is at three and a half% okay and then you have some inflation gap but the inflation gap it's measured visav this green line the trend that extrapolates the old presscot filter okay but then when I when I chart the distribution of the inflation gap which is standardized and I manage to center it around zero see what happens see the curve this is a k square distribution it
• 70:00 - 70:30 has a long tail into 30 and 40 yeah you manage you want to build a standard normal but it ends up being having a long positive tail and seems to be a kai square distribution so even the standardized inflation gap okay this is the standardized inflation gap that means that it's the quarter on quarter data of inflation recorded minus 2%
• 70:30 - 71:00 which is the inflation target and then you have the another data which is the inflation gap which is this one inflation gap you see here inflation gap histogram CPI Q on Q QQ inflation gap and it's this one okay this column okay it's the difference between the the recorded inflation data and the 2% inflation target and you have a k square distribution so inflation the inflation gap has always been mostly positive or it has some long tails of
• 71:00 - 71:30 some very large positive inflation gap which deviate a lot from 2% and that basically makes useless the work of central bank because they they it it never worked to try and pinpoint inflation at 2% because it doesn't work like that is the foundational assumption that it's wrong okay I'm not saying uh the Bank of England is bad i'm saying that unfortunately the Bank of England
• 71:30 - 72:00 has been forced to work with a theoretical and imperial assumption that it's wrong so that's why they do a bad job okay it's when you basically have the wrong tools to do your job then you do a bulk job right and that's I mean the Federal Reserve could be even worse okay so you see here that the month the blue dash line is the real data the green line is the other press code F is the trend of potential trend of inflation you see how the monthtomon is
• 72:00 - 72:30 going not like by my line but it's converging you see it's going here and so maybe it could be that it's going towards the trend i don't know but still it's it's a data to keep in mind now because the green line it's above the real data here I have a negative inflation gap but it's not it's negative compared to its potential because the potential of real inflation is much higher and the potential it's
• 72:30 - 73:00 extrapolated with the HP filter based on all the historical data okay so it's not something that it's out of the sample it's not the forecast the potential is based on historical data but it's what most it's important is this is the distribution It's very similar to a k square distribution so it's and that's by standardizing okay if I don't if I don't use the CLT the standardization of the
• 73:00 - 73:30 inflation gap then I don't have a standard normal distribution by no means at all so again the theoretical assumption that inflation is symmetric to 2% it's wrong or can it be symmetric to zero and it has a standard normal distribution is wrong is not normally distributed it has probably a kai square distribution even if it's a standardized inflation gap distribution and the other presscode
• 73:30 - 74:00 filter it tells me that the potential CPIH it's much higher or what is the real data for the UK economy so it means that working on the whole data set inflation has been always higher okay monthly distribution of standardized inflation gap You see that it's you have standard normal okay because it's the the the inflation gap is standardized so you must have zero mean but
• 74:00 - 74:30 nevertheless you have some long var long data here it's long and positive skewed in the tail which makes it seems like a kai square distribution so this is the problem that's one of the um not the problem this that's one of the empirical findings that proves the fact that even by standardizing the inflation gap inflation it's not symmetric to 2% or not symmetric to zero but it has a lot of
• 74:30 - 75:00 um fat tails values uh a a large standard deviation above zero or above 2% which does make the distribution symmetric but it's Q it's skewed to the positive side and it's very similar to a k square distribution so at that point you are not talking about the normal distribution not a standard normal because again the time series is not stationary so by no means the the data of infl the inflation it's a normally
• 75:00 - 75:30 distributed variable okay again inflation gap you can see here that the data is totally um and here you you have here the 2% target so you see the blue line are the recorded data and by no means you have this small period which is below 2% okay 2008 is after the financial crisis this is 2016 is like going into Brexit you have a oil at $40 this is
• 75:30 - 76:00 that's 20 so it's the business cycle okay but you have this long these are the long periods which is above 2% so to have an inflation steady at two just watch the trend yeah you see the line the blue line is the real data of inflation they jump around they go up 10% they go down and then this is that's the assumption of the central bank steady inflation at 2% asic like if um uh y equals 2 okay you have any wish
• 76:00 - 76:30 y was two right and then you have a as like that that's it that's not possible it doesn't work like that and then the green line is the HP filter which works out the potential trend of inflation so it's very empirically demonstrable that inflation is not symmetric to 2% so having a fixed target 2% you never achieve that you never never never never you are never on
• 76:30 - 77:00 target never you're up above the target or below the target so central banks works on a theoretical and imperial framework which is bollocks it's wrong and that's very important because the cost of inflation it's erodess disposable income so if I have prices which don't deviate too much from from what is an affordable average price then disposable income has
• 77:00 - 77:30 more purchasing power which reflects the value of money and then disposable income can make you afford more things can make you afford to do investments in the economy can can make a force to generate more savings and when you have the um the more savings in the economy then you have the available pool of capital for investments but when the disposable income is all eroded by inflation you
• 77:30 - 78:00 don't have savings you have more debts you have higher inflation and the economy stagnates you are in a paranal cycle of stagnation that's what it has been the UK economy for many decades and that's not because of Europe that's a problem of the UK economy higher structure inflation which has not been um basically confronted with the right tools in monetary policy because you can
• 78:00 - 78:30 all see here i want to make this chart huge watch this chart actual inflation is this one that's the 2% the red line is the 2% target has ever inflation been at 2% for more than a quarter no you never been on target steadily for a long period of time it always bumped around with some very large inflationary shocks so there are more large inflationary shocks that deflation okay you have no you don't
• 78:30 - 79:00 have deflation because this goes from zero that's not deflation you are slightly below 2% but still it's positive here yeah bear in mind guys watch this this is zero it's not negative it's not even deflation yeah that's 1% inflation 0.8 yeah that's 1.8% inflation but so inflation has always been very very positive i showed you that the average it's 2 um 9% 3% inflation has always been on
• 79:00 - 79:30 average here 3% that's the average for all these years from 1989 up to 2024 the British people have lived with 3% CPI age on average for 35 years yeah so you tell me what the Bank of England has achieved nothing because they work with the wrong theoret the
• 79:30 - 80:00 wrong tools the wrong tools are from the wrong theoretical and empirical assumption if you have bad engineering you will have bad tools bad machinery okay so that's why it's important to have conditional volatility of inflation to have a CLT framework that standardize the inflation gap and the output gap so you start to have a range of outcomes the distribution of the range of outcomes
• 80:00 - 80:30 and when you are in a certain part of the distribution it's reflected in higher inflation data or lower inflation data but then you know more or less with more certainty within a range at which point of the business cycle you are and where the business cycle potentially it's going to if if it's on the up or it's going down and the standardization of the of the
• 80:30 - 81:00 inflation gap and of the output gap it's propotic is functional to the fact to have a range a range distribution of outcomes that can inform you what where on earth you are in the business cycle and so you can know with more certainty with within a range if the business cycle is going up or it's going down that's inflation so I hope I will find again the chart for um GDP one second bear with me
• 81:00 - 81:30 charms okay so here again let's go back to GDP so GDP this is CLT but yeah you can standardize but it's more symmetric okay it's within a range by it's by no mean a kai square distribution so when you are in a range we have a range of distribution which are standard are standardized then on the basis of the
• 81:30 - 82:00 fact that you are here or here you know at which point of this range of values which is the output gap you are and so you can manage to know where the business cycle is going if you are expanding GDP or if GDP is going to contract it's going to shrink and then monetary policy it's a thousand seven times more effective because you can incorporate the volatility of the business cycle and you don't work with
• 82:00 - 82:30 fixed parameters which are good at nothing okay um and that's I use also a calmer filter calman I I need to calm down because the calman filter instead of uh the HD or presscode filter it's um it's a method that works perfectly with um data time series with recorded historical data which are not normally distributed so the carman filter theoretically does a better job and
• 82:30 - 83:00 so I took the opportunity to use the carman filter and still I have I see that the UK economy has a marginally negative output gap and the Bank of England is not cutting rate because inflation still it's a high and I showed you now that inflation in the past 35 years on average has been 3% it has not been never 2% so adding a yeah on average 3% for 35
• 83:00 - 83:30 long years it's two generations and you have a output gap which is skewed to the positive side we have a lot of times that inflation has been higher than 2% and I have other test that show me that so that's distribution of inflation deviation from 2% target what watch see what is the distribution it's way skewed to the positive side the minimum it starts from
• 83:30 - 84:00 here 1.6% is the minimum of the skewess and then it goes well into the tail or 6 eight or 10% and distribution of high inflation deviation from 2% target so these are the bars the density so 25 times has been or five times has been 3% 30 times has been 2.5% 20 times as 30 times has been from percent so the density is the number of times so P bar is zero so we reject the
• 84:00 - 84:30 new liaboticis okay number of periods where inflation has been above 2% 101 periods calculator so the uh 35 years per four quarter per year 140 so on 140 quarters for 101 quarters inflation has been above target 2% or has deviated from 2% so you tell
• 84:30 - 85:00 me this is price stability tell me this is price stability no no it's not okay so the wrong theoretical assumption the wrong empirical assumption at the at the foundation of monetary policy it basically deviates the whole construct and you have constant higher inflation and so that's why from 1989 up to now you find that UK
• 85:00 - 85:30 wages have not grown enough it's not that UK it's not only that UK wages have not kept pace with inflation the problem is that inflation for 35 years has been on average 3% with very high peaks of inflation and the distribution of outcomes has always been for highly skewed inflation well above 2% and you see the distribution here again four 6 8% and you see here
• 85:30 - 86:00 the density how many times that's 2% it's here guys yeah 2% is here two and a half you see how many times more it's been three four five six seven 8% there is a lot of density of data when inflation was five four six 8% so that's why monetary policy has not worked at all at least the monetary policy in aggregate what is the money supply and the inflation the interest rate tool it's not worked at all and the
• 86:00 - 86:30 bank of theoretically it would be again it would have to be again at five or 6% to uh crush inflation but there is no point because inflation will go below 2% and you will not be on target and then it will start all the merry go around and say oh the bank of England has time too much has restricted too much uh monetary policy and there is the usual commentary without having a penny worth of empirical data okay another high
• 86:30 - 87:00 inflation fits the distribution you see how deviates from the 2% target and you see from the curve how we go very far five six seven eight% so this is very important and I carried out multiple tests giable distribution it tells me that the scale so we are talking about 5.2 or 4.7 on average inflation deviation when I I account for the high
• 87:00 - 87:30 inflation deviation the scale is in the range of 4.7 to 5.2% 5.3% okay also when I do the common filters and I want to see the potential inflation trend in the business cycle you see that the quarterly data is 5.8% so inflation on trend has always been very high very very high and you see here actual trend the blue line is very getting very close to the potential
• 87:30 - 88:00 trend okay so going back to the model we can do a nice thing we can try to work out the tailor formula the level of interest rate with um the level of interest rates sorry
• 88:00 - 88:30 about that CHS the machine has got stuck a bit here because I plugged up two things at once um bear with me one second it doesn't seem it wants to cover it okay now it's loading you know I'm doing all this work with uh I don't have a lot of computational power so you'll have to bear with me and uh come on
• 88:30 - 89:00 filter i'll have to come down a little bit completion gap summary bear with me chs i want to show you the trailer rules one second oh dear oh dear me i hope you are enjoying the video and uh you find it
• 89:00 - 89:30 interesting okay we have it here okay at the same time we try to gather the parameters okay so for the average um neutral rate I took the [Music] um boy yes okay this one I took this one uh implied real spot
• 89:30 - 90:00 curve and the two and a half the average is 0.08 the 10ear average is 1.19% so let's plug 1.19% we know that pi the the current inflation is 3.4% we know that the target it's 0.02 we know that the real GDP in the past quarter was uh 0.01 now what is potential GDP we go to
• 90:00 - 90:30 our um HP filter we go to our um potential GDP model and we see what is the potential GDP this is the caramel filter okay potential GDP zero i could put 0.012 okay but I remember that was okay let's use this one no sorry pi target it's 2%
• 90:30 - 91:00 sorry I made a mistake so 0.012 okay so I take the T arch parameter for inflation volatility which is 1.21 21 standard deviation and I have a higher parameter for the tar parameter of the GDP condition real GDP condition of volatility I run the code and I have an outcome which is more or less feasible ah this is the the the oh the
• 91:00 - 91:30 distribution sorry oh I have it here okay let's use this one okay let's use the let's take the parameters from here follow me jump so we are on this basket here settings let's make it 18 larger okay so the average 10ear real yield spot rate inflation is 3.4% 4% the
• 91:30 - 92:00 target is 2% the output gap I have a negative output gap and so you see nominal interest rate 6% so even with a negative out a marginally negative output cap because inflation is very high then theoretically the bank of England should have interest rate at 6% okay which it would
• 92:00 - 92:30 basically send the economy into recession in order to achieve a 2% target okay but we know that inflation will not stay at 2% so there is no point to to send inflation into recession the inflation the economy into recession but there is no point in [Music]
• 92:30 - 93:00 um I want to see GCP not too high i need the data for the uh output cap uh GDP output cap okay HP filter so that's minus okay okay soial output so you see here that Q4 2024 quarter on quarter growth was 0.1%
• 93:00 - 93:30 potential output is 0.26 okay so we put it here let's try to make it work so interest rate should be 1.8% 8% okay let's or 2 and a half% if I use a negative real rate okay and I take it from the from the um OS data so but if I use a
• 93:30 - 94:00 positive average 1.19% then we are at 5 and a half% 5.5% so the inter the bank of England should set interest rate at 5.5% and withstanding a negative output cap so negative output cap it's negative uh 0 uh
• 94:00 - 94:30 162 okay so this is even larger so why I'm showing you this i'm showing you this so you see that with my work using the conditional volatility using the optimized output gap having the central limit theorem for the out inflation the output gap because what I want to demonstrate you is because inflation it's structurally higher in the economy the bank of England is forced to keep
• 94:30 - 95:00 rates higher for longer and although you have a negative output gap so growth it's anemic and it's below its potential the potential it's very minimal 0.26 so you are stagnating that's the the full definition of stagnation because you have low GDP growing debt growing unemployment and higher inflation low productivity so
• 95:00 - 95:30 it's a long stagnating period and the problem of stagnation or stagflation it's inflation and so if for real the bank of England wants to inflation to be to go to 2% and below 2% it will have to cause a recession on on top of the stagnation but the real problem here is
• 95:30 - 96:00 that when you go and and check all the microeconomic variables you see that fiscal deficit they have a strong correlation with inflation when you run an OS regression you run a valve model you run a VECM model you see that for a many times that you have a fiscal deficit the then the l the lag effect of fiscal deficit they generate inflation so if there are two things you either
• 96:00 - 96:30 resolve the fiscal deficit and then you start not you are forced in not doing deficits or you have very high interest rate but the picture for the the the structural feature of the UK economy at least in this period past years since 2022 or maybe longer I don't it's stagnation or stagflation and because I showed you
• 96:30 - 97:00 that UK has lived in the past 35 years since 1990 for with an average 3% inflation so if if the structural rate of inflation which is higher is not resolved then the rate of growth of the UK economy will always be very anemic will always be below potential and you you can incur in problems when you the debt is growing faster than the economy
• 97:00 - 97:30 and then the debt to GDP ratio tends to increase you go 100% 105 107 110% % so that's the structural problem it's the persistent high level of inflation and the wrong theoretical assumption for which monetary policy on a global scale has fooled central bankers and the whole population for the past decades and you can see here yeah take a
• 97:30 - 98:00 picture I will send you the code use conditional volatility standardize the inflation output the the the uh the potential the GDP output and uh output gap and inflation output gap standardized those range have a standardized distribution of outcomes on the basis where the potential output is in the negative side of the distribution or the positive side you know exactly
• 98:00 - 98:30 with more precision where in the business cycle are because in in this moment you are In stockflation you have a negative output cap and um high inflation so we are here okay but negative output gap can go as far as minus5 so well large or minus4 so well larger than minus 0
• 98:30 - 99:00 uh 26 or 0.16 so we are very close to zero uh still are we are in this part of the curve of the of the distribution so according which side of the the the CLT standardized normal distribution of the output gap you know where in the business cycle the economy is and then you confront it with the where is the output gap in inflation because it's 34 minus 2 but it's even worse because if
• 99:00 - 99:30 we consider core inflation I use CPI okay but if I consider core inflation is 3.7 so you have a positive output gap which is 1.7% it's nearly double the 2% target which is the 2% target it's fanciful so I want to do another thing for the past 35 years has been on average 3% so if I put on average the inflation target 3%
• 99:30 - 100:00 then we have 0 we have exactly what is the bank of England interest rate today 4.3% 4 and a half% so you see how these things works it depends on what do you inject in a simple arithmetic uh formula what are the parameters okay how you uh calculate this the parameters what models you use to calculate the parameters and then we can because for
• 100:00 - 100:30 example instead of using the T arch I could say okay I have here the output gap the standardized output gap and I see that it has mean zero and the standard deviation is 1.86 I can take the standard deviation for good 1.86 86 let's put 2% let's see what
• 100:30 - 101:00 happens come on boy 5.4 wow the GDP now wow even with a negative output cap if I put a larger multiplier then if I vary the inflation target I would be more or less around the same value but this has to be double checked with Excel and uh I'm too tired to do it now
• 101:00 - 101:30 but you see here that for example you can standardize the output gap and you can think of using the CLT standard deviation for um the um tailor rule formula okay so I hope you enjoy this video because there is a lot of material and um where is it where is it my favorite
• 101:30 - 102:00 uh my favorite thing remember my Taylor rule my formula my arithmetic formula my arithmetic formula I will write it again so the level of interest rate it's based on the average real rate for the one year was 10
• 102:00 - 102:30 inflation plus the conditional volatility on average of inflation the inflation gap plus the conditional volatility of the output gap times the output the resulting parameter that comes out from the subtra of the output gap okay the real GDP now minus the potential
• 102:30 - 103:00 output and for this you use CLT you standardize the output cap and inflation gap so that you have a range and according to where you are in the range you know where you are in the business cycle and according to what is the conditional because you can you can measure the average conditional volatility parameter to the latest conditional volatility parameter and you
• 103:00 - 103:30 have an idea if volatility it's higher maybe you and you have a positive inflation output cap you know that inflation is going to go higher it's it's uh it's very very precise so if the conditional volatility in the past period it's higher than the average historical conditional volatility of the inflation parameter that you're using you already know that probably if you have a positive
• 103:30 - 104:00 inflation output gap standardized then this will go higher so you have a business cycle which is inflating and the economy is going to be hotter in the following months and quarters on the reverse if you have lower volatility and you have more or less depends on what is the inflation gap then you know that the business cycle probably you you are going to have lower inflation which is good but you need to know then what is the output cap if the
• 104:00 - 104:30 volatility of the output cap is lower then maybe you are having some below potential output cap some negative output cap of zero output cap so you are optimal level so there are many states at which the economy can find itself but the conditional volatility is one of the crucial parameters that can inform the interest rate tool in monetary policy and I strongly believe that inflation gap and the output cap they have to be
• 104:30 - 105:00 standardized because inflation is not normally distributed and it's not symmetric to 2% or to zero and is heteroscadastic so you have also error variance that it's not constant you have volatility in the errors so you cannot work with the 2% inflation target by no means and so you at least it's necessary to adjust according to volatility of inflation and then basically it's important to decide if it's worthwhile to have a fixed 2%
• 105:00 - 105:30 inflation target or if it's necessary to find another arithmetic formula or something more difficult may maybe it's a stoastic differential equation that works out inflation as a