The Great Debate UK

from MacroScope:

There be feudin’ at the BoE

The once-good relationship between Bank of England Governor Mervyn King and his most likely successor, Deputy Governor Paul Tucker, is coming  under increasing strain, according to a new book by former Daily Telegraph journalist Dan Conaghan.  It  alleges   King’s management style and and alleged disdain for the financial markets is to blame.

While the Bank of England’s Monetary Policy Committee remains reasonably collegiate, on other matters King more than lives up to the description from former chancellor Alistair Darling that he is ‘incredibly stubborn’, says Conaghan, who now worksas an asset manager.

“The governor can be particularly dogmatic,” he told Reuters. “One of the key things … is the attitude to the capital markets. One of my sources described Sir

Mervyn’s attitude as one of disdain. I’ve heard that repeatedly. Paul is much more pragmatic.”

One tangible upshot of this came at the launch of the Bank’s quantitative easing programme in March 2009, which Conaghan said led to an upsurge in failed trades on the British government bond market, until the central bank found a mechanism to lend back some of the gilts it had bought.

More broadly, Conaghan’s book The Bank: Inside the Bank of England describes something approaching a feud growing out of a philosophical split between King – who champions a purist, economics-driven approach – and Tucker, who is closer to financial market participants.

“It is widely acknowledged within the Bank’s upper echelons and elsewhere that the relationship between King and Paul Tucker … has deteriorated over the past few years. One very senior figure at the Bank describes it as being, at times, ‘a battle-ground,’ where the battles over policy, direction and structure are common. Another senior official at the Treasury concedes that they ‘do not get on, to put it mildly’.”

from James Saft:

Britain eats (leverages) its young

James Saft is a Reuters columnist. The opinions expressed are his own.

Four years, several failed banks and at least one global recession later, Britain has finally discovered what its young people need: 19-1 leverage.

Britain has announced a new housing initiative, the centerpiece of which is a plan to entice first-time buyers into buying newly-built properties with as little as 5 percent down.

Under the plan both builders and the government would contribute funds to partially indemnify lenders against what I am betting are the inevitable losses. Borrowers, who are almost by definition younger and less well off, will still bear all losses, but will be rewarded with the chance to take out the kind of loan which has proven time and again to be a bad idea.

This is utterly wrongheaded -- the best possible thing that can happen for first-time buyers, and arguably for most Britons, is for housing prices to fall to a level commensurate with earnings.

Why are houses in Britain so difficult to afford? Partly because of problems with supply, issues that the housing plan takes some steps, almost certainly insufficient ones, to address. And also because Britons, first out of necessity and then in the fever of greed, borrowed so much money in order to wedge themselves into what little housing was available that they drove prices up to unaffordable levels.

Again, as in Europe and the U.S., we have governments which, when confronted with problems that are fundamentally about debt, decide that piling yet more debt on top is the answer. Like the European Financial Stability Facility, which has proved utterly ineffective in supporting Italian debt, this plan too will fail, but not before many people will be tempted into taking on houses and debts they ought not to risk.

Salvation through inflation: The British way out

By Laurence Copeland. The opinions expressed are his own.

Accusing policymakers of acting out of sheer desperation is a pretty standard jibe by critics trying to put them off their stride.

Unfortunately, the latest round of QE came wrapped in comments from the Governor of the Bank of England which amounted, more or less, to saying: “Look! I’m staying calm – but it’s taking a hell of an effort, believe me!”

As the world economy teeters on the brink of relapse, Mervyn King’s action amounts to saying: “Forget the danger of inflation… we’ll settle for anything rather than a rerun of 2008”. He and his opposite numbers in Frankfurt and Washington are haunted by the fear that the history books may say the 21st century’s Great Depression happened on their watch.

The latest measures are probably not going to work and may make matters worse because the mess we are in is a matter of the distribution of real wealth – positive and negative i.e. net worth – and hence is unlikely to be improved very dramatically by printing money. Specifically, the economy is grinding to a halt because, internationally and domestically, even locally, those who save have accumulated wealth which they would normally feel inclined to lend or invest. But since the majority of would-be borrowers are already indebted to unprecedented levels, and investment opportunities are unattractive given that the output they generate would need to be sold to the same overindebted consumers, wealthowners are opting for the relative safety of Government debt, guaranteed bank deposits, gold and even, it seems, blue-chip real estate and agricultural land.

Like the self-similarity of a fractal, this same pattern is repeated at the largest and the smallest scale.

At the global level, the largest creditors – China and its neighbours, the Gulf Oil producers, Germany  – feel understandably reluctant to keep adding to the trillions of dollars they have already lent to the debtor countries, nor are they overwhelmed by the attractions of direct investment in these countries, especially as the juiciest opportunities are often ruled out by political considerations (imagine a Chinese bid for Intel or Apple, for example).

No excuse for inaction – BoE’s Adam Posen

By Adam Posen. The opinions expressed are his own.

It is past time for monetary policy to be doing more to support recovery. The Jackson Hole conference has come and gone, and no shortage of excuses was provided for central banks to hold their fire — even though most economists acknowledged the grim outlook for the advanced economies.

Too much attention has been paid, however, to the failings of fiscal policies and to the shortfall from effects of earlier quantitative easing. Further asset purchases by the G7 central banks are needed to check not just a downturn, but the lasting erosion of productive capacity and of debt sustainability — especially when even justified fiscal and financial consolidation is undercutting short-term recovery. Easier monetary policy will increase the odds of other policies improving, and those policies’ effectiveness when they do.

It is also past time to stop fearing inflationary ghosts. There is no credible threat of sustained higher inflation in the advanced economies that should restrain central bank action. The rate of wage growth is tepid and compatible with price stability, at most, even in Germany; the inability of wages to keep up with recent real price shocks underscores the ongoing downward pressure from labour market slack. Consumption was driven down by fiscal tightening and household retrenchment as much as oil prices, and those forces will be ongoing. Had consumer confidence not been weakly footed to begin with, the oil shock would not have had such an impact.

Commodity prices have since demonstrated again that they go down as well as up, and thus monetary policy should not react to their short-term gyrations (and deceleration in Western growth will likely send them further downwards). Credit and broad money aggregates are barely growing and current account deficits are slowly shrinking, so no asset price bubbles will emerge. Importantly, interest rates on long-term G7 government bonds display no consistent rise in inflation expectations, no matter how the data is parsed.

Some of us had seen this coming. This is what happens to economies following a financial crisis, particularly when the crisis hits simultaneously across integrated markets. That is why I began advocating more quantitative easing in the UK a year ago. Yet even if some believe that the recent setbacks reflect new developments — rather than just long-run vulnerabilities (fragile Central European banking systems, dysfunctional American fiscal politics, British over-dependence on the financial sector) exposed by the crisis — that still should be enough to downgrade any plausible prior forecast for growth and inflation to where additional monetary stimulus is called for on its own terms.

Just because a downturn is expected does not mean its course is inevitable, and some of the present prospects’ severity certainly still can be usefully offset. The lesson from past post-crisis recoveries, whether from the late 1930s worldwide, the late 1990s in East Asia, or the 2000s in Japan is that aggressive monetary easing can ease the process of real adjustment and limit its lasting damage to economies and to people. Insufficient monetary stimulus, let alone premature tightening, makes fiscal and financial problems worse, and raises prospects for dangerous political reaction to policy failure.

Two very different inflation problems

-Kathleen Brooks is research director at forex.com. The opinions expressed are her own.-

There was more evidence in February that the world economy is re-flating; both China and the UK released inflation data that showed prices running above 4 percent. Authorities in these economies have a difficult few months ahead, if prices continue to rise at this clip then they may have an economic crisis on their hands.

Although the root causes of inflation in China and the UK are fairly similar – rising commodity prices combined with weak currencies – the treatment for both countries couldn’t be more dissimilar. China has to tackle its problem with rate increases and currency appreciation, whereas in the UK a rate rise could seriously hinder the economic recovery.

Taking a step back, inflation always had to rise in China if its economy was to shift to a domestic consumption model and the global economy was to stand any chance of effectively rebalancing. Thus, it could be argued that commodity price increases came at the right time for China’s economic growth story as it put pressure on employers to hike wages. The price of food and energy hit Chinese consumers  faster than they do consumers in the west because of the larger proportion of food in the Chinese basket of goods used to measure price changes (even though the food component was reduced in January, it was only reduced by 2 percent and remains high relative to western economies). Workers need prices to rise, and they need to rise at more than 5 percent a year to give the average Chinese enough money in their pocket to spend on discretionary items.

Pay packets have been increasing in China for the last 5 or 6 years, but they picked up extremely strongly in 2010 (just as commodity prices started to take off). According to some anecdotal data wages in the professional and financial services sectors are now rising at a 16 percent annual clip.

While that is extreme, the general trend towards higher wages is good news. Inflation is driving wage gains, which have been the missing ingredient from the Chinese growth mix. Wages need to rise in China to unleash a tsunami of domestic demand that, if all goes to plan, will help reduce China’s massive surplus and the US’s massive deficit and protect the future of the global economy.

But while some wage inflation is good, too much could cause employers to cut staff, pushing up unemployment and actually weakening consumption. In order to avoid this situation, action is required by the People’s Bank of China (PBOC) to stop an inflationary spiral getting out of control. Although the PBOC has raised interest rates 3 times since October, it needs to hike further to reduce the chances of the economy overheating.

Interest rate decision day: no news is bad news

-Laurence Copeland is a professor of finance at Cardiff University Business School and a co-author of “Verdict on the Crash” published by the Institute of Economic Affairs. The opinions expressed are his own.-

Whether their problem is narcotics or alcohol or simply junk food, addicts are usually planning to give up… but not yet. In the meantime, there are always plenty of excuses for delay.

And so it is for the Bank of England. The inflation rate will soon be double the 2% target, but they still judge it is too soon to raise rates above their current all-time low level. Moreover, yesterday’s announcement makes clear there is no end in sight for the gilt buying spree (the “Asset Purchase Programme”).

The Bank’s masterly inactivity is predicated on the MPC assumption that there is still plenty of slack to be taken up in the real economy. As I said here earlier this week, I am less convinced about the extent of the spare capacity in the UK economy today than they are, and hence I see far greater danger of further inflation than the Bank apparently does.

In any case, the key factor is expectations, where there are two constituencies to worry about. First, the further our inflation rate accelerates beyond its intended long run level of 2%, the more likely it is that workers will begin to build it into their expectations when negotiating their wages and, unless the Bank is right in assuming a large margin of spare capacity, employers will be willing to accommodate the higher wage demands, and inflation will take off.

But we also need to consider expectations in the international financial markets, which have so far been extremely patient with the British Government, appearing ready to give it the benefit of the doubt and pricing our debt so generously that the yield on long gilts is still only about 4½%.  However, if at any stage they lose confidence in the willpower of HMG and conclude that Britain has decided to inflate away its debt – in other words, to allow the domestic and foreign purchasing power of the Pound to fall – they will rush to sell, driving yields up sharply and costing us vastly more to service our debt. At that point, there will be no choice but to tighten credit drastically, since the alternative would involve an inflation spiral where we print money, the pound goes down and the markets push up yields, so we print more money and the markets push up yields even further…

The real beneficiaries of the current situation are the banks, who are able to borrow for more or less zero and lend at 5%, 6% – or even lend the money back to the Government at 4% or more. This money machine may be unavoidable if banks are to be allowed to rebuild their reserves, but it certainly is not an environment in which high street bankers need exceptional talent to generate profits, so there is no justification for the rewards they are currently being offered. In fact, if bank chiefs are indeed so gifted as to warrant bonuses in the millions, I suggest we replace them with men (or women) of lower calibre and pay them something more like average salaries. After all, you don’t need a Formula One champion just to drive a minicab.

from MacroScope:

The perils of predicting BoE policy

As we’ve noted extensively, economists often get it wrong. Leaving aside their collective failure to recognise an impending global recession, you might recall a shock interest rate hike from the Bank of England in January 2007.

This was another event that almost every economist polled by Reuters failed to spot, and there are signs that four years on, economists might be setting themselves up for a similar shock.

The consensus from the last Reuters BoE poll last week showed interest rates would stay on hold into the fourth quarter, even though UK money markets have priced in a 100 percent chance of a rate hike by May. Since the January meeting, some of the bank’s Monetary Policy Committee members have publicly stated their determination to fight strong inflation.

But going back to January 2007, the only analyst out of the 50 polled by Reuters who predicted that shock rate hike was Simon Ward, chief economist at Henderson Global Investors. If the MPC does indeed flay analysts’ consensus this year by hiking rates before April, he stands to repeat his 2007 feat by being the only economist in the last poll to forecast a hike in the first quarter.

“I have been a bit mystified as to why other people haven’t shifted (their views) as inflation figures have really shot up over the last few months,” Ward told Reuters.

He suspects a somewhat dovish speech last month from BoE Governor Mervyn King wrong-footed economists, based on the presumption that King wouldn’t have sounded so dovish unless he was confident that rates would stay on hold for a long time.

“I think that interpretation was incorrect, and King has been outvoted in the past. It’s not like the U.S., where there’s a certain amount of pressure to follow the chairman’s lead,” said Ward.

Are interest rates set to rise?

Whenever he approaches a bend, an F1 driver has to make a fine judgment: brake too soon and he loses vital momentum, too late and he risks losing control altogether, with possibly fatal consequences.

For the past year, the MPC has been getting closer to the bend – the point at which it will have to raise interest rates – so, as each month passes without a touch on the brakes, the balance of risk changes as the danger of losing control of inflation increases.

Unfortunately, this is where the analogy breaks down, because no racing driver ever has to cope with conditions as foggy as do economic policymakers. On the one hand, the signals from the real economy are mixed.The preliminary estimate of fourth quarter GDP showed a 0.5 percent contraction – but these estimates are prone to revision at the best of times, and with the exceptional weather conditions at the end of the year it is hard to have much confidence on this occasion. On the other hand, the inflation danger has been ever-present and growing, and the Bank of England’s 2 percent target has been more or less junked.

Consider the market data. If we look at the index-linked bond market, we see, on the one hand, a real rate which is zero or even negative and, on the other hand, an expected inflation rate rising from about 3 percent to above 4 percent over the next 20 years, which suggests only one thing: stagflation for the foreseeable future.

Against this, Bank of England apologists offer a number of decreasingly plausible excuses to explain why inflation is only a temporary problem, some of which amount to saying “it’s high because it’s high”. For example, blaming inflation on rising commodity prices in world markets is all very well, but if the value of the pound had risen on world markets rather than fallen, the impact on our own price level would have been far smaller – and the fall in the exchange rate is of course a direct consequence of the Bank’s own expansionary monetary policy (Quantitative Easing etc).

In fact, in our own modest way we have contributed to the rise in primary product prices, which has been mostly caused by the American version of QE, flooding the world (especially the Far East) with liquidity and generating a continual excess demand for soft and hard commodities, while the less prosperous parts of the Third World struggle to keep up with the cost of basic foodstuffs.

Against this, if there really is excess capacity in the UK, we should see the underlying inflation rate in the domestic economy falling or even negative. I differ from most of my profession, however, in questioning how much excess capacity we actually have at the moment, especially in the labour market. It remains easy and attractive for discouraged workers to drop out of the labour force into one of the available long term benefit categories (early retirement, disability etc), and the market will have been tightened somewhat by the clampdown on work permits for non-EU residents. Moreover, there are signs that the fall in the value of the Pound has benefitted the manufacturing sector (as it should), which is good news for the economy but will have added a little to inflationary pressures.

A new paradigm for inflation

-Kathleen Brooks is research director at forex.com. The opinions expressed are her own.-

Looking through the minutes of the Bank of England’s policy meetings for the past year, there are a couple of patterns that you see emerge. Firstly, that rates are on hold, and secondly, that the UK’s elevated inflation rate is temporary. Now the European Central Bank has joined the chorus. ECB President Trichet recently sounded confident that prices will moderate, even though consumer prices rose above the ECB’s target rate of 2 per cent in December.

But how long will citizens of Europe and the UK accept rising prices and how long can central bankers continue to stand by while inflation smashes their target rates? To answer this we need to find out two things: firstly, is this rise in inflation really that bad? Secondly, why are central bankers willing to let inflation pass them by without exercising monetary control?

Inflation is a tricky thing to get right. A little is good since it helps growth, but not enough is bad as it can stunt an economy and leave it in a deflationary spiral. There is also another benefit to inflation: it helps to erode debt levels in real terms. When many developed economies are struggling with unsustainable debt loads, a little inflation helps to lower the size of the mountain.

But prices are rising at a 3.3 per cent annualised rate in the UK. While the Bank of England rightly points out that this is due to commodity prices, but its assertion that inflation will prove temporary has been incorrect for more than a year.

Commodity super-cycle:

We are in a super-cycle for commodities. Burgeoning demand for food and raw materials from the fast-growing emerging world is set to dominate demand for commodities for the next few years, possibly even for the next generation. This means that people in the west who were used to low prices for most of the last decade will have to get used to coughing up at the supermarket and at the petrol pump for a while yet.

Monetary policy: QE2 or the Titanic?

“Those whom the gods would destroy, they first drive mad.” – the words of a wise Roman thinker (or was it a Greek central banker?). At any rate, the gods certainly seem to have no benevolent intentions with regard to this country, judging by the statements coming from the Bank of England, in particular the calls for another round of quantitative easing from one member of the Monetary Policy Committee and the cry of “Spend, spend, spend” from another.

The view emerging from the Bank and the Monetary Policy Committee is that the country is in the grip of a slow-growth recession, facing the threat of Japanese-style deflation and a double-dip recession, and that this grim situation requires near-zero interest rates, supported by QE2 if necessary, in order to restore consumption and lending (including mortgages) to pre-crisis levels.

As soon as anyone compares the UK and Japanese economies and finds similarities, I start to worry about their sanity. Leaving aside the massive differences in labour market flexibility, the key difference is that Japan got itself into a mess single-handedly in the late 1980’s, largely because of its unsustainably high levels of saving and investment. Indeed, for the last 20 years its massive stock of accumulated savings have largely insulated it from any sense of urgency. Its fiscal policy consists of running enormous Government budget deficits which are funded out of this stock of private sector assets, so that its expansionary fiscal policy simply serves to offset the excessive thrift of its overprudent households – hence, Japan’s ability to borrow well over twice its GDP without generating any sign of market nervousness about its ability to repay and with a buoyant Yen exchange rate.

Somehow, this does not sound to me like Britain’s current predicament. If we face years of stagnation, it is because of a debt overhang, the absolute opposite of Japan. Yet the Bank – no doubt in line with the majority of the UK economics profession – is convinced that Japanese-style demand weakness is our problem.

Take the deflation threat first. For all the worries, Britain’s inflation rate fails to follow the script. Not only does it repeatedly exceed the Bank of England’s own forecasts, but at over 3% it is still well above – not below – the inflation rates of every other major economy and double the Eurozone average rate. In particular, Germany’s inflation rate is only 1% and the USA’s is 2%.

What about unemployment? Again, it is far from obvious that the UK is in any way out of line with the rest of the industrialised world, given that our unemployment rate is still only 7.8% compared to 6.9% in Germany, 10% in France, and 9.5% in America (and 5.2% in Japan).

As far as household saving and consumption are concerned, the conclusion again depends on what yardstick you use. At 7.7% of disposable income, the UK saving rate is higher than it has been for a few years – it was barely 2% in 2008 – but this is still extremely low compared to well over 13% in the Eurozone and over 15% in France and Germany, not to mention 30%-plus in the Asian tigers. Only the USA has similarly low savings rates.