UK Inflation disappoints again in June

Yesterday in financial markets was a slow day in some respects. Equity markets appear to have calmed down for now and perhaps an element of a mid-summer lull has hit us, although I have learnt in the past that such thoughts can be dangerous! Relatively the UK FTSE 100 is edging forward as the share price of BP recovers and the FTSE 99 get help rather than hindrance from it. There was some interesting news on the UK economy yesterday and as we are due an update on the UK’s consumer and retail price indices today which measure her inflation I will look at UK issues today.

Greek Treasury Bond issuance

Before I move on I have noticed that there has been a change in the planned issue of Greek 12 month treasury bills which was due yesterday and ended up being dropped. However Greece will sell 1.25 billion euros of six-month bills today and I will check on what interest rate they are issued at. Just to give a comparison the yield on the April issue of six-month paper reached 4.55 per cent, up from 1.38 per cent in January.

Comment

I have to confess it still escapes me as to why Greece is doing this and why the 110 billion Euro fund is not being used. I said this when the plans were revealed for this issue (by a comment on this blog) and have discussed before what I think of the Greek public debt management agency and the way it has performed during her crisis. Now we end up with everybody knowing that Greece has 2.16 billion Euros of debt to roll-over and yet she is only issuing 1.25 billion Euros. There is not much space as next week on the 20th another auction is set for  when Greece is due to roll over €2.4bn of 13-week bills.

As to why the 12 month issuance was abandoned well as one year Greek yields are just under 7% and she can borrow at 5% from the European rescue fund….. Except that was true when the plans were announced. Should todays issue go well then the danger is that people wonder what the ECB’s Securities Market Programme was up to today, as in some ways it buying the issue would be logical. It would be good politics (supporting Greece) and good finance as they would get a good 6 month yield and they are making sure Greece does not default over this period anyway.

I notice that Greece is currently claiming something of an improvement in her public finances for this year and I also notice that this appears to have happened before the implementation of her austerity measures. I remember Greek readers of my blog suggesting that any improvement was due to the Greek government not paying its bills and would welcome their up to date views.

UK GDP revision: we are all poorer than we thought

One of the curiosities of economic statistics is that as we get new numbers telling us about the recent past we sometimes also get quite substantial revisions of further back in time. Yesterday was such a day and in fact was particularly significant. The growth rate for the first quarter of 2010 was left unchanged at +0.3% and this was no surprise. However there was a change in the depth of the UK recession which was deeper at -6.4% of Gross Domestic Product (GDP) than the previously reported -6.2% and we grew less in 2007/08 than we thought. This meant that in total we took 0.4% off what we thought our economic output or GDP was. So if you reduce a number by 0.4% and increase it by 0.3% you are worse off. So we have growth but we are poorer at the end of the quarter than we thought we were!

The composition of the growth in the first quarter also had some disturbing implications. If we start with the good news that manufacturing increased by 1.4% on the quarter one also has to report that net exports were revised down such that they had an -0.9% effect over the period. So we are in many respects still waiting for the impact one might have hoped for from the sterling depreciation of 2007/08. You may have noticed that since we remained at the same growth rate that something must have taken up the slack. Unfortunately government spending  on public services rose by 1.5 % rather than the 0.5 % previously estimated and fixed investment by the government also grew strongly.

Comment

As I mentioned yesterday these numbers have disturbing implications. Not only are we all poorer in spite of there being growth (due to revisions) but we also do not have the growth in exports that we might have hoped for from our past currency depreciation and the growth we did have came from government spending which is in the process of being cut. This is not reassuring for the rest of the year and I hope that the NIESR’s estimate for the second quarter proves true at 0.7% of GDP or our recovery will seem very weak and insipid.

I have mentioned the problems that adherents of output gap theory have with the recent “outperformance” of UK inflation compared with their theoretical analysis. To put this into scale many of them were worried that we would have falling prices right now rather than the inflation we have seen and the Monetary Policy Committee followed this group predicting that currently inflation would be around or below 1%. Well as UK economic output has just been revised down they have a bigger problem than before. I will leave it to them to try to bend reality to fit their theory which is being hung onto like it is a religious belief.

One question that does remain is the reason for the delay in the production of these numbers. It was unfortunate that the Office for National Statistics (ONS) did not give a full explanation as this in my view would have enhanced their credibility and their secrecy will only reduce it.

UK Trade Figures

These were as ever something of a curates egg and there was an example of rather outrageous spinning by the ONS using the title “Current account returns to deficit”. This was technically true as we did apparently have a surplus in the last quarter of 2009. However if you look at the numbers which the ONS shows on a chart, every other quarter since 2005 has shown a deficit often a substantial one so I am afraid it is quite possible that it was due to the highly erratic nature of this series. Indeed in the first quarter of 2010 we returned to a current account deficit of over 2.5% of GDP. So I would love to confirm signs of more than a modest overall improvement since our exchange rate depreciation in 2007/08 but it simply is not there and I have been somewhat amazed to see experienced economists claiming it.

However I wish to repeat again my view that Current Account figures are very erratic and incredibly unreliable. I discuss them from time to time as they are all we have on the subject but they are of very poor quality and are often heavily revised years after the event.

UK Inflation remains well above target

The Office for National Statistics has today reported that Consumer Price Inflation was 3.2% in June down from 3.4% in May, that Retail Price Index (RPI) inflation was 5% in June down from 5.1% in May and that our old inflation target RPIX (which excludes mortgage costs) was also down from 5.1% to 5%. So better but still way above target (again).

What caused this months changes?

Falling petrol and diesel prices are by far the main drivers to the downward pressure to CPI annual inflation between May and June. Prices for fuels and lubricants fell by 1.9 per cent this year between May and June but rose by 3.8 per cent between the same two months a year ago. The next most significant downward pressure came from clothing and footwear where price falls this month are a record for the June sales season.

The largest upward pressures to the change in CPI inflation between May and June came from miscellaneous goods and services and air transport. Rather curiously the annual inflation rate for all insurance in June 2010 stands at 22.2 per cent, a record.

Additionally there was upward pressure to the change in the RPI annual rate from housing. This was driven by house depreciation, which rose this year but fell a year ago.

Producer Price Inflation

Last week we got figures for producer price inflation in the UK. According to the Office for National Statistics output price ‘factory gate’ annual inflation for all manufactured products rose 5.1 % in June compared with 5.7% in May. Input price annual inflation rose 10.7 % in June compared to a rise of 11.5 % in May.

So again these were lower figures but are still way above what one might expect at this stage of the cycle. Please take a look again at what input price annual inflation is because this is a sign of what inflation is at the beginning of the cycles for our manufacturing and production industries and it has been above 10% for some time now.

Conclusion

There is no escaping the fact that the UK has a serious inflation problem which has persisted now for the first half of 2010. Whilst it may drift lower as the year goes on unless we see substantial falls in the oil price or a rally in our exchange rate (particularly against the US Dollar) I do not expect it to fall substantially and we may well be still above target when it gets a boost from the rise in Value Added Tax expected in January 2011. I notice for example that Deutsche Bank expect it to average 3.1% this year. So yet again I would like to ask the Monetary Policy Committee for their definition of the words “temporary” and”blip”.

Petrol prices (or rather diesel in my case) have drifted lower so they may in the short-term be a dampening influence but I notice that last months fall in inflation was caused by also sales of clothing and footwear. So the implied view is that many other prices did not fall. Now think again of the economic growth figures that we saw yesterday. These were not convincing giving us slow weak growth (particularly with the depth of the recession we have just had….) which is now combined with seemingly persistent inflation. Whilst the inflation levels are lower this does again remind me of the stagflation of the 1970s.

As a theoretical thought I notice that for once many people are concentrating on the tail ends of the probability distribution. What I mean by this is that there is much talk of deflation/depression at one polar extreme and high or hyper-inflation at the other. As for much of my career I have been an options trader this is a curious development as you see usually investors translate low probabilities as being zero. At the moment low probabilities are being multiplied and exacerbated to such a degree that some seem to think there is no alternative which of course itself has echoes of the past with the acronym tina being associated with Mrs.Thatcher. For now I wish to point out that there are many other alternatives.

I regularly point out the difference between our current inflation target and our old one as there has been quite a gap this year and notice that when people talk to me they often mention this as being a surprise to them. This month we find that CPI is 1.2% over its starget.However our old index of RPIX is at 5% which makes it some 2.5% over its old target or double it if you like. I find it an eloquent observation on the changes which were made in 2003 to our inflation targets. It is a shame in my view that those responsible for the change are not made to explain and justify their action in this regard.

Just to add to the mix we had figures yesterday for the narrow version of our money supply where annual growth  in notes and coins in circulation fell sharply to 5.8% in June from 6.5% in May. Unfortunately this only reinforces the dangers of a version of stagflation developing.

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21 thoughts on “UK Inflation disappoints again in June

  1. Shaun are you saying that inflation and unemployment is going up at the same time because the full employment rate of unemployment has increased?

    Is the increase in growth being substantially down to a growth in government expenditure an example of “crowding out”?

    I’m useless on the ONS website. Is there anything on it which shows a breakdown of GDP to economic sector: manufacturing, retail, financial etc?

    • Hi Sean
      I think that you mean full employment rate of inflation in your first question. This does appear to have moved during the credit crunch although we have moved along the curve and as we get outflows from the public sector we may yet see higher unemployment. Unfortunately for the theory the idea of a full employment level of inflation is rather elusive if you look at the evidence I am afraid.I think that things are simply too unstable currently for many economic concepts…

      As to breakdowns I do look at the blue book on their website but it is always out of date (by the time a year is brought together and published). I use http://www.ons.gov.uk and only mention that because I used to go in on an old link which is now missing some sections.

      As to crowding out that is a good question. I think that the public sector expanded so much during the boom in the middle of the last decade that it probably did crowd out the private sector although it was not discussed at the time. I do not mean conventional crowding out as interest rates were not particularly high but more competition for resources such as a skilled workforce. As to now I do not think there is much crowding out as there are spare resources and interest rates are very low.

  2. As I detect it the talk of hyperinflation is because of its extreme low probability. People like Hendry will bet a small amount on hyperinflation precisely because if it happens then its party time for him.

  3. Hi Shaun

    Just to comment on the Greek position, my understanding is the same as yours. I can’t find the link I was reading yesterday but it seems that the improvement just covers central government finances (not local government) and, indeed, bills are still not being paid! I also understand that much of the reduction is due to stopping capital (one-off) schemes rather than reductions in recurring commitments.

    Interestingly, from today’s kathemirini newspaper

    “However, on the revenues front, the government appears to be struggling as net income rose 7.2 percent between January to June, falling well short of the 13.7 percent target.

    Economists said the pace of revenue growth reflects plunging consumption and investment as the economy slides deeper into recession in the second and third quarters of the year after contracting by 2.5 percent between January and March.”

    • Hi Graham
      In essence the numbers and improvement presented seem unlikely to me particularly as I do remember you and others pointing out that the government was not paying its bills! They are playing a dangerous game I think although the treasury bill offer got away at a not too disastrous a rate.

  4. I must 1st of all add my compliments & thanks to you for all the effort & knowledge you freely grace us with in this blog.

    > Additionally there was upward pressure to the change in the RPI annual rate from housing. This was driven by house depreciation, which rose this year but fell a year ago.

    Now, I am afraid that I am lost. Does this mean that if house prices were to drop, house price depreciation would increase & take some measure(s) of inflation up?

    • Keith I understood it to mean that in the previous period a decline in housing prices occurred. Then in the current period there was some rise/recovery from that lower point, and that this rise in the most recent period makes a positive contribution to RPI.

    • Hi Keith, welcome and thanks for the compliment

      Daniel is pretty much right. Because house prices are rising faster now than a year ago then depreciation is based on the new higher house price and is therefore higher itself and a contributor to inflation as measured by the RPI. So depreciation moves with house prices not against them

  5. I have to confess it still escapes me as to why Greece is doing this and why the 110 billion Euro fund is not being used.

    Is there any possibility that perhaps the fund is not actually ready to go, and this is a symptom of that?

    Re: “tina” and Mrs. Thatcher I was stumped and had to look that one up (“There Is No Alternative”). Of course once I learned that I could see that phrase in your paragraph (!).

    Regarding the newfound consideration (and overemphasis) of previously-ignored statistical tails yes that it pretty interesting. Perhaps somewhat related to your post yesterday on the fallout from carry trades gone wrong, I got to thinking about whether the consequences of that that we are seeing so far are catastrophic or perhaps just a bit on the heavy side? Let me explain. Suppose I was an Icelander and in 2007 I had a choice to borrow yen at 1% or Icelandic Kronor at 13%, say for five years, and that I chose to borrow in yen and thereby assume a currency risk as the price of my low interest rate. As a result of the big shifts in ISK:JPY I now owe (say) 40% more in ISK terms. But the fact of the matter is that I have saved three years of 12%-differential-interest payment so I really am (very roughly) even with where I would have been had I borrowed ISK in the first place and paid 36% more interest over the past three years. While the way things have worked out is unexpected and perhaps more difficult to have planned for than had I known I would have to have been paying 13%/year every year, it seems to me more like me essentially “breaking even” on my bet now that it turns out that I lost the bet that ISK:JPY would remain stable over the lifetime of the loan. And if you weight “break even when lose” with “gain when win”, the expected value still comes out positive. Dunno if that “proves” that carry trades are good trades provided that you understand and are able to handle the “bust” case, or if perhaps it highlights the fact that ISK:JPY could have been and may yet get quite a bit worse (if the expected value of the carry trade is to net out to approximately zero).

    • “Is there any possibility that perhaps the fund is not actually ready to go, and this is a symptom of that?”

      From the Greek press reports, it appears that the 110 billion euros are simply not enough. As the Kathimerini report that Nointerest referred to states:
      “About 4.5 billion euros of short-term securities expire in July and their rollover isn’t fully funded by the EU-IMF deal.”
      Here is the link (in English):
      http://www.ekathimerini.com/4dcgi/news/economy_1KathiLev&xml/&aspKath/economy.asp&fdate=13/07/2010

      From previous Greek press reports (Kathimerini and Eleftherotypia I think), Greece has to find about 190 billion euros between now and the end of 2012. The 110 billion euros package is not enough and, per the agreement, Greece is supposed to issue bonds in 2012 (or late 2011). The T-bills amount to about 9 billion euros between now and April 2011.

      The reason given in the Greek press for not issuing one-year T-bills is the high interest rate. The decision not to issue them had been already reported a couple of days ago. For the rollover, they are substituting with 3- and 6-month T-bills.

      js

      • Oh, important clarification now that I see what I wrote.
        The 190 billion euros Greece has to find is the total, 110 billion euros of it is covered by EU-IMF, so there is a need for another 80 billion. All this assuming (and hoping) the budget goes according to the agreed plan.

        js

    • Hi Dan
      I had been thinking about comparing interest rate profits with capital losses but then thought the following. Those who received the interest rate benefit were individuals in countries with high consumption and so they are likely to have spent it. Unfortunately people usually see this sort of thing as a immediate windfall and spend it. By comparison if it was saved then you could compare it with the capital loss. Some would be overall losers whilst some (usually early entrants) may well have a profit.

      However for where we are now the interest rate “profit” has in general been spent. If we were talking about an investment house then you could set interest rate profit against capital losses more reasonably in theory but in practice they are likely to have paid it out in staff bonuses or at least that is what happened up to the credit crunch with lets face it few signs of a change in behaviour since.

      So either way as we stand now we are likely (with a few exceptions) to turn out to only have losses.

      As to statistical tails it is to an “old” options trader quite a noticeable change in general behaviour, in fact one might reasonably consider it an inversion….

  6. Thanks for this enlightened article. Isnt this the point where inflation collides with a credit freeze. Cheap labour/unemployment and premises might incentivise me to produce more widgets at lower prices. Not this time, because I cant get a bank loan to fund increased production so I keep prices where they are. If some of my competitors have gone to the wall, I might afford to stick prices up. If I am in a regulated industry selling essentials I keep firm on my prices because consumer choice is limited and I can widen my margins by keeping labour costs low in times of high unemployment. If I am exporting I would prefer not to take out more credit either, rather sell my goods at an improved margin courtesy of sterling devluation. Low central bank interest rates have no incentive effect on me because my bank manager moans about how bank costs are set to horrendously increase justifying large arrangements fees and real interest rates even if he wanted to lend me the money, which he doesnt. I’m better holding steady, improve my margin, keep my costs down and reduce my overall indebtedness or improve my cash buffers. My farmer pals dont worry too much because EU subsidies are excluded from fiscal austerity measures and everyone needs food, dont they! My mechanic mate feels like buying and selling second-hand cars because lack of/expensive finance for new has boosted the used sector, increasing prices.

    All my competitors will feed through higher commodity prices because these are driven globally. I’ll do the same.

    Adam Posen then reminds me that the MPC’s inflation targets are being regularly overshot so I should expect this to embed itself in my psychology.

    • Hi Shire
      Thanks for the phrase “inflation collides with a credit freeze”. I like that and will mull it over. To my mind in that one phrase we have something that in general thought and theory (before the credit crunch) was never expected to happen. In a way it links to my answer to sean’s question about the full employment rate of inflation. A nice theory but in practice….. Previously accepted theories are breaking down and new ones emerging.

  7. Andrew Sentance has just stated in a presentation at Reading, as might be expected perhaps, that UK base rate should now be increased gradually to stem the inflationary continuing trend, see http://www.thisismoney.co.uk/news/article.html?in_article_id=508854&in_page_id=2&ct=5

    Then of course, Warren Buffet has just re-referred people to read again (or for the first time) Adam Fegusson’s book “When Money Dies: Nightmare of the Weimar Collapse”, evidently to awaken their understanding of what will occur if inflation is not brought back under control pretty soon.

    Now the rating of Portugal has been reduced. Is the UK next with its refusal to address ongoing inflation?

  8. Is UK inflation bad because

    1) All inflation is bad?
    2) UK inflation is worse than other countries inflation (and we’re an open economy)?
    3) Because it is above our inflation target?

    With regards to inflation targets there is much about what measure of inflation to use, but what is the thinking around what figure (whatever the measure) you set your inflation target at?

    • Hi Sean
      I will give a few brief thoughts as it is getting late. I think that 2 is true as it erodes the competitive advantage from our 2007/08 exchange rate depreciation. I think that 1 has many many parts to an answer and clearly debtors might argue it is good. So I will pose a question in return, what is wrong with 0% inflation? (and who loses from it…).

      As to question 3 there are a lot of issues with inflation targetting but glossing over those and only thinking of credibility then consistently exceeding the target as has happened in the UK is bad as it has eroded credibility and appears from the statistical evidence to have raised inflationary expectations. A genuine temporary rise would not have this effect if people belived an undershoot was just as likely.

      As to your final question I have the same question again as an answer. What is so wrong with 0% as an inflation target? I find thinking of it like that provokes lots of thoughts.

      • Just a quick reply – because I’m supposed to be working!

        I am quite sceptical that solutions exist to our present predicament, and its not for the want of looking for them.

        The usual answer to the question about zero inflation is that wringing the last drop out of inflation would have implications for jobs and economic growth that would mean the price wasn’t worth paying.

        I suspect that targeting small numbers – either positive or negative or in between doesn’t make that much difference as long as this does not deviate too much from what other major players are doing.

        But on the other hand small numbers repeated year after year produce bigger and bigger numbers faster and faster. This is true for the effect of inflation but also of the effect of economic growth. What looks like steady economic growth over a number of years is not in fact sustainable and is building up trouble for the future. I suspect that this isn’t a matter of the mix of factors producing economic growth but economic growth itself repeated year after year. And yet it is this an outcome we are supposed to desire.

        We have an inflation target currently that isn’t being targeted except as an aspiration. I’m not sure that is causing serious problems because we are talking about small numbers.

        It may be more serious that current interest rates are negative. And that is a policy response to the crisis in the level of private debt, most particularly the level of indebtedness of financial companies.

        In a low inflation world wages have less scope to adjust downwards without a cut in money wages or jobs. So some of those wage cuts are now actually pension cuts of course. It also causes people to speculate with their idle cash balances, and so supports asset prices.

        I also can’t forget that the question of why not have zero inflation can only be posed now because of the lower levels of inflation in the last 15 or 20 years.

        It may be argued that the lower levels of inflation as measured by CPI and RPI underestimate actual inflation but that would be a problem for anyone advocating an inflation target.

        What has generated those lower levels of inflation? Perhaps certain policy measures by central bankers. But also cheap manufactured goods, cheap food and cheap oil. I think it is arguable that all these may avail us less in the immediate future than in the immediate past.

        So a given level of growth may bring higher inflation going forward. Until there is a widespread commercial adoption of technology that allows the growth to be less oil intensive.

  9. Presumably Greece was confident of the outcome: i.e. that they could sell at a coupon lower than the borrowing from the IMF fund.

    And it was oversubscribed. Which sounds like good news. Except it pulled the 12 month issuance previously. So, taking my usual pessimistic stance: bond holders will lend Greece for six months but not for 12.

  10. Nice to have you back Shaun,
    For a novice like me some of these replies take two or three readings before I get the gist. Your zero inflation question would seem to have an obvious answer albeit the inverse to the question. Politicians don’t like zero inflation; it doesn’t suit them, much better to have wages and salaries going up annually in some sort of delusion of increasing personal wealth for the population. Adding in Drf’s debauched currency doesn’t even figure unless it becomes too obvious or we see hyperinflation. If we then accept that the political class are the king makers then their will must take precedence. The problem with that is these days the politocrats are reactive not proactive and they always will be until they get the fundamentals right.

    • An important part of the instability is endogenous to the system, not just from exogenous shocks such as political decision making.

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