Sunday, May 13, 2007
Bank has to find the tipping point
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

You may favour the Chinese water torture, allegedly the slow drip-drip onto the victim’s forehead, which eventually drives him mad. Or how about the frog in the bath, in which gradually raising the temperature puts paid to the poor little fellow, even though he thought he was wallowing comfortably?

Raising interest rates – in case it was not obvious that is what I am talking about – will always be as much an art as a science. How do you calibrate it correctly? When do you know you have done enough? When have you arrived at the tipping point?

After the Bank of England’s quarter-point rise in Bank rate to 5.5% on Thursday, this is now the central question. Has the monetary policy committee (MPC) done enough to bring inflation back on track to meet the 2% target in the medium term, partly by taking some of the steam out of demand and the housing market?

Or will the message we get from this week’s inflation report from the Bank (the day after the next set of inflation numbers) be that there is still unfinished business, and that we can expect more action over the summer? After all, the statement accompanying last week’s announcement warned that “relative to the 2% target, the risks to the outlook for inflation in the medium term . . . remain tilted to the upside”.

A bit of history can be useful. If we go back over the past 30 years, we have had some spectacular rate sequences. Moving from 5% in October 1977 to 14% in February 1979 was one. The hike from 7.5% in May 1988 to 15% in October 1989, which did for Margaret Thatcher every bit as much as the poll tax, was another. Mostly, though, movements between interest-rate troughs and peaks have been much more modest than this.

In the 10 years of Bank independence, the first trough-to-peak move was from 6% to 7.5%; the next was from 5% to 6%, and the third from 3.5% (November 2003) to 4.75% (August 2004). Actually, if one is prepared to ignore the one-off cut to 4.5% in August 2005 – the one Mervyn King voted against – you could argue that this particular sequence has led to, by modern standards, a big rise of two percentage points.

But let us allow that rate cut, which would suggest the three postindependence rate-raising sequences amounted to, in market parlance, 150, 100 and 125 basis points respectively; a 125-point average. So far in this mini-cycle we have had 100. That, and the Bank’s statement, might suggest there is more to come, certainly the quarter-point rise to 5.75% the money markets expect.

But let us disentangle that a bit. Apart from Chinese water torture and frogs in baths, we should not discount the possibility that the Bank is engaging in what King once described as the Maradona effect. The great Argentinian footballer once bamboozled the England defence by feinting left and right but proceeding in a straight line. By feinting to hike further, the Bank may achieve the response it wants without actually having to deliver the threatened increases. Better to warn firms and households that there could be more pain to come than to signal a peak. The Bank made the latter mistake as recently as November, by giving a fairly clear signal that a 5% Bank rate was enough to achieve the desired effect.

When will the Bank know it is at a tipping point, that it has done enough? Ben Broadbent at Goldman Sachs has tracked the experience of the last, 2003-4, rate-raising cycle. Mortgage approvals, then as now, began to weaken about six months after interest rates started to go up.

That is not yet clear in the house-price figures: last week the Halifax reported a 1.1% April rise for an annual rate of 10.9%. But the seeds of a housing slowdown are there, with affordability pressures biting harder after the latest rate rise, and could be reinforced by the introduction of home information packs.

Retailers had a pretty good April, but again there are tentative signs of a slowdown in underlying sales growth, similar to the 2003-4 experience, according to Goldman Sachs. The surprise this time, given the pressures on household finances from rising prices, and the absence of a matching rise in earnings, is that sales have not been even weaker.

Both then and now, interest rates were raised to make inflation converge on the 2% target. Three or four years ago, however, inflation was approaching 2% from below. This time, and we will know more about this with Tuesday’s inflation figures, the direction of travel is from above.

Where there is no parallel, so far at least, is in the behaviour of firms, and in particular pricing power. That is the Bank’s big worry – the combination of a rapidly growing world economy and limited spare capacity at home enabling business to carry on rebuilding its profit margins by pushing up prices.

Leading business groups adopted a “What me, Guv?” approach to this last week, the CBI saying that 5.5% would be enough to contain inflation. The British Retail Consortium went further, even describing last week’s hike as “premature” and insisting that shop prices are barely increasing. The British Chambers of Commerce, in its new economic forecast to be published this week, predicts a pronounced slowdown in the economy but is nonetheless assuming a further rise to 5.75%.

In theory, we should not worry too much about pricing power. If the Bank’s actions reduce the growth of demand, the pattern of the past decade will repeat itself; firms will huff and puff about higher prices but not make them stick. In this case, 5.5% will be enough.

For the moment, though, the Bank will remain on alert. Although it was relaxed about the fact that the governor had to write a letter explaining why inflation rose above 3% it will not want to repeat the experience too often.

To paraphrase Lady Bracknell, to do it once is merely a misfortune, to do it twice would smack of carelessness.

PS: Two things generated a lot of interest from last week’s column. The first was my comment that: “Asset-price inflation may be the price we have had to pay for more general stability, but it has been a price worth paying.” This was not a celebration of the rise in house prices, but merely an indication that the alternative was much worse.

Had interest rates been kept high enough to prevent house prices rising, the result would have been general deflation and economic stagnation. Instead of the success of the past 10 years, we would have had something like Japan’s lost decade. Sharply rising unemployment, far from just containing house prices, could have made them collapse. I cannot think anybody could seriously regard this as preferable to what happened.

On a lighter note, the competition for a suitable piece of music for Gordon Brown brought an enormous response. I have been introduced to songs and poetry I had never heard of, and reintroduced to some old favourites. Taxman and Dear Prudence by the Beatles were popular, but too popular – I’d have had to give away the entire print run of my book – as was Shirley Bassey’s classic Big Spender. Gold and Goldfinger featured heavily, courtesy of the sale of those gold reserves.

A worryingly large number of people, from the chancellor’s perspective, chose Jilted John, which carries the refrain: “Gordon is a moron”. Plenty of others suggested sombre, funereal music. I Will Survive featured heavily, and I can just about imagine him belting it out at a Treasury karaoke night. Brown Sugar and Golden Brown were favourites. Gotta Pick a Pocket or Two, and Money, Money, Money spoke to the rising tax burden. Tired of Waiting and It’s Now or Never described his long vigil outside the door of No 10.

But there has to be a winner. Which song would 4 Poofs and a Piano croon if Brown decides to follow David Cameron onto the Jonathan Ross show? First suggested by Neil Staines, who gets a signed copy of The Dragon and the Elephant, I’m going for Queen’s epic Flash Gordon, which contains the line “king of the impossible”. Brown may need to be, or else his premiership could be over in a flash.

From The Sunday Times, May 13 2007


From where I'm sitting, four rate hikes in 9 months appear to have done very little to slow leading demand-side indicators, but the MPC may have a different view of course. They could also be concerned about the fact that it seems the US is almost certainly going into recession within the next 2 quarters.

Posted by: Minh at May 13, 2007 10:24 AM

To say that the UK could have experienced a Japan-like 'lost decade' is a bit misleading. Japan's bust was a result of over-inflated house prices which then collapsed, helping expose the frailties of the banking system. Japan's deflation has been a symptom of insufficient demand.

It's difficult to argue that the UK has suffered from such a problem. The UK's (and the US's) low inflation episodes have been a product of falling goods prices from Asia - a positive supply 'shock'. Policymakers have clearly prioritized short-term stability in inflation over longer-term stability. By accommodating the supply shock (lowering interest rates to keep inflation on target), we now really do face the possibility of a Japan-type bust.

I know this kind of thing is always easier to detect in hindsight. But C'mon David - quit being a cheerleader for the UK economy and admit the flaws which are obvious to everybody else.

Posted by: Sell Everything at May 13, 2007 03:52 PM

I'm not quite sure you understood the point. What would have happened from the mid-1990s if policy had been geared to preventing house prices rising by more than, say, average earnings? Interest rates would have been substantially higher, growth slower and general inflation would have been negative for significant periods. I'm not saying this did happen, I'm saying what could have happened. If you're familiar with the Japanese story you'll know that the bursting of the bubble economy (shares and commercial property being much more important in that than house prices) was followed by a series of monetary and fiscal policy errors - policy being tightened too soon or kept too tight too long.

I'm not uncritical about the British economy, there are structural weaknesses and competitive shortcomings. But the record on growth, inflation and employment over the past 13-14 years has been the best in very many decades. Indeed, it is hard to identify a more successful sequence. Those who do not recognise this either have no sense of history or are obsessed with just one bit of the economy - the housing market.

Posted by: David Smith at May 13, 2007 08:01 PM

It's too early to judge how bad a housing market collapse will be if it happens. So it's hard to know if the property boom will have been 'worth it' or not.

Although it's fair to say that it's wrong to be obsessed by the housing market, it now accounts for over half our wealth, which is pretty scary. I also think that a great deal of recent general economic success has come from consumer spending, which has been underpinned by the wealth effects of housing.

It would be silly to target house prices as part of policy. However, the housing bubble is excessive and could have been mitigated if: the mistaken switch from rpi(x) to cpi hadn't occured, lending standards for mortgages hadn't been so lax, and fiscal policy hadn't been so loose.

Posted by: labarte at May 14, 2007 12:14 AM

I'm with labarte. It's difficult to look at the UK economy without focussing on housing given its central role over the last decade. It would be like analysing trends in the US in the late 1990s and ignoring the stock market.

I agree there's much we can champion: the successful labour market policies of the Conservative and Labour governments; the drive to open up markets and encourage competition; and, so far, the success of inflation targeting.

I just think it might be complacent to believe we've cracked the problems which have dogged the UK economy for decades (this is where my sense of history comes in...) Policymakers thought they had solved Britain's economic problems in the 1960s with the Phillips curve. The 1970s proved them wrong. They believed the same in the 1980s when they started targeting monetary aggregates. The late 1980s/early 1990s proved them wrong again. It seems to me that we've fallen into the same trap with inflation targeting. Goodhart's law springs to mind:

`Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.'

Targeting inflation in a narrow band might not be sufficient to guarantee broader economic stability. The most obvious reason is that it distorts the relationship between asset prices and other prices. And I'm not alone on this one. There's a growing consensus in the academic community that central bankers should target broader economic stability, rather than simply stability in prices.

Posted by: Sell Everything at May 14, 2007 01:11 PM

The problem with general stability is that it is too vague and means different things to different people. That is why inflation-targeting has been so popular wordwide and is favoured by the vast majority of current and former MPC members. The record in the UK has been better than anybody could reasonably have expected when targeting was introduced. As Mervyn King pointed out recently, the combined growth-inflation performance has gone from being something like the worst in the G7 to the best. Nobody in the 1960s thought they'd cracked Britain's economic problems, hence the ill-fated experiment with economic planning.

A few other points:

1. The switch from RPIX to CPI was, I agree, a mistake, giving rise to thousands of silly comments about fiddled figures. But I can't detect a rate decision that would have been different if the change had not been made. If you can, I'd be interested.

2. Goodhart's law does not really apply. Inflation figures are much more straightforward than the broad money data to which he was referring. The issues about inflation figures are those of coverage and technical construction.

3. Housing is typically half of all household wealth.

4. I agree about loose fiscal policy.

Posted by: David Smith at May 14, 2007 01:51 PM

Hi David

Why do you think Hips will slow the market down? From my prospective, all it will do is at as a restriction on supply, and therefore push prices up.

Posted by: kingofnowhere at May 14, 2007 01:57 PM

Dear David,
Research in progress (I hope to have more on this within the forthcoming months) suggests that switching from RPIX targeting to CPI targetting has made NO difference to the way interest rates are set (we economists/econometricians call this lack of a structural break in the MPC's reaction function).
Fresh research for the US, please see

suggests a stable relationship between M0 and output (which is NOT the case for other measures of money). The research is very useful because it covers some 150 years; this period is long enough to detect a "near" true relationship between money and output. Very unlikely that results would be different for the UK.

Posted by: Costas Milas at May 14, 2007 04:31 PM

Very interesting research.

Re: HIPs - I agree it could go either way, though I don't think activity and prices can go in opposite directions for long.

Posted by: David Smith at May 14, 2007 05:04 PM

As for so many people focusing on house prices, I would say rightfully so. I think a great many people would agree that house prices in this country is a damaging factor that is both economically divisive and socially stagnating. It reduces opportunity for social mobility and is a demotivating factor for people, especially young graduates, wanting to 'work hard and get ahead' yet seeing only a future of high debt and foiled aspirations.

There are other factors besides interest rates in determing house prices though, such as the private sector being allowed to consume swathes of council housing (begun by the Conservatives and continued by New Labour), the lack of housing stock created by the government, the change in the amount financial institutions loan for mortages in ratio to incomes, and more second home owners...By the way, didn't Gordon Brown say something in 1997 like, 'I will not allow house prices to get out of control'?

Posted by: Walt at May 14, 2007 07:07 PM
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