Sunday, February 03, 2008
The world is buoyant but UK rates have to fall
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


Imagine, for a moment, you are a member of the Bank of England’s monetary policy committee (MPC). If you are Mervyn King, the governor, you have been reappointed for a second five-year term, with plenty of time to make good the recent damage to the Bank’s reputation. If you are Andrew “uber-hawk” Sentance, another MPC member, you have also been reappointed. So what do you do?

You start, as the Bank always does, by looking at the global economy. There has been a lot of nonsense talked about world recession, given that we are coming out of a period in which the global economy has enjoyed four years of near-5% annual growth, the best for three-and-a-half decades.

True, America slowed to a crawl in the final quarter of last year, its economy expanding at an annual rate of only 0.6%. Hence the nearest thing you will see in central banking to a red alert: the Federal Reserve cutting US interest rates twice, by a combined 1.25 percentage points, in eight days.

But China, India and other emerging economies are growing rapidly and likely to continue to do so. The most significant thing in China last year was that consumer spending, rather than exports and investment, made the biggest contribution to growth, with retail sales up 17%. The American slowdown will nudge China’s growth down but still leave it at about 10%.

America’s gross domestic product, $13,843 billion, was four times the size of China’s, $3,430 billion, last year. But even on this basis, China’s economic growth of 11.4% made a bigger contribution to the world than America’s 2.2%.

When the numbers are adjusted for relative prices, so-called purchasing power parity, as they should be, China is 45% of the size of the American economy, and 10% of the world. So last year just under a quarter of global growth came from China. This, the year of the Beijing Olympics, will again see the biggest contribution of any country coming from China, notwithstanding the severe winter snows.

Add in India, Opec, Russia and Brazil, and well over half of global growth this year will come from outside the G7. If you are sitting on the MPC, then, you will be reasonably reassured that growth is not collapsing. The International Monetary Fund’s new forecast, of 4.1% global growth this year, is down on last year’s 4.9% but still strong. Between 1998 and 2003, for example, global growth averaged only 3.3% a year.

You would not, however, be too reassured. Just as it is possible to have the wrong kind of snow, it is possible to have the wrong kind of global growth. Britain’s economy is not as tied in to growth in China, India and other booming economies as it should be. The slowdown in America and Europe, with the IMF predicting 2008 growth of 1.5% and 1.6% respectively, will have a significant negative impact, only partly offset by what is happening elsewhere.

What about closer to home? Growth in the final quarter of 2007, 0.6% (actual, not annualised), was close to trend. It is slowing, not collapsing, but will soon be growing below trend.

Mortgage approvals in December, 73,000, were below the lowest point in the 2004-5 housing pause and point to further housing weakness, though the Nationwide reported a fall of only 0.1% in prices in January and thinks it has detected tentative signs that demand may be bottoming out.

Consumers, however, are cautious and so is business. The CBI said January retail trading was the weakest for 15 months. Consumer confidence did not improve as much as it normally does between December and January, and remains weak.

There is a lesson for Britain on the other side of the Atlantic and it is that economic weakness can spread and become cumulative in its impact. The MPC would never want to get into the position in which the Fed has found itself, having to deliver panic rate cuts merely to steady the ship. This reinforces the argument for pre-emptive action.

In circumstances like these, the Bank could normally look down the road to the Treasury for a bit of help. Gordon Brown used to bore on about monetary and fiscal policy operating hand in hand, in a complementary way. No longer.

I have been accused of being too kind to Brown’s chancellorship, though not by Downing Street. On the public finances, however, I have long been critical. Exactly a year ago, I wrote of “Brown’s imprudent tax-and-spend legacy”. Other countries had reduced their budget deficits in the good times but not Britain and, as I put it: “If the economy hits the rocks, the public finances do not look robust enough to take it.”

Those chickens are coming home to roost. The Institute for Fiscal Studies (IFS), in its annual green budget — the real one will be on March 12 — predicts government borrowing will top £40 billion both this year and the following two years. In the absence of at least £8 billion of tax rises, Alistair Darling, the chancellor, will break both the government’s fiscal rules, it said, including the sustainable-investment rule that requires government debt over the cycle to be below 40% of gross domestic product. That, by the way, is excluding Northern Rock.

Governments have raised taxes in difficult times, the classic being Sir Geoffrey Howe’s austerity budget of 1981. The IFS does not think this one will, though it would like to see a nod in the direction of a fiscal tightening. I would argue that Darling has no choice but to let the deficit run above-target and hope for something — the economy and tax receipts — to turn up.

The fact is that there are no shots in the fiscal locker, all of them having been squandered by Brown. The Bank is on its own.

So that means lower rates, and the overwhelmingly expected quarter-point rate cut this week. A bigger cut would look risky at a time when, according to the latest Citigroup-YouGov survey, the public’s inflation expectations for the next 12 months have jumped from 2.7% to 3.3%, buoyed by rising food and energy prices, well above the 2% official target.

Cutting rates is not the “no brainer” for the Bank that it is for the Fed. The “shadow” MPC, which meets under the auspices of the Institute of Economic Affairs, votes only 5-4 for a cut this week, showing there is still a debate to be had. One cutter, Peter Warburton, thinks the Bank should slash by half a point, but the other four were content with a quarter. The non-cutters are concerned about strong money-supply growth, the balance-of-payments deficit, sterling’s fall late last year and the “lax” fiscal background.

There will be some on the actual MPC who agree with these worries, including possibly King and Sentance. Each rate cut in the coming months will be the monetary-policy equivalent of pulling teeth, painful and involving lots of shouting. The Bank has to cut. But it is not the Fed.

PS: Long-suffering readers will know I set great store by my skip index, based on the number of builders’ skips in my street — two indicating the economy is on trend, four a boom, and none that we are in trouble. Despite extensive searching this past couple of weeks, sometimes at night, the index is still firmly on zero. Weak housing and subdued consumer confidence is taking its toll and I don’t suppose the weather is helping.

I must confess, however, to being a little puzzled. Another useful indicator is the weight of traffic on our roads, and passengers using public transport. My recent encounters with both suggest little let-up in activity.

Does this suggest the London economy, at least, is still booming? Or is it the inadequacies of the transport system and the people who run it, Transport for London, including that daily monument to incompetent traffic management known as the Blackwall tunnel?

It is probably a bit of both. I will devote a column soon to the damage transport inadequacies are doing to the economy. Not to make it too London-centric I shall try to widen it, so any observations are welcome. In the meantime, I will keep looking for those skips.

From The Sunday Times, February 3 2008


BoE cannot cut rates without sacrificing the Pound and importing more inflation from Continental Europe. Expect 0.25% cut in February and a long draught thereafter.
Regarding the piece titled Home Economics in today's Times...
David famously said that house prices are "sticky downwards". Well, that is proven not to be the case (Spain, US).
The general misconception by commentators is that weak economic growth and unemployment are necessary triggers for a crash. While "sufficient", these preconditions are not "necessary" in debt -fueled economies like US and UK. The US is a clear example. House prices started to tumble with high GDP growth and unemployment at all time low 4%.
A UK house price crash in 2008 is increasingly certain. BTLetters, who rely on capital gains to achieve acceptable investment returs, are leaving the market. The FTB demand has dried out. The only "strong" fundamental of the UK housing market are planning restrictions. But with public finances becoming more constrained (unable to subsidize tenants and key workers) politicians will understand that high price inflation does more bad than good to society.
Prices to bottom out at -20% in 2010.

Posted by: Michele at February 3, 2008 09:02 AM

The outlook for UK house prices depend, mostly, on the availability of credit. It's hard to make predictions on how long negative price growth is likely to last- who knows how long the credit crunch will go on for? Also expect banks to make losses from reckless lending via credit cards/personal loans. There is a real danger of recession. Domestic AD for goods and services will fall if lines of credit are cut. However, at least the UK's current account position will improve!

Posted by: Nigel Watson at February 3, 2008 09:57 AM

Can the MPC really determine the long term course of interest rates? Or can they merely "smooth out the bumps"? Because, certainly in the US, it seems that the Fed simply follows the free market for 3 month govt debt:

Posted by: Minh at February 3, 2008 10:53 AM

Yes, the Bank can influence the long-term course of interest rates. There is no doubt that the neutral level of rates has come down in recent years as a result of the credibility of inflation targeting. That's why the Bank is concerned that inflation expectations do not become detached too far from the target. On this, I wouldn't be that concerned about the public expectations surveys published by either the Bank itself or Citigroup. They may tell you where expectations are in relation to the recent past, but it was always asking too much to expect expectations to settle on the 2% CPI target, given such widespread scepticism about the CPI.

Michele - you should know by now that there is no mechanical relationship between rate cuts and exchange rates. If the Bank did limit its rate cuts this year to a quarter-point that could be sterling-negative because it would be seen as condemning the UK to even weaker growth. As things stand, the eurozone is heading for weaker growth this year than Britain. I certainly don't regard the euro as a screaming buy.

House prices are sticky downwards, which is why they don't fall as rapidly as, say, financial assets, in spite of big declines in activity. This doesn't mean they never fall, which I've never said. It does mean you need certain conditions in place for a crash. US house prices have fallen but I would not yet call it a price crash, certainly on the OFHEO numbers, which are unlikely to have shown an annual fall in 2007. The Case-Shiller series is more volatile. The latest numbers I saw for Spain had 5.1% house-price inflation for 2007, though prices are plainly down from the peak. You may know better.

Posted by: David Smith at February 3, 2008 11:29 AM

Housing: Surely UK house prices are sticky downwards, even when others are falling, at least partly due to the planning restrictions here. Without resorting to arguments like "we're a small island...we're overcrowded etc" (which is rubbish), the government's attitude to planning needs to be changed. I think US house prices are always going to be more slippery in both directions given the construction time, cost of building materials and the regulatory environment. Over here, i know a number of self-builders going to bizarre lengths to find land with the neccessary planning permission. Since the great depresion nominal UK-wide house prices have only fallen during 2 recessions (correct me), and i don't think this one is going to bite us much. In shallower perspective, in November 2004 Capital Economics along with other reputable commentators predicted a -20% correction in UK housing over the next few years; the market was roughly flat, even whilst the BoE was talking about rate hikes well into April 2005. The housing boom has rewarded so many people for doing nothing, of course the media/analysts will talk up a housing crash, it might get attention. and if/when it doesn't materialise no one will remember.

David: For the column on transport and the economy, surely Birmingham has to be noted. Up until a few years ago congestion in and around the city centre was hardly heard of, even today you can still cut through the centre of town on the A38 without having to stop. But what good did Birmingham's love affair with roads ever do for it? In fact ironically the inner ring road is seen as a barrier to regeneration, since it severs the city centre from the surrounding neighbourhoods.

Posted by: Johnny Blaze at February 3, 2008 03:46 PM argue for a rate cut without referencing inflation at all, apart from where you indicate that inflation expectations are increasing! It seems implicit in your argument therefore that the Bank should target growth, not inflation, and that it should also prop up the housing market (your comments about mortgage approvals).

You mention that the US experience illustrates how quickly things can get out of control, and suggest that the Bank cut rates now to avoid finding itelf in a similar to position to the Fed. Is this finally an admission from you that the UK economy is built on fragile foundations (similar to the US) and needs perpetual tinkering and stimulous to prevent uncomfortable truths from seeing the light of day?

Don't you ever think that we might actually need to allow the economy to rebalance - Slower growth (below trend), higher savings, less borrowing (and therefore lower consumption), falling house prices (revert to trend) etc? How about getting the CPI back down to around 1% again for a sustained period and putting a stop to rising inflation expectations? Nobody believes the CPI anyway (as you admit), so surely you should be arguing for even tighter adherence to the lower end of the CPI target. Isn't it time for thrift to be rewarded and recklessness punished?

Must the economy be stimulated at the first sign of trouble even when growth is still robust, inflation is increasing, debt is at record levels, saving is at record lows, and house prices are still going up on an annualised basis?

Posted by: T Gumbrell at February 3, 2008 06:09 PM

No. There have been long periods since independence when inflation has been below target - in fact it has been much more often below than above on both CPI and RPIX. And I addressed the inflation argument in more detail a week ago.

The way the process works is not that the Bank should choose between targeting growth and targeting inflation. Below trend growth will bear down on inflation. That is what economists describe as the transmission mechanism from interest rates to inflation. The only serious argument against cutting rates now is if you believe the economy is not heading into a period of below-trend growth or if the Bank's own forecasts show inflation remaining above the target at the two-year horizon. Either of those is possible when the MPC sits down this week. But inflation is at the target now, 2.1% (only nitpickers would concern themselves with 0.1 percentage points) , will go higher in the short-term but should then drop back, probably well below the target on unchanged rates. There's also a case, as set out in the remit, for tolerating significantly above-target inflation due to external price shocks.

As for the CPI, those who know what it is understand that it is an accurate measure of inflation excluding housing costs. Those who want a measure including housing costs will look at RPI or, to avoid the interest rate distortion, RPIX. I would not have changed the inflation target, though you can now see the impact of that change on public sector pay settlements.

Posted by: David Smith at February 3, 2008 09:14 PM

Beware of the OFHEO data, it doesn't include any transactions financed by non-conforming loans (i.e. no ARMs, no sub-prime, no Alt-A, no jumbo (over $417k)) and only records sales of single family homes (i.e. no condos). So in other words, it failed to capture most of the boom, and now similarly is failing to capture most of the bust.

Meanwhile there are plenty of foreclosures out there with asking prices of HALF what the outstanding mortgage debt on the house is.

Posted by: Minh at February 3, 2008 11:48 PM

Oh dear. Calling an MPC member like Mr Sentance names just because he is more cautious than you about rates cuts (and doesn't happen to think that a re-emergence of cheap money is necessarily the answer) is a bit juvenile isn't it, Mr Smith? For goodness' sake, just because some people see imported inflation as the primary threat, and do not the same sense of urgency for you to preserve the value of your homely abode is completely sensible.

Sticky downwards? You said that house prices wouldn't drop a few months ago, and you said last year that the US housing market had had a "soft landing" - before their crash even started!

Has the rate cuts in the US done them any good? Not yet, and there's no reason why we should make the same mistake.

Posted by: Jake Hywell at February 4, 2008 08:13 AM

Minh, Yes, I'm aware of what the OFHEO measure is and its limitations, as there are limitations to Case-Shiller. I suspect the truth is somewhere in between.

As for Jake Hywell, I know from your previous inane contributuons that you don't understand these matters at all and probably never will, but two things. One is that "uber-hawk" is an affectionate description for Andrew Sentance, who I've known for years and who is proud of his hawkish reputation. Two, if you had the faintest understanding of monetary policy you'd know there is a lag between changes and their effect. Now do go away and leave the debate for people who do understand.

Posted by: David Smith at February 4, 2008 09:05 AM

If this link works, here is quite a useful paper on the differences between OFHEO and the 10-city Case-Shiller index:

You'll see that the main difference appears to be explained, not by high-end properties, but by low end properties backed by non-conforming loans.

Posted by: David Smith at February 4, 2008 09:39 AM

Just as we have burger-economics we should have IR-economics.

Based on current IR of 5.50% in the UK and comparing it to the rest of the world there must be a direct measure between burger economics and interest rates. ie if prices of burgers are cheap then interest rates have to be high in those countries.

Just as well about IR in the UK which is at 5.5%, which many consider is high, I find that it does improve competition in the short term and brings equitable prices in the medium term, and the case for remaining at 5.5% given the inflation expectations is prudent.

Just as we have survived interest rates of 15% in the past, 5.5% is pretty comfortable to contend with and it just needs business acumen to grow enterprises and jobs which any rate cut will not evolve.

So what has happened is neither monetary nor fiscal, its just a shift in business which we have to contend with.

Posted by: Hitesh Damani at February 4, 2008 04:30 PM

All the above is all good and well. But to a bystander it does feel as if the UK and US economies have been on the equivilent of a credit card binge and have a period of pain looming. The amount of debt is a mind boggling figure and is this a big inflation risk in the medium term? How worried should we be? Is it time to put small punt on gold - or a lot into gold if your view of the world is like T Gumbrells?

It also feels that the economies are a bit of a merry go round - interest rates drop, consumers spend, all looks good, then problems develop, BOE/The Fed increases rates to slow things down, things get worse, stock markets wobble or panic, problems develop, interest rates drop and off we go again.... Is this what we are seeing in the US or is there a fair chance that the rate reductions and Mr Bush's stimulus package will work?

And skips is your skip index not subject to the random walk theory? Or perhaps random drive in your case!

Posted by: Dave B at February 6, 2008 02:44 PM

David, do you think that we have a real credit crunch at the moment? I'm not convinced, banks are still quite willing to lend. I think that some newspapers have seriously over-played the whole story. Surely, if the BofE cut interest rates quickly the result will be a reinflation of the UK's credit bubble. The average person's appetite for debt may not be satisfied yet. If rates fall the total amount of debt owed can be increased because the cost of servicing the debt will fall. There may be a few more years of debt fuelled growth to come. The same is also true for property prices. More credit equals more demand. Higher demand equals higher prices. Interesting times.

Posted by: Nigel Watson at February 6, 2008 11:46 PM