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’.”

The QE billions should go direct to consumers

By Mark Hillary. The opinions expressed are his own.

In 1998, the Japanese government was ridiculed for giving away almost $6bn (at 1998 value) of shopping vouchers. The plan was that consumers would spend more of this ‘free money’ and help lift Japan out of the seemingly endless malaise it suffered in the nineties – as many other developed economies were enjoying a roaring decade.

One of the major faults in the Japanese plan was that the vouchers could easily replace the need to spend actual money. If my groceries cost me $100 then why would I still spend $100 of cash on groceries and buy a nice meal in a restaurant with my voucher, when I could just use the voucher for those groceries?

But the Japanese may have been onto something by focusing on demand rather than monetary supply, contrary to most received wisdom at present.

The Bank of England’s Monetary Policy Committee has restarted quantitative easing (QE) in the past week, much to the surprise of the markets and leading some commentators to ask what they might know that the media and financial analysts don’t.

Former MPC member David Blanchflower even used his column in the Guardian to say: “The MPC argued that tensions in the world economy ‘threaten’ the UK recovery. I am unaware of the MPC ever using this word before. Given that a lot of care goes into the exact wording of such a statement all nine members would have had to sign off on this, then things must be pretty bad.”

Perhaps I am over-simplifying the complexity of the British economy, but if the man on the street senses that the economy is not improving then he will reduce spending, luxuries are forsaken, and unsecured credit is paid down.

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:

Primary dealers driving the printing presses

The U.S. Federal Reserve’s hotly-contested $600 billion renewal of its quantitative easing programme is roughly the size of the Gross Domestic Product of Switzerland.

Expectations by forecasters in Reuters Polls on how much more bond purchases the Fed will conduct beyond the $1.7 trillion already conducted varied widely running up to the Fed's announcement that it would go ahead with QE2.

But the high end of forecasts has been consistently driven by the 18 primary bond dealers which deal directly with the Fed. Perhaps that's no surprise, given that they are selling bonds to the central bank at a very good price.

-- The median estimate for QE2 from the Wall Street primary dealers was $1 trillion on Sept 22.

-- That median estimate declined to $625 billion about a week before Nov. 3, when the Fed announced $600 billion in new government bond purchases over the next eight months.

-- In a poll taken two days later, the median estimate from the primary dealers rose again to $1 trillion for the eventual spend on QE2.

-- But the majority of economists in the latest Reuters monthly long-term economic poll, which includes many banks that are not primary dealers, saw the Fed capping QE2 at $600 billion. Only fourof the primary dealers say it won’t go higher.

from The Great Debate:

Quantitative easing and the commodity markets

-The views expressed are the author's own-

A warning by an International Energy Agency (IEA) analyst this week that quantitative easing (QE) risked inflating nominal commodity prices and derailing the recovery drew a withering response from Nobel Economics Laureate Paul Krugman, who labelled the unfortunate analyst the "worst economist in the world".

According to New York Times columnist Krugman "Higher commodity prices will hurt the recovery only if they rise in real terms. And they'll only rise in terms if QE succeeds in raising real demand. And this will happen only if, yes, QE2 is successful in helping economic recovery".

Krugman's criticism is unfair. There are clear links between QE and investor appetite for commodity derivatives and physical stocks (via the Federal Reserve's "portfolio balance" effect), and from investors' holdings of derivatives and physical inventories to cash prices (given the relatively inelastic supply and demand for raw materials in the short term).

In other words, there are financial as well as real economy links between QE and commodity prices. Commodities have some of the characteristics of financial assets as well as physical consumption materials. Via portfolio effects, QE could boost the relative (real) price of commodities even if it did not boost employment and output in the United States by very much.

It is a more open question whether commodity-driven inflation would hinder or promote a recovery in output and employment in the advanced industrial economies. It would reduce the real burden of inherited debts from the boom years. But it would harm savers, and it might harm manufacturers and households, depending on whether increased commodity prices were matched by rising non-commodity consumer prices and wages.

Overall, an unbalanced, commodity-driven inflation would probably be more of a drag on recovery than a help. Reasonable observers have reached different conclusions. In any event, the analyst's warning was certainly not a "classic freshman mistake" or evidence of a new "Dark Age of economics" that the erudite professor labelled it.

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.

QE pause shows there is a long way to go

- Mark Bolsom is the Head of the UK Trading Desk at Travelex, the world’s largest non-bank FX payments specialist. The opinions expressed are his own. -

Thursday’s decision by the Bank of England to keep both interest rates and its asset purchasing programme on hold was hardly a surprise and had been largely priced in to markets.

However, the statement accompanying the decision was hardly a resounding vote of confidence in the British economy. Instead, it would seem that the MPC is in a quandary; on the one hand wanting to stimulate markets, but hamstrung, on the other hand, by the spectre of inflation.

The MPC, along with the rest of the market would have been hugely disappointed at first estimate of 0.1 percent growth during the last three months of the year. That figure is even more disappointing given the huge fiscal stimulus provided by the government, combined with the 200 billion pounds worth of quantitative easing that the Bank has already pumped into the financial system.

Yes – the GDP number was only based on about 40 percent of the available data, but even so, most analysts had forecast growth of at least 0.3-0.4 percent. With that in mind, the actual effectiveness of the Bank’s asset purchasing program has to be called into question. Credit remains tight, and banks still seem to be reluctant to lend to both businesses and consumers. It is clearly going to take more than quantitative easing alone to normalise markets.

One definite consequence of the quantitative easing, however, has been to stoke up inflation again. The annualised rate of 2.9 percent posted in January would surely have surprised MPC members, and almost certainly contributed to today’s decision to pause, rather than definitely end, quantitative easing. Furthermore, those figures relate to data before VAT went back up.

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.

Why we need a bond market crisis

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. -

The spirit of Britain’s Christmas is looking disconsolate this morning. Santa Claus has failed to deliver what our democracy most needed. No, not a deal to let the French have the 2012 Olympics in exchange for a bottle of Beaujolais Nouveau.  Nor the nomination of Tony Blair for the Nobel Peace Prize. Number one on this year’s wish list was something more realistic, and maybe far closer:  a gilt market crisis.

To see the consequences of Santa’s negligence, consider the outlook for 2010. At present, the two main parties have adopted wait-and-see policies for dealing with a budget deficit approaching £200 billion or about an eighth of our GDP.

Neither is proposing to do anything serious until after the election, due no later than May. At most, we have had government promises about what spending would be sacrosanct, leaving us to imagine for ourselves the devastation that will have to be inflicted on whatever is not ring-fenced.

In the face of Labour’s trust-us-till-after-the-election stance, the Tories have felt little pressure to say what they themselves will do if they form the next government.

If no outside force intervenes, the  electorate will be faced with a choice between two parties neither of which is offering any programme for dealing with the biggest economic problem the country has faced since 1945, so that whoever wins the election will have no clear mandate for restoring fiscal balance.

In the unlikely but not impossible event that Labour wins, its supporters will interpret the victory as a vote against substantial cuts, so they are bound to feel aggrieved when the new government proceeds to slaughter their most sacred cattle.

Bank hedges bets with QE expansion

When the Bank of England decided to expand its quantitative easing policy by 25 billion pounds to 200 billion on Thursday, it was essentially hedging its bets.

After Britain’s economy shrank unexpectedly in the third quarter, and with two thirds of the City expecting an expansion to the QE programme, simply shutting off the tap of government bond purchases would risk being more of a shock than the economy could bear.

On the other hand, the Bank clearly believes that the worst is over for the economy and that recovery will come soon — even if it’s going to be weak.

Thursday’s decision means the central bank will keep buying government debt until February, but at only half the pace of before. This still amounts to around 2 billion pounds a week, not including the much smaller sums of corporate debt that the Bank is buying.

What the decision means for a typical household is harder to calculate. The Bank says that its quantitative easing programme has raised the price of government and corporate bonds, making borrowing cheaper.

But for average firms and consumers looking for a loan, the benefit is harder to spot.

There is little clear evidence that banks are much more willing to lend than a few months ago — though the Bank would argue that quantitative easing has been instrumental in avoiding the recession turning into a depression.