January 2008 Archives
Wednesday, January 30, 2008
Fed cuts to 3% - probably more to come
Posted by David Smith at 07:30 PM
Category: Thoughts and responses

The Federal Reserve lowered interest rates for the second week in succession, cutting the Fed Funds rate by half a point to 3%. Its warning of "downside risks" came after official figures showed annualised growth of just 0.6% in the final quarter of 2007. The Fed's statement:

The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 3 percent.

Financial markets remain under considerable stress, and credit has tightened further for some businesses and households. Moreover, recent information indicates a deepening of the housing contraction as well as some softening in labor markets.

The Committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully.

Today's policy action, combined with those taken earlier, should help to promote moderate growth over time and to mitigate the risks to economic activity. However, downside risks to growth remain. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh. Voting against was Richard W. Fisher, who preferred no change in the target for the federal funds rate at this meeting.

In a related action, the Board of Governors unanimously approved a 50-basis-point decrease in the discount rate to 3 1/2 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Philadelphia, Cleveland, Atlanta, Chicago, St. Louis, Kansas City and San Francisco.

Another five years for Mervyn King
Posted by David Smith at 10:00 AM
Category: Thoughts and responses

Mervyn King has been reappointed Bank of England governor for a second five-year term, which was surely the only sensible option. This is the statement:

Her Majesty the Queen has been pleased to approve, under the Bank of England Act 1998, that Mervyn King be re-appointed Governor of the Bank of England for a period of five years when his present term of office expires on 30 June 2008.

Welcoming the re-appointment the Chancellor said:

“I am delighted that Mervyn King has been appointed as the Governor of the Bank of England for a further five year term. He has played a key role in delivering macroeconomic stability in the UK, and his leadership and experience will continue to prove invaluable to the Bank of England."

Among the things King has to cope with is the weakness of the housing market. Mortgage approvals fell to 73,000 last month, down from 81,000 in November, and weaker than the 2004-5 low-point.

Tuesday, January 29, 2008
Ammunition for CPI-doubters
Posted by David Smith at 10:00 AM
Category: Thoughts and responses

Those who do not like the consumer prices index, the government's target inflation measures - and they include public sector workers (and MPs) now having their pay settled by it - have plenty of ammunition in the ONS's review of 50 years of household spending. It shows the rise in the proportion of household spending on housing, included in the RPI but not, of course, the CPI. Mind you, food has declined in importance. Details here.

Sunday, January 27, 2008
Bank should cut, but not panic
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

This is a longer version of the piece that appears in the Sunday Times, and with a headline that better reflects the theme.

Who would be a central banker? The salary isn’t great by City slicker standards; the pension is pretty good, though probably not good enough to compensate for the ordure rained down on you while in office.

So Ben Bernanke, Mervyn King’s old office neighbour when they were both academics, has been attacked for panicking in response to the global stock-market sell-off and for allowing Wall Street to dictate the Federal Reserve’s monetary policy.

People have different views on this – I happen to think the action was right, following the Fed chairman’s gloomier assessment of America’s economic prospects even before Blackish Monday. But the execution of the three-quarter-point cut, the biggest since 1982, was clumsy.

Here, King has finally got what he did not wish for but has long predicted. After five years of independence he warned that the challenges for the Bank were likely to get much tougher. After 10 years, and his first open letter to the chancellor explaining why inflation had gone too much above target, he repeated that warning. He was more right the second time.

What are we to make of the governor’s admission last week that the Bank has “little control over the strength of the economic winds buffeting our economy” and that those winds are likely to continue blowing through 2008?

Does the fact that King is open to the possibility that he may have to write another letter to the chancellor mean that interest-rate cuts are off the agenda? After all, the monetary policy committee (MPC) voted 8-1 this month to leave Bank rate on hold at 5.5%.

The answer, I think, reading between the lines of both King's speech in Bristol and one by Sir John Gieve, joint deputy governor, a few days earlier, is that this was not the message. When, in April last year, that first open letter was written, the Bank was widely attacked for falling down on the job. There is no doubt that this was a scarring experience that contributed to a mood of hawkishness on the MPC.

So the Bank is getting its excuses in first, recognising that there are upward pressures on inflation but attributing them to global developments. These are precisely the circumstances where, according to its independence remit, it can allow inflation to run above target for a period.

The remit says: “The framework takes into account the fact that any economy at some point can suffer from external events or temporary difficulties, often beyond its control. The framework is based on the recognition that the actual inflation rate will on occasions depart from its target.”

Trying to keep inflation at 2% now would squeeze the economy too hard at a time when, according to King, a 5.5% Bank rate is already “probably bearing down on demand”. So there will be rate cuts, and they will be the right thing to do, despite the inevitable chorus there will be from the hair-shirt brigade. They should start with a quarter-point early next month.

Slower global growth, and slower growth in Britain, will mean the rise in inflation is temporary. It is too early to put out the flags but global economic worries mean oil's sojourn above $100 a barrel did not last, though it needs to fall $30-40, not just $10-15. Whether it will with markets as capricious as they have been recently remains to be seen.

How low should UK rates go? My start-of-year prediction was 4.75% this year and I am inclined to stick to that. King distanced himself from Bernanke-style dramatic gestures but plainly did not rule out lower rates, though if does have to write a letter or two (I think he probably won't), he will need all his literary skills.

The hardest thing for the Bank is not whether it should cut rates, but how to justify doing so to people not familiar with the remit or with the forces of slowdown and temporary inflation it is trying to balance.

But though it will be hard, particularly when you have to get past the hair-shirters, it is not as difficult as it looks. Most people know instinctively that many retailers are cutting prices and that petrol-price rises reflect international developments. The end of house-price inflation also makes life easier; there is no doubt that higher mortgage costs have pushed up the public's expectations of inflation.

So the situation is challenging but manageable. And if King is right that at the end of it we will have an economy with higher savings and less dependency on the consumer, nobody – perhaps apart from the retailers – will complain too much.

Finally, what should we make of the warning from George Soros, courtesy of the BBC's Today programme, that both the US and UK companies are heading into recession? Not a lot. The man who brought down the pound in 1992 has a habit of popping up like the ghost at the feast. His recent contributions to the economic and financial debate have not, however, been noteworthy, clouded as they have been by his yearning to see George W Bush out of the White House.

Predicting a US recession has become almost de rigeur, as we have seen in recent days in Davos, although even there the debate has been dominated by the serial gloomsters. Britain, however, is a long way from recession, growth in the fourth quarter being 0.6%, close to trend.

A big slowdown will occur, and it will be touch and go whether this is the weakest year since 1992, as well as the most challenging for the Bank since independence in 1997. But it need not be more serious than that. Provided, of course, that King and his colleagues show intelligence and flexibility.

From The Sunday Times, January 27 2008

Criminals, rats and teens - all surprisingly rational
Posted by David Smith at 08:59 AM
Category: David Smith's other articles


An interview with Tim Harford about his new book, The Logic of Life, which you can buy here.

Tim Harford, despite his jacket, jeans and baseball boots, still looks like the Oxford economics tutor he used to be. But now he has become a bestselling author, and he has done it by applying the economics he used to teach his students to real life.

The Undercover Economist, his first book, sold 600,000 copies worldwide, 160,000 of them in Britain. Books based on economics are not supposed to sell that well, let alone be prominently displayed on the bestseller racks by WH Smith. Were it not for Freakonomics, by the American economists Stephen Dubner and Steven Levitt, which has sold an extraordinary 3m copies, Harford’s achievement would be even more outstanding.

His second book, The Logic of Life, is published next week by Little, Brown. Harford is one of life’s nice guys, so it is a bit of a shock to open the new book and go straight into oral sex, apparently the rational choice of American teenagers worried about Aids or abortion. But like its predecessor it is never short of interest.

Harford cites research showing that laboratory rats make a rational choice between quinine water, which they don’t like, and root beer, which they do. If the quinine water is cheaper than the root beer – they are allowed more of it for every press of the lever in the cage (and they are permitted only a limited number of presses) – they drink more of it to quench their thirst. The rats, in fact, also prove one of the most elusive theories in economics, the idea of the Giffen good, named after the British statistician and economist Robert Giffen.

He said there were certain goods that broke the normal rules of economics – when their price went up, people consumed more of them. For years, the only known example came from the Irish potato famine. As potato prices rose, the Irish chose to consume more of them, and less of the more expensive meat, because they needed to maintain their food intake. In the end, of course, there were not enough potatoes. In the laboratory example, the price of quinine water was gradually raised but remained below that of root beer. True to Giffen’s hypothesis, the rats consumed more of the water despite the price rise, and less of the beer.

People will debate whether all of Harford’s many examples of humans being driven by rational choice work as well as that. I was undecided whether Chris “Jesus” Ferguson, a weedy academic, became world poker champion in Las Vegas because he followed the rules of game theory, a branch of rational choice, or because he simply learnt from experience how to become a good poker player. But the story is almost too good not to be true.

Above all, the idea that we are mainly driven by rational choice, whether we are aware of it or not, is an alluring one. Harford makes clear he is not talking about the rational economic man of the textbooks, the cold calculating machine driven only by financial incentives. Rational choices can be noneconomic in nature, as with the sexual habits of American teenagers.

As he puts it: “I hope to convince you that people are rational nearly enough and often enough to make the assumption of rational choice a useful one.” Mostly, he does.

His examples work because they are realistic and because academic researchers have begun to delve into areas that are interesting and fun. They have proved, for example, that men and women in speed-dating sessions raise or lower their sights according to the quality of the field, so the number of actual dates that result remains constant. Anybody who has been to a college disco knows the phenomenon. There are plenty more such fun examples.

That does not mean Harford’s task has been an easy one. Academic papers can be extremely opaque and difficult to decipher. He usually gets around that by ringing up the authors, most of whom are happy to explain their research in more straightforward terms.

He wrote his first book after leaving Oxford for Shell, the oil giant, where he met his wife. Harford negotiated a couple of mornings off a week to write, putting all the economics he knew into a book for the general reader.

Nobody wanted to publish it at first, but it was taken up by the American arm of Oxford University Press in November 2005, a few months after Freakonomics hit the shelves. Publishers had begun to realise popular economics could sell. Six months later it was published in Britain.

The Logic of Life is in many ways a better book. There is a common thread – rational choice – running through it. It is what film-makers would recognise as a bigger-budget production; or at least Harford was able to use the success of his first book to gain access to people who might not have given him houseroom before.

Thus he sees at first hand the Nobel prize-winning economist Gary Becker putting his own rational-choice theories into practice. Harford turned up by appointment at Becker’s Chicago home and the professor, now in his seventies, drove them to a restaurant, where he proceeded to park in a bay with a 30-minute time limit.

The bays were not checked too often, he told Harford, so it was worth taking the risk of getting a fine against the convenience of parking. He did it all the time – sometimes he got fined, but most times he did not. He was making a rational choice on the basis of the potential cost of getting caught and the benefits of easy parking.

This was exactly what Becker says all criminals do, in the work for which he won his Nobel prize. The tougher the penalty, the greater the cost of getting caught, and the rational choice may be not to risk it.

The case has since been proved by Levitt, of Freakonomics fame, who examined juvenile crime rates by age in different US states against the age at which offenders become subject to the adult courts and thus harsher penalties. Juvenile crime rates continued to rise until the age at which offenders became exposed to adult levels of punishment.

And, sure enough, there was no ticket on Becker’s car when they emerged from the restaurant well over 30 minutes later.

Harford has at least two more books in the pipeline, one of which has the working title of An Idiot’s Guide to Saving the World. In the meantime he continues to write the “Dear Economist” problem page for the Financial Times while travelling the world in search of more of the research-based insights that fascinate him – a lifestyle that is, you might say, an entirely rational choice.

From The Sunday Times, January 27 2008

Will migrants avoid downturn Britain?
Posted by David Smith at 08:59 AM
Category: David Smith's other articles


The stock market, which has given us so much excitement, is very important and has implications for interest rates, as I report elsewhere. But so is the job market. How will it fare in what Mervyn King, governor of the Bank of England, described last week as the most testing set of economic circumstances in 10 years of Bank independence?

One fear is that economic weakness will lead to further problems for the banks. Another is that it will push up unemployment.

So much depends on the job market. If it cracks, the downturn in consumer spending will be even greater. The housing market, having lost one supporting pillar with sharply reduced mortgage availability, would lose its biggest remaining source of support if employment were to tumble.

There is another important test for the job market. Gordon Brown has promised “British jobs for British workers”. Official figures suggest that as many as four-fifths of the jobs created since 1997 have gone to foreign-born workers.

The question is whether migration will be a flexible friend for the economy. As it slows and job opportunities dwindle, will the flow of workers to Britain fade? Or will the migrants continue to arrive, adding to unemployment?

The first thing to say is that, if a cold front is on the way for jobs, it has yet to arrive. True, there have been some gloomy surveys and forecasts for 2008 and there have been one or two announcements from firms about job losses.

The employment numbers, however, remain strong. The latest figures cover the three months to November, when some of the effects of the credit crisis will have begun to be felt, and show a surge in employment of 175,000 to a new record of 29.4m. Employment over the year was up by 263,000.

The number of jobs in the economy, a bigger total than the employment figure because some people have more than one, stood at 31.6m, up 287,000 on a year earlier. Pretty well all measures, in fact, pointed to job-market strength. Vacancies in the final quarter of 2007 rose by 12,200 to 681,100, the highest for six years. The economic inactivity rate slipped.

The claimant count - those claiming jobseeker’s allowance – dropped by 131,400 in the 12 months to December and is now at its lowest rate since June 1975. Unemployment on the broader Labour Force Survey measure also fell. Hours worked, a good indicator of the underlying strength of the job market, rose.

There may be trouble ahead but so far employment has not skipped a beat. That should change, though not as dramatically as some fear. The consensus among economists is that this year will show below-trend growth, probably matching the 1.8% of 2005, a weak year.

Even that will not mean job growth comes to an end, however. Economists expect, on average, a rise in employment of about 0.4% – equivalent to some 120,000 new jobs. They also expect a modest rise in unemployment, but certainly not carnage.

Exactly how uncomfortable it feels will depend on another factor – the flow of migrant workers coming to Britain. There is anecdotal evidence that this flow has started to fade and that, for some groups of workers, it has even begun to go into reverse.

The economic outlook may be dull in Britain, but Poland, the Baltic states and many of the other new EU members are booming. Poland is set for at least 5% growth this year. True, these economies remain a long way back in terms of income levels but the gap is closing. The weakness of sterling against the euro has also reduced Britain’s attractiveness to eastern Europeans, many of their currencies being linked to the euro.

There is also an issue on the demand side. It may be that the bits of the economy that are weakest are those that provided the draw for migrant workers.

The weakness of the housing market means there are fewer direct employment opportunities for Polish plumbers and building workers from other accession states. The weakness of the financial markets means there is less demand for bankers and brokers in the City and Canary Wharf from other parts of the EU. The retail and catering trades are also struggling.

An even bigger impact may come from the fact that other European countries are in the process of liberalising their rules to allow in workers from the newer member countries. Germany relaxed its restrictions for skilled workers in November and over the next two years will complete the process of full liberalisation. Remember that part of the reason Britain attracted so many workers from eastern Europe was that most other EU countries restricted entry.

Is there any hard evidence on this? Given the strength of the job market, it would be unrealistic to expect too much yet. The latest official figures run only to the third quarter of last year. They show the number of “A8” migrant workers (those from eastern European countries that joined the EU in May 2004) applying to work in the UK under the worker-registration scheme dropped to 54,000 from 63,000 a year earlier, a fall of 14%. There was also a drop between the second and third quarters in migrant workers registering from the newest EU members, Romania and Bulgaria.

This is a big issue. Whether the migrant flows continue will determine whether the pendulum starts to swing back so that there are indeed more “British jobs for British workers”.

It may also mean, for firms, that more challenging times are on the way. Though few say it explicitly, migrants have provided a quick fix for their recruitment problems.

What if the flow of migrant workers into Britain turns out to be more cyclical than had been thought, and not a permanent shift? Official population projections have been hugely influenced by recent migration experience. The latest 2006-based projections assume net migration of 190,000 a year. For comparison, the 1996-based projections assumed only 65,000 of net migration annually.

The cumulative difference over time between these assumptions is enormous, particularly when differential birth rates between the foreign-born and indigenous population are taken into account. A lot rests on government assumptions about migration, which drive a projected rise in population to 65m by 2016 and 71m by 2031. This year we may find out whether those assumptions are realistic for the bad times as well as the good.

PS: Just as every generation thinks it has discovered sex, so we tend to believe we are the first to have hit on the idea of globalisation. In fact, as a magisterial new book by Ronald Findlay and Kevin O’Rourke points out, globalisation goes back a very long way. Power and Plenty: Trade, War and the World Economy in the Second Millennium, makes a case for pinpointing the dawn of globalisation in the 13th century, when Europeans ventured east from Venice and west from Genoa.

But there is also an argument, as the authors point out, for saying that globalisation came even earlier, about the year 1000, when there was extensive trade and commerce involving western Europe, eastern Europe, central, south, southeast and east Asia, sub-Saharan Africa and the Islamic world which, as well as the Middle East and North Africa, took in Muslim Spain.

In the “Islamic golden age”, in fact, it was only the Islamic world that had direct trade contact with all the other discovered regions. If that was the globalised world of the time, Islam was at the centre of it.

When we think about the shifting global economy these days, the emphasis has been on the rise of China and India and their return to the past dominance of the global economy. But largely thanks to oil, parts of the modern Islamic world are also enjoying something of a return to former glories. Nowadays, of course, power is often exerted through multi-billion-dollar sovereign wealth funds.

From The Sunday Times, January 27 2008

Wednesday, January 23, 2008
Mervyn and the minutes
Posted by David Smith at 06:00 PM
Category: Thoughts and responses

For those who have not seen it, this is Mervyn King's Bristol speech and these are the minutes of the monetary policy committee (MPC) meeting which voted 8-1 to leave Bank rate unchanged at 5.5%. Also today, we have fourth quarter GDP figures which were stronger than expected at 0.6%.

What are we to make of all this? I'll have more to say on rates on Sunday, but a couple of points. Firstly, the minutes. Though the vote to hold was clear-cut (Blanchflower was the only cutter) it was also partly tactical. Back-to-back rate cuts were not warranted, the MPC thought, particularly when money market rates had eased and sterling fallen. There was also concern about "supply-side" inflation pressures.

Second, King's uncomfortable "not so good" combination of slower growth and higher inflation. The governor thinks a 5.5% Bank rate is restrictive and that a lower pound is needed to rebalance the economy. But he is worried that what the Bank sees as a temporary hike in inflation will raise inflation expectations. There's a bit of circularity here - while money market inflation expectations are restrained by higher rates, one factor pushing up public inflation expectations has been higher mortgage costs.

So the Bank isn't following Bernanke's dramatic moves. But King will want to avoid appearing too rigid.

Tuesday, January 22, 2008
Fed cuts to 3.5%
Posted by David Smith at 01:50 PM
Category: Thoughts and responses

Ben Bernanke did not even wait until the markets opened. The Fed Funds rate has been cut to 3.5%, getting there several months earlier than expected. Drama indeed. The vote was 8-1, with William Poole voting against. This is what it said:

"The Federal Open Market Committee has decided to lower its target for the federal funds rate 75 basis points to 3-1/2 percent.

The Committee took this action in view of a weakening of the economic outlook and increasing downside risks to growth. While strains in short-term funding markets have eased somewhat, broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households. Moreover, incoming information indicates a deepening of the housing contraction as well as some softening in labor markets.

The Committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully.

Appreciable downside risks to growth remain. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Charles L. Evans; Thomas M. Hoenig; Donald L. Kohn; Randall S. Kroszner; Eric S. Rosengren; and Kevin M. Warsh. Voting against was William Poole, who did not believe that current conditions justified policy action before the regularly scheduled meeting next week. Absent and not voting was Frederic S. Mishkin.

In a related action, the Board of Governors approved a 75-basis-point decrease in the discount rate to 4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Chicago and Minneapolis."

Posted by David Smith at 08:45 AM
Category: Thoughts and responses

Equity markets did not respond enough last year to the risks of US recession. This year they have, dramatically, hence the fall since the start of the year and the rout over the past couple of days. Does it tell us there is going to be a world recession? No, or at least not yet. After four years of powerful growth, roughly 5% a year, the global economy will slow, possibly quite sharply, but a recession is highly unlikely. America will be a closer call. Central banks will cut, and probably more dramatically than they would have done.

Watch stock markets, but also watch the oil price. It is down 15% from its $100 peak and is telling us about global growth prospects. In the meantime, what about the role of the ratings agencies? The downgrading of bond insurer Ambac from triple A to AA rating was one of the triggers for the sell-off. The agencies failed to spot problems in sub-prime backed securities on the way up and are now helping push the markets down. Not very impressive.

Monday, January 21, 2008
The Treasury's Northern Rock package
Posted by David Smith at 08:45 AM
Category: Thoughts and responses

Details have been released of the Treasury's financing package, involving the issue of government-backed bonds, for Northern Rock. The aim is to generate competition among potential private sector buyers to avoid accusations of a stitch-up. But the Treasury's press release, here, acknowledges the possibility of nationalisation and says how it might work. More details of the financial package are in the Treasury's statement to the Stock Exchange, here.

Sunday, January 20, 2008
Don't bank on the euro as sterling slides
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


It tells us something that I have received many more e-mails and letters about sterling’s big fall against the euro than I did a few months ago for a different reason – the $2 pound.

Perhaps we are more European than we think. That is certainly the case in terms of second-home ownership on the Costas and the French countryside. People are also concerned about the impact of sterling’s weakness on import prices. There may be another reason. When sterling is strong the effects are mainly beneficial, certainly for consumers and tourists. Even exporters do not complain too much.

But when sterling is weak it recalls the time when the pound was the tail that wagged the economic-policy dog. There is no question of sterling’s fall against the euro forcing the Bank of England to raise interest rates. There is a risk that sterling weakness, if maintained, might stand in the way of the rate cuts that the economy needs.

For most of last year, sterling was remarkably stable against the euro, at an exchange rate averaging roughly 1.50 euros to the pound. It began to weaken in August, at the point when the credit crisis burst onto the scene.

Sterling stabilised at about €1.45 but embarked on a further big fall from early November. This, as luck would have it, was after Bank governor Mervyn King advised the model Gisele Bundchen, who had complained about dollar weakness, that if she wanted a stable currency for her fees she should look no further than sterling.

To be fair to King, it was his message on interest rates that jinxed the pound, not his modelling advice. This was when the Bank, in its November inflation report, signalled it was switching from wanting to raise interest rates further to wanting to cut.

The European Central Bank, guardian of the euro, had also been widely expected to raise rates further before the end of last year. The ECB, however, has yet to talk of cuts, let alone deliver one as the Bank did last month. Indeed, Jean-Claude Trichet, its French president, has been making hawkish noises about raising rates should there be evidence of inflationary pressure.

It amounts to a loss of sterling’s interest-rate advantage. Add in those dreadful third-quarter current-account figures, loss of confidence in the British banking system as a result of Northern Rock, and the accompanying loss of reputation for the Bank, Treasury and Financial Services Authority and there is a plausible explanation for some of the fall.

The eurozone has not suddenly become an economic success story, however, and will struggle to grow faster than even Britain’s diminished growth rate this year, as began to emerge last week. Tensions within the euro area persist. A change in interest-rate expectations and tough talk from the ECB does not add up to a 14% fall for sterling against the euro over the past year, equivalent to Harold Wilson’s “pound in your pocket” devaluation of 1967.

So something else has been happening, and appears to be directly linked to the credit crisis.

Peter Spencer, in his latest report for the Ernst & Young Item club to be published this week, notes that before August 9, when the crisis broke, there were big short-term capital flows into Britain for a particular reason. Banks and other lenders borrowed internationally, including elsewhere in Europe, to fund some of their UK mortgage lending. These money-market flows helped support the pound.

But when they stopped, as money and credit markets froze, this source of support came to an end. Northern Rock, the credit crisis, the weakness in Britain’s housing market and sterling’s fall are thus directly linked, and by more than just confidence.

This may suggest that, as markets thaw, sterling will regain some of its former composure against the euro. That is what I expect, and there is tentative evidence of it. The big fall, which took the pound down to not much above €1.30, may be drawing to a close, though it is unlikely sterling will recover to anything like its previous highs.

Will this episode have any effect on British attitudes towards joining the euro? On the face of it the euro, having been the ugly duckling of the currency world, has turned into a beautiful swan.

The eurozone has lower interest rates, a harder currency and for now a better-regarded central bank than Britain. These are the conditions that, thanks to Germany, drew a Conservative government under Margaret Thatcher into the arms of the European exchange rate mechanism (ERM).

These days euro membership is so far on the political back burner we do not even bother to ask the question in opinion polls, though it might be worth another outing. When last asked, membership was opposed by two to one. The Treasury vetoed Tony Blair’s last chance to take Britain into the euro in 2003.

Gordon Brown, having presided over two “no” verdicts on entry when chancellor, is not about to warm to the single currency and has plenty of other things on his plate without opening this can of worms. The Tories are ideologically opposed.

So we will watch what happens to sterling and the euro. If the pound falls much further, quite a lot of things could happen. Britain, with a softer currency, could become a less attractive location for migrant workers from Poland and the other EU accession countries.

On the other hand some of the activity that was relocated to other parts of Europe a decade ago, when the pound rose sharply against the euro’s constituent currencies, could find its way back here. With 55% of UK goods exports going to euro countries there could, whisper it quietly, be a revival of British manufacturing.

PS: House prices stopped rising at a point where Halifax calculates private-sector housing is worth £4 trillion, 3.4 times mortgage debt. So the question is asked – do rising house prices do us any good? Would we be better off if they fell?

There are four daft arguments on this. One is that a rise in prices does you no good because until you exit the market you cannot realise gains. But that is true of any asset and plenty of people tap into housing wealth through equity withdrawal.

The second is that because you live in a house it differs from other assets and should not be regarded as wealth. Yes, it is different, and in some respects better. Shares may give you a financial shelter. Housing gives you an actual one.

A third is that the value of housing is always precarious. What if that £4 trillion were to turn into £3 trillion? But house prices are less volatile than shares, and that is also true of any asset.

Finally, are rising prices good for owners but bad for the country? Again this does not stack up. The 70% who are owner-occupiers gain, while the 30% nonowners do not lose – they just don’t gain.

There are better arguments against rising prices; they freeze out potential buyers, steer investment towards “unproductive” housing and reward inertia rather than risk-taking. The tripling of prices over 10 years was certainly too much of a good thing.

The question is the wrong one. The value of housing is boosted by “small island” supply factors but in essence reflects past rises in income and expectations of future growth. Stagnant house prices would tell us the economy had done badly and prospects were poor. Part of the current house-price concern reflects worries about Britain’s prospects.

From The Sunday Times, January 20 2007

Friday, January 18, 2008
Peak oil - a detailed rejoinder
Posted by David Smith at 12:30 PM
Category: Thoughts and responses

When I wrote about peak oil recently - saying we were nowhere near it - some people responded by saying that a mere economics writer either should not delve into this territory or should bow to the weight of the geological evidence. Well here is the most detailed study of that evidence, from Cambridge Energy Research Associates, and its conclusion is the same as mine; we are a long way from the peak. It sees global liquids capacity, currently 91m barrels a day, rising to 112m bpd by 2017. Its press release is here.

Not a happy Christmas
Posted by David Smith at 10:30 AM
Category: Thoughts and responses

Retail sales fell by 0.4% last month, in spite of some heavy discounting by stores. Sales in the latest three months showed a rise of just 0.4% on the previous three months. Department stores appear to be having a particularly grim time, their worst since 1994. Details here.

Thursday, January 17, 2008
Gieve on the credit crisis
Posted by David Smith at 02:30 PM
Category: Thoughts and responses

In a speech Sir John Gieve, the Bank of England's deputy governor, notes that a tightening of credit conditions by banks in the early 1990s led to a 2% drop in GDP relative to what it would have been. Then, he says, the authorities were constrained from cutting interest rates by membership of the European exchange rate mechanism. The question this time is whether the Bank will be constrained by the short-term rise in inflation he also warns of. The speech can be accessed here.

Tuesday, January 15, 2008
Unchanged at 2.1%
Posted by David Smith at 09:45 AM
Category: Thoughts and responses

It may be the lull before the storm, particularly given yesterday's producer price numbers, but consumer price inflation was unchanged at 2.1%. Some interesting details from the ONS, including the fact that clothes discounting in December was less deep than a year ago.

The details:

"Large downward contributions to the change in the CPI annual rate came from:
• Housing and household services due to gas and electricity bills which increased by less than last year when tariff increases were being phased in;
• Furniture and furnishings where the price of kitchen units fell, reflecting discounting on some lines, and prices increased by less than last December across a range of other furniture.

The largest upward contribution to the change in the CPI annual rate
was from food and non-alcoholic beverages, particularly cauliflowers,
tomatoes, onions and cabbages. Bread and cereals and sugar, jam,
confectionery and chocolate also contributed.

A further upward contribution came from clothing and footwear, mainly
due to greater discounting of clothing the previous December, across
a range of men’s and women’s clothing. The largest effect came from
women's dresses.

There was a small upward contribution from miscellaneous goods and
services, mainly due to an increase in mortgage arrangement fees,
within financial services.

Retail prices index (RPI) inflation fell to 4.0 per cent in December,
down from 4.3 per cent in November, mainly due to average mortgage
interest payments where there was a smaller increase than last
December. Fares and other travel increased, due to air fares, which
rose more than they did the previous year. Otherwise the main factors
influencing the RPI were similar to those affecting the CPI.

RPIX inflation – the all items RPI excluding mortgage interest
payments – was 3.1 per cent in December, down from 3.2 per cent in

Sunday, January 13, 2008
A sense of balance on consumer gloom
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


Now that St Michael has been consigned to the dustbin of Marks & Spencer's history, we have to look to Sir Stuart (Rose, that is) for guidance from on high about the outlook for consumer spending.

That guidance, following M&S's gloomy results, was bleak and chimes in with that of some economists. Trading conditions in the high street will be eyewateringly tough and the gloom could extend into 2009, he said. Clothing is suffering its toughest time for a decade. Prices of non-food items are down 6% year-on-year, despite rising costs.

The stock market has delivered its verdict on this, and now economists will be busy factoring it into their forecasts. They may get even gloomier about the spending outlook, although M&S seems to have suffered in comparison with some of its rivals, particularly the supermarkets.

So how much will consumer spending slow? And how much does it need to slow given continuing worries about inflation and the balance of payments?

In the third quarter of last year, which we should probably regard as an age of innocence before the credit crisis changed everything, consumer spending showed a rise of 3.6% on a year earlier — not a boom but certainly very strong.

This year, according to the average of recent forecasts, spending growth will be less than half of that, 1.7%. Michael Saunders of Citigroup, who topped my forecasting league table for accuracy last year, thinks the shift in mood will be even more dramatic than this, with only 1.1% growth in spending this year, rising to a mere 1.4% in 2009.

Not since the last recession ended in 1992 has consumer spending been so weak. To paraphrase M&S's advertising slogan: This is not just a slowdown, it is a recipe for savage retrenchment on the high street.

Long experience has taught me that you write off the British consumer at your peril. One factor that has been overhyped is the mortgage "re-set" as people come off existing fixed-rate mortgages onto higher ones. According to an analysis by Barclays Capital, this is a red herring. The maximum pain from re-sets this year will be £2.1 billion and the likelihood is of something significantly lower.

But on the basis of a stagnant housing market, weak real-income growth and a degree of debt aversion — and perhaps even a bit of an appetite for saving — a number for spending growth this year of below 2% seems entirely plausible. The question, though not obviously one retailers want to hear, is whether it is weak enough to rebalance Britain's economy.

In the third quarter of last year, as many readers will know, there was a shocking £20 billion current-account deficit — 5.7% of gross domestic product. As I hinted last week, there are reasons to question some aspects of the figures, particularly the sharp shift in investment income. But the fact is that there is a substantial payments gap, which has contributed to sterling's recent fall.

Figures last week showed the trade deficit in goods in November was £7.4 billion, the same as in October. This was lower than in the July-September period, when it averaged £7.6 billion, but not so you would notice.

For those who like big numbers, our trade deficit in goods is on course for £84 billion for 2007, up from £77 billion in 2006. The deficit with Germany is likely to have been £18 billion and that with China nearly £15 billion.

Britain still runs a sizeable surplus in services, so the overall number for the goods-and-services deficit is likely to have been £48 billion last year, not much worse than 2006's £46.4 billion, but still a lot of red ink.

People often ask me why deficits such as these do not lead to immediate economic repercussions or a greater sense of crisis, as used to be the case. The answer is that these days, flows of goods and services are dwarfed by capital flows, and Britain has been pretty good at attracting those.

In 2006, the latest full year for which official figures are available, Britain attracted £80.3 billion of foreign direct investment, partly offset by £49.4 billion of investment abroad by UK companies. Short-term capital has also been attracted by Britain's higher interest rates.

It cannot, however, be a permanent way of life for British consumers to spend willy-nilly on imports, financed by foreigners taking an ever-bigger stake in the economy. Richard Jeffrey, head of research at Ingenious Securities, sees the current-account deficit as "an obvious symptom of overheating", and points out that it has risen from only 1.3% of gross domestic product (GDP) in 2003 to a likely 4.9% last year. That is perilously close to the 5.1% red ink of 1989, the height of the Lawson boom and just ahead of the long and painful recession of the early 1990s.

There are differences. In the late 1980s the North Sea still gave Britain a healthy trade surplus in oil, whereas now there is a deficit, so the true extent to which consumers were sucking in imports of other goods was greater. That is not surprising; back then consumer spending peaked at more than 8% real growth, very much higher than recent rates.

Even so, the current account did improve in the years after that 1989 low point as a result of a deep consumer recession — a peak-to-trough fall of 3.6% in consumer spending between mid-1990 and early 1992 — together with sterling's substantial devaluation following Britain's exit from the European exchange-rate mechanism. By 1997 it was back in balance.

Does this need to happen again? It depends what your view is on what size of current-account deficit is sustainable. The Treasury, in its autumn pre-budget report, predicted that the deficit would stabilise at about 2.75% of GDP and seemed comfortable with that. Others will think that 2.75%, more than £40 billion a year (the Treasury's analysis came ahead of those awful third-quarter numbers), is too big for comfort.

The Treasury thinks that Britain will continue to attract significant capital inflows from abroad. If they dry up, the adjustment might have to be very painful.

PS: Gordon Brown and Alistair Darling are becoming a familiar double act at the prime minister's monthly press conferences, which some have interpreted as a sign that the economy is really in trouble. For me the bigger concern is the message rather than the medium.

Last week prime minister and chancellor both came close to openly calling on the Bank of England to cut interest rates, which was picked up in the markets. Had the Bank cut, and it was under intense pressure to do so, it would have been interpreted as a clear "political" move and, in some quarters, one intended to keep Mervyn King, the governor, in his job.

That is daft, and shows how politicians have to be wary about saying anything about interest rates. They also have to think about some of their other messages.

In calling on public-sector workers to accept tight three-year pay deals, both Brown and Darling appealed to their sense of the greater good. By accepting such deals, they said, workers would help to keep inflation and interest rates low for everybody.

Three-year deals, it so happens, are a good thing, but why not tell it like it is? If the government means what it says about holding public spending growth to 2% a year for the next three years, half its recent rate, then there will be only one consequence of higher public-sector pay: fewer public-sector jobs. Perhaps prime minister and chancellor are not confident of their ability to hold the line.

Talking of mixed messages, there was one in the annual forecasting league table a couple of weeks ago. The figures for Lombard Street Research, taken from the Treasury's monthly compilation of independent forecasts, were wrong, the result of a glitch somewhere between Lombard Street and the Treasury, so the firm did better than its position suggested.

From The Sunday Times, January 13 2008

Thursday, January 10, 2008
The Bank and the ECB
Posted by David Smith at 04:00 PM
Category: Thoughts and responses

The Bank of England's monetary policy committee left Bank rate at 5.5% and, as is customary, issued no statement. The European Central Bank left its key rate at 4% and in the press conference afterwards Jean-Claude Trichet, its president, warned that the ECB was prepared to act pre-emptively to head off inflationary pressures. It's unlikely it will but the upshot was that the ECB gave us a more hawkish "hold" than the Bank, which is still widely expected to cut in February.

Tuesday, January 08, 2008
Mixed signals
Posted by David Smith at 10:00 AM
Category: Thoughts and responses

The British Retail Consortium reported that sales in December were up by 2.3% on a year earlier, and by 0.3% on a like-for-like basis. This was the weakest December outturn for three years and reinforced the BRC's calls for an interest rate cut this week. But, again, it was not as dire as earlier warnings from retailers had suggested.

Meanwhile, the Halifax house price index showed a surprise 1.3% rise on the month - even bulls had looked for nothing more than a flat figure. This pushed the "raw" annual rate up to 6.3% in December, from 3.1% in November. However the Halifax prefers to concentrate on the latest three months compared with a year earlier, which showed a dip to 5.2% in October-December from 6.3% in September-November.

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

Shadow MPC votes 5-4 to cut again
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

The outcome of the most recent Shadow Monetary Policy Committee (SMPC) monthly E-Mail Poll (in conjunction with the Sunday Times) is set out below. The recommendations are made with respect to the UK Bank Rate decision to be announced on Thursday 10 January.

On this occasion, four SMPC members voted to leave Bank Rate unchanged, while five members voted for a reduction. As happened last month, the rate cutters were split, with three desiring a reduction of ¼% but two wanting a cut of ½%. This would deliver a rate cut of ¼%, if the normal Monetary Policy Committee (MPC) voting procedure was adhered to. The same was true of the December SMPC recommendation, which was in line with the ¼% rate cut announced later on 6th December.

However, the shadow committee endeavours to say what should happen to rates, rather than what will. All of the SMPC members were worried about the global credit crunch and the danger that this could lead to a cracking of the robust UK economic conditions reported in the recent data. Several were perturbed by the poor current account balance of payments figures released on 20th December, however, and some thought that this could limit the scope for rate cuts.

Comment by Tim Congdon
(London School of Economics)
Vote: Cut by ¼%
Bias: Wait and see

The monetary situation is puzzling. Clearly banks will react to the crisis of summer and autumn 2007 by restricting balance sheet growth, and that signals slower money growth in 2008. But asset prices should still be benefiting from the high money growth of the 2004 to 2007 period. Instead the last few months have seen a sharp fall in property values and bear markets in some sectors of the stock market. Apparently wealth holders want a higher ratio of money to non-money assets, which is a ‘confidence effect’. Given that the Bank of England has already cut rates by ¼% (when I had advocated a ½% cut), I am in favour of another ¼% cut and continued action to bring inter-bank rates back into line with ‘the Bank Rate’ (as, at long last, it is again being called). But I do not expect 2008 to be a particularly bad year for the economy, with only somewhat beneath-trend growth.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Cut by ¼%
Bias: To ease.

The coordinated action of central banks to offer longer term credit facilities to commercial banks by means of a series of auctions has helped to ease money market conditions in the last week or two, but concerns about counterparty risk in the inter-bank market remain acute. These signs of sustained stress in the money markets point to fears that the balance sheets of banks and other financial institutions are still burdened with structured securities that are either overvalued or of uncertain value. In the case of some banks this requires further balance sheet repair and, possibly, more recapitalisations. Until such concerns have eased, the wide spreads between yields on Treasury bills and money market interest rates will persist.

More broadly, the overheating of the underlying housing market needs to cool further. Signs of such cooling have become more evident in the past three months as - by most measures - house prices have continued to fall on a monthly basis (e.g. according to Halifax, Nationwide and Rightmove, as well as the Royal Institution of Chartered Surveyors poll), and mortgage approvals have declined by 31% over the past year to the low levels of early 2005.

However, when bubbles burst they normally spill over to affect other sectors. Not surprisingly there has been greater price discounting by retail stores against a backdrop of softer official sales figures in October and November, and weaker survey data (e.g. from the Confederation of British Industry). On the industrial and business side of the economy order books have held up so far, but business expectations for future output have slipped, while all service measures were weaker in October and November. As yet employment and unemployment data outside the financial sector have not been affected, but economy-wide earnings have been more subdued than at any time since the period of the global downturn in 2001-03.

These data on economic activity and wages are supplemented by weakening monetary data: in November £M4 broad money again rose only 0.1% over the month, slowing to 11.1% year-on-year. My conclusion is that, at current interest rates, the economy is likely to undergo a more extended period of weakness. This will require a lower level of interest rates to restore credit demand and economic activity - even if bank balance sheets are repaired quickly.

Comment by Ruth Lea
(Arbuthnot Banking Group and Global Vision)
Vote: Hold
Bias: Towards cuts

If a week is a long time in politics then a month is a long time in economics. The gloom over economic prospects, in general, and the housing market, in particular, has sharply intensified since the end of November. This mood seemed to be encapsulated in the minutes of the December Monetary Policy Committee (MPC) meeting which cast aside inflationary concerns and focussed on worsening growth prospects. The deteriorating situation in the credit markets (which has since improved following concerted central bank intervention) and the potential knock-on effects for consumer spending and business activity clearly influenced the MPC’s decision.

There is little doubt that various surveys of business and retail activity have, on balance, turned negative recently but the latest official data on the economy (admittedly always retrospective) were relatively robust. November’s retail sales were firm – they were 4.4% higher than a year earlier – and the overall assessment by the Office of National Statistics (ONS) was that “positive underlying growth (was) sustained”. The current howls of anguish from the retail sector may, however, be justified. But it should be remembered that the retailers are prone to a seasonal cry of “wolf, wolf” and we will have to wait until the official December data are released on 18th January to find out what has actually happened to retail sales in the Festive month. The housing market continues to weaken and will almost inevitably weaken further next year as the “reset crunch” kicks in.

Even though inflation measured by the target Consumer Price Index (CPI) remained at 2.1% year-on-year in November there are undoubtedly further upward pressures coming through from food and energy prices. The MPC, of course, cannot afford to ignore the inflationary implications – especially as the pound is weakening. There is still a case for moderation in easing monetary policy. I vote for no change in January – though my bias is towards further cuts.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold
Bias: Neutral

I believe that the December rate cut was a mistake, and that we should certainly not be contemplating further rate cuts at this stage. One way to express why is the following: it seems to me that from our current situation there are two paths, and neither of them merits a rate cut yet. Along the first possible path the recent credit turmoil and the turnaround in the housing market are short-lived, minor events. Broad money growth, which has stalled in recent months, resumes its 11-14% growth rate, GDP growth slows to perhaps a shade below 2%, the housing market drops no more than 5-10% peak-to-trough, and consumption sails through the recent difficulties fairly serenely. On this scenario, once the recent turmoil has passed, our attention will turn back to above-target inflation, and we will be looking at interest rates rising up above 6% once again. Cuts now will just mean greater rises later.

Along the other possible path, recent events are more lasting in impact. Broad money growth does not resume - perhaps banks reconsider their prudential liquidity ratios for themselves, or maybe new legislation (or interpretation of Basel II requirements) forces a rise. The housing market falls 20% or more, peak-to-trough. GDP growth slows much more sharply, to perhaps a little more than 1% in 2008, and households start to save more and borrow less. If this is how matters are going, I do not believe that interest rate cuts now will achieve anything. Experience of the past twenty years suggests that house price trends, once underway, are very difficult to affect with interest rates. If banks must adjust their prudential liquidity ratios, interest rate cuts won't change that. Instead, it would be better to leave interest rates where they are until changes can be made decisively in order to have a material impact, and to ensure that below-trend growth does not turn into recession. I am not sure which of these scenarios is the more likely, though I incline towards the latter. But, either way, interest rates should remain on hold for now.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Cut by ¼%

If the economy is in a credit crunch of the Bernanke-Gertler variety, then cuts in interest rates will not necessarily reduce the ‘external finance premium’ proxied by the spread between the London Inter-bank Offer rate (LIBOR) and bank rate. Credit rationing is a rational outcome of increased uncertainty which can only be alleviated by the availability of funds. To some extent the Bank of England, in concert with the US Federal Reserve and the European Central Bank (ECB), has addressed this issue. The problem then reduces to an evaluation of the effect of further interest rate cuts. It can be argued that large cuts are needed to restore confidence in money markets. The counter-argument is that large cuts signal a loss of control and panic reaction - much like the Bank’s behaviour during the Exchange Rate Mechanism (ERM) ejection crisis of September 1992 - which ultimately will have negative implications for the Bank’s credibility. The alternative is to restore confidence by signalling a controlled and measured approach, in other word cutting rates in stages. The Bank has taken the first step in this direction. It is ready to take the next.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Cut by ½ %
Bias: To ease

Since last month, the central banks have injected large amounts of liquidity in a coordinated way in order to bring down the differential between three months’ LIBOR and the rates on government bills. This operation has had some success but it has been only limited. Therefore, the need for a cut, of 0.5% now, remains. Between these operations and further cuts I suggest that the monetary authorities aim for market rates of around 5%, which is still well below current rates.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold
Bias: Wait and see

The New Year is a traditional time for looking ahead and it seems appropriate to summarise the latest projections for 2008 and 2009 generated by the Beacon Economic Forecasting (BEF) macroeconomic model. These employ the raft of official statistics for the third quarter of 2007 published on 20th December and the fourth quarter financial market prices. The result is that UK GDP is expected to follow last year's annual average increase of 3.1%, with rises of 2.1% in 2008, and 1.9% in 2009. This is slower than the projected growth rate for the OECD area as a whole of 3.0% in 2008 and 2.8% in 2009, compared with a part predicted 2.8% in 2007. The root cause is the tax and regulatory induced sclerosis of the supply side of the British economy.

The outlook for inflation is determined by the imbalance between the supply of, and demand for, broad money in the long run but it is influenced in the short term by the price of oil (a figure of US$90.5 per barrel of Brent Crude in 2008, rising to US$91 in 2009, has been assumed, compared with US$72.9 in 2007). UK CPI inflation is expected to average 2.9% in 2008, and 3% in 2009, compared with the 2.4% projected for last year on the basis of data for the first eleven months. Equivalent figures for the old RPIX target measure would be 3.7% in 2008, and 3.6% in 2009, against a likely outcome of 3.3% in 2007. OECD inflation is expected to average 2.7% in 2008 and 2.6% in 2009, compared with 2.3% last year.

One factor helping to constrain British inflation in the longer term is that the growth of M4 broad money is expected to slow from an annual average of 12½% last year, to 8¾% this year, and 5¼% in 2009. Such a deceleration has long been a feature of our forecasts, and it is now, rather belatedly, beginning to appear in the data. Britain’s rapid monetary growth has buoyed asset prices, stimulated home demand, and boosted tax receipts in recent years, but poses a long-term threat to sterling, which may be an accident waiting to happen. Apart from the risk of a run on the pound, the other main monetary danger is that the re-entry from the money and credit boom will be accompanied by rising bad and doubtful debts, stepped up credit rationing, a private sector recession and a ballooning fiscal deficit. This is the possibility that the financial markets and the media have concentrated on, and also the MPC, if the December minutes are any guide. However, anyone attempting to traverse a narrow ridge in a blizzard can fall off on either side of the mountain. An exclusive concentration on the risks in just one direction makes a serious accident more likely, not less.

One problem facing the monetary authorities is that Britain’s public finances are in dire shape for an economy that has not yet suffered a recession. This gives rise to problems of ‘policy inconsistency’, and limits the scope for using Bank Rate to stabilise the economy, unless the MPC are prepared to take undue risks with inflation. Public Sector Net Borrowing is expected to be £41¾bn in 2007-08, £50¼bn in 2008-09, and almost £56½bn in 2009-10. However, the really bad news in the 20th December ONS data release was the large upwards revision to Britain’s other twin deficit, that on the balance of payments, for 2006 and the first half of last year, and the very large deficit recorded in 2007 Q3. The current account deficit is now expected to deteriorate from £67¾bn in 2007, to £78¾bn in 2008, and £82½bn in 2009, before easing in 2010. The latest published consensus forecasts for the current account deficit in 2007 and 2008 are £43.5bn and £45.8bn, respectively. There are likely to be a rash of adverse revisions to these figures as the pre-Christmas ONS data are incorporated into published forecasts.

This suggests that the MPC will not have an easy time over the next few years. Three month inter-bank rates, which drive the real economy in the BEF forecasting approach, are expected to settle at around 5½% in the second half of this year and remain broadly at this level through 2009. Bank Rate does not play such an active role and is expected to end 2008 at 5¼%, and hold this level through 2009. The main constraint on rate cuts is likely to be a weakening of sterling, particularly if overseas central banks buy less of it for their reserves. House prices have enough momentum to go up by not quite 3½% 'through' 2008 (Department of Comunities and Local Government index, Q4 to Q4) and 1½% through 2009 but are expected to be broadly flat for some years thereafter. This represents modest declines in real terms from 2009 onwards.

Overall, while recognising that there are serious downside risks to the credit creation process and economic activity, I do not believe that the subsequent data retrospectively justified the unanimous MPC decision to cut Bank Rate in December, and suspect that more damage will be done if inflationary expectations take off, or there is a run on the pound, than will be averted by further rate reductions in the immediate future. This implies that rates should be held in January. Beyond that the only viable policy seems to be ‘wait and see’, while noting that US rate reductions, for example, stimulate the British economy through the trade account and are a substitute for rate cuts at home

Comment by Peter J Warburton
(Director, Economic Perspectives Ltd)
Vote: Cut by ½%
Bias: To cut

The UK banking sector lent £89bn in sterling in the third quarter of 2007, equivalent to 25% of GDP at current prices (strictly speaking, lending was only £76.2bn, because loans of £12.8bn secured on dwellings were transferred out of the sector due to net disposals and securitisations). Where did this £89bn go? A quarter, £22.3bn, was mortgages and other lending secured on residential property; £23.6bn was to financial intermediaries other than insurance and pension funds, credit companies, fund management groups, collective investment vehicles and securities dealers; fund managers borrowed £7.2bn; another £10.3bn was borrowed by “activities auxiliary to financial intermediation” and £10.9bn went to the development, buying, selling and renting of real estate. The rest of the economy borrowed £14.7bn.

If we were ever in any doubt that borrowing has been the principal driver of asset market activity, then this analysis should surely settle the matter. The UK economy sits atop a gigantic peak in transactions activity – in household and commercial property, in large businesses and in equities. The Treasury expects to collect £15bn in stamp duty in the current fiscal year. Frenetic trading of business, property and financial assets has been fuelled by massive amounts of bank and capital market credit. An unavoidable consequence of the global credit downturn, or crunch, is that finance is becoming harder to obtain. Net secured lending to individuals slumped from £9.5bn in September to £7.3bn in October. The value of gross mortgage approvals fell from £29.3bn in September to £25bn in October. Property transaction volumes in England, Wales and Northern Ireland fell in November to stand 29.5% below a year earlier.

These sharp declines illustrate the significant potential that exists for transactions activity to contract. The scope for a co-ordinated slump in turnover values is real and imminent. Some transaction volumes have already fallen back, despite the surge in bank credit in 2007 Q3. The second quarter was a phenomenal period for mergers and acquisitions activity and the likely peak of private equity deals in the UK. The further in time we move away from this frenzied quarter, the starker the comparisons are likely to become.

Third quarter national accounts data revealed the extent of the imbalances that have developed. A current account balance of payments deficit of 5.7% of GDP and a large inventory accumulation, equivalent to 70% of the gain in real GDP, are examples. It is reasonable to expect a significant deceleration in quarterly growth during 2008, with an increasing likelihood of negative real growth. M4 growth has plunged from 1.3% in August and 0.9% in September to 0.2% in October and 0.1% in November.

In the light of these dramatic developments, the obstacles to a reduction in Bank Rate have been swept aside. It is now a question of how far and how soon to cut. On the basis that the additional liquidity injection by the Bank of England cannot be guaranteed to have a permanent effect on LIBOR spreads, there is a strong case for a double-cut in January. Interest rates should fall, not only to forestall a sharp deceleration in economic activity but also to counteract the unintended tightening implied by unusually wide LIBOR spreads.

The November ONS retail price First Release continues the recent pattern of slowing private sector inflation balanced by rising inflation of administered and exogenous prices, such as oil prices and indirect taxes. With annual private sector inflation back to around 1.5%, Bank Rate has scope to fall to around 4.5% during 2008.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold
Bias: To ease

The official data published up to now has shown a limited impact so far on the UK labour market from the credit crisis. The number of people claiming jobless benefits fell by 11,100 in November, the fourteenth consecutive monthly fall, taking the unemployment rate down to 2.5% - matching a thirty two year low. The more comprehensive Labour Force Survey (LFS) data showed the unemployment rate fell by 0.1% to 5.3% in the three months to October, the lowest since 2006 Q1. The unemployment level was 1.64m, down by 15,000 over the previous quarter. The employment rate rose to 74.5% in the quarter to October, with total employment at 29.29m, up 114,000 on the previous quarter and 226,000 on the year. Despite the tighter labour market, however, whole economy average earnings growth eased by 0.1% on both the including and excluding bonuses measures, at 4% and 3.6%, respectively, in the three months to October compared to the same period last year. But this cannot continue if economic growth remains above trend and price inflation accelerates further, as is expected.

This suggests that, in order to cut interest rates further, there must be a lot of confidence that UK economic growth will ease sufficiently to deliver enough spare capacity to ensure that a negative output gap begins to exert downward pressure on inflation. Otherwise, the tightness of the labour market, elevated inflation expectations, and high retail price inflation (RPI was 4.3% year-on-year in November), suggest that annual consumer price inflation could accelerate up to, and perhaps top, 3% quite quickly during the course of this year.

UK rates though can be cut further but only on the basis that the economy does slow to a 2% to 2.5% range in 2008. If not, any cuts should be quickly reversed. New methods of dealing with the logjam in the credit markets, which is being reflected in high inter-bank rates, should help to separate the two issues. The central Bank Rate should be set for the real economy. The issue of credit spreads should then be dealt with separately, especially as there appears to have been little adverse impact so far onto the real economy from the credit crisis. The chance of a policy mistake caused by cutting rates – in an attempt to solve a problem that is not due to the level of Bank Rate - is high. I would leave rates on hold in January at 5.5%, but with a bias to ease.

What is the SMPC?

The Shadow Monetary Policy Committee (SMPC) is a group of independent economists drawn from academia, the City and elsewhere, which meets physically for two hours once a quarter at the Institute for Economic Affairs (IEA) in Westminster, to discuss the state of the international and British economies, monitor the Bank of England’s interest rate decisions, and to make rate recommendations of its own. The inaugural meeting of the SMPC was held in July 1997, and the Committee has met regularly since then. The present note summarises the results of the latest monthly e-mail poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (University of Derby and Beacon Economic Forecasting). Other current members of the Committee include: Patrick Minford (Cardiff Business School, Cardiff University), Tim Congdon (Visiting Fellow, London School of Economics), Gordon Pepper (Lombard Street Research and Cass Business School), Anne Sibert (Birkbeck College), Peter Warburton (Economic Perspectives Ltd), Roger Bootle (Deloitte and Capital Economics Ltd), John Greenwood (Invesco Asset Management), Peter Spencer (University of York), Andrew Lilico (Europe Economics) Ruth Lea (Arbuthnot Banking Group and Global Vision) and Trevor Williams (Lloyds TSB Corporate Markets). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that nine votes are cast.

Thursday, January 03, 2008
Credit conditions tighten
Posted by David Smith at 10:00 AM
Category: Thoughts and responses

The Bank of England's quarterly credit conditions survey helps confirm why the housing market has been so weak over the past three months. It finds: "Contrary to their expectations in the Q3 survey, lenders reported that the availability of secured credit to households had been reduced materially over the three months to mid-December. They expected a further reduction in secured credit availability over the next three months."

This will be something of a surprise to the Bank, which had thought that weaker demand was the main driver of the downturn in secured lending. Unsecured lending has been less constrained, which explains its recent pick-up. Companies are facing tougher credit conditions. The details are here.