Sunday, April 27, 2008
Bank walks the inflation tightrope
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


It never rains but it pours. While the credit crunch hangs over the economy like the grim reaper, food prices have jumped to their highest since 1945 and oil came within a whisker of $120 a barrel. Faced with the twin perils of recession and inflation, policy- makers are earning their money.

Tim Bond of Barclays Capital puts it neatly in a paper called "Out of the frying pan". Conditions are slotting into place for a gradual easing of the credit crunch this year, he argues, but this will be followed by a re-acceleration of global growth next year, putting upward pressure on prices. The credit crunch will give way to an "inflationary crunch", he says.

If he is right it does not look pretty. Central bankers would be damned now if they did not respond to the credit crunch, but they will be damned again if, because of that response, they let the inflation cat out of the bag.

Two decades ago, too many interest-rate cuts in response to the October 1987 stock-market crash were partly responsible for the inflation of the late 1980s.
This time, of course, it feels different. The Bank of England's 50 billion (or more) special liquidity scheme will either be seen in the coming months as doing the trick in helping to get markets moving again or a desperate last throw of the dice.

The scheme, which has the backing of lenders large and small, and will have their participation, deserves to succeed, and was not intended as a rescue operation for the banks or the housing market. Rather, if the economy is to come through the credit crunch, money needs to keep flowing and a downward spiral avoided. The Bank is acting as banker to the system.

That was also part of the spirit behind Royal Bank of Scotland's 12 billion rights issue. RBS is not battening down the hatches for recession but ensuring it has the capital base to keep lending flowing for growth. As Sir Fred Goodwin, its beleaguered chief executive, put it: "Were we not to have done the rights issue it could have impacted on our ability to continue doing business at current levels, and that in turn could have made the economy less good, which would in turn make our problems and other people's problems more acute."

How serious is the potential inflationary shock? One curiosity in recent months has been that as economic gloom has deepened with the credit crunch, weakening global-growth prospects, oil and commodity prices have surged.

Sure, the world's population is growing and eating better those who can afford to but we did not discover that over the past six months.

Yes, the global oil supply-demand situation is tight and the producing countries, including Saudi Arabia, no longer seem interested in a stable price. Again, though, that is not new.

So while there are fundamental factors that explain the end of the age of cheap food and energy, the suddenness of the rise in recent months points to a significant financial explanation. Investors have piled in.

Does that mean prices will reverse as quickly as they rose? The International Monetary Fund (IMF) looked at this in its world economic outlook this month and concluded that prices were likely to decline but only modestly, except in the event of a global downturn that spread significantly to emerging economies. Financial flows can, however, change rapidly.

The IMF also ascribed the weak response of oil supply to high prices to the politics of Opec (the Organisation of Petroleum Exporting Countries) and caution by the oil companies in increasing investment because of earlier episodes of very weak prices.

How big a problem are soaring commodity prices for Britain? One of a trio of Bank speakers in recent days, monetary policy committee (MPC) member Tim Besley, who voted against this month's rate cut, noted that "the world does appear to have become a more inflationary place of late".

All countries are experiencing the food and energy effect. Britain's inflation rate, however measured, remains low, including in comparison with the rest of Europe.

Besley's charts demonstrated that the relationship between commodity-price rises and general inflation is much weaker than it used to be. One reason is that the industrialised economies have become less industrial. Another is that tax and processing make up a high proportion of the final price. So, while the crude-oil price has doubled over the past year, petrol has risen by an average of 16% (diesel by a heftier 23%). Food prices, properly measured and weighted by the Office for National Statistics, have risen by 6%.

Another potential inflationary effect, from a weaker pound, was highlighted by Besley's equally hawkish MPC colleague, Andrew Sentance. The Bank, he insisted, had not abandoned sterling, which was still an important element in monetary policy.

The key issues were whether any rise in import prices led to so-called second-round effects on wages, and whether consumer spending remained subdued enough to contain firms' pricing power. The evidence on wages is encouraging, though consumer spending, on the official numbers, is probably too strong for the Bank.

What should we deduce from all this? Taken together with the minutes of the Bank's meeting this month, it is clear the MPC does not think it has lost control of inflation. Those who voted to cut (seven out of nine) were concerned that to not do so could lead to an inflation undershoot in the medium term. Those are not the sentiments of a central bank quietly abandoning its inflation objective.

Besley drew the distinction between previous episodes when commodity booms had spilt over into high inflation and the recent period. Back then, most notably in the 1970s, central banks allowed real (after-inflation) interest rates to turn sharply negative. The US Federal Reserve has negative real rates now but the Bank does not and doesn't want to.

That is why the markets were right to interpret the Bank's announcements and speeches in recent days as signalling a slower pace of rate cuts in future. But rates will fall further, and the first-quarter slowdown confirmed in official figures on Friday made room for them to do so.

Another speech, from the Bank's chief economist, Charlie Bean, talked of walking a tightrope between the credit crunch and inflation. Doing so, there is always a risk you will fall off in either direction. The best way of avoiding this, it seems, is to avoid sudden movements.

PS: How much does media coverage affect the economy? Can we "talk ourselves into recession", as business people often suggest to me?

Coverage of the credit crunch's consequences migrated from the business pages to the front pages some months ago. Whether every reader understands the intricacies, they know something is up. The sense of unease is widespread.

There is a bad-news bias, because that's what sells. But when the IMF talks of the biggest financial shock since the Great Depression, the Bank takes unprecedented action to provide liquidity, and the prime minister and chancellor hold emergency meetings with banks, it is hard to pin all that much blame on the media.

In the end, reality is what matters. If people decide in a few months the gloom was overdone they will respond accordingly in their spending decisions. That happened 10 years ago after the last big financial crisis, when the Asian, Russian and hedge-fund crises came together.

Once people decide it is right to be gloomy, however, that mood can be hard to shift. Long after the economy came out of recession in spring 1992 it was thought to be still in it.

Years into the "miracle" of low inflation and continuous growth, the economy was reported as being in trouble and the government disintegrating. Does any of that sound familiar?

From The Sunday Times, April 27 2008