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Bank of E set to do nothing as stagflation hits services

June 5, 2008 | posted by Michael Baxter in UK economy, rate of interest | comments (0) |

It’s that time of the month again – how can it possibly have come round so fast, when the boys and girls at the Bank of England sit and cogitate until, at midday, with fanfare, they announce the official rate of interest for the next month.

Will the rate fall, in which case it will be a kind of fanfare for the common man; rise, in which case the media will want to have members of the MPC hung, drawn and quartered; or will rates stay on hold, in which case the fanfare will turn to whimper within a few seconds?

It will be a big surprise if the whimper does not win out.

You know why – inflation.

You know why some say the Bank of England should cut rates: the economy is up the creek without a paddle, it needs to see rate cuts, and as we are in such a mess, inflation will fall, in due course, anyway. Or so they say.

Yesterday the OECD said the UK needs to cut interest rates by ¾ per cent, but that we can’t because of inflation.

The Bank of England is worried it may not have enough ink cartridges for all those letters it will be writing to the chancellor soon. With inflation set to go way over target – and firmly into letter writing territory, how can it cut rates?

Yesterday it was the latest CIPS/NTC report on services that had policy makers in agony.

“Against the backdrop of a difficult economic climate, characterised by low business morale and rising price pressures, overall activity and new work both contracted for the first time in over five years,” said CIPS.

Its tale of woe continued: “Of particular note was a series record contraction of employment as companies responded to increasing levels of spare capacity. Confidence amongst panellists also fell – slipping to its lowest since October 2001. On the prices front, there was another record increase in input costs, prompting companies to raise their own charges at a stronger rate.”

Latest sector data showed that Financial Intermediation remained the worst performing of the sub sectors in terms of activity and new business in May – so there’s no surprise there.

Following fifty-seven successive months of uninterrupted growth, employment in the UK service sector contracted markedly during May. The seasonally adjusted Employment Index fell sharply to a reading of 46.5, down from 51.0 in April, signalling the strongest contraction in staffing levels in the survey history. Job losses were widespread with the strongest decline registered in the Hotels & Restaurants sector.

Paul Smith, economist at NTC Economics, said: “The latest set of results makes for rather grim reading, with the worry of stagflation in the UK now becoming increasingly real. While the activity and new business indices continued to deteriorate and entered negative territory for the first time in over five years, average overheads continue to rise, with input price inflation again setting a survey record over the month.

“Against this backdrop of rising costs, a weakening demand environment and faltering sentiment in the sector, it was perhaps unsurprising to observe a drop in employment. However, it was the scale of the fall that is likely to make policymakers sit up and take notice, and therefore raise the pressure on the authorities to provide support sooner rather than later.”

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But when the interest rate is negative what can you expect?

June 2, 2008 | posted by Michael Baxter in rate of interest | comments (0) |

But while people ask of oil, will it, or won’t it, maybe it’s time to look elsewhere.

Inflation maybe be up a tad in the UK, maybe the Bank of England’s governor will be writing to the chancellor soon, and inflation may be showing nasty signs in the Eurozone and US, but the real fears must relate to the rest of the world.

Take Argentina. Officially, prices are rising by 8.9 per cent. That is bad, but wait until you hear this. Today, the Telegraph reported on a claim made by union staff of the statistics office there, that actually the figures are being deliberately distorted. The true inflation rate is 40 per cent, and the country’s government is trying to use inflation as a way of paying off debt, so they say.

Then there’s China. Behind the Great Wall prices are rising by 8.5 per cent, but the official rate of interest is just 7.47 per cent.

In Thailand, inflation has soared to 6.2 per cent, yet the interest rate is just 3.25 per cent.

In fact, according to Bloomberg, in no less than 11 Asian economies real interest rates are negative.

Now we have been here before. Negative interest rates are not unprecedented, back in 1975 UK inflation was 24.2 per cent, but the rate of interest that year ranged from just under 10 per cent to 12 per cent. So that means the real rate of interest was around minus 14 per cent.

It is nothing like that, but right now in the US the real interest rate is negative too.

The low real US and UK interest rates are leading to falls in the pound and the dollar, which in turn will bring inflationary pressure down the line.

But on the other hand, high inflation in Asia could eventually make the local currencies fall.

If Chinese inflation continues to outpace US and UK inflation, then at some time in the not too distant future, its currency, the yuan, may look too expensive, and the pressure may be for it to fall, rather than rise as US politicians are demanding.

And back to the UK, last week the CBI revealed its latest retail survey, and it showed that 56 per cent more retailers said that they raised prices this month than reported cutting them. This is the highest ratio since May 1992.

The trouble is surely this.

For ten years we had low inflation, thanks to external factors – cheap oil, cheap imports from China and India, the Internet enforcing unprecedented price competition. We became spoilt. Rates were slashed because inflation was low and cut down rates could be justified.

Governments spent, consumers spent, asset prices leapt in price, consumer borrowing just rose and rose.

Central banks and policy makers seemed to convince themselves low inflation was down to them. It wasn’t.

Now, inflation is occurring because the real factors that kept prices down no longer apply.

Consumer spending at the levels it reached in 2007 is not sustainable. If it were to continue at that level, inflation would indeed rise.

Inflation remains a threat for as long as policy makers try to see a return to those days.

If instead the economy moves to a sustainable level – with spending less than income, with savings at the level they should be at, given the pending pension crisis, then inflation pressures will ease. Oil will fall in price, so will the cost of food.

Economic growth should come from investment feeding innovation, not through mass credit card spending.

But do policy makers dare take the necessary steps?

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ECB holds, but Germany and France reveal different cards

May 9, 2008 | posted by Michael Baxter in Eurozone, rate of interest | comments (1) |

If its public are waiting for the European Central Bank to do some kind of a U-turn, and slash rates, then the bank may well want to use these words, borrowed from a certain former British female Prime Minister, “You turn if you want to, we are not for turning.”

Actually, the ECB’s president was a little more prosaic than that, “There’s absolutely no reason to say that vigilance has disappeared from our potential vocabulary,” he said.

The ECB is still fretting about inflation: “Inflation rates have risen significantly since the autumn, owing mainly to increases in energy and food prices,” said an official statement, and inflation should stay “high for a protracted period of time.”

As a result of that the ECB kept rates on hold again yesterday; they have now been at 4 per cent for over a year.

The general feeling is that rates will fall later this year, but by then the Bank of England may have cut rates once or even twice, which in turn will put the pound under further pressure.

But at the moment, the actions of central banks in setting interest rates seem less relevant than they used to. What matters is the money markets.

And here’s something interesting:

For while the cost of borrowing has not really changed that much across the Eurozone since the onset of the credit crunch, in Germany interest rates on fixed rate mortgages have fallen by 30 basis points, while in France they have risen by around 50 basis points. Rates have risen in Spain and Italy too, although not by so much.

Why is that? Capital Economics puts it down to the strength of the housing markets in the respective economies. “Germany has not experienced a large increase in house prices over recent years,” said Ben May, European Economist at Capital Economics, and therefore, “there seems little prospect of a housing crash.” He added “German household finances are in good shape too.”

The bottom line, Germany’s consumers are well poised to up their spending; French, Spanish and the Italian, to draw in the purse strings.

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IMF clashes with Alan Greenspan and Bank of E

April 10, 2008 | posted by Michael Baxter in inflation, rate of interest | comments (0) |

The debate may seem academic, but actually it has far reaching implications. When central banks set the rate of interest, should they then take into account asset prices?

Alan Greenspan might be known as the maestro, but he says that central bankers have no way of knowing if asset prices have risen too high. In effect he is saying you can’t expect the likes of Ben Bernanke and Mervyn King to be able to second guess the markets.

That’s why Mr Greenspan did something of a turnaround in the run up to the dotcom crash. Originally he talked about irrational exuberance, but then softened his tone. These days the maestro has started using the phrase ‘leaning against the wind’ when talking about taking asset prices into account when setting rates, and suggests that it can’t be done.

In the UK, Paul Tucker, a director at the Bank of England and a member of its rate-setting Monetary Policy Committee, recently gave a speech in which he said: “For too long, the debate has got sidetracked. Into whether we can rely on monetary policy ‘mopping up’ after bubbles burst. Or into whether monetary policy could be used to control asset prices…But let me make this absolutely clear: there are formidable obstacles to finding a solution.”

But yesterday, in its latest report, the IMF seemed to disagree. “Financial developments,” it said, “have fueled the continuing debate about the degree to which central banks should take asset prices into account in setting monetary policy…Recent experience seems to support giving greater weight to house price movements in monetary policy decisions, especially in economies with more developed mortgage markets where ‘financial accelerator’ effects have become more pronounced. This could be achieved within a risk-management framework for monetary policy by ‘leaning against the wind’ when house prices move rapidly or when prices have moved out of normal valuation ranges, although it would not be feasible or desirable for monetary policy to adopt specific house price objectives.”

It has been suggested that the solution to all this is simple enough. All you need to do is change the time frame over which central banks have to keep inflation in check. If the Bank of England was allowed to take into account the longer-term forces that determine inflation – and focus on keeping it under control over the long-term, it would in any case look more closely at asset prices.

The trouble is this. Low interest rates can help encourage investment into business. This can result in higher productivity, which in turn can reduce inflationary pressures. So in some respects lower interest rates could lead to lower inflation in the long-term – at least, that’s our view – although it is not a conventional opinion.

But this positive force is contradicted by another force – lower rates encourage higher consumer borrowing, and lead to higher house prices which in turn encourage consumer booms which could be both inflationary and unsustainable. The key, surely, is to find a way that ensures lower interest rates do not automatically lead to escalating asset prices.

This can be achieved through encouraging mortgage providers to insist on lower income-to-loan multiples, through encouraging more mortgage deals that offer fixed rates over the long term, and perhaps through tinkering with the way buy-to-let investors can offset interest payments on their mortgages against revenue.

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Bank of E set for big announcement, but what does it mean for sterling?

April 10, 2008 | posted by Michael Baxter in rate of interest | comments (0) |

And finally, we couldn’t leave you without mentioning today’s meeting at the Bank of England.

Most economists expect to see a quarter of a per cent cut, some think the cut could be even bigger – although there are still those who fear that inflationary pressures mean rates should be left alone.

To an extent, it seems irrelevant. We have seen money markets go to the opposite extreme from the position they occupied three years or so ago. You will probably recall Alan Greenspan talking about a conundrum. At the time, the long-term rate of interest set by money markets was at a similar level to the rate set by the Fed – it even dipped lower. This was known as a reverted curve. It was called a conundrum, because in the past such a phenomenon seemed to occur shortly before a recession, something Greenspan thought was unlikely.

Actually, although Mr Greenspan called this a conundrum, he chose these words more to try and focus press and market attention, than because he didn’t know what was happening. The truth was that money was flooding in from overseas –from Japan, from China and from OPEC countries. The rate of interest set by the markets was low because the supply of money was so plentiful. Mr Greenspan knew this.

Now, things are tight. As you know, many banks have been upping mortgage rates of late, LIBOR rates have remained high. Even if the Bank of England were to slash rates today, don’t expect the cost of borrowing for Joe public to fall any time soon.

That’s not to say markets won’t react; eventually – they will. And that brings us to the pound.

Yesterday, the pound fell to another all-time low against the euro. The reason: expectation of a fall in interest rates.

With inflation rising in the Eurozone, and with the region in reasonable shape – although Spain, Ireland and Italy have their fair share of problems, it seems likely the rate of interest in the Eurozone will stay on hold for a while. In fact, there is an outside chance that by the year’s end, the British rate of interest set by the Bank of England could be lower than the Eurozone rate.

When the rate of interest falls in a country, it becomes less attractive as a host for money deposits, so money leaves, causing the currency to fall. It was expectation of this that led to the recent falls in sterling.

A lower pound could be good for the UK. We are more reliant on overseas trade than the US, and so a falling pound may have a bigger impact upon British exports than a falling dollar on US exports.

But don’t underestimate the importance of the US on worldwide trade. As the US slows, so will trade. The effect won’t be immediate – but the global economy has relied upon the US consumer for a long time. The jury is out as to whether the US consumer has paused for breath, or is in bigger trouble than that – but it is naive to assume the global economy can shrug off the effects of a slowing US. The IMF put the chances at one in four that global growth will fall below 3 per cent this year – and by some definitions that is a recession.

Now is not the time for the UK to pin its hopes on an export-led recovery, prompted by a falling pound.

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IMF clashes with Fed and Bank of E over house prices

April 4, 2008 | posted by Michael Baxter in House prices, rate of interest | comments (3) |

How much do house prices matter? Many claim there is only a modest link with the rest of the economy. Earlier this decade, when house prices were rising rapidly, there was also a surge in remortgaging. But the Bank of England used to say that most of the money taken out from mortgage top-ups was spent on the home – extensions, for example, or on buying other assets, and did not create higher consumer spending, and was, therefore, sustainable,

It was all rather convenient, because it gave the Bank an excuse not to take into account house price inflation when setting the rate of interest.

Earlier this week, we received a comment on our blog making a similar observation.

If this view is right, then falls in house prices would not necessarily lead to a recession.

This has become a key issue. Others argue that the single biggest factor that created the credit crunch was the refusal by central banks to do anything to check rising house prices. As a result, they say, asset prices spiralled and an unsustainable bubble was created. They conclude: the unwinding of this bubble in the US is the true cause of all the woe doing the rounds at the moment.

Alan Greenspan, on the other hand, decided against taking into account asset prices because, he argued, it was not possible to tell whether the price changes were based on solid foundations or were unsustainable.

So who is right? Do rising house prices lead to higher consumer spending, and then higher long-term inflation? Should central banks set interest rates accordingly? Or were they right in the first place, and should they carry on ignoring house prices?

It does seem a little unlikely that there is only a modest link between house prices and consumer expenditure. Sure, many homeowners might be paragons of responsibility, and ensure sure they never spend the extra wealth they accumulate via their homes on holidays, eating out, or LCD TVs. But, economic growth is often determined by the actions of individuals on the margin.

If some individuals have funded their spending by releasing equity in their home, then these individuals will now be suffering – and their fall from fortune alone could have a disastrous knock-on effect.

In recent years property possession levels have remained quite modest – some suggest this illustrates the strength of the economy, but equally, these low possession levels may have simply been down to the ability of individuals struggling to make ends meet to top-up mortgages. In short, people struggling to make payments could just borrow more. And when house prices went up again, borrow yet again.

What is clear is that savings in the UK have been low for some time, while consumption has been high. Money saved for the future – pension payments in particular, has been modest.

But, as the Halifax constantly reminds us, our net wealth, thanks to rising house prices, has been increasing. Therefore, concludes the Halifax, the low savings rate has been sustainable.

But you can’t have it both ways. You can’t on one hand say there is no correlation between consumer spending and high prices, and then say, in any case it doesn’t matter that consumer spending is high, because house prices have been going up.

It also seems likely that many homeowners, and buy-to-let investors in particular, see their property, or properties, as their pension.

In the UK in particular, property investment is seen by many as the safest form of investment, so who needs money stashed away in a pension policy, invested in high risk equities, when instead you can invest in bricks and mortar, and get leverage on your investment to boot?

But this is a dangerous mindset. When the baby boomers retire and try to release the equity tied up in their properties, the result could be a surge in demand which can not be met by supply. Inflation could be the result.

Spending is only sustainable if it can be met by output, and for this to occur we need to invest our money into sectors that create wealth.

Now the IMF has taken a look at this controversial area in its latest World Economic Outlook report.

“We find that the effects of monetary policy changes on output are larger in those economies where housing finance markets are relatively more developed and competitive,” said the IMF.

As for its recommendation: “We conclude that economies with more developed mortgage markets could become more economically stable by pursuing a monetary policy approach that responds to house price movements.”

The IMF report added, “Paying attention to house price developments does not require changing the existing monetary policy approaches. Rather, these approaches should be interpreted in a more flexible manner, for example, by extending the time horizon over which inflation and output are returned to target.”

In other words, rising house prices lead to higher consumer inflation in the longer-term, so if central banks are told to target inflation over an extended time frame, they will automatically take into account house prices.

The IMF also found the highest correlation between house price growth and consumer spending was in countries where access to mortgage credit is easiest. Interestingly, in seventh place, the UK sits quite a long way down the list of countries which enjoy the easiest access to mortgage credit. The US tops the list, followed by Denmark, Netherlands, Australia, Sweden, Norway and then the UK.

This would suggest then that the UK is less reliant on house prices than other economies. But, then again, house prices have risen faster in the UK. So while it might be marginally harder to raise mortgage debt in the UK, house prices are so much higher that, in absolute terms, mortgage debt in the UK is relatively high. In fact, mortgage debt as a percentage of GDP is only higher in the Netherlands and Denmark.

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Fed digs deeper hole with rate cuts

March 19, 2008 | posted by Michael Baxter in US economy, rate of interest | comments (0) |

The markets had expected a bigger cut, they had priced in a full percentage point drop, and yet when Mr Bernanke and chums chose to lower rates by a mere 0.75 per cent, there was much celebration.

In proportional terms, it was the biggest fall in interest rates for a very long time.

On Wall Street, and over here, the Fed seemed to be drawing praise. For a while, they had said Ben was asleep at the wheel, in denial over how bad the crisis was – but not any more.

With prices rising, the fear is that deflation could return, and the Fed is pulling out all the stops to avoid that. In Japan, the decade of lost growth was kicked off after the central bank proved itself reluctant to take the measures needed – when finally it lowered interest rates to zero per cent, it was too late.

The Fed wants to avoid those mistakes.

But not everyone at the Fed was so keen to cut rates. Of the ten men and women who voted, two went against the pack, and voted for a more-modest 0.5 per cent cut. The markets didn’t care, Bernanke is their hero, and his earlier reluctance to lower rates forgiven.

Yet, something strange did happen. The long term rate of interest, that’s the rate set by the markets, rose. Some traders at least, appear to believe the Fed has laid down a recipe for inflation – and that in the longer-term, rates will need to rise much higher as a result.

In fact, yesterday also saw a 0.3 per cent rise in producer prices in February – the inflation genie is either knocking very hard on its bottle, or is actually escaping right now.

Previous deep recessions have been caused by falls in asset prices – such was the case in the 1930s, such was the case in Japan in the 1990s. The trick the Fed has to pull off is to allow asset prices to fall to sustainable levels, without setting off a very nasty recession.

If it boosts the economy too much, then it is merely delaying the day and could create even bigger problems in the future.

If it doesn’t boost the economy enough, then it will be very difficult to avoid a downward spiral.

But never lose sight of the fact that the underlying problem in the US is too much spending and not enough saving – the Fed, by cutting rates so much, is delaying the time when this essential readjustment occurs.

Editors footnote

The Japanese recession was in part made much worse because of a refusal amongst banks and authorities to acknowledge how serious the problem was. They were too slow to make their write-downs and too slow to face reality. Judging by all the doom and gloom, that is one criticism at least you can’t level at Wall Street and the City.

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Bank of E jumps on the roller coaster

February 21, 2008 | posted by Michael Baxter in rate of interest | comments (0) |

It was another day on the roller coaster for members of the Bank of England’s Monetary Policy Committee yesterday.

You may recall, last week the bank released its quarterly inflation report – and what a downbeat report it was too. It dropped a hint that in the shot-term inflation may rise by more than one full percentage point above target, but that in the longer term there was real danger of its staying above target too. The Bank’s governor, Mervyn King talked about a difficult balancing act.

So that’s the backdrop, this is what happened yesterday.

First off the blocks were the latest minutes from the Bank of England Monetary Policy meeting which reduced the rate of interest by a quarter of a per cent to 5.25 per cent.

And here is the oddity, while the Bank has been warning about the dangers of inflation, and has been trying to dampen our expectations for big rate cuts this year, one of the MPC members, David Blanchflower voted for a half a per cent cut. The rest all voted for a quarter of a per cent cut.

Now Mr Blanchflower, also called Danny Blanchflower, although we are sure he never managed Tottenham Hotspur, has always been the committee’s arch dove, in fact he has voted for a rate cut in the last five meetings. But the fact he voted for such a sharp fall in rates, when the Bank was trying to portray a “steady as she goes” type image, shows how contentious this whole issue is.

Then yesterday two pieces of data were released telling a quite contradictory story.

The news from wage land is good. According to a Bank of England survey, private sector pay settlements are expected to average just 3.3 per cent in 2008.

But, the news from manufacturers is not so good. According to the latest industrial trends survey from the CBI, a balance of 22 per cent of firms told the CBI that they expect their domestic prices to go up over the next three months. Now that is worrying, because if you correlate past CBI findings with the official figures published three months later, you will find that the CBI score suggests that manufacturers’ output inflation, already at a 16-year high, has much further to rise.

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The reluctant cut – Bank cuts rates – but dishes out warning

February 8, 2008 | posted by Michael Baxter in rate of interest | comments (3) |

It was a kind of grudging rate cut. Yesterday, the Bank of England knocked another 0.25 per cent off the interest rate – but seemed to be spitting feathers as she did it.

Sure, there seems to be a line-up of economists from here to Timbuktu predicting rates will be slashed this year, and yet the Bank has damning words. “Some slowing of demand growth, by reducing the pressure on capacity, is likely to be necessary to return inflation to target in the medium term.”

The Bank further rattled the inflation cage, saying, “Inflation at 2.1 per cent in December was close to the 2 per cent target, but higher energy and food prices are expected to raise inflation, possibly quite sharply, in the coming months.

“The Committee needs to balance the risk that a sharp slowing in activity pulls inflation below target in the medium-term against the risk that elevated inflation expectations keep inflation above target.”

But while the UK’s central bank still seems to be striking a hawkish note, it’s nothing like the ominous presence of hawks circling above Frankfurt.

Yesterday, the European Central Bank kept rates on hold, and its president Jean Claude Trichet said he was “prepared to act preemptively” in the event of second-round inflationary effects.

It’s all a little odd, because the one place where the central bank doesn’t seem to think inflation is a threat is the place where it is highest.

While in the UK the central bankers worry about inflation of 2.1 per cent, and the in the Eurozone inflation of 3.4 per cent has bankers rattled, in the US, prices rose by 4.1 per cent over the last year.

It seems Ben’s helicopter view of the economic terrain is very different from bankers in London and Frankfurt.

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Bank of E set to do nothing as stagflation hits services

But when the interest rate is negative what can you expect?

ECB holds, but Germany and France reveal different cards

IMF clashes with Alan Greenspan and Bank of E

Bank of E set for big announcement, but what does it mean for sterling?

IMF clashes with Fed and Bank of E over house prices

Fed digs deeper hole with rate cuts

Bank of E jumps on the roller coaster

The reluctant cut – Bank cuts rates – but dishes out warning

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