Markets and retailers were up in arms yesterday. In recent days most pundits were saying the Bank of England was about to stick, that interest rates were to stay on hold. And then, at 12 o’clock yesterday, when the UK’s central bank did indeed confirm that interest rates were on hold, and staying at 5.5 per cent for another month, markets went into sell mode, and retailers could not hide their dismay.
Kevin Hawkins, Director General at the British Retail Consortium, for example, said, “The longer the Bank delays cutting rates again, the greater the risk of the economy heading in the wrong direction.”
The call to cut interest rates is growing into a deafening roar. Earlier this week the Telegraph quoted Peter Spencer, chief economist for the ITEM Club as saying, “The central banks are rapidly losing control. By not cutting interest rates nearly far enough or fast enough, they are allowing the money markets to dictate policy. We are long past worrying about moral hazard.
“They still have another couple of months before this starts imploding. Things are very unstable and can move incredibly fast. I don’t think the central banks are going to make a major policy error, but if they do, this could make 1929 look like a walk in the park.”
As you probably know, most economists expect to see a steady decline in interest rates this year, and some think that by the year-end, rates could be as low as 4 per cent. And while there’s a feeling a month’s delay in cutting rates to 5.25 per cent won’t matter too much, it seems to be agreed that the Bank of England is running out of time, and really must move very soon.
It’s very popular at times like this for central bankers to get the rap. Last year, Jim Cramer of CNBC exploded with rage with the Fed saying it had “no idea” how bad markets and the economy were looking.
But maybe the problem isn’t with the central bankers at all. Maybe they do know what they are doing - maybe the problem is that it’s the markets and retailers who struggle to see the big picture.
In fairness, not all are guilty. Simon Ward, economist at New Star Asset Management said yesterday, “The economy has slowed significantly in recent months but it is not clear that growth is weaker than the MPC desired when they tightened policy last year. Household inflation expectations and business price-raising plans remain at or above levels that troubled Committee members then. Meanwhile, financial conditions have eased significantly over the last month as interbank lending rates have tumbled and sterling has weakened sharply.”
But there is another problem lurking behind the scenes, one that appears to have gone largely unnoticed, although we are sure Mervyn King and his rate-setting chums are aware of the danger.
Actually, the problem is a two-pronged fork. Sterling is on its way down, it has fallen from nigh on $1.10 a few weeks ago to just $1.96. It’s down against the euro too. This time last year there were around 1.5 euros to the pound, now it’s nearer 1.33.
Why is the pound falling? Well the fashionable thinking lies with expectations of interest rates. Since just about all economists and their dogs expect interest rates to fall rapidly in the UK this year, therefore it is assumed that it will become less profitable to put money on the UK money markets. Instead, money will flow to regions where rates have not fallen so fast - for example the Eurozone, where the European Central Bank is still striking a hawkish note. And the currency markets have started discounting this expected future trend.
But there is another less-fashionable explanation.
These days we don’t hear so much about the Balance of Payments. Time was when a rising balance of payments deficit would have elicited cries of alarm, and previous prime ministers, such as Harold Wilson, must have felt all their waking hours were taken up fretting about our balance of trade.
But just because it is not fashionable to worry about the balance of payments, it doesn’t mean you shouldn’t. Being a dedicated follower of fashion is a dangerous thing to do if you are an investor or economist.
And remember this. In the US the dollar remained strong when interest rates were at or around 1 per cent, and went into freefall when US rates were over 5 per cent - why was that? Well, the US current account had hit a level that even the trendiest of economists, who said things like that didn’t normally matter, raised eyebrows. Remember, it was the massive US trade deficit that led Warren Buffet to say he was going to be focusing his investment strategy on non-US dollar denominated assets.
But back here they were saying sure, the UK deficits were bad, but not as serious as in the US, where the current account deficit as a percentage of GDP is much higher.
But over the Christmas period, the Office for National Statistics released data to show that the UK’s current account deficit had hit a worrying 6 per cent of GDP in the third quarter of last year. The total deficit came in at £20bn, compared to £11.4bn expected by experts.
To put this in context, in the same period the current account deficit in the US was $178.5bn, or 5.1 per cent of GDP.
The truth is, the pound has been grossly overvalued against the dollar for a very long time, and too high against the euro.
If the UK is to really correct the lack of balance in the economy, it needs to expand through seeing a rise in exports, with consumption staying flat.
But there is a downside. When Harold Wilson’s government devalued the pound, our pipe-smoking premier said, “It does not mean that the pound here in Britain, in your pocket or purse or in your bank, has been devalued.” But he was wrong, as the pound fell against other currencies, inflation lifted, almost cancelling out the benefits achieved through a falling currency.
In November, our import price inflation hit a 14-month high of 3.7 per cent. If rates fall too fast, we could see a rout on our currency, creating massive inflationary pressures.
Shakespeare’s Shylock talked about taking his “pound of flesh”; it appears while retailers want more life-blood pumped into the economy through seeing falling interest rates, this could lead to a rise in inflation that will be far worse than a mere flesh wound.
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