Friday, 4 July 2008

The rate hikes begin

With each passing month, the inflation numbers are getting worse. As the numbers deteriorate, the options available to central banks are becoming narrower; either raise rates and take the inevitable hit on growth and financial stability, or let the problem slide and watch inflation slip further. With double-digit inflation hovering on the horizon, some central banks are beginning to act.

Does the idea of double-digit inflation sound too alarmist? Last month, the RPI inflation rate was only at 4.3 percent; at least 5 percentage points south of a double-digit rate.

Looking at today’s inflation rate is like trying to drive by looking in the rear view mirror. Inflation is a forward-looking phenomenon, and therefore central banks should assess future expectations when formulating policy. In the absence of a credible policy response to rising prices, private sector expectations are adjusting rapidly upwards.

People are not daft; they see what is going on, and they do not like it. So far, central banks have acted too slowly to counter the inflationary threat. People have noticed this growing cowardice in the face of the inflationary enemy.

Whatever economists might think, inflation is not a concept that tests the intellect. When prices start to rise, everyone quickly grasps that money in your pocket today buys less in six months time. Therefore, it is better to spend it before it loses value. Saving is futile when inflation rises above the bank deposit rates; each pound held in the bank will be worth less in the future.

Although inflation destroys the incentive to save, it does not generate a huge consumption boom. Rising prices erodes the value of fixed incomes, unless wage growth keeps up with inflation people become poorer. In fact, inflation is the mother of income inequality. It punishes those on pensions, and those who cannot push through inflation indexed wage increases. It favours the rich, who generally hold real assets and can diversify their wealth, and punishes the poor who cannot.

Inflation is a terrible thing; and ordinary people instinctively understand this. Therefore, once inflation expectations take off; they quickly run out of control. Imaginations run wild; people begin to expect the worse; and once the idea of double-digit inflation enters the popular imagination, it becomes almost self-fulfilling. If people think double digit inflation is possible; it will happen.

Already, 50 countries, including six of the 10 most populous ones, are now dealing with inflation rates in excess of 10 percent. Close to three billion consumers are currently suffering double-digit rates of price increases. If it can happen there, it can happen here.

Some central banks are waking up and starting to act. Yesterday, the ECB finally understood the dangers ahead and hiked rates by a 0.25 percent to 4.25 percent; Earlier, Sweden's central bank raised its benchmark interest rate a quarter point to a 12-year high. The Norwegian central bank raised rates earlier in the week.

Other central banks do not quite have the message yet. Notably, the Fed has been slow to notice the growing inflationary dangers. Its sudden post-credit crunch monetary easing is beginning to look positively foolish. It has not put a floor under equity prices, it has not prevented growth from slowing, and it has not stopped house prices crashing. The monetary easing has not even stabilized financial markets. It has, however, done wonders to excite inflationary expectations.

Here in the UK, the Bank of England did not go quite as mad as the Fed. Nominal rates have come down a little, while rates adjusted for inflation hover fractionally in positive territory. Nevertheless, over the last few months, the MPC repeatedly missed the opportunity to tie down decisively inflationary expectations. Instead, it relied on luck, hoping that a modest slowdown in activity might be sufficient to bring inflation back down close to target. So far, luck has not shined on the hapless MPC.

The MPC would find it easier in the end to try to contain inflation when it hovers at between 4-5 percent, rather than to attack it when it is approaching 10 percent. The mood is shifting, rate rises are coming; and the sooner they arrive, the less painful they will be.


Markbaldy said...

It is unfair to just blame the BOE for low interest rates - Gordon Brown has been instrumental in promoting low interest rates to prolong his "miracle" economy... ie. one based on consumer spending of money they didn't have... by using their property as cash machines. (reliant on continued house price inflation)
If you remember all the New Labour spin leading up to the 2005 election, you will recall Gordon Brown bragging about low interest rates were under them compared to
higher rates under the Tories... so please Gordon, do not tell me the BOE has independence because I just do not believe it!

Anonymous said...

Interesting but I think you are missing the point. We have deflation in the West and inflation in the emerging market. The West is not printing, whereas the likes of China and Saudi Arabia are.

Now that the oil subsidies are being removed in China and India, and soon everywhere, the demand destruction is going to throw the price back under $100.

Then there'll be no disguising the West's deflation.

I disagree with you. But please keep posting on the topic because it's always interesting.


Mark Wadsworth said...

Hmmm. Inflation or deflation? Nobody knows.

All we do know is that in a downturn, Cash Is King.

sobers said...

Mark Wadsworth: quote"Hmmm. Inflation or deflation? Nobody knows.

All we do know is that in a downturn, Cash Is King."

Not necessarily. If we have stagflation (which looks on the cards) money in the bank will be having its value eroded, while assets will also be losing value as well (property/stocks etc).

I'm beginning to wonder if "practical" assets that have a productive capacity in the event of a societial collapse will be the best thing to have - The man with a chainsaw (if he can get the fuel) will be in a strong position if the oil/gas pipelines from Russia get turned off.

It's all going a bit "survivalist" for my liking. Makes you wonder how soon we would have gangs roaming the streets if the economy really took a dive.....

aSteve said...

IMHO the only thing in question in the inflation/deflation debate is the formal definition of the two terms... which mean different things on different time horizons to different people.

Essential goods/utilities etc. to go up in price in the short term... then stabilise or fall. Asset prices on a substantial downward trend. Monetary expansion - almost at its peak... expect repayment of debt and/or substantial debt write-off over the next few years. Substantial average wage rises (unlikely) in the medium to long term.

dearieme said...

Time to pop down to the pub and buy a gun?

powerman said...

I'm already giving serious thought to growing veg on an allotment and brewing my own beer to try and get living costs down.

Edward Harrison said...

Great post, Alice. You hit the nail on the head. As I see it the BoE can either let inflation rise, hoping it is only a temporary rear view mirror phenomenon, or it can raise rates now to be cautious.

Raising rates now, while it might be economically sound, is politically courageous and could prove to throw the UK into a deep deflationary recession.

Does the BoE want the blame for that, even if its the right medicine? That's a entirely political question.

From where I sit, the BoE should raise rates, however unpalatable, because allowing inflation now could create greater pain down the line. My bet is they won't do because they don't have the stomach for the political fallout as the Northern Rock scenario demonstrated.

Mark Wadsworth said...

Sobers, it's not just UK house prices that are down 10%, the FTSE is down 10%, meanwhile my cash after interest and tax has only lost 2%.

Anonymous said...

"money in the bank will be having its value eroded, while assets will also be losing value as well (property/stocks etc)"

Surely the contradiction in this statement is obvious. How is the money in the bank eroded if you can use it to buy more house or more stock than it used to?


electro-kevin said...
This comment has been removed by the author.
electro-kevin said...

There must be millions of repossessions looming, surely ?

electro-kevin said...

Sorry - the link won't work.

Go to Times On-line and search

'4 million pay mortgages on credit cards'

Anonymous said...


"Surely the contradiction ...."

Maybe it depends upon what your money in the bank will buy. If you only have enough to buy 'ever more expensive' food and fuel, then your money will be eroded. If you can afford to buy 'cheap' property or stock, then you stand to make a profit at some time in the future. "You can never pay too much for something but you may buy too early."

A David

Anonymous said...

A question.

Has there ever been a realy long deflationary period in history? When I look at the table of RPI from 1948(RP04), there are only seven months of negative inflation (around 1959/60). Does anyone expect there to such a scenario now and if so, why?

A David

CF said...

I believe that there were extended periods of deflation during the pre-1914 gold standard.

Anonymous said...

Much as I would like them to, I just cant see the BOE raising rates. They will try to hold their nerve and hold rates for a while yet and hope the commodity bubble bursts. If it does I expect they will be cutting hard once inflation eases.

Very good blog btw