Tuesday, 17 June 2008

The letter - any views? Well, I have a few....

So the letter finally arrived. The Governor of the Bank of England- Mervyn King - had to openly admit that the Bank of England had failed to meet the 2 percent inflation target.

This letter writing thing is a little strange. Since the beginning of 2006, inflation has been systematically above 2 percent. However, 3 percent is the magic number that generates a frank admission that there is a problem.

So what does the letter say? As expected, it starts with a long and predictable exercise in blameshifting. The causes are many and various; food, oil, global demand, global supply, domestic gas and electricity prices, and the depreciating exchange rate. In fact, it is everything but the policy decisions of the MPC. Their decision to keep interest rates too low for too long doesn't get a mention.

The excuses are shameless. These factors, of course, have only short term temporary effects on inflation. Many of these problems have turned up quite recently. The data shows that the inflationary problems have been building since at least 2006. For example, over well over two years the RPI has been above 4 percent (see chart above).

The real reasons for today's higher inflation rests with the MPC. The UK has a floating exchange rate; which means monetary policy and therefore the price level, is firmly under the control of the central bank. If the MPC wanted to reduce inflation, all it had to do was raise rates. However, it chose not to, and now we have inflation.

The governor follows his lame excuses with the key question - how long will inflation stay above 3 percent? He raises the question, but doesn't really answer it. He merely says that inflation will peak at the end of the year, which sounds a lot like "the inflation numbers are going to a lot worse". He then predicts that inflation will stay above target for most of 2009. However, he does assure us that inflation will reach 2 percent. There is, however, no time frame for delivering that assurance.

Then, we come, the policy response. So far, the response to this higher inflation has been three interest rate reductions. Taken by itself, this response appears to verging on insane. However, the governor explains that the rate cuts were part of a risk balancing exercise; where the bank weighed higher inflation with slower growth. In retrospect, the balancing act appears to more like stumbling around in the dark; inflation has risen dramatically while the economy is still slowing.

As for future policy responses, the governor seems to be adrift. The interest rate path necessary to achieve the 2 percent target is "highly uncertain".

Uncertain? I can tell you right now what the level should be; a 6 percent base rate. A couple of hefty hikes within the next few weeks, and we can be guaranteed of having 2 percent inflation by next spring.

In sum, the letter had a few simple messages. First, it wasn't the MPC's fault and offered a totally unconvincing defence. Unfortunately, the data accuses the MPC of persistently showing weakness and a lack of determination in the face of growing inflationary pressure. Second, we should expect even more inflation over the next two years. Finally, the letter confirms what we all know about the MPC; it isn't quite sure what it should do, other than perhaps, keep "balancing the risks".

Unfortunately, inflation is not the kind of problem that compromises with central banks that spend their time "balancing the risks". Inflationary expectations are rising, sterling remains weak, and the central bank's response looks confused. In other words, we should expect many more years of high and persistent price increases, along with a lot more letters from the governor.


Roy said...

harsh but fair.

Edward Harrison said...


I tend to be fairly hawkish as I am an Austrian school libertarian. However, I would say that I tend to agree with King regarding inflation. I think oil is in a bubble right now and I don't foresee rises of the magnitude we have seen. Could prices rise to $180. They could do. But they would need to in order to maintain the previous level of inflation.

The BoE has no control over commodity prices. The MPC should set rates only according to the price inflation that is related to the business cycle or to avert a wage-price spiral.

I still think, with unionisation at a low ebb and difficult price level comparables from 2007 to compare oil and food to, inflation will ebb without rate hikes.

Were I giving advice I would suggest the BoE hold and the Fed raise rates. The BoE still has a positive inflation-adjusted rate and it is higher than the Fed or the ECB.



Anonymous said...

Invest in euros.

Sterling is moribund.

(being polite.)

Parity soon.

traderboy said...

anonymous, i'll take the other side of that trade. the one going to parity is EUR/USD, not EUR/GBP...

Edward Harrison said...

trader boy, I agree. the euro is overvalued versus the dollar. Even sterling is overvalued against the dollar. I had a former flatmate over here from Hampshire and we went to the pub to watch the European cup (no England, I know. It was Greece-Russia.) and he was astounded at how cheap pints are in the states.

The dollar has reached its nadir. I'll grab that trade with you -- maybe not all the way to parity but at least to 1.25-1.30.

andyrich29 said...

Spot on Alice.

Higher IR's are on their way. At least 1 increase by the end of the year.

This will be necessary to control inflation "expectations".

Alistair Darling wants us all to get poorer (yes even more poorer) by taking below inflation pay cuts over the next couple of years too.



Am I right in thinking that Alice is arguing that if we raised interest rates, sterling would strengthen and this would reduce commodity prices in pound terms?

wildgoose said...

My opinion, for what it's worth.

I'm confident that the Oil price is a bubble which can be ignored for now despite the short-term pain.

The problem is the massive indebtedness of the UK economy (including the
Government) combined with the fragility of banks with excessive loan books backed by depreciating assets (e.g. houses), and whose customers are using their deposits to pay down debt and thus threatening to blow apart the banks' Basel II lending requirements.

Unwinding this debt bubble without triggering Japanese style deflation is the problem that the Governor is now trying to avoid.

If only they had had the sense to raise interest rates earlier before it all went out of control! Mind you, part of that problem was the government's doing by deliberately changing the measure of inflation being used so as to stoke the housing bubble still further.

They need to raise interest rates, but do so slowly. That way they get to inflate away some of the debts whilst still being seen as doing something, so as to limit the damage to the perception of the Bank of England as a responsible organisation. Jean-Claude Trichet will help in this - he's already declaring that Euro interest rates will climb, giving the Bank the political excuse they need to follow, and Bernanke at the Fed likewise.

Interesting Times!

Markbaldy said...

The BOE wants the best of both worlds - a bouyant economy and low inflation.
It is trying to balance on a knife edge and this tack will only delay the slide into the abyss... it WILL NOT STOP IT.
We are too far in debt and reliant on other countries for the BOE to have any real influence.
There will be a recession in the UK and I don't see what could pull us out of it ? We have little industry, few energy supplies, can't feed ourselves and have a weak government that is only interested in spin and creating a big brother society - a grim but true vision of the future I think !

aSteve said...

I disagree with you, a little, on this one, Alice.

I think you're right that an increased interest rate would resolve our inflation - but it would certainly have a massive implication for GDP "growth" and would make our presently perilous balance of payments even worse. Not only that, but government borrowing would be hit hard - and with >£600bn gross debt, that's not a small concern.

While I would like to see rates increased to 6, 8 or 10% - I don't think it can be done without inflicting massive additional damage to the economy. I'm with Mervyn King on this.

On the topic of blame, given that I think the BoE are doing a pretty good job under difficult circumstances, has to lie elsewhere. I place the blame firmly at Downing Street - who demanded fixed inappropriate targets - that ham-strung the BoE preventing it from managing the economy using their best understanding for a decade. Low inflation and high employment are two metrics that we use to establish government performance... there should be no surprise that, when the government demand that these statistics are managed, that - eventually - the strategy fails.

I blame the government for imposing inappropriate monetary policy targets.

monoi said...

As you point out in earlier posts, real interest rates are way higher than the BOE headline.

I checked mortgage rates yesterday, and if I had to remortgage, it would mean an increase of about 40-50% in the rate I would have to pay. After paying a fee of £5700. I have a perfect credit record, and it is only 20% of the house value (ok, maybe a bit more now !).

The market is doing it for the BOE.

andyrich29 said...

Correct asteve. High employment doesnt necessarily mean good economy.

Germany has high unemployment but a good economy.

You can always rely on Labour to screw up the economy.

rich010273 said...

As soon as the Government targetted the CPI rate it would have known that growth must be sacrificed to achieve it.
People have had 10 years of growth (not knowing that this has in fact made the average person poorer) so now the chickens are coming home to roost.
I believe a recession is a good thing as it clears out all the wastage in the economy. Higher interest rates would induce this. Only way to get rid of inflation ( caused by money supply) is to increase interest rates. This would also keep the value of the pound in your pocket but may mean that all the heavily in debt people in this country have a miserable next 10 years.

Anonymous said...

You can't have a solvent economy and full employment. The latter forces you to create "make-work" employment in the public sector which creates huge inflation (both real printing to pay the salaries, and CPI in increased effective demand bidding up prices), and bankrupts the government. No government would be crazy enough to try it.

Oh, wait a minute! That's exactly what Labour did since 1997. And judging from today's Times Unison are about to tear up the contract they just signed 2 weeks ago and demand more money from taxpayers.


powerman said...

I agree that artifical price controls on the cost of borrowing money are the root cause of this, but I hesitate to blame the MPC for this.

They were working to an inflation target set by Brown, and had to use a very suspect measure of inflation (which deliberately excluded real estate purchase prices), which was also set by the government of the day (largely under Brown's aegis).

Anonymous said...

From the Tinfoil Hat dept:

Looks like the BoE is massaging interest rates (and the £) down to somewhere near Euro levels.

Wonder why?

Think, think, it's a hard one isn't it...