Sunday, June 06, 2004
Bank must not slip on oil
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

LONG experience has taught me that there are two topics related to economics guaranteed to get on the front pages. One is rising petrol prices, particularly if combined with a threat from men in lorries that supplies may be about to dry up. The other is rising mortgage rates, notably if linked with the suggestion that house prices are about to fall.

Combine the two, and you have something like a news editor’s dream story — rising petrol prices and higher mortgage rates — and we have seen quite a lot of that in recent days.

From the perspective of the Bank of England’s monetary policy committee (MPC), however, it is not quite as simple as that. In the old days a rise in the price of oil could be seen, rightly, as inflationary.

Oil went up. So did industry’s costs and prices, and so did wages in response. A general inflation followed, at least for a while. Britain’s two worst episodes of inflation in modern times — 26% in 1975 and 22% in 1980 — followed big increases in the price of crude oil.

The other enduring relationship has been between oil prices and growth.

Professor Andrew Oswald of Warwick University has a neat chart linking world oil prices with US unemployment. There is, indeed, good reason to believe that the recessionary effects of higher oil prices are now much more dominant than the impact on inflation.

Why should this be? Wage-setting behaviour has changed. With the exception of a few remaining union dinosaurs (the RMT springs to mind), workers no longer expect automatic compensation for every little blip in inflation. The so-called second-round effects of rising oil prices — seeing them embodied in higher wage settlements — may be lacking.

What this means is that dearer oil has a similar effect to a tax. The more that people have to pay for petrol or heating, the less they will have for spending on other things. Even in our borrowing culture, it is hard to believe that the scare stories about £1-a-litre petrol will not have had some effect on consumer confidence.

The same is true for companies. In the past, firms would have automatically passed on the rising cost of oil to customers. Some, no doubt, blamed dearer oil for price increases introduced for other reasons.

There are some oil-related price rises around at present, notably by the airlines. But most firms are heavily price-constrained. Even if they want to raise prices, their customers will not wear it. They will have to take some of the hit in the form of lower profit margins. For firms, as well as consumers, higher oil prices are a tax.

Thus the MPC, as long as it is reasonably confident that there will be no serious second-round effects from higher oil prices, should not respond in a knee-jerk way to them. Just as I argued a couple of months ago that the Bank should not make a Pavlovian response to rising house prices, so the same is true now for oil prices, for slightly different reasons.

The story does not, however, end there. We know that the Bank wants to raise rates for other reasons.

Since it increased the base rate from 4% to 4.25% a month ago, two significant pieces of information have emerged. The first was that, in its quarterly inflation report, it forecast that, at the new level of rates, inflation would overshoot the 2% target in two years. There is, in other words, unfinished business. The second bit of information was that, at the meeting that agreed on the last quarter-point rise, the committee considered, but rejected, a half-point rise.

Since then, too, there have been plenty of indicators of the kind that in the past have persuaded the Bank that higher interest rates were necessary. Mortgage borrowing was a record £9.8 billion in April, up by more than 15% on a year ago. House prices, according to the Nationwide, are rising by nearly 20%.

What this adds up to is considerable strength for consumer spending and, sure enough, the CBI’s retail survey shows its strongest readings for two years. Industrial surveys point to a strong upturn.

There are, as George Buckley of Deutsche Bank points out, figures on the other side of the equation. First-quarter gross domestic product was unrevised, remaining relatively weak. The latest purchasing managers’ index for the service sector showed unexpected weakness.

The markets, however, are now convinced that the Bank will not wait until the next inflation report in August before raising rates.

They are right to take that view. The signals from the MPC over the past few weeks point to a greater urgency in completing the unfinished business left over from last month.

But will it be this week or July? Before the latest flurry in oil prices I was convinced that the case for June — and the first back-to-back monthly rate rises since January-February 2000 — was powerful. If the expectations of higher rates have been lodged in the minds of the markets and other players, why wait and prolong the agony? An accompanying signal that this was probably enough for now would help.

The only thing that has made me pause in that view is the behaviour of oil prices. If oil prices are volatile and rising, that argues for a delay by the Bank.

The indications at the end of last week were that the decision by the Organisation of Petroleum Exporting Countries (Opec), meeting in Beirut, to lift quotas by 2m barrels a day from July 1, with another 0.5m from the beginning of August, was having a significant calming effect on prices.

If that continues over the next few days, there will be little reason for the Bank to wait beyond this week before raising rates again. But if the turbulence returns, the MPC should sit on its hands.

PS: There aren’t many places for economics anoraks to make a pilgrimage to, but Bretton Woods is one, and this particular anorak did so last summer. A sprawling resort in New Hampshire, it is where, just before D-Day 60 years ago, the financial leaders of the countries that were to be on the winning side began planning the post-war international financial system.

In 1944 Bretton Woods, which today is a swanky hotel above my pay grade, was suffering from the privations of war. Lord Keynes, Britain’s representative, shivered and suffered as he tried to get his plan for a new world central bank agreed. He lost out to the rival plan, based around dollar dominance, proposed by Harry Dexter White, America’s representative.

Out of Bretton Woods the Washington “twins”, the International Monetary Fund (IMF) and World Bank, were born. White, later accused of being a Soviet spy, was the IMF’s first executive director.

Bretton Woods also produced the post-war system of fixed but adjustable exchange rates that helped to cement the “golden age” of the world economy of the 1950s and 1960s.

Periodically, and particularly before the creation of the euro, there were calls for a new Bretton Woods to stabilise volatile global currency markets and send the speculators packing. Such talk is rarely heard these days, though we have had some significant currency swings over the past couple of years.

There are, on the other hand, plenty of calls for reform of the IMF and World Bank. The “Washington consensus” has been heavily criticised by the likes of Joseph Stiglitz. a former insider. Not only that, but in a world of freely flowing capital, the IMF is in danger of becoming an irrelevance with insufficient resources, while the World Bank often lends to countries that could as easily obtain finance on the markets.

After 60 years, it may be time for a change.

From The Sunday Times, June 6 2004

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