Sunday, February 11, 2007
Wave of money won't drown us
Posted by David Smith at 11:00 AM
Category: David Smith's other articles


These weeks are doing nothing for my state of health. The Bank of England has turned from faithful old labrador into a snarling hound of the Baskervilles. Watching the trading screens at noon on Thursday, I have to confess to a disconcerting fear of being bitten.

It was easy to list the reasons why the Bank should not raise rates. January’s vote for a hike had been wafer-thin and was regarded by some who backed it on the monetary policy committee (MPC) as the February move brought forward a month. The data leading up to the meeting were mixed. Experienced monetary policy practitioners know the dangers of increasing the dose too quickly, before earlier moves have had time to make an impact.

But — and I know of nobody who was relaxed about it — the doubts were there. What if Mervyn King, the Bank governor, had been told of another bad inflation number, perhaps a rise into the “letter-writing” range — at which he has to publicly explain himself to the chancellor — of 3.1% or above? What if he knew something we didn’t? The nerves were jangling. Boring it isn’t.

This week’s inflation number, we can expect, will still be close to 3%. The possibility that the governor will, as he puts it, rediscover the lost art of letter-writing, remains. But how worried should we be?

The current inflation scare — a “record” 3% rise in the target consumer prices index (CPI) measure — can on one level be simply explained. Higher domestic energy prices; 30% on electricity bills and nearly 40% on gas in the 12 months to December, have been worth a percentage point on inflation. After years of flat or falling food prices, the 4.5% increase over the past year pushed up the CPI by 0.4 points. Education, most notably the introduction of higher top-up fees in October, has added 0.2 points to the inflation rate.

Without these factors, indeed, we could be looking at a CPI inflation rate closer to 1.5% than 3%. I can’t say we would not have had any of the recent interest-rate rises, but it is hard to imagine we would have had as many, or be expecting more. I’ll get back to that in a moment.

You can only play this game so much, of course. Inflation is inflation. Removing all the things that are rising sharply in price gives you a low number but does not reflect genuine experience.

But just to stay with it a second, if domestic energy prices had risen last year in line with the rest of Europe, the inflation effect would have been 0.2 percentage points. At least some of the rise in food prices (notwithstanding last summer’s heatwave) must reflect producers’ rising energy bills. The circumstances that gave us today’s high inflation will not be repeated, and in some cases will be reversed — British Gas announced significant gas and electricity price cuts last week, to take effect next month. Hence the widespread expectation (including inside the Bank) that in a few months inflation will be falling sharply.

As an aside, is it just me or has criticism of the official numbers subsided, particularly now retail price inflation is nearly 4.5%? The new openness at the Office for National Statistics — allowing people to work out their inflation rates with the ONS’s inflation calculator — may have paid off.

So the inflation scare can be broken down into a series of special factors, rather than the beginning of a new period of fast-rising prices and economic turbulence (subject to the proviso that wages continue to behave, as for the most part they are). It is true that, outside these special factors, other things are less helpful than before — shoes and clothing are still falling in price but some other goods are not, although that may also be an energy effect.

That said, perhaps we have reason to be grateful to the utility firms, farmers and food retailers, and even to the government for increasing university fees. Why so? In the absence of above-target inflation it would have been harder for the MPC to have raised rates. Yet the economy’s exuberance — strong growth, buoyant housing and a six-year high for the stock market — justified at least some monetary tightening.

Some would say, indeed, the Bank’s problem is that it is obliged to focus on the inflation target when a more rounded approach to monetary policy might suggest higher interest rates. Many of those criticisms, in turn, focus on growth in the money supply, M4.

M4, or “broad” money, is a direct descendant of sterling M3, the money-supply measure targeted by the Thatcher government more than a quarter of a century ago. In those early days it was a wayward mistress. It took Sir Alan Walters, Margaret Thatcher’s personal economic adviser and a man blessed with more than his fair share of common sense, to point out that the economy was being crucified by high interest rates, in spite of runaway growth in broad money.

Lately, broad money has come back into fashion, after its growth hit a 16-year high of 14.4% in the autumn. It has slowed somewhat since then, although it is still at 12.8%. So-called M4 lending — the amount being pumped out in loans — rose 15.1% in the 12 months to December, close to recent peaks.

What is this telling us? It does not appear to be associated with the recent rise in inflation and has not triggered much of a rise in inflation expectations. If the City thought M4 was telling an inflationary story, gilt-edged stock — UK government bonds — would have sold off heavily.

What it does help explain is the strength of asset prices. Mortgage lending has been strong (although other consumer borrowing has been weaker), but it is showing signs of tailing off. Even so, there is an M4 explanation for the rise in house prices.

There is also an explanation for the strength of share prices. The strongest growth in M4 lending has been to “other financial corporations”. In November that was up 31% on a year earlier. This lending has been helping to fuel the boom in hedge-fund and private-equity M&A (mergers and acquisitions) activity.

So, while the Bank has had reason to act because of the rise in consumer price inflation, the impact of its actions may be felt most in asset markets, where inflation has been higher and where some cooling was needed.

Where do rates go now? Most economists have pencilled in at least one more rise despite Thursday’s reprieve. But these things are never set in stone. This week’s quarterly inflation report from the Bank may signal that the markets are too aggressive in their expectations on interest rates. I think we know enough about the MPC to believe that if it was sure a further hike was needed it would have acted last week. There’s still all to play for.

PS: Who will be chancellor when Gordon Brown moves into 10 Downing Street? Apart from the remote possibility that he won’t, which is why the bookies have George Osborne at 14 /1, the favourite is Alistair Darling, 4/5 on, despite suggestions that voters won’t take to a Scottish double act as chancellor and prime minister.

Ed Balls, on the way to finding a new constituency when his existing one is abolished, is English and 3 /1 with the bookies. He is followed by Stephen Timms, Treasury chief secretary, 8/1; David Miliband, perhaps Labour’s next leader but one, 10/1; and Jack Straw, fancied by some — in a betting sense only — 12 /1. John Reid is 16 /1 (surely not); Alan Johnson, 20 /1 (unlikely); and Peter Hain, also 20 /1 (I don’t think so).

I can’t help thinking, however, that all these names might be a bit on the dull side for Brown, keen to recreate the “Flash Gordon” excitement of 10 years ago, when he made the Bank independent.

Could a woman provide a bit of excitement? Britain has never had a female chancellor. Patricia Hewitt is rated by the bookies at 40 /1, but Brown would probably go for the Treasury cleaning-lady in preference. Ruth Kelly, well down in the lists at 66 /1, could be one to watch, though. As a former economics journalist she obviously has an excellent pedigree, and she worked at the Bank before becoming an MP and junior Treasury minister. The Treasury spoke well of her, before her subsequent travails.

From The Sunday Times, February 11 2007


Latest info on the UK's growth prospects

Posted by: Carlini at February 23, 2007 09:26 PM

It's always instructive to look back on these articles with hindsight.

Posted by: eDiets Review at May 7, 2009 12:13 AM