Sunday, May 18, 2008
World events make the Bank impotent
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


Sombre there is no other word for it. One good measure of the seriousness of the economic situation is that the Bank of England governor has stopped making jokes. Gone are the quips about disco dancing or the true meaning of Christmas not being clear until Easter (as far as retail sales statistics are concerned).

As he moves into his second term, King confesses to waking up each morning worrying about the banking system. He is aware the last thing a miserable, put-upon public wants at this stage is a laugh-a-minute central banker. Long faces are this season's look at Threadneedle Street.

Mind you, there must have been one or two smiles behind closed doors after more than one daily paper chose to lead last week on the governor's declaration that the "nice" decade was over.

Mine and the Bank's recollection is that he first declared the nice decade over in October 2004, did so again in October 2006 and has been doing so at regular intervals since. You might ask how nasty it has to get before people decide things are no longer nice.

As some readers will be aware, "nice" has a special meaning for the governor. To economists, nice stands for "non-inflationary, consistently expansionary". It describes, in other words, the period we have been through of very low inflation and continuous economic growth.

Unlike many in financial markets who are convinced that we are seeing the return of inflation in a big way, I am not persuaded we have broken out of the long run of low inflation. A 3% inflation rate on the consumer prices index (CPI) is not high in the context of a doubling of oil prices in a year and a surge in other commodity prices. Retail price inflation of 4.2% is remark- ably low in these circumstances.

Even if both rise by a percentage point or so, we will have escaped a potentially damaging inflationary shock very lightly. The Bank's remit allows for larger deviations than this from the 2% CPI target because of "external events and temporary difficulties", which is why 1% to 3% is not a target range, though falling outside it calls for the governor to write a letter of explanation.

The trouble is we have got used to extremely low and very stable inflation; the longest run of low and stable inflation in the post-war period. And this, of course, is what the Bank is judged on. The letters the governor expects to write in the coming months (he has to write one every three months if CPI inflation stays above 3%) will be seen as a failure.

There is another reason why the mood is sombre. After more than a decade in which the Bank and its monetary policy committee (MPC) have come to be seen as the masters of the economic universe, we now see its powers are limited to the point of impotence.

The first area of impotence is interest rates. What we are seeing is not, in the main, an interest-rate shock, but the fact is that three- month Libor (the London interbank offered rate), the most important rate in the economy, is about 5.8%, while Bank rate is 5%. Libor is closer to where it should be if Bank rate was 5.75%, the level reached before the MPC started cutting last year.

The picture on mortgage rates is more varied. A two-year fixed rate, 95% loan-to-value, is up from 6.33% to 6.94% since July last year, while a similar 75% loan-to- value mortgage is almost unchanged at 6.08%. The average standard variable rate is down from 7.44% to 7.24%, the average tracker from 6.22% to 5.97%.

But the normal pass-through from rate cuts is not happening, and in many cases official rate cuts have been meaningless for borrowers; the opposite has occurred for them. The Bank has also been powerless to prevent a sharp drop in credit availability at all rates, even if it had wanted to.

The second area of impotence relates to global commodity and energy prices. "Core" inflation in Britain, excluding food and energy, is running at 1.4%. Without the impact of higher global food and energy prices the Bank would be in danger of writing a letter explaining why inflation had dropped below 1%.

To be fair to King, he takes this one on the chin. He knows that for much of the "nice" decade the international inflation backdrop was favourable but the Bank got the credit for delivering low inflation. He knows he cannot lay the blame for everything on international events, as Gordon Brown does. King insists the Bank's job is to deliver low inflation whatever the global circumstances, though to try to do so immediately at present would inflict unnecessary pain.

But the influence of global events means things can change quickly. The inflation picture changed substantially over the past three months and can do so again over the next three or six, in either direction. Headlines about "no rate cuts until 2010" are not sensible.

The final area of impotence concerns sterling. The pound's 14% average fall since January last year more against the euro broke the long run of strength that had accompanied the entire independence era since May 1997.

You can argue that the Bank has brought about sterling's fall by cutting interest rates while the European Central Bank held steady, though calculations in the Bank's inflation report last week suggest this does not explain much of the fall.

You can argue that the Bank is also culpable for its part in the Northern Rock fiasco, which undermined international confi- dence in the British economy and sterling. Some currency dealers have been looking for an excuse to sell the pound for some time and the prospect of Britain catching a cold from America offered it.

There are other explanations. Sterling was a big beneficiary of M&A (merger and acquisition) flows in the first half of last year. When these stopped abruptly, the pound lost one of its means of support.

The truth is nobody knows, and the Bank can't do much about it. Raising interest rates might send sterling lower still. Sterling's fall helps to rebalance the economy but fuels inflation through higher import prices. The Bank is powerless. No wonder the mood is sombre.

PS: Now I have reminded you of the meaning of "nice", let me offer clarification on a more esoteric matter, the fiscal rules. Alistair Darling's 2.7 billion tax giveaway last week would have been astonishing in any circumstances; the biggest tax cut since the pre-election budget of 2001. If the weakened Brown government is prepared to give this much away before a by-election, think what might happen before a general election.

It was more astonishing, of course, because only weeks ago the chancellor's cupboard was bare and his March budget raised taxes, mostly from next year on from drinkers and drivers. Even then, the Institute for Fiscal Studies (IFS) said the government risked breaking at least one of its fiscal rules.

So 2.7 billion was money the chancellor did not have, whatever the merits of cutting taxes. Does it guarantee the rules will be broken? The two rules, to remind you, are the golden rule: "Over the economic cycle the government will borrow only to invest and not to fund current spending." And the sustainable investment rule: "Public- sector net debt as a proportion of gross domestic product will be held over the economic cycle at a stable and prudent level."

That level is 40% and the Treasury says it must be below that "each and every year" to meet the rule with confidence. The Rock could have bust it but the Treasury pleaded special circumstances. Surely it will be busted by the 2.7 billion, which cannot realistically be clawed back next year?

Perhaps not. Robert Chote, IFS director, points out that the Office for National Statistics is in the process of revising the GDP figures, partly to better account for financial services ("financial intermediation services indirectly measured" in the jargon). An upward revision of GDP might allow debt to stay below the 40% ceiling. But we would all know the rules had been bent again.

From The Sunday Times, May 18 2008