The Great Debate UK

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.

from MacroScope:

Could Turkey’s central bank surprise markets this month?

This Thursday, Turkey's new central bank governor Erdem Basci will chair his first monetary policy meeting.  What can we expect from the man who is seen now as the architect of the country's novel monetary policy? Most analysts predict there will be no change this month to interest rates and banks' reserve requirement ratios. But could the bank, which shocked markets with an out-of-the-blue  rate cut in December and a big further rise in short-term RRRs last month, throw another  curveball? 

ING Bank is among those which believes the central bank could again surprise markets this week.  Using Turkish banks' net off-balance sheet currency positions as a proxy, ING analyst Sengul Dagdeviren reckons short-term capital inflows are on the rise again. Banks' net off-balance sheet FX positions had halved between Nov 5 to March 4  to just over $12 billion, as the central bank drastically widened the gap between the overnight borrowing and  lending rates -- a move that discouraged short-term swap positions. But these positions have risen back over $21 billion in the month to 8 April, Dagdeviren says, noting this coincides with a 5 percent gain in the Turkish lira against the dollar.

"Given the (central bank's) strong stance against short-term inflows and strong lira, the chances of seeing CBT action on the FX side in the 21 April meeting have increased," ING tells clients, suggesting the bank could choose to apply reserve requirements on short-term swap transactions or raise the RRRs on banks' hard currency reserves.

If that happens, it will enrage the banking sector further.  Count stocks, FX and bonds to start  move south again.

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.

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.

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.

from The Great Debate:

Real commodity prices and the U.S. rate cycle

-- John Kemp is a Reuters columnist. The views expressed are his own. --

Commodity prices exhibit a strong cyclical component -- though it can be masked when producers are carrying a lot of excess capacity.

The attached chart shows the real price of various commodity baskets (Jan 1980=100) overlaid by U.S. interest rates (discount rate, later funds target), and the business cycle (NBER Business Cycle Dating Committee).

Prices began rising well ahead of interest rates after three of the last four recessions. Commodity markets anticipated future increases in demand even as policymakers prefered to hold back while recovery became more firmly established.

The current price rebound is unusual only for its strength.

Part of the explanation is the increasing weight of China and other emerging markets in global commodity consumption. As a result, the U.S. business and rate cycles and those of the other advanced economies now affect less than half the consumption of many commodities worldwide.

Prices are geared to the global cycle, which is not captured by measures of industrial output and capacity in the United States and the rest of the OECD.

Little chance of a rate hike until at least Q3

-Jane Foley is research director at Forex.com. The opinions expressed are her own. -

Bank of England Governor Mervyn King’s speech this week was well timed insofar as it has nipped in the bud a growing fear that inflation in the UK could be lurching higher.

King maintains that the present rise in the CPI is due to temporary factors.  As yet there is nothing in the rhetoric of King or in the minutes of Monetary Policy Committee meetings to suggest that the Bank is preparing to push interest rates higher.

As a consequence, there is still every reason to suspect that the Bank will be keeping rates on hold at least until the third quarter.

It cannot be denied that UK December CPI was far stronger than expected and that January CPI is likely to be even higher.

However, the temporary nature of the factors that are causing the surge (namely base effects linked to energy prices and the temporary reduction in Value Added Tax) suggests they should not significantly alter medium-term inflation expectations.

There is a risk that if headline inflation was to persistently exceed expectations that this may have a carry through into wage demands.  This risk cannot be dismissed out of hand because inflation last year failed to fall to the lows predicted by the Bank.

A tough spring in store for the pound

- Jane Foley is research director at Forex.com. The opinions expressed are her own.-

The pound has started the year on a negative note.  Ongoing concerns over the budget deficit, an impending general election, the prospect that the Bank of England (BoE) may yet increase quantitative easing (QE) and a drop in consumer confidence are all clouding the outlook.

That said, sterling has already paid a high price for its weak fundamentals.  In 2009 EUR/GBP averaged 0.8909, this is 17 percent higher than its average in the 12 months leading to the Northern Rock crisis and 35 percent above the average rate between 2000-07.

A lot of bad news is in the price but a sustained sterling recovery is unlikely until there are concrete signs of resolution to the UK’s deficit problem.

In the midst of the deficit concerns, the government is still too uncertain about the prospects for economic growth to stiffen its commitment to austerity and, according to opinion polls, the opposition is not enjoying a decent enough lead to ensure it of election success.

This has left the pound worried by the possibility that this spring’s general election may produce a hung parliament and sensitive to the brutal suggestion from Pimco that if Labour return to power the UK may suffer a credit downgrade.

On a more positive note, the UK most likely emerged from recession in Q4.  This is hardly a cause for celebration, however, since most major economies emerged in Q2 or in Q3.

You never know when rates will rise

-David Kuo, Director at the financial website The Motley Fool. The opinions expressed are his own.-

Go on. Admit it. You didn’t see it coming, did you? You never thought a member of the G20 nations would dare to break ranks and raise interest rates this soon.

But Australia has done just that. The Central Bank of Australia has increased the cost of borrowing by 0.25 percent to 3.25 percent. It is doing what it thinks is right for the country regardless of what the rest may think. Now, Asian countries, keen to avert another bubble, may follow Australia’s lead and ratchet up interest rates before long.

Of course, Australia’s economy is vastly different to the UK’s. It has huge deposits of iron, aluminium and nickel that are in demand by mineral-hungry China. That said, Australia did briefly flirt with a downturn, which it successfully corrected with 21 billion pounds of fiscal stimulus.

But the UK is not Australia. We do not have huge deposits of mineral, and we are not near fasting-growing Asian countries either. What we do have are consumers saddled with over a trillion pounds of debt following a decade of binge borrowing, and a national debt burden of similar magnitude. Therefore, it is unlikely that we will experience demand-led inflation. In fact, consumers are saving more of their household income than they have done for eight years.

The most recent Office for National Statistics report shows that between March and June British households saved 5.60 pounds out of every 100 pounds of household income. That is very different from the first three months of 2008 when we not only failed to save any money, but we even borrowed 50 pence for every 100 pounds of household income.

That said, we are still some way off getting our overstretched household finances back on an even keel. So, the savings ratio could go higher. In fact, it is still some way short of the long-run savings-ratio average of 8 percent of household income.