The Great Debate UK

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).

Why is the West bankrupt?

By Laurence Copeland. The opinions expressed are his own.

The UK, USA, the PIIGS (Ireland and Italy are together in the same stye), France is in poor fiscal shape  – OK, Germany is ostensibly living within its means, but it looks a lot less solvent when you remember that it has underwritten the rest of the euro zone (in large part, to protect its own irresponsible banks). In any case, as I have argued in previous blogs, this or a future German Government is likely to cave in to the pressure from its own electorate and from inflationist economists at home and abroad to join the party and spend, spend, spend. Only Australia and Canada, riding high on the commodities price boom, and a handful of small countries, look stable.

Where will it all end?

With inflation, almost certainly, but beyond that, it is hard to say. However, there is one prediction I would offer for the medium to long term outcome, and it applies not only to the euro zone, but to Britain and America too – in fact to the whole of the comfortable, complacent industrialised world – and it is this.

We are living through the death throes of an ideal, a dream which has turned into a nightmare – it is the end of the social democratic welfare model.

I am referring to the whole panoply of benefits (entitlements, as they are called in America), labour market regulations (employment protection, minimum wage legislation, limits on the length of the working week etc. etc.) and other social democratic devices intended to inflate like airbags to protect us all from shocks from any possible direction. The whole edifice built up in Western countries to shelter us from the need to earn a living is now clearly unsustainable. We can no longer afford a regime which allowed, indeed encouraged us to live permanently beyond our means both as individuals and as a society.

Two aspects of the current crisis make this apparent. First, and most obviously, we are all more or less like Greece – our debts may be proportionately smaller, but they are still crippling. Our pensions regime may be less egregiously wasteful than Greece’s, but they are still more generous than we can afford. As for healthcare and care for the aged, they are a crippling burden and demographic pressures will make them impossible for any country to sustain at anything like present levels.

What could the Q1 GDP figures mean for my business?

By Jamie Jemmeson

-Jamie Jemmeson is a Trader at Global Reach Partners, the foreign exchange company. The opinions expressed are his own.-

The alarm bells have been ringing in the UK since the surprise contraction in Q4 GDP 2010.  The Bank of England (BoE) remains in limbo between the ECB, who recently hiked despite their problems with sovereign debt and the US, where quantitative easing remains in force until at least June. The release of the preliminary Q1 GDP on the 27 April could be instrumental in determining not just how the currency and financial markets perform, but in directing measures the BoE and coalition government may have to take. Since the surprise contraction in GDP, the BoE has been forced to sit on its hands and watch inflation continue to increase while reiterating its belief that this is just a temporary phase. There is a real dilemma in the UK that has split the market; will the UK face the daunting reality of a double dip recession?

Data that has recently been released has done little to reassure the markets; the British Retail Consortium reported that retail sales for the month of March tumbled at their fastest pace in 6 years as spending cuts, tax rises and high unemployment took their toll on consumer confidence. As a result, Sterling is very vulnerable to the outcome of the UK GDP figure later this month. This means businesses that import and export are exposed to a great deal of risk when protecting their budgeted rates in foreign exchange for the year.

If the UK does enter a double dip recession on the 27 April, the value of Sterling is likely to fall. Consumer confidence is already near record lows and will plummet further if we see the inevitable media frenzy that would accompany the news of a double dip. The result could be a decline in retail sales and higher unemployment, two factors that will not be greeted with open arms by UK businesses. The BoE’s task of tackling inflation will become a steeper uphill slog as the justification of an interest rate hike would become difficult. Various rating agencies have already warned that weaker growth could jeopardise the UK’s prized triple AAA rating, a downgrade can only have negative effects. Finally, let’s not rule out the possibility of further quantitative easing down track that would naturally weaken the Pound.  All of this uncertainty would weaken Sterling, and hurt businesses that import goods and raw materials as a result. However, companies that are manufacturing goods for the export market may embrace the weakness in the currency as the demand for British made goods become more appealing.

If the UK dodges the silver bullet and avoids the double dip recession, hope and confidence may start to be restored. The net effect should result in a stronger currency and strengthen the coalition government’s position. The main price driver this year has been interest rate expectations. A return to growth would give the BoE more scope to start tackling the mounting inflationary pressures by increasing interest rates. In this benign scenario it is more than likely that the nation’s AAA credit rating will be preserved thereby enticing business and foreign direct investment while allowing the Coalition Government to continue to plough on with their austerity plans to improve the nation’s finances.

The net effect will be positive for Sterling. The rising pound would assist in tackling some of the imported inflation. For those who are importing this would be a timely boost and a noticeable help in pushing prices lower. Conversely businesses that are manufacturing goods for export would see their products become less competitive in price terms.

from Breakingviews:

Tragic quake may add to inflation pressures

The full economic impact of the sixth most powerful earthquake ever recorded is not yet known. Many hundreds of lives have been reported lost in Japan. Aftershocks are a danger and other nations fear a tsunami running across the Pacific will spread the damage more widely. Though uncertainty is rife, the earthquake is more likely to add to global growth and attendant inflationary pressures than subtract from them. It also raises concerns about Japan's long-running fiscal dangers.

The earthquake struck close to a relatively sparsely populated area of Japan. In contrast, the Kobe earthquake in January 1995 struck one of the most populated and industrialized regions, killing 6,434 people and causing damage estimated at around $100 billion. The current quake will leave a large reconstruction bill -- but, on current indications, a smaller one than for Kobe.

Industrial and agricultural output in the area of the earthquake will be harmed. Some automobile and other industrial plants have had to close and may require repairs. Japan's exports may be dented temporarily. Food prices in Japan may be pushed higher.

But spending over the coming months to remedy the destruction will tend to more than offset the economic losses suffered. There are already calls for a supplementary budget and there is no doubt that the government will be quick to repair infrastructure in the northeastern region -- and will have to borrow more as a result. The Bank of Japan has promised to provide ample liquidity.  Firms, meanwhile, will rebuild capacity, with insurance companies bearing much of that cost.

The earthquake will therefore mean an at least partial reversal of the austerity which the already embattled prime minister, Naoto Kan, has sought. The risks for Japan of fresh government spending when public debt is double the country's GDP are plain, though bond yields are still very low and fiscal crisis is not imminent. But economic growth is more likely to be stimulated than to fall.

Markets have initially seen the opposite risk, that global growth and demand will be hurt by the earthquake. But if Japan, the world's third largest economy, must spend to rebuild, Asian and global growth are likely to be a little stronger, too. That also means global commodity demand and inflationary pressure are more likely to be pushed up by the earthquake than to be reduced. Supply of some commodities may be harmed; the need for them increased.

The earthquake leaves the world shocked. Yet its economic impact may ultimately be to reinforce current trends: the global economy is recovering, but rising government spending and borrowing will one day have its toll.

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 Breakingviews:

Tightening needed in unstable, but growing, world

By Ian Campbell The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

LONDON -- The stagflationists are losing the argument. The world is inflating and that is indeed a worry. But inflation is coming from growth that seems increasingly strong and from money that is looking far too loose for a reviving world. The risk is that oil and other commodities soar much higher now, as they did in 2008, only this time the spike may not recede quickly.

Ben Bernanke, the U.S. Federal Reserve chairman, cannot be held responsible for social unrest in developing countries. But there is a link between ultra-loose money and global commodity and asset prices. The Fed has successfully pursued an ultra-loose monetary policy to help avert a second Depression. But the $600 billion second round of U.S. money printing looks a precautionary overdose whose inflationary influence is widespread.

Oil at close to $100 per barrel is injecting inflation into the world economy. Political unrest is a factor, but it is secondary. Food and other commodity prices -- less sensitive to Middle Eastern unrest -- are also surging. Global price hikes are now a big risk.

The cause? The U.S. and most Western economies are out of their hole and joining in emerging economies' growth fest. January's ISM report on the huge services sector of the U.S. economy showed the strongest figure since August 2005 and input prices roaring ahead.

There are problems here for both developed and developing economies. As Charles Bean, deputy governor of the Bank of England, said this week, if external inflation is very strong then the central bank will have little choice but to clamp down harder on domestic sources of inflation -- even in a still weakly recovering economy like the UK. Jean-Claude Trichet, the president of the European Central Bank, talked down expectations of a rate increase on Feb. 3, suggesting that energy-driven inflation would be transitory. If the world is indeed gathering steam, he may be wrong.

Australia's central bank has just raised its growth forecast for the coming years. Rates are rising around the globe. China, India and Brazil have tightened, and now so has Indonesia. The West will have to follow. For inflated asset markets there will be risks. But the shift from ultra-loose to tighter monetary policy is going to have to happen soon.

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.

from Breakingviews:

Beijing’s keep-’em-guessing approach has flaws

Two days before Thursday's strong inflation figures, the People's Bank of China surprised with a rate hike. Global markets sold off, but quickly recovered. The effect of conducting monetary policy through short sharp shocks is waning. It looks time for a well-explained, concerted plan to fight rising prices.

Chinese policymakers favor a keep-'em-guessing approach. The first rate hike in three years came out of the blue, and the central bank remains mute on its reasons. Only annual inflation of 3.6 percent, above the official target, gives a retrospective clue. Similarly, the People's Bank has not explained why it ditched its bewildering practice of moving rates by 27 basis points at a time.

Surprise and silence can be beneficial. One fear is that if investors see monetary policy as a one-way bet, they will pile on hot money. Pronouncements are often made at odd times of day or night, and sometimes before the data that justifies them is released. In comparison, the U.S. Federal Reserve rarely makes rate decisions outside regular meetings, and tends to hint strongly beforehand.

China's tactics are risky. Investors can misinterpret: this week's rate hike was seen by some as a one-off, and by others as the first of many. Policy uncertainty increases companies' cost of capital. And sometimes surprises are not followed up by action. After the central bank vowed in June to make the exchange rate more flexible, the yuan barely budged for two months, causing anger among some trade partners.

Meanwhile, policy shocks lose their effectiveness over time. While the People's Bank worries about inflation, the real interest rate on deposits remains negative, and house prices have shown no signs of easing. The market doesn't believe policy makers will sacrifice growth by tightening dramatically, so they are still driving up asset prices.

There may be good reasons why Chinese policy makers prefer to keep mum. On big questions, the Party may have not formed a consensus. Some decisions may be taken for reasons that might be unpopular with other governments, especially where they impact on China's export competitiveness. But while mystery has its place in fighting inflation, a clear plan might be a more powerful tool.

from The Great Debate:

There is no such thing as inflation

In 1987, UK Prime Minister Margaret Thatcher whipped up a firestorm of criticism from her opponents on the left when she told a magazine reporter that "there is no such thing as society", only individual men and women, and families.

The interpretation of those comments remains fiercely controversial. From the context it is not certain the prime minister was clear what she was trying to say.

But according to one interpretation the prime minister was encouraging her listeners to look beyond the impersonal aggregate of "society" to the individuals behind it.

The distinction between aggregates and individual components is something the Federal Reserve should bear in mind as officials mull whether to launch a new round of asset purchases to keep inflation from falling further and stimulate the recovery.

Because in some sense there is no such thing as inflation, only a collection of price rises for individual items, some rising faster and some slower.

It is clear price increases do have a structural component. Policymakers and economists distinguish between a general rise in the level of prices ("inflation") and relative price increases for individual items (Adam Smith's "invisible hand" guiding the reallocation of scarce resources).

But in an economy characterized by uneven spare capacity, with bottlenecks in some areas and unused capacity in others, excess demand and inflationary pressures may not show up evenly. Even as all prices rise (inflation), price rises are likely to be largest in those parts of the system with the worst bottlenecks, while increases in areas suffering significant under-employment of resources lag behind.