Sunday, June 15, 2008
Bank should not raise rates over oil
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


The next few days will do much to determine whether prospects for Britain’s economy over the next 12 to 18 months are merely poor, or start to look dreadful.

On Tuesday the May inflation figures will be published and, while these things can never be predicted, are set to show the rate rising above 3%, triggering an open letter from Bank of England governor Mervyn King to Alistair Darling, the chancellor. Inflation on the target measure was 3% in April and should have been pushed above it now by rising food, petrol and utility bills.

The contents of that letter and of the minutes of the June meeting of the Bank’s monetary policy committee — published on Wednesday — will tell us much about whether the money markets are right to expect a series of interest-rate rises in the coming months — which could be the last straw for the economy.

Most economists, in contrast to the markets, have taken the view that the Bank cannot raise rates in the current circumstances. Yes, inflation is high, they concede, but this is due to global commodity and energy price developments. And yes, inflation expectations have risen, but there is no sign of any follow-through into higher wages. The Bank has to hold rates and grit its teeth.

So, if one were to preview the exchange of letters on that basis, King will cite the factors, mainly external, that have pushed inflation higher. He will say the Bank does not take any of this lightly, and is serious about getting inflation back to the 2% target, but it recognises that to try to do so quickly would hit the economy unnecessarily hard. A gradual return to target will be its strategy and, by implication, there will be no nasty upward lurches in interest rates.

Darling, in response, will say he understands the Bank’s difficulties and the factors behind them. He will say, in essence, that the government is happy for the Bank to take its time, which it plainly is. A Treasury research paper, “Global commodities: a long term vision for stable, secure and sustainable global markets”, sets out the factors that have pushed prices higher and will be used by the chancellor and Gordon Brown to try to influence other countries at this weekend’s G8 finance ministers’ meeting in Japan and other upcoming gatherings.

The risk, however, is that King’s tone and the minutes are more hawkish. The Bank’s own figures, released on Thursday, showed a jump in inflation expectations for the next 12 months from 3.3% to 4.3%. Official figures last week had industry’s raw material and fuel costs up by nearly 28% on a year ago, with factory gate prices rising by almost 9%.

The European Central Bank threw a sizeable spanner into the works with its warning 10 days ago that it was likely to raise rates next month, though subsequent guidance that this will be a one-off move calls into question why it chose to cause such a fuss for a quarter-point change in rates.

There is no doubt that central banks are becoming more hawkish. The Bank of Canada surprised the markets by not cutting rates last week. Amid a few green shoots for the American economy, the Federal Reserve seems to have reached the end of its rate-cutting cycle. I don’t expect the Bank to raise rates, but cuts that were expected a few weeks ago now look at best delayed. Until central banks can be confident that the price of oil will fall significantly, they will remain on alert.

There are wider issues to do with oil, some of which I will return to in the coming weeks. Jeff Rubin, chief economist at CIBC (Canadian Imperial Bank of Commerce) Markets, and his colleague Benjamin Tal, in a paper “Will Soaring Transport Costs Reverse Globalization?”, chart the rise in the cost of shipping goods from China to America, up from $3,000 for a container in 2000 to more than $8,000 now.

The initial impact of this is on consumers, raising the cost of goods from China, but long term the impact could be profound. Rubin and Tal describe higher energy prices as “the largest barrier to global trade today”.

Already there is anecdotal evidence that British firms looking at relocating operations to China change their minds when discovering the cost savings are modest and could be eroded by rising transport costs. Some work is even returning to Britain because of these factors. Such examples are rare but worth watching.

A second big issue is whether inflation targets were set at levels that were too ambitious. It is easy to forget how tough, relative to Britain’s past experience, a 2% consumer price inflation target (equivalent to about 2.75% retail price inflation) is.

Low inflation in the past, even in the so-called golden age of the 1950s and 1960s was 3% to 4%. You have to go back a long way, to the inter-war years and the 1870-1914 period, for a run of inflation as low as we have had over the past decade and a half.

This is not a time for abandoning or increasing the inflation target but it is an issue that will have to be addressed if global forces pushing prices higher persist, and achieving the target becomes possible only if the economy is subjected to a permanent squeeze.

The usual caveats about oil apply. The rise of the past few months is reminiscent of the last days of the dotcom boom, as investors scrambled to buy because they believed the world had changed. Everybody associated with the oil market has an axe to grind.

BP, which lent support to the high price last week with its new statistics on world energy, wants to get its hands on more oil. “While resources are not a constraint globally, the resources within reach of private investment by companies like BP are limited,” said chief executive Tony Hayward.

The International Energy Agency, which like most western governments refuses to blame the markets, wants Saudi Arabia and other Opec countries to raise output. Gazprom predicts $250 a barrel and sees oil as an instrument of Russian political power.

It is a paradise for speculators and oil producers. By the time the damaging effects of high prices on demand and economic activity are clear, the speculators will have moved on, like locusts, to cause mayhem elsewhere. If the Bank were to raise interest rates in response to high oil prices, they really would have caused mayhem.

PS: I don’t often return to something quite so quickly but numbers in last week’s column drew such a response I feel obliged to. I reported projections from Ross Walker of Royal Bank of Scotland that real household disposable incomes would grow by 2% this year and 2.2% next, preventing a consumer recession. How come, when average earnings are growing less than the retail prices index and food and energy bills surge ever higher?

It is a good question, so he and I put our heads together. The read-across from average earnings to real incomes is not that close because households have other sources of income, as anybody who fills in a tax return knows.

So at the end of last year, earnings were growing by 3.7% but retail price inflation was 4.1%. Real household incomes, however, were rising by 2.6%. Some of that was due to strongly rising employment; real incomes are an overall figure rather than on a per-capita basis.

Another reason, according to RBS, is that real income growth for much of 2006 and 2007 was squeezed by rising tax and National Insurance. That is not expected this year and next. Inflation should also eventually fall — the retail prices index benefits from falling house prices.

Walker emphasises that his projection is not for very strong real income growth, which has averaged 2.8% over the past 20 years, nor for anything other than a modest rise in consumer spending. The statistics, so far, suggest we are not as squeezed as we feel. That could change, though, notably if the small rise in unemployment turns big and nasty.

From The Sunday Times, June 15 2008