UK News

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.

from The Great Debate UK:

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 MacroScope:

Darkening outlook for UK housing

The outlook for the UK housing market has darkened again. The usually optimistic bunch of property market watchers polled by Reuters, who have tended to predict ever-rising property prices no matter what the season or financial climate, now say the market will move sideways for the next two years.

They say that in the next few months, the small double-dip in prices that has begun will continue. Modest gains predicted less than three months ago for this year and next essentially have been wiped away.

No one should be surprised by this.  It smacks of an awakening to reality more than a slight change to a few variables in the statistical model. What’s perhaps most striking about these new poll results is that economists think houses are even more overvalued now than they were in July even after a few straight months of falls.

The poll found the proportion of property market watchers who expect a double-dip in prices has swung to a three-quarters majority from about one in four minority in July. As polls go, that is a big shift in sentiment in a very short period of time. The consensus points to a 5 percent fall from here on top of the 1.4 percent fall over the last two months, but the forecast range goes as far down as 22.5 percent from here.

That tallies with anecdotal evidence. A friend who is heavily invested in London property says he's having trouble selling and says a 15-20 percent fall in the market is likely.

Transaction volumes in Britain’s property market have slowed to a trickle, mortgage approvals are low, and banks are now asking for huge deposits and making rigorous income and credit checks before lending huge sums of money.

Rents are rising again after years of stagnation because people either can’t afford to buy or are scared to buy ahead of another potential fall in prices.

from MacroScope:

Crisis, what crisis, time again in Britain

Britain's recession, like the downturns in most other places, is being hailed as either having reachえｄ bottom or tailed off in its decline. The latest to trumpet the beginning of the end is the British Chambers of Commerce, which said business orders and sales had continued to fall in the second quarter but at a slower pace than previously.

So does this mean that the Bank of England will soon start raising interest rates from the negligible 0.5 percent reached last year as policymakers sought to pump liquidity into a failing economy? Not according to researchers Capital Economics, which argues in a new report that market assumptions of higher rates at an early stage are misplaced. They offer three reasons:

-- A return to strong levels of activity and rapid price gains in the housing market is unlikely for some time, even at very low interest rates. Meanwhile, the overall economy is likely to expand at only sluggish rates in the foreseeable future. And even if the recovery continues to gather pace, the large amount of spare capacity - or slack - in the economy suggests that there should be no hurry to tighten policy at all.

-- Even when monetary policy is finally tightened, some part of this will involve the reversal of the Bank of England’s quantitative easing programme. Although the likely order of events is far from clear, this could delay the need for a conventional tightening in the form of higher interest rates.

-- Thirdly, there is good chance that monetary policy in general takes a back seat to a substantial tightening of fiscal policy as the government responds to the growing pressure to sort out the public finances. This is likely to take the form both of higher taxes and a severe squeeze on public spending and would require monetary policy to be kept correspondingly loose to prevent the economy from slipping back into recession.

So, essentially, the BoE will not be able to raise rates because a) the economy is a long way from good b) it has other things to unwind first and c) life is going to be so miserable for Britons that low interest rates will be their only salvation.

This latter point is beginning to excerise a lot of thought in Britain, with the head of the Audit Commission criticising politicans for failing to be honest about the need for cutbacks, given a forecasted £175 billion public deficit this year -- more than 12 percent ofgross domestic product.

"People had better understand this is an unprecedented situation. We have never seen anything like this in your lifetime or mine," Former prime Minister John Major, who knows quite a bit about crises, told TV presenter Andrew Marr.

(Reuters photos: Eddie Keogh and Darren Staples)

from MacroScope:

UK house prices close to a trough?

MacroScope is pleased to post the following from guest blogger Simon Ward. Simon is chief economist of Henderson Global Investors in London and previously worked for New Star Asset Management and Lombard Street Research. His own blog is Money Moves Markets.

UK house prices are no longer expensive relative to a measure of "fair value" based on rents. Prices fell significantly below fair value during the major house price busts in the 1970s and 1990s but a big undershoot is unlikely in the current downturn because low interest rates will limit forced selling.

The notion that housing is no longer overvalued is controversial because the house price to income ratio remains far above its average since 1965. This average, however, is unlikely to be a good guide to fair value because the ratio has trended higher over time, reflecting factors such as improving quality, the pressure of an expanding population on constrained supply and a high income elasticity of demand for housing.

An alternative approach is to use rents rather than income as the basis of comparison. Rents already incorporate fundamental influences on housing demand and supply. People need to live somewhere – the choice is between buying your own home or renting, not between spending money on housing or retaining income for other purposes.

An economy-wide rental yield can be calculated from national accounts data by dividing the sum of actual rental payments and imputed rents of owner-occupiers by the value of the housing stock. The yield averaged 3.6 percent between 1965 and 2007. This seems low but the measure includes subsidised social housing and takes account of vacant properties.

The housing boom pushed the rental yield down to 2.8 percent at the end of 2007, suggesting that prices were then overvalued by about 29 percent, based on the 3.6 percent long-run average. The Halifax index has fallen by 21 percent since December 2007, while rents had grown 6 percent by the fourth quarter of last year. These changes imply a current yield of about 3.8 percent, consistent with small undervaluation.

The rental yield rose well above the 3.6 percent long-run average during prior housing busts. If the overshoot in the current downturn were to equal the undershoot during the boom, the yield would rise to 4.4 percent. This would be consistent with a further fall in prices of about 14 percent, assuming unchanged rents. A decline of this order is widely expected.

from MacroScope:

Show us the money

It says something about the current world that a new economic indicator is about to be unleashed by the Bank of England and it basically tells you whether banks have been doing what they are supposed to do -- lend.

The first Trends in Lending report is due out on April 21 at 0830 GMT. Always nice to have a new indicator, but this one may get a bit more attention than would have been the case a few years ago. It is designed to provide up-to-date information about bank lending to households and businesses.

Consumer groups, regulators trade bodies, the BoE, the UK government and lenders themselves will draw up the report under the rubric of something called The Lending Panel -- which a cruel cycnic might say sounds a bit like a high-interest loan shop.

Clearly, the purpose of the report is to show whether banks have been passing on the ultra-low interest rates that the BoE has been handing out.  What do you think it will show?

Web round-up: the ups and downs of investment ISAs

With ISA season coming to an end in less than a month, investors need to act sooner rather than later to make the most of the tax-free benefits on offer. You can not carry your annual allowance of 7,200 pounds into the next tax year, so it is a simple case of ‘use it or lose it’.

But with interest rates plummeting to an all time low, returns on cash individual savings accounts are miserly. So are stocks and shares ISAs a better home for your money? Financial experts certainly seem to think so – and so it would appear do investors.

A report by Barclays Stockbrokers says that the Bank of England’s decision to cut interest rates to 0.5 percent has led to a change in outlook for savers, with 63 percent saying that equities will provide the best returns this year. Of those planning to invest in a stocks and share ISAs in the 2009 tax year, 74 percent say they intend to maintain the same level of investment as 2008 and 20 percent plan to increase their investment.

Barbara-Ann King, Head of Investment Strategy at Barclays Stockbrokers said the report shows that “cash is no longer king.”

Dan Clayden, independent financial adviser from Clayden Associates, agrees: “The FTSE is around 40 percent down on its peak, so to me the equities market looks very appealing.”

Meanwhile, Tamsin Brown on whatinvestment.co.uk writes that investors looking to gain any serious returns from their ISA allowance will have to move out of their comfort zone. “Those looking to invest in a cash ISA at the moment will be lucky to find one offering much above the rate of inflation. Therefore, ISA investors seeking tax-free income this year have to be prepared to take on a little risk if they want their yield to do more than just keep up with the increase in the cost of living.”

However, Jennifer Hill at timesonline.co.uk writes that investors should be wary of the pitfalls. “Supposed ‘safe havens’ are not as low risk as they might seem. Money is pouring into corporate bond and equity-income funds, which can both be held within a stocks and shares ISA, since some are yielding up to 10 percent against an average of only 1.99 percent for cash ISAs. However, advisers said many savers may not appreciate the risks.”

Can MV=PT solve credit crisis for BoE?

Britain could begin a telling exercise in classical monetary theory on Thursday as the central bank gets set to test a newly minted policy of “quantitative easing”.

In an effort to pump more money into the financial system and encourage banks to get lending again, the Bank of England has been given the green light to basically create more money.

 It will use the electronic funds to buy short- and long-dated gilts and a host of commercial debt in the hope that that will free up other capital to the banks, allowing them to lend more.

At root, the exercise is based on MV=PT, known as the Fisher equation of exchange and a mainstay of Keynesian monetary theory.

In the equation, M is the quantity of money and V is the velocity at which it travels around the economy. P stands for the general level of prices and T equals the number of transactions performed over a given accounting period.

In theory, V and T are more or less stable, meaning that all other things being equal, the amount of money in circulation has a direct impact on prices and/or the number of transactions.

By pumping more M into the economy (or at least making more M available), the central bank is hoping that economic activity will pick up (T will increase) and the economy will be reflated (P will pick up). In theory.

Rate cut round-up: “policy mistake” or “confidence boost”?

The Bank of England’s decision to cut interest rates to a record low of 1.0 percent may have been widely predicted, but this did little to hold back the avalanche of commentary that began the moment the news came through at noon today.

Interest rates, which have now been cut five months in a row, are at the lowest level in the Bank’s 315-year history, and the list of people calling yet another easing pointless appeared to be getting longer.

Economist Ros Altman, writing on www.theguardian.co.uk, said: “This is another policy mistake. More panic cuts are not the answer to our economic crisis. Policymakers are desperately trying to boost the flagging economy and encourage more spending… but lower rates are a very crude weapon. They punish those who have got money to spend while benefiting the very groups (banks in particular) whose actions caused the mess in the first place.”

She wasn’t alone. BBC blogger Stephanie Flanders wrote: “It is hurting. But so far it isn’t working… Savers say they are being punished for nothing – rate cuts are hitting their income, while having less and less impact on the economy at large. They have a point.”

Meanwhile, Melanie Bien, of mortgage brokers Savills Private Finance, was quoted in several publications as saying: “Today’s cut was expected by the markets. It will assist those on base-rate trackers with no collars or standard variable rates if those lenders pass on any of the cut. But beyond that it will have little effect.”

The Sun didn’t hold back either, calling the rate cut a “desperate attempt to revive the flagging housing market” while The Daily Mail website said the MPC was “going for broke”.

Are interest rates at one percent the answer?

The Bank of England has gone into further into uncharted territory with its decision to cut rates by half a point to just one percent. Many economists think they will be down to zero by the Spring.

But like gunfighter running out of bullets, the Bank is, in the view of some observers, just wasting ammunition by using the interest rate weapon.

The problem lies, they say, in the availability of credit, not the price of it. What use is a nice cheap loan on a house if a bank is demanding a whopping 25 percent deposit?

Do you think the Bank of England could do more to stimulate confidence and get credit flowing again — and if so, what could the central bank or the government do?