Thursday, 11 June 2009

Lets start the clean up now

FTAlphaville has just reported that the 10 year UK government bond yield has hit four percent, giving a spread over BoE's bank rate of an unprecented 350 basis points. As the chart above clearly illustrates, before the crisis the spread was negative and comparatively small. Something is going badly wrong in the UK government debt market.

With its massive borrowing requirement, Brown and Darling are trying to issue historically unprecedented quantities of new debt. So lets go back to basics and remind ourselves about supply and demand in the debt market.

An increase in the supply of bonds will pull down prices, and push up yields. For those unsure about the relationship between bond prices and yields, take it on trust that there is an inverse relationship between the two. With government debt issuance starting to accelerate, it is as inevitable as night follows day that yields will start to increase.

The Bank of England thinks it has a solution to this problem of rising bond yields. It will print cash and buy up government debt. In effect, the bank is trying to increase demand in the hope of pushing bond prices up and pulling yields down. In short, the BoE thinks it can manipulate demand.

However, it is a solution that can only work if you assume that private sector holders of government debt are brain dead and unable to calculate the long-term consequences of unrestricted cash creation and uncontrolled government borrowing. Inflation is always the inevitable result of this reckless expansion of monetary and fiscal policy. And since inflation destroys the real value of government debt, investors need to be compensated with an inflation-adjusted yield, which is why long-term interest rates are beginning to rise alarmingly.

The Bank of England could just keep on buying the debt to try to put a c eiling on yields. After all, it has an unlimited capacity to create cash. However, it doesn't take a lot of imagination to see how this strategy could quickly spin out of control. Faster monetary growth means of course higher inflation. Investors would quickly realize that UK government debt is too dangerous in terms of inflation risk and start to dump their UK bonds. It is not inconceivable that there could be a run on UK government debt. It has happened before, most recently in the mid-19 70s.

The Bank of England also has an answer to this potentially horrific scenario. It defends its current strategy by pointing to the threat of deflation. The truth, however, is that the UK economy never came near the deflationary trap. The CPI inflation rate is well above target and if fuel prices are excluded, then the adjusted CPI is well above three percent. Moreover, there are signs that this unparalleled surge of cash creation and the gigantic fiscal deficit has begun to feed through into output. There are some signs that growth may resume in the third quarter. If this does prove to be the case, then the danger of a sudden inflationary spiral would be both extremely serious and immediate.

So what is the alternative? The Bank of England must discontinue printing cash immediately. At the same time, it should hoist the bank rate by 300 basis points, allowing it to reconnect with interest rates in the rest of the economy. This will have the practical implication of restoring a degree of interest-rate control to the monetary policy committee. These two policy changes would almost certainly see bond yields rise sharply. The government would have to announce an emergency budget which would announce a credible fiscal consolidation strategy. There would be a need for some immediate budget cuts, tax rates would have to increase, particularly VAT.

In terms of the real economy, output would contract. In the short run, unemployment would continue to rise. However, the economy would benefit enormously over the medium term by having in place a prudent and sustainable monetary and fiscal framework.

The question confronting the UK economy today is not inflation versus deflation, but a mild recession today versus a catastrophic depression in the future. Consider the consequences of continuing with the present strategy. If bond yields continue to rise, all interest-rates will be also pulled up, thus creating the conditions for a prolonged recession. Sooner or later, UK policy makers will have to tackle this ever more chaotic macroeconomic mess. I say lets not hang around for another financial crisis. Let's start the clean up now.


Mitch said...

With gordon in charge you got no chance, just keep the wolves away till he is back in No10 then boom....well bust.

Anonymous said...

And people wonder why the mortgage rates are going up :)))

Anonymous said...

It looks like we're going to get our currency crisis before the autumn.
Hold on tight, this is going to get ugly.

Mark Wadsworth said...

AC, top stuff.

It really is as simple as that - I refer to it as the interest rate see-saw; the government can push down long term rates (at the expense of higher short term rates/inflation) or it can keep inflation in check by pushing up short term interest rates (which all things being equal lead to lower long term interest rates).

Just two minor quibbles:
"An increase in the supply of bonds will pull down prices, and push yields up."

Should read "... push up yields. - don't end a sentence with a preposition.

"Lets start the clean up now."

Should read "Let's start the clean up now!"

QG said...

"I say let's not hang around for another financial crisis. Let's start the clean up now!"

But you are not a politician Alice and the sad truth is that any politician who promoted your ideas would suffer at the polls for giving the electorate unwelcome news.

I have a question for you Alice:

If we did experience a gilts strike and Brown was forced to go to the IMF, how would you feel about that? The reason I ask is that I know it is irrational to desire that our government kneels before the IMF but emotionally there is apart of me that would really enjoy watching Brown grovel. Do you know what I mean?

Rick said...

It just goes to show how much of 'growth' isn't technically 'growth' at all if the effect is to increase inflation. Real growth should help to attenuate the effects that monetary inflation has on prices.

Anonymous said...

How interesting. You post this here and I have just finished reading Denningers latest.


Kosh said...


A clear solid path to sensible economics, the last time I saw a Chancellor desire something similar to this was Ken Clarke in 1993-7.

I suspect that the Treasury top to bottom know what they should do, but lack the courage to do it, so they've thrown everything they have in the wrong direction and broken every rule of sensible economics.

Alice I like how you've responded here to the criticism levelled about nay-saying without providing solutions (from 2 days ago). I doubt they'll be satisfied, but I sure am.

Anonymous said...


Last September RPI inflation hit 5%. At the time, bank rate was also 5% and unless the MPC raised it sharply, you warned we would soon be in for double digit inflation. Fortunately, the MPC ignored your advice and slashed bank rate to its present rate of 0.5%.

What happened to inflation - did it spiral out of control? Are we heading for double-digit price growth? Did inflationary expectations rise sharply (as you predicted). Thrice "no" is the answer! In fact, RPI has fallen to its lowest level since the 1950s. Admittedly CPI is still stubbornly sticking at 2.3%, but this hardly constitutes the rampant inflation which you promised us was just round the corner.

What's more, this isn’t happening just in Britain. In France, inflation is at 0.1%, the lowest since 1957; in Germany it is -0.1%, the lowest since 1987, whilst in Italy the rate is currently 0.9%. Collectively the Euro-zone CPI rate is 0%. Outside of Europe, the US the inflation rate is -0.7%, in Canada it is 0.35% and in Japan it is -0.1%. In other words, not only do we not have double-digit price growth – we haven't even got single digit price growth! The entire G7 (and much of the world beyond) is experiencing extremely stable prices.

Even more interesting, inflation is at this low level even though the economic downturn has yet to have its full effect on the unemployment figures. Over the next twelve months this will rise by a further 1mn or so in Britain, with similarly proportionate rises throughout most OECD countries. The effect of this will be sharply to constrain wage growth and inflation. We might not experience the deflation which some commentators have feared, but we certainly need not worry about rampant inflation.

Strangely enough, for the entire time I've been reading your blog, hyper-inflation has always been just round the corner. And this is rather the point. Hyper-inflation is always in the future – a future which never actually arrives. So, let me ask you two questions:

1. To what level will inflation rise? I would like a very specific answer e.g. 23% CPI.

2. By what date will it have risen to this level? Again a very specific answer would be appreciated e.g. no later than 22 July 2010.

Young Mark

Anonymous said...

I think "Young Mark" almost made his own point.

France,0.1%, lowest since 1957;
Germany,-0.1%, lowest since 1987,
Italy, 0.9%.
Euro-zone CPI rate is 0%.
US the inflation rate is -0.7%Canada it is 0.35%
Japan it is -0.1%.

While in the UK it is +2.5%(ish).

So we have inflation ~2% higher than pretty much all of our trading partners.......the source/cause of which can only be the state of our economy???


sobers said...

@Young Mark:
My 2 cents:
1) Inflation will rise to double digits at least, possibly well into the teens if we suffer a currency/debt funding crisis as well.
2) Timescale: Positive RPI by end of 2009. CPI prob 3%ish. Steady rise through 2010 as interest rate cuts drop out of RPI, and current oil price rises off the $30 bottom kick in. If BoE raise rates in 2010 that will kick RPI higher than CPI (at this point the BBC will forget RPI exists and focus on CPI). By end of 2010 inflation to be in the 5-7%range for both. If BoE then fail to raise rates rapidly and reverse the £150bn of QE, inflation will hit double figure by middle of 2011. I have severe doubts that any govt will take the difficult steps to drive inflation out of the system when the economic recovery is still very weak.

At any point in the next few years there remains a high probability that there will be a funding/currency crisis which could raise inflation drastically within months due to a rapid devaluation of sterling. That is the wild card that could trigger the high teens inflation or even above.

Anonymous said...

Young Mark. I don't know if this will help your dilemma but have a read of
Only a small fraction of the new money being printed by the BoE is circulating in the economy. It is mainly being held onto by the Banks as the "first receivers" of the money, so that they can pretend not to be insolvent and keep buying the governments debt (Guilts). There are real economy reasons that are keeping prices from going up other than those caused by currency depreciation (imports). The inflation in the money supply has already occurred, the trick (BoE)will be to stop the Banks blasting that money into circulation and exploding prices of goods and services.

Josh said...

10 percent inflation this time next year?

Alice Cook said...

Young Mark,

Inflation hit a 16 year high last September, and the BoE has failed to meet its target for around 3 years. I first voiced my concerns on inflation in March 2007, therefore I feel quite vindicated.

Second, only in my most excitable moments, do I use the word hyper-inflation. In fact, I don't remember the last time I had a post using that word.

As for future inflation, I hope it will be lower than 2 percent. I want to see the BoE raise rates and stop printing cash and no longer monetize the fiscal deficit.

Lets for a moment, assume that good sense does not prevail and we continue to have a zero interest rate policy, with the BoE continuing to print circa 10-15 percent of GDP of new money this year.

I would say we would need to factor in a two year period before we see the full effect of this moentary irresponsibility. By June 2011, it is quite feasible that inflation could be within the 5-10 percent range.

Finally, I would, in the friendliest possible terms, suggest that you take a close look at what financial markets are saying. Ask why long term t-bill rates are rising and have departed so dramatically from the bank rate.

Forgive me for being anecedotal but I recently had a lunch with a friend who works in major investment bank based in the city. She put it wonderfully when she said that in the city "inflation is the new consensus".

As always, your comments are most welcome and appreciated.


Alice Cook said...


I don't want to see Brown humiliated. I would hate to any Prime Minister of this country go around the capitals of this world begging to be bailed out.


sobers said...

I DO want to see Brown humiliated. I want him to have to go begging round the Far and Mid East trying to raise the money to keep his client State in benefits, and when he fails, have to come home and tell all the 'diversity officers' and other non-job holders that the money has run out and they're all sacked. Oh happy day!!!

boiling frog said...

Good blog, good discussion. Thanks Alice and commentators.