June 19, 2008 | posted by Michael Baxter in inflation | comments (0) |

Well, we are sorry.   The economic debate moved into a new phase yesterday.  Maybe we are now set to go through the most critical period yet in the story of this extraordinary economic crisis.   And it has come down to that old-fashioned issue: pay restraint.   Real income is falling, will we see a wage price spiral?    Following a period of massive inflation in executive pay, trade unions are reasonably asking why their members can not receive pay rises in line with inflation.    It is a mess.

Here is the story in 10 stages.

Stage 1 – On April 25, in this column, we said that painful as it is, we will just have to accept that higher commodity prices mean we are worse off.  Providing we do that, take it on the chin, the rate of interest will stay down, and unemployment should not be affected too badly.  But, if we try and somehow avoid paying the cost of rising commodity prices, through demanding and then getting inflation-busting pay rises, interest rates will go up, unemployment will rise.

Stage 2 – On May 9 we told how, according to KPMG and Recruitment and Employment Confederation (REC), April saw the lowest rate of pay inflation during the last 57 months.

Stage 3 – On June 12 we told that average earnings, including bonuses, rose by 3.8 per cent in the year to April 2008, down from 4.0 per cent in March.    At that time, the retail price index was rising at 4.2 per cent.   Theoretically, providing  wage inflation minus improvement in productivity is no greater than the government’s inflation target, then there is no need for a rise in interest rates.    Economic productivity was up 1.7 per cent in the year.

We also said: “Unions do not the have the muscle they once did. A repeat of the winter of discontent seems unlikely.  There has been plenty of anecdotal evidence to suggest some workers at least are accepting pay cuts.”

Stage 4 – Earlier this week, Shell’s tanker drivers were awarded a 14 per cent pay rise over two years.

Stage 5 – Yesterday (June 18),  the BBC headlined a story suggesting our gas and electricity bills will rise 40 per cent by Christmas.

Stage 6 – In his letter to the chancellor, made publicly available on June 17, the Bank of England governor talked about wage inflation.  “This has been moderate up to now,” he said, but added, “The prospective squeeze on real incomes associated with higher inflation, together with the reduced availability of credit, is likely to lead to a further slowing in activity this year.  This will reduce pressure on the supply of capacity of the economy and dampen increases in prices and wages.”

Stage 7 – Yesterday, Brendan Barber, General Secretary of the TUC  said: “Our economic difficulties are caused by reckless lending by bankers and inflation comes from higher oil, food and commodity prices … Inflation and the pressure on wages will drop as the economy slows. That does not suggest we are heading for a runaway wage-price spiral.”

Dave Prentis, general secretary of Unison said: “Public sector workers have had below-inflation pay deals year-on-year. We are balloting 800,000 local government members for strike action over a 2.45 per cent pay offer and, if inflation continues to spiral, we will trigger the re-opener clause in the NHS deal and go back for more money.”

Dai Hudd, assistant general secretary of Prospect said: “If the fuel tanker drivers’ settlement represents pay restraint in the private sector, can the public sector have a little of that restraint as well?”

Stage 8 – At Prime Minister’s Question time yesterday, Tory MP Sir Michael Spicer  asked: “Why are there so many strikes at the end of a Labour government?”

Stage 9 – In his Mansion House speech, yesterday, Mervyn King said: “This year our real take-home pay will rise at a slower pace than national productivity. Rising fuel, gas, electricity and food prices, mean that average real take-home pay will stagnate this year. It will not be an easy time, and I know that some families will find it particularly difficult. But it is only a temporary slowing in the growth of our real take-home pay, and remember that this is the opposite side of the coin to the falls in prices of manufactured goods from countries such as China and India, which in the nice decade allowed our standard of living to rise at a rate faster than productivity.”

Ominously he also said: “There should be no doubt that the MPC is prepared to take whatever action is needed to return inflation to the 2 per cent target and to keep expectations of inflation in the medium term anchored to the target.”

Stage 10 – Yesterday, the minutes of the latest MPC meeting were revealed, and it emerged they considered upping interest rates.

We have been through a period of almost-obscene rises in pay for people in senior positions.    Incredulously, now MPs want an inflation-busting pay rise.    This has already created resentment.  Now we are being told we have got to accept that over the next year or two we are going to be worse off.  You can’t blame unions wanting to press for higher wages. 

Margaret Thatcher famously described unions as “the enemy within”. On this occasion, it is tempting to conclude the enemy sits higher up the hierarchy.

But, if unions are successful, and wages do rise, the Bank of England will have no choice but to up interest rates, and maybe by quite a bit.  Unemployment will rise, until wage increases stop.   Such a scenario will make a recession inevitable.

June 18, 2008 | posted by Michael Baxter in inflation | comments (0) |

If Desmond Lynam was the governor of the Bank of England it is unlikely he would have struck a more assuring note.  “Don’t worry.  Relax.  Take it easy.  Sure, inflation is up, but it is all down to one-offs.  Take a deep breath, that’s better.  There will be no rises in the rate of interest here.”

Well, Mervyn King is no TV presenter, so he said it instead in the natural language of central bankers, econ speak.

“Dear Chancellor,” he said…”World agricultural prices increased by 60 per cent and UK retail food prices by 8 per cent.  Oil prices rose by more than 80 per cent and UK fuel prices by 20 per cent.  Wholesales gas prices increased by 160 per cent, and UK household energy and gas bills by around 10 per cent.”

Or, in other words – it isn’t my fault.

Inflation will get worse, and higher than the bank of England predicted in its inflation outlook published just a few weeks ago, he said; it could even pass 4 per cent…but.

But…”There are good reasons to expect the period of above-target inflation we are experiencing now to be temporary.  We are seeing a change in commodity, energy and import prices relative to the prices of other goods and services.  Although this clearly raises the price level, it is not the same as continuing inflation.”

He added: “In contrast to past episodes of rising inflation, money spending is increasing at a normal rate.  In the year to 2008 Q1, it rose by 5½ per cent, in line with the average rate of increase since 1997, a period in which inflation has been low and stable.”

So, there is no need to worry then.  The chancellor warned that inflation would be with us for a while, because as you know inflation is determined by an annual equation. Even if prices start falling, which, by the way, the Bank does not expect to happen for a while, it will take some time before the annual figures fall back significantly.  

But, by the end of next year, the Bank reckons inflation will be back to target.

The big fear relates to pay growth – “This has been moderate up to now,” says Merv, and added, “the prospective squeeze on real incomes associated with higher inflation, together with the reduced availability of credit, is likely to lead to a further slowing in activity this year.  This will reduce pressure on the supply of capacity of the economy and dampen increases in prices and wages.”

That’s the ironic thing about hikes in the price of oil.  In the long-term, higher oil can be deflationary, as it makes us worse off, leading to lower demand for other goods. 

For his part, Alistair said: “Dear Mervyn …I agree.”

Well, he said a bit more than that, but that was his letter in a nutshell.

Apart from one sentence, that is, which had a bit more significance: “To return now to inflationary pay settlements would undermine rather than raise people’s living standards with a damaging circle of wage increases eroded by steadily rising prices.”

So it is all okay then.  Inflation will fall back soon, providing wages don’t shoot up, and as unions don’t have the muscle they once had, this won’t happen, and we can go back to slashing interest rates soon.

It is just that there are major flaws in these arguments.  To find out why, read the next article.

June 18, 2008 | posted by Michael Baxter in inflation | comments (5) |

Oh governor, what did you say?

“Money spending is increasing at a normal rate.  In the year to 2008 Q1, it rose by 5½ per cent, in line with the average rate of increase since 1997, a period in which inflation has been low and stable.”

And in that one sentence Mervyn King may have committed a major faux pas.

This debate over inflation has a lot more to it than the internal affairs of Britain.  And so did the years of modest inflation we saw earlier this decade.

Let us remember the late 1990s and early noughties.    This was the era of a retail boom, of consumer borrowing, of tiny saving. An era in which we saved though our houses, and that was about it.

We should have had inflation.  That we didn’t was down to a number of factors.  One is still with us, and working – weaker unions, meaning more modest wage rises.  But the other two factors have gone.

First there was the Internet; this prompted price competition never seen before, and surely was the catalyst to the fierce price competition which then followed on the High Street.  But this was a one-off, and has had its effect now.

Then there were cheap goods from China, India et al.  Well, that period is at an end.

Suppose we had experienced the spending boom of the late 1990s and early noughties with these factors which don’t apply today.    It seems likely we would have had inflation – severe inflation.

All the factors that the text books say should cause inflation were in place; instead, due to factors outside the control of central banks, we had low inflation.

Now the Bank of England is saying we should relax because spending is only growing at the same rate seen since 1997.  ONLY?

The last ten years or so have seen this curious position of lack of kilter.   In the UK and US we weren’t saving enough.  In China, Japan and the oil exporting countries, saving was too high.     That was another reason why inflation was so low; perhaps it was the true underlying reason.

Economies said this had to change. Now it is changing.   The credit crunch is forcing us to save more.    The rise in the price of oil and food is down to consumers in places such as China spending more.

In short, inflation is down to the global economy changing the way economists said it should.

That is the true issue at stake today.

June 12, 2008 | posted by Michael Baxter in inflation | comments (4) |

While all around the panic relates to inflation, and that we are in danger of seeing a re-run of the 1970s, more evidence emerged yesterday to suggest that the reality is quite different.

The 1970s, remember, were characterised by rising unemployment and rising prices.    The Great Depression was characterised by rising unemployment and falling prices.

The 1970s crisis was initially kicked off by a surge in the price of oil, which led to an upward spiral of wage inflation.  The era was characterised by strong union activity,  and loose monetary policy – with negative real interest rates in many economies.

The 1920s/1930s depression was initially kicked off by falling asset prices, followed by banking collapse.  It was a similar story in Japan in the 1990s.

When the stock market crashed in 1929, major indices did not return to their previous high until the early 1950s.   House prices fell in the UK during the 1930s.

In a way it would actually be quite good if the present crisis was more like the earlier one.    Policy makers in the 1920s and 1930s, and Japan more recently, made a series of mistakes.   Japanese banks were slow to admit to the full extent of their losses.  It seems unlikely – fingers crossed, those same mistakes will be repeated.

But the similarities with the 1970s are obvious too.  Oil keeps rising.  Although oil is much more expensive, even after allowing for inflation, than it was the 1970s, these days our consumption of oil takes up a smaller proportion of GDP.  Oil would need to approach $200 and demand stay at current levels before our oil consumption to GDP was comparable to the 1970s.   It does, however, seem quite possible this will happen.

Evidence of mounting inflation is everywhere – and around the world.  In the UK, producer price inflation keeps hitting new all-time highs.  But inflation is also a major problem in developing economies, including China, India, Russia, Brazil and Eastern Europe.

In the UK, evidence has emerged to suggest a new wave of strikes may begin.   If inflation worsens, and union pressure leads to inflationary wage increases, then the only possible medicine will be sharp rises in the rate of interest, just at a time when slowing consumer spending, collapsing house prices and struggling industry suggest a desperate need for interest rates to be slashed.

But here is the other side of the argument, an argument that was strengthened yesterday.

Markets are down again.  The FTSE 100 fell to 5723, 700 points below its start-of-year price.    It is now 1,000 points below its seven-year high set last year, and more to the point is 1200 points below the all-time high of 6930 set on the last day of the last millennium.  So in effect we are sill in a bear period.  A bear period lasting eight and a half years – which we think is the longest bear run since the big one kicked off in 1929.

In the US, it is not quite so severe.    The Dow hit its pre-dotcom crash peak on January 14 2000 – with a score of 11722.    It passed that level in 2006, and at no stage this year has it fallen lower – although it did go within 20 points in March of this year.  Right now the Dow is over 300 points above that mark – although it has fallen 500 points this week so it is quite possible it will fall below that mark soon.

But bear in mind the 1930s, 1940s and early 1950s saw either deflation or very modest inflation.    Inflation today is much higher, and after allowing for rising prices, it seems the Dow is actually lower today – that’s in real terms, than in 2000.

More to the point, the NASDAQ is still only half of the heady heights it reached during the dotcom peak.

In other words, it is not just house prices that are falling off the edge of a cliff; US and UK major indices have suffered an appalling eight years or so.

But then yesterday also saw the unveiling of the latest UK job statistics.

It made the TV and radio news headlines  – UK unemployment rose by 38,000, hitting 5.3 per cent, from 5.2 per cent the previous month.  

It is no surprise.  Sven-Goran Eriksson and Avram Grant are not the only people to have joined the dole queue lately.    We all know that over the next few months jobs will be lost in the City, in retail and the housing sector.

Then again, by historical standards, unemployment is still low; will it stay low?

And this is when the debate gets interesting.

Because yesterday, to accompany news of the relatively small rise in unemployment, came another statistic which was more significant, but has not fallen under the full glare of the public spotlight.

Average earnings, including bonuses, rose by 3.8 per cent in the year to April 2008, down from 4.0 per cent in March. Average earnings, excluding bonuses or regular pay, rose by 3.9 per cent in the year to April, up from 3.8 per cent in March.

Remember, the retail price index rose by 4.2 per cent in the year to April.  So it appears earnings have not kept pace with inflation.

Normally, wages are only creating inflationary pressure if their rate of change, minus improvements in productivity, is above the official inflation target.      Economic productivity rose by 1.7 per cent over the year, so yes, wages are going up a little faster than they should, but only by a tiny amount.

Unions do not the have the muscle they once did. A repeat of the winter of discontent seems unlikely.  There has been plenty of anecdotal evidence to suggest some workers at least are accepting pay cuts.

This is a trend to watch.    So far it would seem that despite the escalating rises in oil and food, the dreaded secondary effect on wages is just not happening.

This is good news, but it could turn to bad news.  Central banks need to watch this very carefully.  Remember, there is typically an 18-month time lag between a change in the rate of interest and its full impact.

The combination of rising unemployment, falling asset prices – both property and equities, and modest wage rises which could easily turn into wage falls, means there is a real threat of deflation.

The challenge facing central banks is to anticipate deflation 18 months in advance, so that they can relax lending in time. 

Right now, central banks seem to have an almost unprecedented balancing act.  The economy could go either way – inflation or deflation.  One wrong move – and it could be disastrous.

Senior management at commercial banks may be overpaid, but right now, central bankers deserve every penny of their remuneration.

May 15, 2008 | posted by Michael Baxter in inflation | comments (2) |

Don’t say you weren’t warned. 

Back in August 2006 we headlined: “No more Mr NICE economy?” and warned that inflation was coming back.  It wasn’t our first warning.    Governments and consumers were borrowing, spending was on the up, money supply was growing – every economic text says that when this happens inflation is the result.  Yet inflation remained stubbornly low.  It seemed a puzzle.  Was it really that central bankers had got so clever that, finally, inflation had been slain, for good?

In November 2005 this is what we said: “The last few years have witnessed a phenomenon that economic theory suggested was impossible. Consumers and governments went out and spent – and then spent some more, and yet inflation stayed firmly in check. This created the golden scenario of a low rate of interest at a time of high expenditure and borrowing.

“Economists had explained this quantum shift by saying: “Ah, yes, it’s a new paradigm now.” They argued that the combination of ever-fiercer competition and low cost of goods from China had changed the rules.

“But if the history books tell us anything, it’s this: when experts say it’s a new paradigm, beware. They said that before the dot com crash, they said that about the high level of corporate valuation before shares crashed across the board, they are saying that now about house prices and they are saying that now about inflation.”

And now, inflation is well and truly back, and not just here. 

As Ambrose Evans-Pritchard pointed out in the Telegraph: “Inflation rates have reached: Venezuela (22 per cent), Vietnam (21 per cent), Latvia (18 per cent), Qatar (17 per cent), Pakistan (17 per cent), Egypt (16 per cent) Bulgaria (15 per cent), The Emirates (11 per cent), Estonia (11 per cent), Turkey (9.7 per cent), Indonesia (9 per cent) Saudi Arabia (9.6 per cent), Argentina (8.9 per cent), Romania (8.6 per cent), China (8.5 per cent), Philippines (8.3 per cent), India (7.6 per cent).”

Yesterday, a reader’s comment on our blog referring to yesterday’s piece on food inflation, which blamed trade subsidies, said: “No mention of monetary inflation? M3 growing at 20 per cent surely must be THE cause!”

Is he right?  Are we now paying the price for years of loose monetary policy?  Have central bankers let us down?

This morning, many media accounts seized on the warning contained in the latest Bank of England inflationary report that there would be no more rate cuts for two years.    Others think the Bank’s prediction will not be adhered to.  Capital Economics, for example, still believes interest rates will be cut.  Yesterday, Jonathan Loynes, Chief European Economist there, said, “We still think interest rates will eventually fall considerably further as the economy continues to weaken and inflation concerns finally fade.”

But is this all really down to our excessive spending in the past?    Surely, food, oil and other commodities are going up in price because of China and India, not because of loose monetary policy.

Sometimes it is argued that inflation is a symptom of a bigger problem.   Inflation occurs when we spend too much.  But on this occasion, our excess spending led instead to rising house prices and too much debt.

Maybe there’s a choice:  debt or inflation?  After all, don’t forget, high government borrowing of the 1970s was reduced in real terms because of inflation.    Back then, if you like, we chose inflation. 

Maybe today we are choosing the course of repaying debt. Then again, loose monetary policy in the UK and US certainly led to massive trade deficits, which are now unravelling in the form of a falling dollar and pound, which in turn is creating inflationary pressure – oil is, after all, measured in dollars, so as the dollar falls, oil goes up.

But it was US spending in particular that helped fuel the Chinese growth story.  So maybe loose monetary conditions in the West fuelled Chinese growth, which led to the escalating price of oil and food.

It does seem, however, that while there is a good chance food and oil will rise even further in the short-term, they will fall back in price eventually.    Demand relative to price is just not that inelastic.   This, will in turn will cause prices to fall back.

The potential fly in the ointment is wages.  If wages go up in response to the higher prices of food and oil, then the inflationary pressure will stay in place.

And that’s the dilemma for the Bank.    Thanks to the credit crunch, money is tight.  The latest data, out yesterday from the Office for National Statistics, recorded a 7,000 rise in unemployment in April.    Furthermore, after revising the figures for the previous month, it is now recording three months of rises in unemployment.

Right now, the hope for recovery rests with wages not rising.  It rests with us having to pay the real cost of rising food and oil.  That spells trouble.  But, if we get out of jail, if interest rates move lower, if relaxed monetary conditions allow wage rises, the trouble will be so much worse.

An economic slowdown now, is the price we pay for greater stability in the long-run.