Rates

I know I have covered this before but barely a day goes by without the position worsening.  The Bank of England is charged mainly with controlling inflation but also with supporting Government economic policy and ensuring stability in the financial system and it now finds itself all but rudderless in the midst of the greatest storm for more than thirty years.

The Bank’s main tool of monetary control is the setting of official interest rates.  Ordinarily, the base rate determines the rate at which banks lend to each other and to their customers but this formerly dependable relationship has broken down with potentially catastrophic results.  The other mechanism the Bank can deploy is that of lending huge quantities to financial institutions, thus ensuring they themselves have enough money to continue to lend.  Again, this has ceased to be the case.  Now, banks which have money, mainly those with large depositor bases, are not lending it and those which have no money are having to lend at rates at a far greater premium to the base rate than would normally be the case.

This means that whilst the Bank of England Monetary Policy Committee, which is responsible for setting rates, wrings its collective hands and agonises about the spectre of inflation.  In fact, they may worry all they like about inflation but they have lost the power to do anything about it.  Much of the inflation we are experiencing today results from increases in commodity prices, whether soft, such as agricultural products, or hard, oil and minerals.

The Bank seems to have put these price rises down simply to increased global demand, all of a sudden we are driving further and eating more, but much of the money pouring into commodities, as with property, is borrowed.  Rising real interest rates will reduce this speculative activity, perhaps with a crash in prices, which will show up in reduced inflation.  The Bank really should be worrying more about recession and making bolder interest rate cuts.

Having presided over ten years of an asset price bubble fuelled by cheap credit, it is a bit late in the day for the MPC to start worrying.  Of course, the Government should shoulder some of the blame for setting the Bank a one dimensional objective but I would be surprised to see anyone in power admitting that.

With one eye apparently on the threat of inflation, the Bank of England Monetary Policy Committee has been reluctant to embark on the type of rate cutting spree we have seen in the United States.  Instead, in Britain we have been teased with a mere quarter of one percent off base rates.

Dictating Monetary Policy, however seems no longer to be the preserve the Bank as lenders increasingly ignore official rates as they are buffeted by the effects of the credit crisis.  Lending rates which once moved in tandem with the base rate have now lost this linkage as mortgage lenders and others in the business of loans seek either to rebuild battered balance sheets or make opportunistic profits.  The next time the MPC sits, they may wring their hands with anguish, agonising over whether they run the risk of stoking future inflation but the harsh reality will be that they may have become mere bystanders, looking on as others take control over interest rates. 

This may be fine in the short term but those in power should worry that this state of affairs persists into a downturn, perhaps meeting out additional punishment to an economy in dire straits.  A gentle unwinding of an over borrowed populace is one thing, a recession would be quite another.  The Bank needs to take control by force, if necessary, even if that means we may face higher inflation eighteen months down the road.  The position in the UK seems to be nowhere as bad as that in the States and the Bank may find that it responds well to a few deep cuts in interest rates.  Those of us without a seat on the MPC will just have to hope that they are in touch with this new reality.

I had intended to make my own modest comments about the recent cut in the Bank of England base rate but did not get there before the announcement and was travelling to Australia post-announcement.  Since arriving here, I have been suffering from the brutal jet lag that only travelling half way around the world with small children can induce.

Anyway, I have also had the chance to catch up on the podcasts of some of the business radio programmes I enjoy and it was interesting to note that sentiment seem to swing from no expectation of a cut to its seeming inevitability in just a few days.  Economists, and those putting themselves forward as economic pundits (perhaps, there is no difference) are an odd lot, they seem to revel in being negative.  For them, it makes much better copy if they propound all of the reasons why the outlook for inflation, in particular, is poor and appear to have little faith in those steering the economy, or trying to, to make the correct decisions.  For the wannabe policy makers, the risks of being optimistic are too high and they have the benefit of being able to apply hindsight to events after the fact. 

I do wish I had the time and inclination to keep a record of predictions made by economists.  It seems like only yesterday (well, six months) that economists from every institution were predicting several hikes in interest rates in doom laden tones.  Yet, here we are, and those self same experts are falling over themselves to time the next drop in rates.  Clearly, it does not pay to be too bashful to a successful economist, nor must they be the types to mull over the past.

Thankfully for them, few seem to mind that they are often wrong, particularly their employers.  For the rest of us, it may make sense to discount predictions by a factor similar to the confidence with which they are made and to be very cautious about acting upon the views of these soothsayers.

I am not for a minute suggesting that economists have no purpose, quite the opposite, but they are too often used to obtain column inches for their employer rather than being usefully employed. 

With Wall Street banks set to lose Half a Billion Dollars between them, according to the BBC, could the world be set for very rocky times.  If nothing else, individuals and corporations will find it quite a bit harder to borrow than before.

Companies could be caught in a bear hug; their costs, in the shape of credit and ever rising commodity prices, are being pushed up and consumers are running for cover.  We are entering uncharted waters here and Central Banks (so long the heroes) are undecided on how to react.  The US Federal Reserve has cut rates aggressivley but the European Central Bank faces inflationary pressures and a two speed economy in the Eurozone.  The Bank of England, still smarting from a couple of humiliations this year, feels the need to look resolute and may find it hard to cut rates quickly, even if needed.

It may get quite a bit worse before it improves.

To my slight disappointment, the Bank of England Monetary Policy Committee voted to keep interest rates on hold at 5.75%.  I have to confess to having an interest in this as a mortgage holder; it would have made my life a little more comfortable had rates come down by 0.25%.  Despite my interest, I still believe they have got it wrong.  The perils facing us at the moment are unknown and could cause the economy and, therefore, real people, genuine hardship.

The US economy faces the possibility of a recession, at worst, or a serious slowdown.  House prices in the States have dropped in nominal (i.e. cash) terms for the first time since the Great Depression of the Thirties so it is impossible to overstate the seriousness of the current position, although most are relatively sanguine for the moment.  The world is by no means as dependent on the US as it once was but it still represents a large chunk of global activity and China and others have benefited enormously from the outsourcing of manufacturing.  Europe, much of which has squandered all opportunities for structural reform of sluggish economies is being hurt by the fall in the dollar.  If the US slows down by much, this will add to their woes.

It is easy to forget what happened to Japan fifteen years, or so, ago.  An asset price bubble (it is laughable to remember that it was once said that the land on which the Imperial Palace in Tokyo stood was worth as much as California) burst sending the economy into a cycle of low growth and deflation from which is yet to emerge.

No, I worry that the balance of risks lies on the side of a downturn, clearly, though, the MPC disagree.  I hope that they are right.  The old adage is that if America sneezes, we catch a cold.

It has not been a good year for the Bank of England or its governor, Mervyn King.  Firstly, they missed their inflation target and were stung into an ill-judged rate rise and recently they have overseen in part a run on a British bank for the first time sine the 19th century.

The current credit crisis has crept up on them whilst they were looking in the other direction and the fallout threatens to undo all of the good work they have done to their reputation in the ten years since independence.  Inflation (as measured by retail prices) has been slain, or, at least, seriously wounded, but a huge surge in asset prices propelled by easy credit may take years to unwind.

Some asset and commodity price increases are rooted in shortage of supply being outstripped by genuine increases in demand but many (probably some US house prices, for example) are simply a result of access to cheap money enabling people to bid prices up and up.  Get it right, sell your property, downsize and re-enter the world of ordinary RPI much the richer, and you're laughing.  Get it wrong, be born to poor parents too late, and you may never got to enter the market, which, every year pulls further away.

Where is the Bank (or, more accurately, the rate setting Monetary Policy Committee)looking now?  Is it still smarting over earlier mistakes, a collective state of mind which makes further errors more likely, or is it trying to predict where the credit crunch could take us and, therefore, where the greater potential problems may lie?

Having felt the need to react instantaneously on missing their inflation target, it is likely that the MPC will dither over reducing rates. The world has suddenly become a good deal more complicated for central bankers and the next few months will see whether the battered Bank of England can do something to restore its credibility amongst them.