March 6, 2008 | posted by Michael Baxter in UK economy | comments (0) |

It’s that time of the month again today. Once more, the men and women who sit on the Bank of England Monetary Policy Committee will decide upon the rate of interest for another month. Most expect rates to stay on hold, they probably will, but behind the scenes it seems that, this time, the MPC faces a massive dilemma.

The reasons for a cut in interest rates are overwhelming. The trouble is, so are the reasons for not cutting rates. Which side in this battle of hawks and doves will eventually win?

Here are some of the arguments for: First argument relates to the money markets. Usually, when markets expect rates to fall, then the three month interbank (LIBOR) falls below the official bank rate, as markets start discounting for future falls.

Yet, when the Bank of England lowered rates to 5.25 per cent last month, the LIBOR rate did something odd – it went up, and is now 50 basis points above the official rate, at around 5.75 per cent.

Why is this? It seems at least part of the explanation lies with banks’ concerns about credit risks. Sure, the recent fears over monoline insurance may be a factor, but above all, it seems they are just worried, and want to hold more cash.

In other words, the Bank of England may want to see interest rates fall, but the markets are not obliging – so the BofE may conclude it needs both to lower interest rates some more, and change liquidity requirements for the banks, and perhaps pump more money into the system, just to get money market rates at the level it wants.

Of course, with the housing market apparently on the edge, with various evidence suggesting our disposable income has barely changed now for several years, and with many fearing a recession could be around the corner, a cut in interest rates, which was then adopted by the markets, would help to kick-start the economy.

It’s not that a cut in rates would merely encourage further borrowing, maybe in an economy as indebted as ours that would be a bad thing, but it wants to make debt cheaper for those already with higher borrowings. That would help lift the feeling of gloom.

But what about inflation? Is there not a risk that lower rates would stoke up inflationary pressures even further. And this takes us to the really interesting aspect of the debate.

Inflation is set to rise – that is clear. The Bank of England may well find the CPI index will rise by more than a full percentage point above inflation soon, forcing it to write another letter to the chancellor. But, the key is not so much what will happen in the next few months, when we know prices will go up, but what will happen beyond that.

You need to bear in mind, increases in prices are not the same thing as inflation. Inflation is a sustained rise in prices, and this usually only occurs when demand is higher than supply. The key for predicting inflation is said to be whether there are second-round effects – whether, for example, wages increase in response to higher wages. At the moment, this is not happening.

The central banks, goes the argument, have no control over the price of oil and food; to increase rates because inflation is pushed up by forces it has no influence over, would be foolhardy.

The US could be on the verge of recession, the UK may follow; this means demand will fall, ergo inflation will fall too. Right now, goes the argument, we are merely experiencing an inevitable time lag as inflation reacts only slowly to changes in the economy.

Think of it this way. You are having a shower in a bathroom you are unfamiliar with. Someone else in the house turns on a cold tap, before realising you were in the shower, and then turns it off. This reduces the supply of cold water in your shower for a few seconds. You don’t realize this, and so you turn your cold tap up. In a few seconds you will experience a double hit. The shower will simultaneously respond to you turning up the cold tap, just as it was cooling down anyway. Brace yourself, for now, the water is ice cold.

The danger is that if central banks respond to inflation cost pressures, they will leave rates high, just at a time when inflation was about to dip anyway. This could then lead to a crash in asset prices – and the big fear, the West will see a repeat of the Japanese experience – ten years of economic malaise. Or, as it is sometimes called, the lost decade.

So, you see, it is very important central banks get the call right.

But here is the flip side of the coin. Demand, especially in the US and UK, is far too high. Saving has not been anywhere near high enough. Usually, inflation would have set in, but thanks to other external factors, such as the Internet promoting price competition, and cheap imports from China, inflation has stayed modest.

So, while it might be argued that the factors that are currently leading to inflation are one-offs, so too are the factors that led to low inflation.

But are these factors one-offs? Oil is high, because demand for oil is high. This has led to a rise in the use of biofuels – as alternatives to oil. At the same time, the world’s consumers are demanding more food products – especially meat – which has led to a sharp rise in demand for wheat. And by the way, growing crops to feed animals to produce meat is not efficient, we get far more from the land if it is used to grow food we eat directly. So the move towards greater consumption of meat is, perversely, leading to greater demand for agricultural crops such as wheat.

This argument would suggest that the recent rise in inflation across the world is, after all, down to growing demand.

Until recently, consumers in the West were spending heavily, while in China, Japan and the oil-exporting countries, saving was even greater. This means that overall, saving was greater than demand, hence low global inflation.

There is a danger this has changed. And what this means is that in the West, we can no longer afford to borrow our way into consumer-led growth. If we do, inflation will occur.

Returning to that shower analogy. Sure, someone somewhere else in the house has just turned a cold tap on, making your shower too hot, but only for a short while. But, supposing someone else in the house had left a hot tap running for some time, and they are about to turn it off.

January 23, 2008 | posted by Michael Baxter in UK economy | comments (0) |

If you ever studied economics at A-level you would have been told that the answer to a deficit in the balance of trade, was increasing the rate of interest. Such a move, goes the theory, will lead to less demand, and therefore less imports. Strange then, because in the real world, the relationship seems to work the other way round. A cut in interest rates leads to less money flowing into the economy, so the currency falls, and exports improve, and imports reduce.

So how can theory and practice be so different?

The answer really lies in the difference between short and long run. In the short run a cut in interest can lead to a cheaper currency, helping the balance of trade; in the long run, well there the picture gets murky.

Yesterday, in what, by the way, was one of the best speeches we are aware of from a central banker on the issues plaguing the global economy, Mervyn King put his finger on key issues. He talked about two gales, both blowing in different directions. The gale from the US – the credit crunch, and the gale from the east – higher commodity prices.

“A lower average level of the exchange rate can, by supporting overall economic activity, help protect us from the worst effects of the wind blowing across the Atlantic” said Mr King, “but, by pushing up import prices, it will exacerbate the impact of the other wind now buffeting the UK economy, which comes from the east – the inflationary effect of higher energy and food prices.”

And that says it all. Lower interest rates are good because they help push the pound down, thus lifting exports and help grapple with the underlying lack of balance in the economy. But lower interest rates encourage more borrowing, thus exacerbating the underlying problem of too much spending and not enough saving.

A lower pound helps exporters, but it leads to inflationary pressure too.

Yesterday, Mr King made the headlines when he joked, “It is possible that inflation could rise to the level at which I would need to write an open letter of explanation, possibly more than one, to the Chancellor.”

He added, “Although there is little we can do now to avoid some rise in inflation this year, the task of the Monetary Policy Committee is to ensure that it is short-lived. If inflation expectations were to pick up in the wake of a rise in inflation this year, then only a more-prolonged slowdown would allow inflation to return to target. But if the rise in inflation does not affect longer-term expectations, then inflation could start to fall back towards the end of the year.”

The fundamental problem, though, as Mr King rightly pointed out, “The low level of national saving is apparent from the current account deficit – our new net borrowing from overseas – which in the third quarter of last year was, relative to GDP, the biggest in the past fifty years and the largest in the G7. It is possible to run a current account deficit for a considerable period. Australia, for example, has done so in every year since 1974. But our own position is becoming more difficult. For some years we have been able to finance current account deficits by borrowing, often through banks, at unusually-low interest rates on world capital markets. Such borrowing is now becoming more expensive. Unless we spend less and save more, our current account position will deteriorate.”

To read the full speech click here

January 21, 2008 | posted by Michael Baxter in UK economy | comments (1) |

Cast your mind back to the period just after last Easter. Back then, the word subprime had crept into economic talk, but only in a small way. As for credit crunch and Northern Rock, well, the first term had no meaning and the second referred to a successful bank. But even then, we had an inkling of problems to follow, and maybe the biggest clue came in a letter sent on the 17 April. For that was the day the Bank of England’s governor, Mervyn King, put pen to paper, or at least secretary’s fingers to word processor, and produced his apology for inflation.

Inflation had jumped to 3.1 per cent, more than a full percentage point over target, thus triggering the requirement for the letter.

In that climate of over-shooting inflation, interest rates went up, maybe too high. Now of course we are in interest rate cutting mode. Last year, faces at the Bank of England went red, maybe they overreacted as a result. But here’s something for you to ponder. Will the next few months see déjà vu?

Back in April last year, this is what Merv said in his letter, “The actual inflation rate will on occasions depart from its target as a result of shocks and disturbances. Attempts to keep inflation at the inflation target in these circumstances may cause undesirable volatility in output.” He added, “As the substantial increases in household gas and electricity prices that occurred a year ago drop out of the annual comparison, and the falls in those prices which have already been announced take effect, CPI inflation is likely to fall back within a matter of months.”

He was right, five months later the CPI rate had fallen to just 1.8 per cent, and it was tempting to ask what the fuss was all about.

You need to bear in mind, there is a time lag between changes in the rate of interest and the correlated change in inflation. It can take up to two years for the full effect of a rate change to be felt. When the Bank of England upped rates soon after the infamous letter was sent, in terms of its impact on the inflation rate at that time, it was something of an irrelevance.

In hindsight, the rate rises of that time were a mistake. Some were calling for even higher jumps in interest rates – but it appears they were wrong.

Now look at today. Inflation stands at 2.1 per cent, so it is just a mere 0.1 per cent above target. But it is set to rise.

Capital Economics has calculated that if oil stays at around its current high price, then by February, the rise in petrol prices will probably lift the inflation rate to about 2.5 per cent. Add to the mix, the steady rises in food prices, coupled with the falling pound (sterling has fallen by around 7 per cent against the dollar over the last two months,) then it is clear inflation will rise, significantly.

Come the summer there will be a downward and upward effect. This time last year oil was steadily rising. It fell to $51 last January, but by July it was up to $70. Remember, inflation is an equation that compares data over the last 12 months with data from the previous 12 months. Remember, also, there is a time lag between changes in the price of oil, and what we pay for petrol on the forecourt. So it seems that actually, once the big jumps seen in oil slowly ease their way out of the annual figures, inflation will start to fall – probably this summer, so the oil impact on inflation will peak during the summer (this assumes no more rises in the black stuff.) But, at that time, our utility bills are expected to rise. The time lag between a change in the price of oil and a change in our energy bills is even bigger than the time lag between oil and the retail price of petrol. So it seems that inflation will remain high, and well above target throughout most of this year.

Given this, there has to be a very real risk of inflation once again going over target – creating the need for the Bank of England’s governor to write yet another embarrassing letter to the chancellor – maybe, even, exactly a year after it happened last time, although the following month seems to be a more-likely candidate.

Given all this, it does seem a tad strange that just about everyone is expecting to see sharp falls in interest rates this year.

How can this be? Does it mean the Bank of England is bowing to the pressure from the media and the Government, and is putting its statutory requirement to take measures to keep inflation under control, on hold. Well, to an extent, this might be the case. The pressure to lower rates is huge – but then don’t forget, the time lag between changes in interest rates and inflation is nearer two years. What the Bank of E does now, will have little impact on the inflation data for most of this year.

Really, the Bank needs to focus on what inflation will do at the very end of 2008 and in 2009, and by then, the effects of the rises in the price of oil should be easing out of the system – inflation should be falling.

But, there is a danger with this. First of all there’s the falling value of the pound. If the pound continues to sink – and there‘s good reason to think it will, that will create massive inflationary pressure.

By the way, there’s even a theory the UK deficit on its current account as a percentage of GDP has been substantially understated, because official figures incorrectly allocate revenue generated by multinational companies based in the UK, from their overseas subsidiaries. If this is right, then the downward pressure on the pound will grow.

Surely, though, the real mistake was made earlier this decade when interest rates were slashed to a level which was just too low. It was this action that created an unsustainable asset bubble that fed too much debt, which lies behind the problems we are suffering from today.

And in creating this problem, it seems one major policy mistake was made. Gordon Brown, you will probably recall, changed the inflation index the Bank of England was to target. Out went the RPIX index, which included things like council tax and housing rental costs, and in came the less-exhaustive CPI index. And during that period when the Bank of England cut rates to target the CPI index, the RPIX remained a lot higher.