Markets tumble again – wage inflation drops – is this more like the 1930s than the 1970s?

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

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.
markets 08

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Fed moots bubble fighting role

May 14, 2008 | posted by Michael Baxter in US economy | comments (0) | Print This Post

You can’t lean against the wind – at least that’s been the wisdom in financial circles.

Famously Alan Greenspan once described the dotcom boom as irrational exuberance and he tried to talk shares down.  Then he appeared to have a road to Damascus moment, and decided that central banks could not possibly second guess markets. So, he chose instead to sit it out.

And he continued to sit it out when house prices shot up in the US.   

It was a policy Ben Bernanke agreed with and has long maintained that central banks can not be expected to monitor asset prices.

But of late the flak has risen to – well, bubble proportions.  Greenspan is being blamed for the financial crisis.  He let rates fall far too low, they say.  This enabled house price inflation, which is not leading to wider inflation.

Even his good friends at the IMF have joined the bandwagon – and recently said that maybe central banks should after all “lean against the wind.”

It is a complicated argument.  These days, the Bank of England monitors the CPI index, but even before that the index it targeted, the RPIX index, was inflation net of house price growth.

Some argue that it is just a case of changing the brief.  If central banks were told to target inflation over the longer-term, then presumably they would take into account factors that influence inflation in the longer-term, which would possibly mean house prices.

Instead, central bankers have to fret when inflation goes much above target.  In the UK, for example, the Bank of England is worrying about inflation going more than a full percentage point over 2 per cent.  This is why it has been reluctant to cut rates faster, even though many believe that once the current jumps in food and oil drop out of the annual equation, inflation will fall rapidly.

Now the Fed has dropped a hint it is changing its tune.   Apparently it is considering the possibility of using interest rates or using extra regulation to try and stop bubbles emerging in the future.

According to the FT: “Top officials are re-examining the Alan Greenspan doctrine that central banks should not try to tackle asset bubbles and should focus on mitigating the fallout when they burst.”

The trouble is, these ideas always come too late.  The aftermath of bursting bubbles are dangerous times.  That’s when regulators try to fix the mistakes they made in the past, and invariably go too far.  Sarbanes Oxley, for example, which was passed in the wake of the collapse of Enron and WorldCom, led to an exodus of firms listing on US stock exchanges. 

Bubble fighting is not a bad policy to adopt – but it can come unstuck.    AT&T emerged out of a bubble in laying telegraph wires across the US; Google was able to buy cheap server technology in the wake of the dotcom burst; it is a complicated world out there, and so often we find solutions create a new set of problems.

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Ben does it again

May 1, 2008 | posted by Michael Baxter in US economy | comments (1) | Print This Post

Down went US interest rates yesterday. This time they were lowered by 0.25 per cent, to 2 per cent – but now markets are concluding that is the end of it.  Not so long ago they were predicting US rates would eventually fall to 1 per cent, now markets are pricing-in rises in US interest rates later in the year.

The Fed is worried about inflation – two members of its rate setting committee voted against the cut.

This time the Fed changed its tone.  It removed the words the “downside risks to growth remain” and added “uncertainty about the inflation outlook remains high.”

So that’s it then.  The Fed reckons the risks to growth are receding, and that inflation is returning. 

But many disagree.  Capital Economics, for example, said, “However, the surge in energy prices since the start of the year (and many other commodity prices as well) looks more and more like an unsustainable bubble. We suspect that prices will fall back soon easing near-term inflationary pressures and leading to a drop back in inflation expectations as well. That would allow the Fed a free hand to respond to signs of further distress in the real economy.”

But the US rate of interest is now a full two percentage points lower than the euro rate.  No wonder the dollar has fallen so far.

This is hitting the Eurozone economy – with Airbus, for example, forced to announce yesterday it was upping its prices.

The truth is, the falling dollar is, along with other things forcing the dollar down, proving a strain on the global economy.

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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) | Print This Post

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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The dilemma which haunts the west

January 10, 2008 | posted by Michael Baxter in UK economy, US economy, credit crunch | comments (0) | Print This Post

Today is that time of the month again, and by the time you read this you will probably know what the Bank of England and European Central Bank have elected to do. For the UK’s central bank the question is when, rather than if. It seems clear interest rates are going down soon, but whether it is today, well, since you will be reading this article at least 6 hours after it is being written, you are in a better position to judge; by 12 o’clock the cat will be out of the bag.

The European Central Bank has a tougher call. Inflation in the Eurozone hit 3.1 per cent two months ago, and stayed there in December. Yet there are signs the Eurozone’s economy is slowing. Perhaps the problem relates to the euro itself, for while inflation in some countries is rising - it hit 4.3 per cent in Spain last month - in others, such as Germany, it’s falling.

Talking of Germany, the runes could be suggesting the economy is stalling again. Industrial production fell 0.9 per cent in November, while retail sales fell 1.3 per cent on the previous month. The good news: no one is talking about Germany hitting recession at the moment, but the economy now looks set to grow a lot more slowly this year than was previously expected - and remember, with the US coming off the rails, Europe, and that very much includes the UK, needs a strong Germany.

But cut through the dilemma facing the ECB and an even bigger challenge is revealed, for right now the rationale for a rate cut is matched, it would appear, by only one thing, and that is the rationale to increase the rate of interest.

For the last ten years or more, the Fed and European Central Bank and the Bank of England, have played with the rate of interest, keeping inflation in check, but not so much that economic prosperity was unduly affected. In the US and UK, and some EU countries, the result has been economic boom. Make no mistake, for many developed countries the last decade or so has been a golden age for economic growth.

Yet, by slashing interest rates, a property bubble was created. Some say that in future the Bank of England’s inflation remit should cover inflation of asset prices, but then, which asset prices? If it is told to take into account house prices, maybe it should worry about shares too, but then while house prices have shot up this decade, shares, at least shares on the FTSE 100, have fallen. So if asset prices were included in the inflation data, the UK’s central bank would have to take into account even more contradictory data; the resulting equation would become far too complex.

Maybe the answer to the problem already exists - it’s called the Retail Price Index - which includes mortgage payments and council tax - perhaps the decision to make the Bank of England target the CPI figure earlier this decade was a massive mistake.

But then again, back in the early years of this decade, deflation was a very real fear. Economists were thinking about Japan, and how it left it too late to fight deflation, and found even zero interest rates were too high. As a result, the economy of the rising sun has been something of a land of permanent economic sunsets over the last decade and more.

So it was the fear of deflation that lay behind the decision by central banks to slash interest rates - we can blame them for going too far and creating a debt bubble - but then again, if they had been more circumspect in reducing rates, today we might be blaming them for creating an economic depression.

But the dilemma is made even more difficult when you take into account the Japanese wilderness years were preceded by soaring asset prices - and a property market explosion that couldn’t possibly come to an end because, after all, Japan was a highly and densely populated island. Yet the bubble burst, and the pain was far too serious for the Bank of Japan’s prescription of economic paracetamol to work.

As we said earlier this week, the British economic depression of the mid-19th century followed a boom in the construction of railroads, and the 1930s depression followed a period of massive technological advances - rising productivity can create the danger of demand lagging behind supply, leading to recession, or even depression. Such a crisis can be avoided by borrowing from future earnings to push up demand.

Also bear in mind that in the US, inflation is measured using a system called hedonics. We all know that PCs and TVs and mobile phones pack in more features per dollar these days. Well, in the US that is taken into account, so if, for example, PCs stay at the same price, but become more powerful, then this change is shown up in the data as negative inflation. As a result, US data indicates lower inflation figures for the US than they would if they used the same criteria that the British Office for National Statistics employs.

Then there are the massive rates of savings in China and Japan. In Japan savings are high because of the economic uncertainty, in China it’s a cultural thing. When global savings are high, global deflation can be the result. So by their high spending, US and UK consumers were merely re-addressing the balance.

So what’s the answer? Well, actually, there is no clear answer at all.

We are too keen to cast blame, to look for someone who we can say is responsible for the mess. But maybe the real problem is this - it’s just the way it is.

To the charge that Alan Greenspan and Gordon Brown are responsible for creating an unbalanced economy with too much debt and too reliant on consumers, we would say they are innocent.

To the charge that Gordon Brown tried to take credit for the good times, when actually, economic prosperity was down to factors largely beyond his control, we would say guilty.

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Central banks plan lifts off

December 18, 2007 | posted by Michael Baxter in Banking, UK economy | comments (0) | Print This Post

There is one good thing about the plan hatched by central banks last week to save the financial system from a downward spiralling crisis. The banks who will benefit from the plan, banks such as…well that’s just it. We don’t know who the banks are. Shhhh, it’s a secret.

When the Bank of England tried to pump money into the system during the autumn, the UK’s banks took one look at the money they were being offered, and said, “Thank you very much Mr Banker, but no deal.”

It wasn’t that they didn’t want the money. It wasn’t even that they weren’t prepared to pay the extra interest payments the central bank was charging. No, the problem was this: they didn’t want to admit they wanted the money in the full glare of the media’s spotlight. Why was that? Well, perhaps they were worried the Bank of England, when dishing out the readies, would say something like, “don’t panic, the bank we are lending to is solvent.”

Yesterday, the Fed unleashed the hounds of promise, or dollars as they are also called. $20 billion of them found their way onto the markets. And in the UK, the LIBOR rate, that’s the interest rate determined by markets, and which we hear so much about these days, fell. At around 6.4 per cent, down from 6.6 per cent, it’s still way above the official bank rate of 5.5 per cent, but at least it’s moving in the right direction. It doesn’t really matter if it takes a week or even two weeks for the money markets to find a level more conducive to the flow of money, as long as they get there eventually.

Today, the Bank of England, ECB and Swiss National Bank will be doing their bit, with the UK’s central bank dishing out £10 billion.

Will the central banks’ plan do the trick? Or will interbank rates start moving back up again after a few days?

It depends on whether you think this whole crisis is just about confidence, about a simple misunderstanding between banks who are not sure who they can safely lend money to when, in fact, all is fine, or whether the problems really are deeper than that.

The bottom line is that the financial crisis has been caused by excess lending. That clever little wheeze called Collateralized Debt Obligations, seemed like such a good idea. You make a risky loan, but reduce your own exposure by slicing the loan into chunks and selling it on.

That’s fine if it’s a one-off. If there is, say, a one-in-ten chance the loan will go bad, and you sell it on to, say, nine more companies, each with a similar stake in the loan as you, then if the loan goes bad you are only going to take a hit equating to 1 per cent of the total.

But supposing those nice little odds persuade you to make more loans; supposing you also buy chunks of loans off others too. Supposing that for every £1 you lend and split up into say 10p chunks, you buy nine 10p chunks from other banks. Then, if failure occurs across the board, your total hit is just as bad as it would have been if you had sold the loans on.

The danger is that the option to provide CDOs, lulled you into a false sense of security, encouraging you to make loans you wouldn’t have otherwise considered.

If the current crisis is simply down to lack of confidence based on ignorance, then the move from the central banks will help.

But if the problem is deeper than that, then the only silver bullet that can possibly come to aid, is the natural business cycle.

The recent levels of surging lending can really only be justified if you take into account rising productivity levels. In the UK, our productivity improvements still lag behind our main competitors, and that is the problem that really needs fixing.

Analysts, commentators and economists, can call out for central banks to slash interest rates, they can plea with the government to do more to help, they can even howl at the moon if they want, but unless the underlying problem is fixed, any other action taken will be little more effective than firing a spitwad at a major battle tank.

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