Sunday, August 13, 2006
Bank experiments with a 5% solution
Posted by David Smith at 11:00 AM
Category: David Smith's other articles

Changes in interest rates in Britain used to be as common as blackbirds but are now almost as rare as golden eagle sightings. So it was just my luck to be away last week when the hawks flew into view.

Fortunately we get several bites at the cherry these days. First was the announcement itself. Then last week we had the Bank of England’s quarterly inflation report, much of which was devoted to explaining it.

Finally, we will this week get the minutes of the MPC (monetary policy committee) meeting which decided on the hike, including the all-important vote. I suspect, for all the talk of a knife-edge verdict, the decision to raise from 4.5% to 4.75% on August 3 was fairly clear-cut.

Before I get into the meat of that I’ve been doing a bit of detective work on why so many people were wrongfooted by the hike, leading to an adverse market reaction. Mervyn King, the governor, said a careful reading of the data should have meant nobody was surprised.

So why were they? The action took place in the space of three days last month, with inflation figures on July 18, taking in the strong June retail sales numbers on the 20th and ending with gross domestic product data (and revisions to past figures) on the 21st.

The inflation numbers, which at 2.5% were above the 2% target, raised the starting-point for the Bank’s new projections. The sales and GDP figures conveyed a picture of robust economic growth.

But in the middle, on July 19, we had the minutes of the MPC’s meeting two weeks earlier. This was a picture of serenity; inflation risks evenly balanced and nobody talking about higher rates. The problem was that this view was a fortnight old. Keynes’s famous maxim - “When the facts change, I change my mind, what do you do, sir?” - applied to the MPC.

Does this mean we should never take any notice of the minutes or, for that matter, speeches by committee members? No, but according to the governor, the MPC is not in the business of giving “hints” or “steers”. Other central banks call it managing expectations, but at least we know where we stand.

Where do we go now? I argued three weeks ago that as long as “second-round” effects of higher energy prices were contained, as they have clearly have been on wages - pay growth remaining astonishingly subdued - the Bank could stand pat. I did, however, point out a fortnight ago that the decision was too close to call and that nobody should be surprised by a hike (though they were).

That is water under the bridge. Built into the Bank’s new forecast is what Sherlock Holmes might have called a 5% solution. If base rate rises to 5%, in line with what the markets were expecting when the new quarterly forecast was put together, inflation will gradually head back to the 2% target.

It may be a bumpy ride. King gave notice that there is a 50-50 chance that inflation goes into “letter-writing” territory over the next six months - in other words rises above 3% and requires a public letter of explanation from the governor to Gordon Brown. If that happens, then for presentational reasons the rise to 5% could come before the end of year and there will be pressure for more.

We have been here before, and each time a letter has been threatened events have conspired to head off the danger. This time part of the risk comes from the way the Office for National Statistics decides to treat university top-up fees when they are introduced this autumn. As with energy prices, that is outside the Bank’s control, and outside the influence of monetary policy. But central bankers are human, and a missed target hurts.

If 5% is all it takes, I for one would not have too much trouble with that. It would exert a calming influence on consumers and the housing market, without doing serious damage. It would be in sharp contrast to past responses to soaring energy prices. It would be a gentle touch on the interest rate tiller.

But these are, as King said, times of unusual uncertainty. What would I worry about if I were sitting on the MPC? Not about strong growth in the money supply, M4, which appears distorted by lending to the financial sector. The main concern would be, as last year, the coming pay round. Whether consumer price inflation tops 3% in the coming months, inflation on the tried and trusted retail prices index, which will be boosted by this month’s and any subsequent rate hikes, could touch 4%. Wage bargainers will have to be even more saintly.

It is important to recognise, however, there are risks in the other direction. The doves have not entirely flown the cote. The Bank expects global growth, currently enjoying its strongest sustained run for more than three decades, to moderate only slightly. It is possible the US-led world economic slowdown is more pronounced than this. Nouriel Roubini, professor of economics at the Stern School of Business, New York University, sees a 70% chance of an early US recession.

At home, a big question is over the amount of spare capacity in the economy. Unemployment is at its highest for six years and has risen by 223,000 over the past year. Taken together with subdued wages, that suggests a lot of spare capacity.

But the Bank, in bolstering the case for higher rates in its inflation report, argued the economy is actually quite close to capacity limits, largely based on the results of business surveys. If the labour market figures are a better guide, as they have been in the past, that would suggest the MPC is worryingly unnecessarily, and that wages will continue to behave benignly.

There’s also another bit of the Bank’s analysis I find unconvincing. Inflation would have risen further on the back of higher energy prices, it says, were it not for those subdued wages and the fact that companies have been prepared to absorb higher costs at the expense of a squeeze on profit margins.

Therefore, the danger is that when energy prices fall, firms will seek to rebuild those margins and may relax their grip on wages. With the 2% official inflation target governing behaviour, the risk is that a fall in energy prices will not lead to much of a fall in inflation.

But why? If energy prices fall, firms will not suddenly stop bearing down on costs. Because their profit margins will automatically recover, they will not need to raise prices. As for wages, the time of maximum danger is when energy prices are pushing up inflation, not when they are falling. This seems to be a phantom danger.

As I say, if 5% is the outcome, fine. If August 2006 turns out to be like the Augusts of 2005 and 2004 - one move followed by a year of inactivity - fine too. The risk is that the Bank talks itself into an inflation problem that isn’t really there, and then has to deal with the consequences.

PS Long-standing readers will be aware of my skip index, a usually-reliable economic indicator based on the number of builders’ skips in my street. Zero means recession, two is roughly normal, four represents a boom. Out of interest, there are three at present.

Now I can report a new development - the scaffolding index. There’s been a recent outbreak of scaffolding being erected outside ordinary family homes. Some of it is understandable; if you are having a new roof or converting a loft it is hard to do it without scaffolding. But some of the scaffolding is going up for jobs where a ladder would have done in the past, such as painting the window frames.

I can’t tell whether this is due to health and safety rules or a new kind of oneupmanship, in which scaffolding becomes a symbol of financial virility. But I’ll be monitoring this one closely in the coming months. One thing I’ve noticed about scaffolding, though, is that once up, it tends to stay up - often for months. So perhaps not the most timely indicator.

From The Sunday Times, August 13 2006


I have read some of Roubini's recent blogs on the state of the US economy and he is pretty apocalyptic about the coming six months.

He is not of the school that says as the American economy cools, Europe and Japan will take up the slack and carry on driving the global economy. Indeed, from a UK perspective, it's hard to see how demand from heavily indebted consumers could grow significantly to help take up any slack.

Do you not share Roubini's view that if the American economy hits the skids, the knock-on effects for the global economic picture will be pretty unpleasant?

Posted by: Tom at August 14, 2006 10:26 AM

When labour came to power ' things could only get better'
lets summarise today's fundamentals:
Real unemployment is rising.
Real inflation is rising.
Real consumer debt is rising.
Real government expenditure is rising out of control.
Real interest rates are rising.
two out of the five above would be enough to be concerned, all five have now created an inevitable scenario that is irriversable.
Oh well, We can always agree as an nation to go collectively in denial!!!!!

Best wishes

Arik Schickendantz

Posted by: arik schickendantz at August 15, 2006 06:08 AM

The real questions we should ask about banking are these:-

i) Is it right that private commercial companies create "out of thin air" virtually the entire money supply of the world as a loan with interest on it?

ii) Is it right that the governments create just a near non-existant portion of money as coins, and cash debt free into the economy?


It would be interesting to see what David Smith has to say about this if anything.


Posted by: Robert Searle at August 15, 2006 09:37 AM
Therefore, the danger is that when energy prices fall, firms will seek to rebuild those margins and may relax their grip on wages.

On what do you base your suggestion that energy prices will fall? As North Sea gas extraction rates fall, as nuclear power stations are decommissioned and as coal generation plant is closed under the EU large combustion plant directive electricity prices are set to continue increasing indefinitely. Gas for heating and chemical feedstock is also increasing due to increasing reliance on imports which will consistently be higher priced than indigenous production (if even available).

Globally there is no evidence for oil price falls without demand reduction. So yes, energy prices falls are a phantom danger. Not for the reason you suggest but rather because the price fall itself is phantom.

Posted by: Chris Vernon at August 16, 2006 08:32 AM

David won't answer because he's away with the fairies in a dreamworld of falling oil prices (any time now! no really!), eternally soaring property prices (lalala I'm not listening), ever low inflation (the official figures are spot on, and the skip index says it all) and ever low interest rates (Wha!? A rise?).

He's getting on you see, and unfortunately red braces, pinstripe shirts and Gordon Gecko hairstyles aren't in fashion any more.

Have a heart and wish him on his way into retirement.

Posted by: Paul Owen at August 16, 2006 09:36 AM

I think that's a bit mean - this website has always promoted an intelligent discussion about economics. I don't agree with everything David Smith says, indeed I don't agree with quite a lot of what he says, but he makes a good case for the opposing view. Resorting to personal jibes only gives the impression you can't find real holes in his argument.

Posted by: Jonathan at August 16, 2006 04:23 PM

Fair point Jonathan, I don't agree with everything that David says but give the guy his due respect.

Posted by: Werewolves at August 16, 2006 06:14 PM

Dear All,

We live in a spineless society that does not address the issue of the need for interest free monetary reform. I am not suprised by the response.......It is shame people cannot understand what really MATTERS in economics, and why it is so important. Addressing the status quo is not going to achieve for banning anyone from the site because they are speaking the truth does not say for the kind of calibre of individuals here.

You will pleased to know I will not be disturbing you things that MATTER.


Posted by: Robert Searle at August 17, 2006 08:31 AM

I agree with R.Searle. Relentless credit inflation wrecks the capital structure of the economy and we will all regret it in the end.

Posted by: M.Scott at August 21, 2006 01:21 PM

The reason I discouraged Paul Owen from posting comments is that he never has intelligent to say, unlike almost everybody else - so nothing's changed there. He's also posted comments on the site under my name, which is probably breaking the law, and which is why he was banned. Anyway, he's clearly got his difficulties.

In response to Robert Searle, I've had a brief look at your work. The trouble is, we have to live in the world as it exists, not a theoretical construct. I don't see the world changing along the lines you suggest.

On energy prices, you'll see a big debate on this in the discussion forum. My argument is that oil prices have overshot because of a combination of circumstances - the strongest period of world economic growth for more than three decades, post-Iraq Middle East tensions, including Lebanon and Iran, and temporary supply worries elsewhere, including Nigeria and Alaska. One of these I am confident will not last is the strength of the global economy. The others can be debated, though the supply-demand balance is improving.

Posted by: David Smith at August 21, 2006 03:16 PM