Yesterday saw the continuation of a recent trend whereby we saw weaker than expected economic figures from the United States. This is something that has been evident for the past few weeks, not that you would tell from the performance of American equity indices. I know the Dow Jones Industrial Average fell just under 40 points but it still has had a strong week. In the event US Durable goods orders fell by 1% in June as opposed to expectations of a small rise and just to add to the gloom orders for May were revised down to -0.8% from -0.6%. Now durable goods as an indicator can be erratic but it is part of a series of numbers predicting a slowdown in the US economy. Some see these economic statistics as harbingers of a “double-dip” for the US economy. Personally I think that such claims are running in advance of the evidence which points to a slowdown in growth and we will have to wait for more evidence to see how much growth will slow. No wonder the Chairman of the Federal Reserve Ben Bernanke called the outlook “uncertain” last week, in the code in which central bankers speak that means he is worried too.
Mervyn King’s speech
Moving on to another central banker who thinks that the outlook is uncertain Mervyn King and two of his colleagues on the Monetary Policy Committee Paul Fisher and David Miles were interviewed by the Treasury Select Committee yesterday (for those unaware of UK political life this is a committee of Members of the House of Commons which looks at finance). We got an interesting insight into their views and intriguingly a view on the recent deliberations in Basel on bank liquidity and capital rules. To quote Mr. King.
I was able to attend the meeting in Basel of central bank governors and heads of supervision that took a further step forward towards a new global Basel III deal for capital and liquidity requirements on banks………..In the years ahead, stronger capital and liquidity standards will help to ensure our financial system is more robust, leaving it less likely to succumb to a crisis. But in Basel we reaffirmed our collective view that it is important to implement the new standards over a long transition period because bank balance sheets are still recovering from the current crisis.
The emphasis is mine. Having written yesterday that I felt that the changes in the proposed rules coming out of the Basel deliberations had been weakened looked like another move to help the banks I did not at that point realise that central bankers like Mervyn King were there actually doing this. I thought that their influence was more off the scene and back to the apocryphal use of the Governor of the Bank of England’s “eyebrows” to influence events. For anyone wondering what will happen going forward I think that the phrase highlighted in bold is quite clear that the banks and their recovery are the main priority and such issues as trying to prevent another crisis and raising banking standards in terms of capital can take a back seat to this. Those who believe that regulation is a way out of our current problems must find such a view very disappointing. Regular readers will know that I always feared that when it came to a choice which weakened the banks then the regulators would cave in and favour the banks. As the memory of the credit crunch is still quite recent it concerns me how much further our authorities will weaken as time goes by.
Following on from this Mr. King then gives us his view on the world economy and it is not a particularly optimistic one it would appear.
More fundamentally, the key underlying causes of the crisis – in terms of the imbalances in global demand – have still not been tackled. Those imbalances are likely to be larger this year than last, and will probably still be around three-quarters of their level at the peak immediately prior to the crisis.
I found the latter sentence in that quote to be rather chilling as it would appear on the face of it that Mr. King thinks that very little has improved and that in some respects we are worse off than last year. My immediate thought is that perhaps if we had some real reform of the banking system then we might see a genuine improvement rather than worrying forever about global imbalances. Whilst there are issues with them I find it helpful to think of such issues inversely, i.e tell me of a time when there were not global imbalances.
Mr. King then goes on to give us a motoring metaphor to explain his and the Monetary Policy Committee’s position.
The MPC faces a difficult challenge in balancing those risks. To do so, we judge that at present it is right to keep our foot firmly on the accelerator in order to stimulate the economy. As you would expect, there is a debate about quite how hard we should be pressing on the accelerator. In the months ahead it may be that the MPC judges that the inflation outlook warrants pushing down even harder or that we should ease back somewhat. The debate is about the appropriate degree of stimulus, not about applying the brakes.
Of course, there will come a point when we will certainly need to ease off the accelerator and return Bank Rate to more normal levels. I look forward to that time because it will probably be a signal that there is a smoother drive ahead, with the economic outlook improving in a durable way. But I fear there is some considerable distance to travel before we can begin to use the word “normal”.
This metaphor if a little over-extended is revealing. For example if we look at inflation it is hard to see any circumstances in the near future where “the inflation outlook warrants pushing down even harder” (on the accelerator) after all it was only last week that another MPC member Spencer Dale was pointing out that inflation has been above target for 41 out of the last 50 months and that in his opinion it would now be so until the end of 2011. I think the message is quite clear Mr. King is very concerned about the world economy and is ready if he feels it necessary to increase the degree of monetary stimulus being applied to the UK economy. The fact that he may already have put “the pedal to the metal” to use an American phrase does not seem to concern him. It would appear that we will have to wait a long time for him to vote for a rise in interest rates,after such a speech we could wait quite some time.
We got an interesting insight also into the Governor’s view on inflation in the UK.
CPI inflation is currently above target at 3.2%, and it has been high for much of the past four years. Given the changes to VAT announced in the Budget, it is likely that inflation will remain above target for much of next year. If this high inflation were to become engrained in inflation expectations, it would be difficult to bring inflation back down again.
So in effect we find that he does agree with Spencer Dale’s recent comments. I find it fascinating that he can talk about the possibility of “high inflation” becoming “engrained in inflation expectations”, after all if four years of generally overshooting the target does not cause this I would like the Governor to share with us what he thinks would. Perhaps he would be kind enough also to share with us in what circumstances an increase in inflation would make him respond to it with policy action.
On the same subject Paul Fisher came up with a revealing phrase.
Since then, upside risks to inflation have remained, or indeed become more magnified and actual CPI inflation has been higher than we previously expected.
This to me indicates some form of intellectual confusion or perhaps outright confusion. He appears unable to decide whether upside risks to inflation have “remained” or “become more magnified”. There is quite a difference between the two and the appropriate policy response. Imagine a sailor at sea setting his sails without knowing if the wind was the same or stronger and wondering how he managed to end up in the wrong place.
I think that the obvious conclusion is that we are much more likely to see an increase in monetary stimulus than a reduction in 2010 and perhaps for much of 2011 too. Whilst Andrew Sentance is a dissenter to this line of thought we heard yesterday from 3 members of the MPC who appear to be in favour of such a policy.
I wrote at the end of last year and beginning of this that I would have nudged rates higher in the UK to say 1.5%. I felt then that this would be an appropriate response to building inflationary pressures. After all one is supposed to be setting such things looking around 18/24 months ahead whereas the MPC seems unable to raise its nose from the immediate grindstone. However our MPC seems to be on the one hand terrified of disinflation and deflation but on the other to be willing to ignore inflationary pressures and call them “temporary”. Such an asymmetric policy apart from being logically flawed is unlikely to work.
If we go back to the recent past the MPC felt that 0.25% moves in interest rates had an effect on the UK economy and often moved interest rates by this amount. There was a period when around 4.5 % was considered the level of interest rates which was neither stimulative nor contractionary. So we are currently 16 moves (of 0.25%) below this to give an idea of the change in policy. Yet still it would appear that they are afraid that this and £200 billion of QE is insufficient. The thought does not seem to have occurred to them that they may have done too much. In terms of Mr.King’s metaphor they may have flooded the carburetor.
The other thought I have on reading speeches from MPC members is that they seem to be only thinking of the measures they have done and do not think of new alternative ones. They seem a little trapped to me in rigid lines of thought. One of these seems to be that the banks must be rescued and that this is more important than reforming them or perhaps even the underlying economy. Tucked into this must be the view that our banks as they currently stand are our saviour, a somewhat curious view when you look at what they are actually responsible for.
The MPC needs some new thinking. After all should UK growth continue to surprise on the upside they could be left looking dreadfully wrong footed.
Spain and her economy
After discussing the recent improvement in Spain’s government bond yields and looking and mostly failing to find a logical reason there were two events which were of note yesterday. The ten-year government bond yield rose a little to 4.24% and perhaps news got out of this article from Desmond Lachman in todays Financial Times.
It would be very much more constructive were Spanish policymakers to recognise the huge policy challenges that lie ahead and were they to go soon to the IMF for much needed financial support. It would also help if they took serious measures to recapitalise their savings and loan banks.
As the Greek authorities painfully learnt earlier this year, it is better to get ahead of the policy curve than to wait for the markets to force a country to have to approach the IMF in the midst of a full-blown financing crisis.
I saw a picture of Elena Salgado the Spanish Finance Minister on the front page of yesterdays El Pais looking very relaxed. Either she is a good actress or she was unaware of what was being written in the FT.