Wednesday, 14 May 2008

Brace yourself for 4 percent inflation

Mervyn King is looking for understanding as price stability goes out the window. He promised reporters that "Inflation will return to the target and growth will eventually recover to a sustainable rate. But we will have to be patient".

Patience is not what the problem needs right now. If the MPC was serious about reducing inflation, it would raise rates. The relationship between rates and inflation is a straightforward one, as the chart above clearly demonstrates. It goes something like this; higher rates, lower inflation, lower rates, higher inflation.

Recent UK experience amply bears out this simple relationship. After a seriously misjudged rate reduction in 2005, inflation surged in 2006. Towards the end of the year, the MPC got the message, increased rates, and by early 2007, the CPI edged downwards. Two more rate increases followed and inflation was close to being under-control.

Why did it all go pear-shaped? Along comes Northern Rock, sub prime, and the credit crunch. The banks whinge about a systemic crisis, the government panics and bullies the MPC behind the scenes to do something. The MPC flakes under the pressure, reduces rates three times, and inflation picks up sharply.

Instead of following their mandate, King told us today that he doesn't have the stomach for a serious attack on inflation. However, rates aren't going anywhere for quite some time. The Bank are now promising 4 percent inflation and a vague forecast that by 2010 the Bank might actually meet their target. That is the best they can do, right now.

If inflation reaches 4 percent, then 6 percent isn't so far away. At that point, base rates would become negative. As the experience of the 1970s attests, there are few economic distortions more damaging than negative rates.

A hopeful disposition is not a counter-inflationary strategy. As a recent BoE survey suggested, inflationary expectations are picking up. The labour market remains very tight. Once wage setters fix on the idea that inflation will hit four percent, the Bank of England might have to face some serious difficulties.

Interest rate policy comes down to a simple case of backbone. Raising rates back up to 6 percent would see inflation come down quickly. A little courage today, prevents a lot of pain and misery in the future. When it comes to inflation, cowardice and indecision never goes unpunished.


VADO said...

rates up, inflation down, what is so hard to understand?

The=Haunted said...

I think they will spout some clap-trap about inflation not being the real issue. This will be their excuse to lower interest rates and allow inflation to boil over on the back burner. I think the logic I heard was that the inflation causing commodities are external to the UK economy and so raising rates won't help. Hmmm, what happens when the pound continues to weaken and we need to pay for these external commodities I wonder.

Sweep the streets said...

A compelling chart - is it really that simple - interest rates up, inflation down?

Vodka drinker said...

Mervyn has no clue what to do. Cut and he gets inflation, increase and he has failing banks.

Anonymous said...

I wonder if we are going to get a widening of the divide between public sector and private sector workers, as the former use unions and guilt-tripping to bully their way to inflation-busting national wage increases while the latter are stuck with global wage arbitrage and an increased tax rate to pay for the public sector's wage hikes.


aSteve said...

Aaagh... The simple version of events is that higher interest rates means lower inflation and vice-versa. That works rather well when the monetary system is functioning normally.

The monetary system is not functioning normally.

The abrupt end to the securitisation of debt has left a lot of money looking for investment opportunities. This is what is driving up the commodity markets and is why we're seeing alarming price rises creeping rapidly through the system.

This effect is not like ordinary inflation where more money lent into the pockets of ordinary people drives up prices wherever supply does not outstrip demand. Where (M4) money is invested in securitised debt, this pushes repayment out long into the future.... but allows the borrowing it funds to be spent on commodities today. Where money is "invested" in commodities (driving up their wholesale price) this doesn't prop-up the ability of the consumer to buy them at their inflated prices. The "investment" is self-defeating because it will push down demand. Playing the commodity card is a 'one-shot' deal - not something that can be perpetuated month-on-month; quarter-on-quarter; year-on-year. The price of goods will rocket in the near term (giving some scary big CPI numbers) but this is distinct from traditional inflation. It can't be repeated over-and-over... it will cause at best a slow-down in economic growth (what increased rates are supposed to do) or, potentially, far more than that... a full-scale economic recession/depression.

Pushing up interest rates at this point would not reduce prices, it would just reduce demand... goods would either be sold outside of Britain (to a nation with lower interest rates, probably), or (more likely, IMHO) simply not sold.

CPI Inflation is rocketing now - but not for the reasons it has in the past. Dramatically rising rates (as much as it would suit my interests) is simply not an option... it would likely result in a crippling blow to business - resulting in mass unemployment... debtors would desperately strive to increase their prices, not decrease them, in a frantic attempt to keep up their interest payments and avoid bankruptcy... while eliminating all discretionary consumption... a futile effort if most of their customers are in similar dire straits.

I believe King... this is extraordinary rather than ordinary inflation. It is extremely unlikely to react to increased interest rates... but increased interest rates are extremely likely to cause a major recession.

The BoE is all-out-of-options... all that is left is to wait until the economy stops aqua-planing and re-gains traction before we start taking decisive action.

I'm not saying that rates can't rise - but this rise won't be caused by an effort to tackle CPI inflation. It might be caused by a sovereign debt crisis... for example, if for some reason (like in 1992 when ERM manoeuvres failed spectacularly) our national debt needs to expand abruptly. This would, in a modern context, represent an economic disaster for the vast majority in Britain.

Anonymous said...


Let me get this straight. Are you saying:

1) Money can buy assets or goods;
2) Money no longer buying assets (e.g. houses, equities, ABS) is now chasing goods (particularly food and oil)
3) Therefore inflation as experienced by purchasers of food and oil (while deflation in assets)
4) And thus it's temporary because the money is parked there and eventually will come back out

Did I paraphrase that something like you meant?

I too agree commodities are a one-shot play and about to burst but that's the inflation side. There's also the supply/demand side, which for oil is a one-way ride to peak oil, with temporary pull backs due to reduced demand in a recession.


Anonymous said...


BTW, the whole point of a recession is that it's a cure for the excesses of the bubble. Business failures and borrower defaults shouldn't intimidate the BoE from their mandate because it's not their job to prop up crappy companies and foolish debtors.

If you can't survive and interest rate hike you don't deserve to live (metaphorically speaking).

Keeping interest rates artificially low punishes good businesses by allowing bad businesses to stay in business. We need the creative destruction.

To paraphrase Andrew Mellon, liquidate them all.


rich010273 said...

With the BOE remit on CPI the UK is much more likely to have a recession than the US.
This seems to be being ignored by the "Growth is good" mantra from Brown.
Strange as it sounds a recession is actually good for an economy as it eliminates wastage. Not so good for your average person though.........

Anonymous said...

A little off topic for this post, but I think I've just solved the housing crisis and public sector debt. Consider this plan:

Build a huge council sink estate on unused land in the middle of nowhere. Put a huge wall around it with barbed wire and snipers on the top. Put the following amenities in the centre: Aldi, Netto, a post office, a tanning salon, a kebab shop, a William Hill, an Argos.

Dump into it everyone who has been:
- On benefit for over two years
- Imprisoned more than once.

Oh yeah, sterilise everybody on the way in.

And there we have it. Rehousing for society's most vulnerable, stimulus to the construction industry, reduced welfare costs, and the end of the underclass in a single generation.


Mark Wadsworth said...

Nick, I have long thought that this would be a good solution. Paying Housing Benefit to subsidise and hence push up rents in city centres where working people would like to live is madness.

Alice, top marks for this:
"The relationship between rates and inflation is a straightforward one, as the chart above clearly demonstrates. It goes something like this; higher rates, lower inflation, lower rates, higher inflation."

The Sahara looks damp compard to that.


Only 4%? I bet the real inflation rate is much higher for the bottom, what, third of the populace?

aSteve said...

Nick (post 1):

Your four-point plan is similar to what I'm saying, except that I am approaching it from the sense of commodities - not goods. A hoarding demand for commodities rises - but the demand for goods falls. This is the trigger for a recession. The commodity play is risky - it might work or it might fail... the decision falls down to the willingness of governments to bale people out when they see the risk of abject poverty... and, in doing so, enrich the speculators. It is a tough game of poker, but it is all about speculation and little to do with supply and demand (right now) - since demand will fall and we have no reason to believe that supply will fall faster. After the recession, of course... it is anyone's guess.

I am familiar with peak oil, but I am not a "believer" - in the sense that I do not believe it credible that we will experience a supply driven shock. We use a preposterous amount of oil right now - completely unnecessary amounts - technology can and will provide alternatives solutions in a timely fashion - in my view.

Nick (post 2):

Part of me agrees with you without compromise... but there is a snag. The viability of Britain depends upon the strength of our currency... which needs to devalue, but not collapse. This, I strongly suspect, is very difficult to orchestrate... As far as I can see, over recent years, inwards investment in Britain (swelling the proportion of world cash reserves held here) can be seen as a bubble in its own right. If that bursts rather than slowly deflates, shifts in currency would make it almost impossible for any British business to operate in today's global environment. I think that the only potentially viable strategy is a policy of attrition against those who morally, maybe, should spectacularly implode.


Yes, I think that the UK is likely to have a recession. The latest BoE inflation report confirms a 10% official probability of a recession lasting over a year starting in 2008. (See the fan-chart for GDP.) One should recognise that the BoE mandate is for economic growth... not just to control CPI inflation.

Brown's mantra for economic growth (i.e. rising GDP) is utterly critical... as, without it government borrowing - even at its current levels - would not be viable. If you review Brown's policies they are all to keep the GDP figure high and rising... and not principled strategies to strengthen the British economy. At some point such a strategy is doomed to failure... I think that time is now.

Nick (Post 3) & Mark:

I hope that's an attempt to be amusingly dark.

This is frighteningly close to the Nazi solution to dwindling wealth. In case you missed the history lesson... it didn't work out very well.


CPI is _expected_ to rise to 3.7% - we already know that food inflation can be at ~6% when CPI is at ~2.5%

The thing about inflation is that it isn't a belief spectacular rate of inflation that serves you a jolly-good-kicking, it is sustained and moderately high inflation that really hurts... especially those on fixed income and long-term contract rates...

aSteve said...

On peak oil..

..._permanent_ supply driven shock...

On CPI... isn't a brief spectacular...

These comments need an edit tool. ;)

Alice Cook said...


edit tools, you are right about that. Perhaps, what you need is your own blog. The same goes for you Nick.


aSteve said...

:o) Nah.

I'd have nothing to start writing about on my own blog.

Alice Cook said...


Start writing about M4. I am serious. You almost have blog going on my site. You could call it son of UK bubble blog. :)

There is definitely enough room for a few more UK economy blogs.


aSteve said...

:o) Yesterday evening I was trying to explain to a friend the basis of the model I'm using to make predictions about CPI. It was the "first hand-wave version" - but it sounded remarkably plausible over a couple of beers... even though I do say so myself. He insists I should publish... but... I suspect... with no substantial academic exposure... he rather under-estimates the effort needed to go from wild hand-flailing to a robust and persuasive text worthy of publication.

In a nutshell, I think that M4 is an inappropriate measure of money – because it is too narrow, and is measured anomalously for practical purposes. Sure, it is easy to generate M4 statistics, but they don't reliably articulate anything real about the economy. Money is not homogenous - it is stratified by risk, spend-ability, lend-ability and interest-rate. It is only short-term spendable credit/money that demand-drives consumption prices. For assets (investments – and let's not ask what is consumption and what is investment for a moment – that's a cultural issue) bought with leverage, the financier of the leverage, and not the asset owner, is the dog that wags the tail.

With exponentially expanding securitised debt, it became necessary to pass ever greater sums of immediately spendable money into long-term investments to buy debt securities in each time-slot. Inflation did not result from the credit expansion because securitised finance does not expand immediately spendable money... it merely transfers it from investors to borrowers. With mortgage backed securities, there was the additional caveat that the money was ear-marked to be spent only on property... which, in turn, skews the market for property – since the pool of money chasing houses is almost entirely independent of the property buyers themselves. The inevitable shock was not caused by US-subprimers failing to pay their mortgages (that was a consequence) but rather because a significant part of the spendable money available to their demographic was securitised funding. The cause of the sub-prime meltdown was that investors could no-longer raise sufficient immediately-spendable money to continue to finance securitised finance of the mortgage bubble. Sub-prime was the first casualty because people described as sub-prime engendered least confidence among the financiers – independently of whether or not they were the greatest objective risk. Sub-prime borrowers in the USA suffered a similar catastrophe as during the 1930s depression... an abrupt and unexpected change to their money supply... a sudden withdrawal of credit. The main difference between today and the 1930s is that in the 1930s, almost everyone was sub-prime... today, in America, there is a cultural divide. In the UK, the same securitisation of debt has affected a larger proportion of the population – and the worst affected demographic is differently selected than in the USA. In the UK, age is the most important determinant of creditworthiness – with most assets deemed worthy as security owned by elder generations. The same economic shock, however, is happening here. We are seeing the same wholesale withdrawal of securitised debt finance – and those dependent upon it are in for a very rude awakening... no matter how hard the authorities try to soften the blow.

I still think M4 is interesting, but its usefulness is very, very limited. It is not M4 that is important, but the proportion of M4 that is immediately accessible to consumers – either by the mechanism of credit – or in instant-access bank accounts. Every different account needs to have a weighting to estimate the velocity of money of that kind. It isn't easy to picture this graphically – but I think we need one axis for Sterling-amount; one axis for a classification of velocity (rate of transfer) – and another over time. The next step would be to analyse the demographics split of the account-holders... this would likely identify future economic shocks and asset-bubbles engineered by currency manipulation.

Far more interesting than M4, right now, to me, is GDP and the national debt. I strongly suspect that currency manipulation has skewed our GDP figures – and that this has been an intentional policy to support debt-expansion... that has lined the pockets of a fortunate few in a position to exploit overly generous government spending. GDP is, however, a far more complicated beast – and I could be wrong about it on a multitude of levels.


Asteve, I second Alice. If you have a tale to tell - and you have - don't bury it in comments sections, distil your ideas and put them out in a blog. I'd read it, for a start.

Alice Cook said...


However, I am a bit worried that if you do set a blog up, you won't come and comment on this blog quite so often.


aSteve said...

:) Ta...

For me, rather than having something to say, I feel like one of the "Famous Five" on a mission to solve a mystery that's beyond the grown-ups... maybe with a bit of Scooby-doo thrown in for good measure... (A trillion dollars? Zoiks! How many Scooby-snacks is that?) What I've found especially interesting about it is the diversity of topics this has forced me to think about... a fascinating fusion of history, geography, politics, psychology and religions... where I can apply philosophy, mathematics and lateral thinking amid a seemingly high-tech myriad of acronyms and definitions. A more challenging and engaging puzzle I don't think exists.

You're not alone in telling me to write about it... though I think my sister intended me to grasp that she wanted me to shut up... It reminded me of the classic: “You should be on TV, I can switch that off.” ;)

I've scared friends with early attempts to explain what I think I've grasped... (Warning: this probably won't make sense!) They think I've learned a new fact (and can't grasp why a mere fact should be worthy of much interest) but it is not the facts themselves that are worthwhile - rather the model of the world that they suggest... It is hard to seem credible explaining that I think I've uncovered a dual model for the same universe that I'm pretty sure they see (the one I saw until 2007) – but that in the dual model, several things that are utterly baffling in the first, suddenly make sense. The new model doesn't invalidate the first – it complements it... facts of little relevance in the first have great influence in the second... and, it seems, people find it difficult to mentally flip between the two... so, instead establish bizarre justifications for everything they see based upon a single model.

In an attempt to be concrete (so you think me slightly less of a nut-job, and delay the men in white coats) consider house prices. The year is 2003 and you think that house prices look quite steep... they're definitely far more expensive than when your parents bought – because now, in spite of significant career advancement, they couldn't afford to buy from scratch somewhere similar at today's prices (even ignoring retirement.) Something has definitely changed – there's no denying that. What? Some say it's immigrants over-crowding the country... but that doesn't really wash if you think about it without a red mist. Some think it's because society has broken down and marriage and cohabitation are no-longer absolutes... but that should make us less affluent and drive down asset prices. Some think it's because the elder generation worked hard, but the younger fritter their life away with iPods... yeah-right. Some think it's because we're living longer – but look at the birth rate! Some say that it's because we mustn't “concrete over the countryside” - supply and demand - but a more preposterous hyperbole is hard to imagine. Some say that it's because people value owning their own home – but it misses the point that people always did! Ask an MP about soaring prices in Northern Ireland – and they'll say that it's the peace-dividend... ignoring the fact that I'd accuse them, with that comment, of inciting fresh bombings... it's obvious that they don't have the first clue. It's like asking offal for an opinion – but less rewarding! So, if all the explanations for soaring house prices are bunkum – and the majority cling to them because, maybe, it serves their purposes; they're too busy fire-fighting to give it much thought; the media present this as a universal good – whatever... but there must be a real reason... mustn't there? Things like this don't happen by chance, do they?

So, if we've eliminated the buyers as the cause; and we've eliminated the houses as being no significantly better than – say – 30 years ago... why are they so expensive? The only variable left is the money... £1 is £1, isn't it? Well, no, it isn't. Money has zero value independently of time – since it only affects the world when it is spent... and, in any case, it isn't so much money (in a traditional sense) that is relevant - as credit. The first thing that your average pleb doesn't realise is that there isn't a fixed amount of money in the world. The £1 in their pocket might have to compete against an arbitrarily large number of £1s in other people's pockets tomorrow... and there is remarkably little direct control on how many. Fractional reserve banking and M4 expansion at every instant that a bank issues a loan – I think – is utterly beyond the comprehension of many. By the time you've explained that, people's heads are spinning... but you've not even got to the good part! Governments and central banks are aware of FRB – and use central banks and interest rates to preserve the value of money over time. The really good part is securitised debt... Not only does securitized debt usurp government control over interest rates, but it also subverts fractional reserve banking... by treating IOUs (I.e. CDOs etc) as if they are money – because they're almost equivalent... as long as they work... but, unlike treasuries – they're under no democratic control. They're not even regulated!

The genius about securitized debt – and structured finance in general – is that it subverts sovereign control over currency. This is, without a doubt, debasement of currency... exactly what de-throned monarchs; impoverished entire nations; ignited (and funded) wars – civil and foreign – and has been among the most insidious events that litter history. AAA-rated bonds are considered (almost) equivalent to sovereign debt (treasuries) within our monetary system... but AAA-rated bonds were being synthesized artificially by investment bankers from far lesser contracts. One would think that this wouldn't be the sort of change that investment bankers could get away with for very long... but they could. First they could ensure that the vast majority of the paper they wrote funded corporate takeovers; real-estate purchase and other new specific lending (student debt, for example) which fell outside the metrics used to guide monetary policy – by being prescriptive about the kind of lending that could be securitised. It was not about safe lending at all – it was about lending that didn't raise the base rate of interest – and, hence, allowed insiders to reap spectacular profits by borrowing short (at BoE rates) and investing long on asset backed securities – which pay a small premium over base. It was such a good wheeze that a speculative frenzy took over – and mortgage originators could make profits if they could find snails to take on mortgages – no questions asked – “Yes Mr Escago, I understand you earn £200K/anm eating cabbage, but can't find your pay slips... just sign here please and the £1m shell is yours.” The investors were blinded by their supposedly risk-free returns and couldn't get enough... a classic bubble – but it was a bubble in asset backed paper issued by investment bankers – *not* in real estate, per se. The houses are just the same as they ever were – and the buyers just as selfish, dishonest and desperate too. The noughties have no monopoly on Lust, Gluttony, Greed, Sloth, Wrath, Envy or Pride... they've blinkered the under-educated and allowed them to be manipulated by a small elite.

I think that this, without going to details of the most likely way that the collapse of secutisation will affect the wider economy, is the end of the first chapter. We know “what” has happened.

The chapter I'm next most interested in is “how and why?” Why has the public interest not been served? Why has over half of all securitisation in Europe been against British assets? Where does Maastricht fit in, and is it relevant? Is the Labour government complicit in the fiasco by intentionally stripping the BoE of its oversight of investment banks – handing that responsibility to the unproven FSA – who, if they were described as unfit for purpose, would consider this a major complement? What's the deal with John Gieve (the shonkiest excuse for a human ever – moved into his role as “Deputy Governor for Financial Stability” after leaving the home office amid fraud-related problems and other failures)? Why is Blanchflower (a member with predominately US sympathies) voting on the MPC? Why did Brown's government try to hang Northern Rock on Mervyn King - when it it utterly transparently obvious that he was about the only person *not* responsible for its failure? Is Brown's obsession about “Economic growth” (I.e. increasing GDP) about covering-up eye-watering government debts, and – if so – was the debt used honestly? Who, exactly, advised Brown on how to play Chancellor, and how were they rewarded? Was it really Arthur Anderson – who went on to collapse after proven involvement in Enron – the largest ever corporate fraud? Arthur Anderson definitely advised Brown on Pensions. You can't expect me to believe that a history-major, from the grim bowels of Kirkcaldy, interested in socialism and securing government actually masterminded the largest financial scam in British history, do you? What is the real tie-in between Brown/Blair and Bush? Is there a link to terrorism 9/11 or 7/7? Is there a link to Afghanistan or Iraq? If senior Labour politicians were aware, how could they be so stupid as to find themselves on the hook - selling honours for peanuts? Do either of the opposition parties grasp what has happened? Do Labour grasp what has happened? Is that why Blair left and no-one opposed Brown? Is this why anti-terror legislation seems to be primarily focused on quashing civil unrest rather than addressing credible terrorism?

I suspect I've gone on a bit... I've kept a copy... but it isn't really the right format for a blog. :-$

Anonymous said...


While I appreciate the complement I'm afraid quality blogging takes an unusual convergence of personal qualities and available time. I suspect I lack both. I tried doing a personal blog once but it was rubbish and I couldn't make the commitment.

That fact I tried and failed makes me appreciate good blogs all the more, hence why I read this one so much.

Asteve - Yes, my final solution to welfare was half jest, but only half. I don't believe people have a right to children (if they did, where does that right come from? The fact they CAN have children is just deriving "ought from is", an age-old philosophical error). I also believe people have children they can't/won't support themselves and shouldn't bring children into the world who are condemned to misery from birth just because they want kids. The welfare state perpetuates the underclass by keeping these scroats alive long enough to reproduce and then guaranteeing the survival of their offspring. There's a serious Malthusian problem here and I can't think of any good reason why such people should be allowed to have children.

The solution is to stop economically irrelevant people breeding. (It would be better to simply stop supporting them, but they'd still have kids and it would guarantee very high child abuse and poverty levels - better to stop the next generation being born)

The problem comes with the solution. How do you implement a just and fair solution to the scroat reproduction epidemic that doesn't have all kinds of unintended consequences. Such a program would be government administered and as such would be hugely inefficient, would give bureacrats too much power, and would inevitably result in the wrong people getting the wrong treatment.

So I only meant it as a joke in the sense I think it couldn't be done properly. If Gordon Brown takes the country any further towards ruin, maybe I'll start thinking its worth the risk


aSteve said...

I think that outrageous propositions have a nasty habit of becoming reality as desperate people resort to desperate measures.

I think that everyone has a right to have children; a right to decent safe and secure accommodation and general security. With these rights come responsibilities. None should have the right to demand their selfish ends are provided at the expense of others simply because they refuse to take responsibility. The problem, of course, is much deeper... many people face poverty, just as many live in exuberant wealth, purely as a consequence of previous ill-informed government policy.

I refuse to accept that it can ever be appropriate for government to step in and prevent people from living their lives how they wish. Conversely, I think it outrageous that benefits such as free housing and cash handouts are earmarked exclusively for those who do not help themselves. Not only is it demoralising for the responsible but inaffluent - but it is demoralising for the demographic it sets out to assist... it enforces a Pavlovian sense of learned helplessness - which can't be a good thing.

Alice Cook said...


I would love to see more UK blogs. In the US, there are so many good ones and it is a shame that there isn't more here.

On the question of blogs, I have given it some thought. Unless, you are someone really special, personal blogs are really dull. Blogs have to focus on a key issue that has general interest. Blogs also have to say something beyond the regular media. Finally, the audiences tend to be fickle, so you have to put something up every day.

In the absence of a regular blog, I do hope you keep producing your excellent comments and insights here.


Alice Cook said...


I would love to see more UK blogs. In the US, there are so many good ones and it is a shame that there isn't more here.

On the question of blogs, I have given it some thought. Unless, you are someone really special, personal blogs are really dull. Blogs have to focus on a key issue that has general interest. Blogs also have to say something beyond the regular media. Finally, the audiences tend to be fickle, so you have to put something up every day.

In the absence of a regular blog, I do hope you keep producing your excellent comments and insights here.