Sunday, January 06, 2008
Fear of falling dominates the outlook
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


How times change. Exactly a year ago the early-January debate was about whether the Bank of England would raise interest rates to cool a rapidly-growing economy. It did. Now the question is whether we will see a two-in-a-row cut this week to boost a sagging economy.

In January 2007 the housing market bears had gone into hibernation. Now they’re enjoying a picnic. Sterling was flavour of the month 12 months ago and about to hit its highest level for more than 20 years. Now it is every forecaster’s fall guy. Oil prices were falling. Now they have hit $100 a barrel.

Let me go through some of the questions raised by these contrasts, say a bit about prospects for 2008 - though you may already have had enough of that kind of thing - and end with this week’s interest rate decision. As always, the only certainty about forecasts is that some of them will be wrong. The hope is that not all of them are.

How weak will the economy be? The plimsoll line in this context is 1.8%. Anything weaker than that (the economy’s growth rate in 2005) would give us the slowest growth since 1992. Anything stronger and this would still rank as a fairly modest slowdown.

Until the credit crisis broke, Britain’s quarterly growth rate was 0.8%. On the basis that quarterly growth is half that rate during this year, the arithmetic implies an annual growth rate of 2%, compared with 2007’s 3.1%, which is what I will go for. Unemployment on this basis may drift higher but not by much, say to 875,000 compared with 813,000 now.

How about inflation? Let me digress a little into both oil and sterling. In both cases, the easiest thing would be to go with the flow and assume that current trends will continue. Oil was one of the stories of last year, virtually doubling in price. If it does so again we would be looking at $200 a barrel this time next year.

At some stage, however, oil has to respond to a weakening of demand growth as a result of a slower-growing global economy, the past four years having seen the strongest run since the early 1970s. At some stage too, extra production will come on stream, even as the switch to alternative energy gathers pace. The Organisation of Petroleum Exporting Countries may also decide that current high prices will damage its long-term interests and raise output. So I think oil will end 2008 lower than it started, possibly substantially so.

As for sterling, its fall in recent weeks has been the product of several factors. It has been caught in the dollar-euro crossfire and hurt by the damage to the Bank and Treasury’s reputations as a result of Northern Rock, together with the government’s wider difficulties. The apparent willingness of the Bank to cut rates more aggressively has contributed, as has the perception that Britain is heading for US-style economic and housing weakness. Then there are the twin deficits, poor public finances and that horrendous £20 billion current account deficit for the third quarter.

Sterling has fallen but it is only a little bit below its average, measured against a basket of currencies, of the past 11 years. It remains well within that generally stable range, roughly 91 to 107 on the Bank’s index.

Though Britain does have a balance of payments problem, the third quarter numbers overstated it, with overseas earnings distorted. This year’s full-year deficit will probably be around £50 billion. The Bank, meanwhile, will not ignore sterling in its rate decisions.

The outlook for sterling is complicated by what happens to the dollar - it may confound people by recovering - but I would be surprised to see a large scale sterling sell-off and would expect its average value, currently just below 97, to remain within the range of recent years.

Where will that leave inflation? The Bank itself expects it to be slightly above target at the end of this year, and it should know, but I think it will be a shade below, say 1.9% on the consumer prices index.

What about house prices? I deal with this in more detail in our Home section and this, clearly, is another bandwagon it would be easy to jump on. The Bank’s latest credit conditions survey showed that lenders had tightened the availability of secured lending in the latest three months and expected to do so further over the next three.

That implies further downward pressure on house prices, though I note the Land Registry had them up 0.6% in November, and by 8.1% on a year earlier. I took some encouragement from the Bank’s survey, however. It showed that the sudden shift in the housing market is overwhelmingly a credit crisis effect, and mainly on the mortgage supply side, rather than a sudden collapse of confidence among buyers. It may be that credit conditions remain very tight all year. More likely is that there will be a gradual thaw as we move into the spring, helped by lower interest rates. My prediction for house prices remains one of stagnation - broadly flat.

So should the Bank start the ball rolling with its 2008 rate cuts this Thursday? A year ago the “shadow” monetary policy committee (SMPC), which meets under the auspices of the Institute of Economic Affairs, voted 5-4 for a January rate hike and the actual committee duly obliged, to the surprise of the markets.

This time the SMPC votes 5-4 again, but this time for a cut. Will it prove to be prescient once more? Among members of the shadow committee, Patrick Minford is again in the vanguard, calling for a half-point reduction. Peter Warburton is another half-pointer calling for a back-to-back cut “to forestall a sharp deceleration in economic activity”.

Tim Congdon, John Greenwood and Kent Matthews all favour a reduction, but only by a quarter of a point. Of the other members, Trevor Williams and Ruth Lea both chose to hold now but with a bias to cut in future. The others, Andrew Lilico and David B.Smith, had no bias either way.

What should the actual MPC do? What will it do? There is clearly an argument for cutting rates this week. As Shakespeare put it: “If it were done when ‘tis done, then ‘twere well it were done quickly.” The economy is slowing, the Bank’s own survey showed that credit conditions have tightened significantly, and there is no doubt that rates are heading lower during 2008. My guess for the end of the year is 4.75%, compared with today’s 5.5%, though some think more aggressive action will be needed.

Bearing in mind the risks of disagreeing with the SMPC, I would be inclined not to cut this week. The three-month interbank rate has come down by nearly a percentage point since the Bank cut last month. Christmas and New Year spending was far from uniformly bad. There is a hint from Incomes Data Services of higher pay settlements, though a similar warning a year ago came to nothing. And, of course, we have had oil at $100 a barrel.

This week’s decision will be close but I would wait until February. That way the Bank can have a fuller look at the data. It might also make the currency markets think twice about regarding sterling as a one-way bet.

PS Finally, the intensely-awaited answers and winners in my Christmas quiz. They are as follows. Q1. Milton Keynes was named after the 20th century’s most distinguished economists, Milton Friedman and John Maynard Keynes. True or false? False. Q2. The Bank of England was founded by a Scot. True or false? True, William Paterson. Q3. The Bank’s monetary policy committee has nine members. What is the smallest number to have voted on an interest-rate decision — five, six, seven or eight? Five, in August 2007. Q4. Alan Greenspan showed youthful prowess on which musical instrument? I allowed both clarinet and saxophone. Q5. Ben Bernanke, his successor at the Federal Reserve, is an expert on which period of American economic history? The great depression. (He also played the saxophone).

Those song lyrics. Q6. “.*.*. there is a barber showing photographs." Penny Lane. Q7. “Our lips shouldn’t touch". Move over darling. On films: Q8. Two Clint Eastwood spaghetti westerns. A Fistful of Dollars and For a Few Dollars More. Q9. A film featuring a bank run starring James Stewart. It’s a Wonderful Life (of course). Q10. A film with Eddie Murphy about commodity traders. Trading Places.

There were plenty of correct entries, and some great tie-breakers, so my attractive young assistant had to draw names out of the hat. The winners of the book prizes are Pauline Chilton, whose suggested new name for Northern Rock was Branson Pickle, and Bob Brown who, perhaps thinking ahead to nationalisation, suggested the Bank of Northern England.

From The Sunday Times, January 6 2008


Alternative thoughts on your sterling comments.

Interesting observation on the distortion in the Q3 current account data. What about the basic balance though which has shown a large deficit in recent years? Does this make sterling very vulnerable to short term capital outflows as the base rate is steadily cut and the positive interest rate differential with the other major currencies is eroded?

Or looked at from a different angle, currency movements have moved in an opposite direction to that predicted by interest rate arbitrage. If the yen carry trade breaks down as the world becomes more risk averse, won't this undermine high yielding currencies like sterling irrespective of the domestiic growth slowdown?

Finally, sterling traded betyween 0.64 to 0.70 against the euro until last year, closly hugging its pre ERM withdrawal mid-point. The breakout to 0.74 already represents a material breakdown in the currency and is consistent with the stronger basic balance in the euro area, as well as the convergence in growth rates.

Posted by: Ian Macfarlane at January 6, 2008 01:06 AM

You make a fair point. Basic balances have not been a great predictor of exchange rate movements in recent years but if capital inflows into the UK are to fade then they will be more influential. My argument is that the markets may have become slightly too convinced of the euro's hard currency status, partly because the ECB is perceived to have done well during the credit crisis and partly because of its unwillingness to cut rates. Some of this perception will unwind, I suspect, as strains in the eurozone economy emerge and pressure on the ECB to cut grows.

Posted by: David Smith at January 6, 2008 11:29 AM

The last cut to 5.5% from 5.75% was only politically motivated. It says a lot about the BOE and its independent and also it says a lot about the fact that the UK it woul;d appear are patantly unable to cope with a historically low rate of 5.75%.

Rates should be higher to curb the debt fest that has ensued since 2001 and should inded not have even been lowered in the aftermath of 9/11. But, there we are hindsight is a wonderful thing...

Posted by: Pete Balchin, Solicitor at January 6, 2008 11:48 PM

Sterling is likely to get flattened over the next two years. The true state of the UK economy is becoming apparent now, and the markets are beginning to price it in. (I've moved all of my assets that weren't already in EURO (most of them) into CHF, silver, and Yen in anticipation of the trouncing.)

The residential property market is now earnestly beginning to follow the commericial market into crash mode. The politically motivated Bank will lower rates to counter this, but it is unlikely to work. Sterling will fall significantly (against a basket) as rates fall. The statisticians at the Bank and treasury will have their work cut out for them as the try to show that inflation is (fictitiously) still constrained. RPI will continue to diverge from CPI. Maybe Gordon will introduce a new 'core' inflation measure to get rid of those inconvenient energy and food price issues! Falling property values will reveal how important rising values were to consumption. Consumption will plummet. The UK will be in recession by 2009. By mid 2008 the sterling exchange rate will fully reflect this reality.


Posted by: T Gumbrell at January 7, 2008 01:06 PM

Not much point commenting on that lot, except that in the scenario you sketch out RPI inflation would fall very sharply, probably dropping below CPI inflation. Maybe that's what you meant by divergence.

Posted by: David Smith at January 7, 2008 02:01 PM

David, what's the distortion on overseas earnings that you mention in your article? From eyeballing the data and reading the ONS's comments, it's not obvious what this is. Thanks.

Posted by: Sell Everything at January 7, 2008 03:02 PM

Your point about the markets taking the euro's hard currency status on board too strongly is well made. I wonder how long we will have to wait for the ECB to lower rates though.

Some members of the Governing Council see inflation has a temporary bump that will be corrected by lower growth. However, the ECB operates on consensus rather than a simple majority vote which almost guarantees they will remain behind the curve. There are a number of issues that could prevent broad agreement emerging in the short- term.

First, the Council seems haunted by fears of second round effects. Second, growth is unevenly spread across the region. Third, the money and credit aggregates have yet to reflect the credit crunch.

So a rate cut may have to wait for inflation to peak and start falling and for growth to drop well below trend across the region. This may only occur later in the year.

On the other hand, the ECB was equally hawkish in 2001 and was cutting rates agggressively 6-months later. Admitedly corporate and household cash flows were in much worse shape then. But the ECB is nothing if not pragmatic, as their response in injecting liquidity at an early stage of the credit crisis demonstrates.

It should make for a volatile time until they do cut rates, though how much of a premium over the fed funds rate can they withstand.

Posted by: Ian Macfarlane at January 7, 2008 03:36 PM

On the balance of payments, it may be no more than a hunch, but I suspect some of the sharp deterioration on the income account in the third quarter reflects immediate credit crisis distortions. The ONS also attributes some of it to the strength of sterling and high UK interest rates, some of which has faded as a factor.

Posted by: David Smith at January 7, 2008 03:45 PM