Sunday, August 19, 2007
Swallows in the air
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


From our earliest days in the kindergarten as cub economics reporters, one thing is drummed into us. Don’t get carried away with one month’s figures. One swallow doesn’t make a summer.

It is usually pretty good advice. Official statisticians are skilled at making fools of us all. All too often, something that appears one month to mark the beginning of a cast-iron trend will have reversed itself the following month.

That is the spirit, perhaps, in which we should treat one of the most surprising sets of figures for a while; last week’s inflation numbers. Before they came out analysts saw little prospect for much improvement.

Some were suggesting there would be no return to target this year because of high oil prices and the rising cost of food. Even the Bank of England was uncertain, its latest inflation report this month warning of a “higher profile” for inflation in the near term.

The last time inflation was below target, after all, was as long ago as March last year. Fifteen months of inflation at or above (mainly above) target was hard to take for the Bank and provoked accusations that it had lost control.

Everything was good about last week’s figures. Not only did consumer-price inflation drop from 2.4% to a below-target 1.9% but retail-price inflation fell from 4.4% to 3.8%. RPIX inflation – excluding mortgage-interest payments – dropped from 3.3% to 2.7%. Goods-price inflation fell, from 1.4% to 0.5%; service-sector inflation from 3.7% to 3.5%. Core inflation fell from 2% to 1.7%.

Two things were particularly gratifying. One was that the “DFS effect”, highlighted here, worked as predicted. Furniture stores such as DFS pushed up their prices sharply in June – ahead of the summer sales – only to cut them even more sharply last month.

The other was that there are now serious doubts about the Bank’s big worry; the return of pricing power. Given the power of the supermarkets, their influence on inflation is enormous.

Part of the rise in inflation we have seen over the past year was because the supermarkets stopped competing aggressively on price. They have started doing so again in a big way, on everything from £5 copies of the latest Harry Potter to product-by-product price comparisons on billboards.

The inflation figures reminded us we are still in a low-inflation era in the UK. They reinforced the argument that we might have seen an energy-related inflation blip. They were a riposte to all that harrumphing about the Bank falling down on the job.

But, as I learnt all those years ago, one swallow doesn’t make a summer. Indeed, one worry about the figures was they were almost too good. Will last month’s sharp fall to a below-target 1.9% be followed by a couple of months above the target? The euphoria that greeted last week’s numbers would soon be extinguished and talk of higher rates reignited. A statelier progress towards 2% might have been preferable.

Before dismissing the numbers, however, it is worth remembering that the Bank did, in my view, respond disproportionately to one month’s figures very recently. There is no doubt that when inflation rose to 3.1% in March (as reported in April) and Mervyn King was forced to pen his open letter to the chancellor, a new steeliness began to affect the monetary policy committee (MPC) as criticisms rained down on it from the outside. The only criticism from here, incidentally, was that they were in danger of panicking themselves into a crisis.

After inflation moved into letter-writing range, the MPC’s decision to hike from 5.25% to 5.5% in May was unanimous. Four of its members, including Mervyn King, came back for another hike in June. Having failed then, the governor and his more hawkish colleagues succeeded in getting a rate hike through last month.

Not only that but there are quite a few other swallows around. Pay growth is so subdued as to be almost surreal. Including bonuses, average earnings grew by just 3.3% in the 12 months to June, down from 4.6% as recently as February. Industry’s raw-material and fuel costs last month were up a mere 0.1% on a year earlier, and this was before oil prices dropped back from their recent highs.

Even the MPC’s minutes struck a more dovish tone than expected after its inflation report a week earlier. The committee voted 9-0 for no change in rates and, according to the minutes, “most members emphasised they had no firm view on whether rates would need to rise further”. Armed with this, my conclusion would have been that the case for higher interest rates was so gossamer thin as to be nonexistent.

And that was without something I have not so far mentioned, the turbulence in markets. To be fair to the MPC, they appear to have devoted a lot of attention to “substantial volatility in financial and credit markets”.

There is a precedent here, for those prepared to delve a little into history. In August 1998, the Bank warned in its quarterly report that the inflation risks were on the upside. Two months later it cut interest rates by a quarter of a point, the first in a series, in response to the financial-market crisis – Long Term Capital Management and all that – then raging. The MPC’s vote for a cut was 7-2, by the way, with the two wanting a full half-point reduction.

In the nature of these things, markets that were recently looking for rate hikes will soon be looking for cuts. My strong sense is that this is not a road the Bank and other central banks, including the Fed, want to go down. One reason they have been keen to provide liquidity, or stand ready to do so, is that they see it as a problem that requires a market response, not a monetary-policy response. Hence the Fed cut only its discount rate on Friday. It becomes a monetary-policy problem only if it starts seriously to hit economic growth.

One swallow doesn’t make a summer. But there are quite a few circling overhead just now. Does this mean we can now firmly rule out a hike in Bank rate to 6%? No. Does it make such a move unlikely? Yes. As for cuts, let’s see how the market crisis pans out.

PS Two weeks ago I offered a chance to beat the Treasury mandarins. The exercise came from Michael Blastland and Andrew Dilnot’s new book The Tiger That Isn’t (Profile Books), and the only assistance was to say the correct answers might lie outside the range given.

Here are the questions: Q1. What share of income tax is paid by the top 1% of earners? a) 5%; b) 8%; c) 11%; d) 14%; e) 17%. Q2. What posttax joint income would a childless couple need to be in the top 10% of earners? a) £35,000; b) £50,000; c) £65,000; d) £80,000; e) £100,000. Q3. How much bigger is the UK economy (inflation-adjusted national income) than in 1948? a) 50%; b)100%; c) 150%; d) 200%; e) 250%. For Q1, a mere 19% of officials answered e), 17%, the closest to the correct answer of 21. I knew that. But Q2, I have to say, surprised me, I would have gone for £50,000 but the right answer is £35,000. Only 10% of officials got it right; 48% agreed with me, but 21% thought £65,000, 19% £80,000 and 3% £100,000. Let’s hope they are not in charge of tax policy.

The third was an easy one. Roughly speaking, the economy doubles in size in real terms every 25 years, so the correct answer was about 300%, and 250% merited a mark. But only 3% of officials knew that; 10% said the economy was only 50% bigger; 25% went for 100%; 42% chose 150% and 17% thought 200%.

So who outsmarted the mandarins? The field for this quiz was a bit smaller than those I’ve done on noneconomic matters, which could be the August effect or could tell you where the interest of readers really lies. But Rohan Da Silva was a clear winner, getting all three right. Geoff Hope-Terry was one of a number who got two out of three – like me he went for £50,000 for the second question. I liked his tie-breaker: Treasury officials are called mandarins because they speak a different language to the rest of us. They both win copies of the book.

From The Sunday Times, August 19 2007


Recorded inflation will stay below target has too.

Interest rates have to be cut to prevent a financial melt down. If interest rates fall repossessions will fall again. Those that have lent recklessly will be off the hook. CDO's will become profitable to buy again. Who gives a damm about moral hazard. The credit bubble will be reflated

Posted by: Nigel Watson at August 19, 2007 10:56 AM

On interest rates, i think Mervyn King is well and truly into Maradonna territory - signalling moves sincerely where there are in fact none to be made. Speaking at the inflation report he clearly indicated another hike was a necessary evil, whilst knowing that we would read his real thoughts in the minutes. In this case we should surely believe what we read in the minutes (ideas expressed amongts esteemed colleagues) over what he says in public.

Also, is this a good time to bury bad economic news, (Darling)? China's more aggressive stance on its use & potential abuse of US Treasuries certainly didn't get enough attention. As central banks ECB, BoJ (on/off) and the Fed were busy pumping liquidity back into their money markets, why was the PBoC draining liquidity out?

As if there weren't enough idiots still in the markets (Jim Cramer included) offering duff analysis, the BBC and Daily Hate rush to our assistance, the BBC's coverage lacks consistency, calling an end to volatility after Friday's moves. I couldn't get a hold of an FT anywhere on friday morning, so i just went for Andrex like normal people.

Posted by: Johnny Blaze at August 19, 2007 01:36 PM

Just browsing the internet, your blog is very, very interesting.

Posted by: Freddie Sirmans at August 20, 2007 10:47 PM

It looks like monetary policy is being decided far more by the markets than by the MPC.

Money supply was inflated by loose lending criteria which grew from misguided credit rating policies.
Whilst a monetary tightening will probably now be triggered by the markets realization that maybe they have been mistaken and over loosened.

The MPC (in conjunction with other central banks) is probably able to keep an even course in the longer term. But the financial establishment seems able to cause large deviations in the short term.

The central banks could reduce these perturbations by enforcing the greater transparency that they espouse in these very institutions.
Thereby improving their effectiveness.

Posted by: Nick Thorne at August 20, 2007 11:16 PM

Swallow in the air ?
OR Gallows in the air !

Dear David,

Statistics tell us what has happened and what is happening, doesnt explain.....WHY.
Sentiment on the other hand, is understood by everyone and acted upon by everyone.
The current unwinding of high risk credit derivatives is not irrational, it is based on collective sentiment that that class of asset has just become too hot to touch.
A return to fundamentals after speculative booms is not instigated by any one factor it just starts by a change in perception of risk.

Best Wishes

Arik Schickendantz

Cash is ready to be crowned.....K..G !

Posted by: arik schcikendantz at August 21, 2007 03:40 PM

I think that the recent strength of the pound has helped keep inflation down. I think this is a blip and that there will be further increases above 2% inflation over the next few months. Effectively inflation will continue to rise until interest rates are raised enough to plunge the economy into recession.

BTW what's your latest prediction on oil prices? Still apparently heading for $40 a barrel? It must be around two years since you made that prediction 2 years in which oil production has reached a plateau globally and fallen in the UK, Mexico and even Saudi Arabia?

I think we may reach a low of $60 US a barrel this winter, but no lower. What's your prediction?

Posted by: Alex A at August 22, 2007 06:30 PM

No, that doesn't work. The sterling index is roughly where it was this time last year and lower than at the start of the year. If you're talking about sterling's rise against the dollar, that was too recent to affect consumer price inflation.

As for oil, the argument was more sophisticated than you appear to have understood. We've never had a sustained period of oil prices above $40 a barrel - in 2006 dollars - in history, so the question was how long this one would last. As I explained recently - "OPEC still has us over a barrel" - prices have been kept high by the great strength of the global economy, enjoying its best run since the late 1960s/early 1970s and by OPEC's price-supporting production cuts. When either or both change, prices will come down significantly, not before. We got below $50 last winter before traders realised OPEC meant business and the US economy wasn't going to slow.

Posted by: David Smith at August 22, 2007 11:14 PM


Re: "OPEC still has us over a barrel"

But this was historically not the case - this is a new paradigm. OPEC historically never had us over a barrel since the North Sea came on. But falling production in the North Sea, Mexico etc., together with rising demand in India and China has allowed them effectively be able to control the price. I believe there is a worldwide change in the mindset of oil exporting countries. Rather than attempt to maximise production they will be looking to maximise profits from their exports of what is a tremendously valuable resource. Any fall in demand will be met with further supply cuts.

BTW when is your prediction for peak oil? It doesn't appear far off to me. Dave Cohen from

"I don't know if the current plateau is the peak of world production, but if my calculations are correct — including both geological and aboveground factors — then it is not possible for the world to get much above the May, 2005 EIA peak of 85.277 million b/d. Right now, the 5-month average for 2007 is 84.171. So, we need to make up 1.106 just to get back to that level. If non-OPEC supply grows as I expect, and assuming OPEC does nothing, I think we can beat that peak in 2009 by about 0.5 million b/d. But it would definitely be all downhill after that for production outside of OPEC. This depends on the natural gas liquids production, which I am tracking. With OPEC, we can divide that organization into 3 parts.

Persian Gulf (excluding Iraq)
The "OPEC 6" (North, West Africa, Venezuela, Indonesia)
Forget #2 — Iraq is doomed forever as far as we care. The "OPEC 6" looks like it can't grow much, with Algeria and Angola on the plus side, Venezuela and Indonesia on the minus side, and Nigeria blowing itself up all the time. Colonel Chavez is a disaster.

So that leaves #1, the Persian Gulf. Can they increase production? Will they increase production? I suspect that nothing much will happen until non-OPEC supply stops growing, which I anticipate, as I said, to be about 2009. At that point, any growth would have to come from the Persian Gulf. My non-OPEC supply forecast, which is 0.5 million b/d per year for this year and the next two, may be optimistic. We shall see.

As for other liquids, biofuels will disappoint unless there is a cellulosic ethanol breakthrough. Even if there were, it would take a lot of time to get that going. Also, I think the Canadian tar sands production will grow, but at a slower rate than operators there expect.

And I haven't even touched on the demand side, which is more risky than the supply side at this point. The price signal will not be strong enough. "

Posted by: Alex A at August 25, 2007 08:20 AM

If you think that OPEC has never exerted control over oil prices, that is a strange interpretation of history, particularly in the 1970s and early 1980s. The North Sea was important, but small in both production and reserves in relation to OPEC. OPEC is exerting control again for the same reasons as in the past - it has most of the world's oil reserves and it has rediscovered some discipline.

I don't think we're in sight of peak oil. Some people appear to think this is a question simply of geology whereas it is, of course, an economic question too - the higher the oil price the more that what were marginal reserves come into play. If current production levels represent the peak, the International Energy Agency, for one, has got it badly wrong. This was its prediction in November last year in the annual World Energy Outlook:

"In a Reference Scenario, which provides a baseline vision of how energy markets are likely to evolve without new government measures to alter underlying energy trends, global primary energy demand increases by 53% between now and 2030. Over 70% of this increase comes from developing countries, led by China and India. Imports of oil and gas in the OECD and developing Asia grow even faster than demand. World oil demand reaches 116 mb/d in 2030, up from 84 mb/d in 2005. Most of the increase in oil supply is met by a small number of major OPEC producers; non-OPEC conventional crude oil output peaks by the middle of the next decade."

Posted by: David Smith at September 2, 2007 04:18 PM


There is a difference betweeen "exerting influence" and having us "over a barrel". To clarify my argument we appear to be reaching a cross-over point where the OECD countries are now producing less than OPEC.

"OPEC is exerting control again for the same reasons as in the past - it has most of the world's oil reserves and it has rediscovered some discipline"

This discipline is mighty easy to rediscover if you find you can, like Saudia Arabia, reduce your own production, find prices responding and no other supplier able to take your place. Then finding willing Asian buyers at almost all time nominal high prices and observing that North Sea and Mexican production continue their relentless decline.

And of course the high price of oil has resulted in booming conditions in the major oil exporting countries - increased domestic consumption leads to even faster falling exports than production is falling.

I think the IEA have got it badly wrong:
"To correct for earlier over-optimistic forecasts, the International Energy Agency (IEA) has reduced its estimates for non-OPEC oil production by 410 kb/d from second quarter 2007 onwards. This change has been little noticed in the press.

According to the July 13 issue of the IEA's Oil Market Report, the original non-OPEC forecasts for 2005 and 2006 proved over-optimistic to the tune of 1.0 mb/d. This discrepancy is mostly due to decreasing OECD production. Moreover, OECD supply has consistently come in below initial forecasts for the past ten years."

If you want to get your forecasts right I suggest you spend some more time reading some more independent minded people such as Dave Cohen:

and also reading some of more well considered articles on

rather than endlessly practice your no-doubt beautiful joined up writing!

Posted by: Alex A at September 3, 2007 10:37 PM

I'm very familiar with the peak oil debate - and have been for many years - having first read and been fascinated by M. King Hubbert's classic 1956 article about a quarter of a century ago. What I also know is that the peak oil school has consistently predicted that we are there, and consistently been wrong, over a number of years, first predicting global peak oil in 1990, in line with Hubbert's orginal prediction, and then at various points since. I suspect you are younger than I am, and have not been through the various peak oil scares. I don't have any axe to grind on this one, unlike most people who get involved in this debate. I just believe, having looked at it, that we are still some decades away from peak oil. The arguments on the OilDrum, in Twilight in the Desert, and elsewhere, are no more convincing than those I was hearing a couple of decades ago.

Posted by: David Smith at September 4, 2007 10:04 AM