UK inflation disappoints yet again whilst long-term government bond interest-rates are in a liquidity trap

Yesterday saw a quiet days trading for the Dow Jones Industrial Average in the United States and it ended only 3 points up at 11,010. However the trend in equity markets turned overnight with the Nikkei 225 equity index in Japan falling by some 200 points or 2.1% to 9388. This means that the spread between the Dow and the Nikkei is now some 1622 points or 17.3% of the Nikkei’s value. As recently as late April 2010 both indices were at a similar level at just above 11,000 or in round terms approximately where the Dow is now.

One factor which impacted on Japan was concern about a further tightening of Chinese monetary policy. This was caused by the fact that China’s central bank temporarily raised reserve requirements for six lenders from 17% to 17.5%. The banks involved are  Industrial & Commercial Bank, China Construction Bank Corp., Bank of China, Agricultural Bank of China Ltd., China Merchants Bank Co. and China Minsheng Banking Corp. However this fear did not affect Chinese equities which rose. Another impact on Japan was the continuing strength of the Yen which is at 81.93 versus the US dollar and is now strengthening again versus the Euro as it trades at 113.3 versus it. So exporters may well be hoping the Finance Minister Noda delivers on the “bold action” on currencies that he promised today. I also note that he added “if needed” to his sentence which if you consider market levels will probably be interpreted as a weakening of Japan’s resolve rather than a strengthening.

Government Bond Yields

We are entering into an era of incredibly low government bond yields. This has various impacts and not all of them are reported often.

1. The fall in yields has made it easier for governments to finance their deficits. This has  proved both helpful and convenient for many governments who have received a fiscal boost from this move. Some like Spain have chosen to spend the “gains” which I consider to be risky as bond yields are by no means guaranteed to stay at these levels.

2. These levels of long-term interest rates should be providing a boost to the world economy as not only are restraints on government spending loosened a little but many private-sector long-term interest rates depend on them. So one might hope for lower corporate lending rates and mortgage rates. I have reported on here before on the falls in the Fannie Mae 30 year fixed mortgage rate. This should be giving the economies a boost.

3. In a slightly odd connection high-grade corporates can now borrow as cheaply or on occasion more cheaply than governments or sovereigns. In essence the market is saying that Microsoft is more likely to pay its debts than the US government. Whilst markets may well have a point this sits somewhat oddly with the fact that it is much cheaper for governments to borrow!

For those looking at the situation let me put some of this into numbers for US government bonds and I am comparing closing yields on the 4th January with last night. Two-year 1.04% versus 0.35%,five-year 2.65% versus 1.11%,ten-year 3.84% versus 2.4%,thirty-year 4.65% versus 3.75%.

Long-term interest-rates and the liquidity trap: QE2 is probably doomed to fail before it even starts

Quite striking is it not? However there is a clear implication for the possible success of QE 2. One of the main mechanisms of quantitative easing is to stimulate the economy by lowering long-term interest rates. However as we have already had considerable falls in this area one and economies are slowing it would appear that the economic impact has been lower than expected.

My contention is that long-term interest rates are as capable of going into a Keynesian “liquidity trap” as short-term ones are. Comments on here have mentioned that many corporates are awash with funds but I suspect that in the main these are the ones who do not need them and the one who do either cannot get funds or have to pay a high price for them. Price becomes irrelevant when the system breaks down.

Not everybody has benefitted from these trends and ones mind already turns to the peripheral Euro zone nations so if we look at ten-year government bond yields for these nations at the close on January 4th 2010 we get, Greece 5.72%,Ireland 4.78% and Portugal 4.07% much lower than the figures they have now.

UK Inflation disappoints again

We got figures for September inflation from the Office for National Statistics today and yet again they were a disappointment.

CPI annual inflation – the Government’s target measure – was 3.1 per cent in September, unchanged from August.The largest downward pressures to the change in CPI inflation came from a variety of transport costs. The largest upward pressures to the change in CPI inflation came from: clothing and footwear where prices overall rose by 6.4 per cent this year, a record rise for the August to September period,and food where the largest upward effects came from meat and fruit.

So we see trends which have been pronounced for a while. If one remembers that we keep being told that the rises in inflation are “temporary” then we should if one takes such a view seen falls in our inflation rate this summer. Instead we are seeing rises in food prices and clothing and footwear stopping this. These are being impacted by the rises in commodity prices that I have written about on here often.

The Retail Price Index was impacted by the same factors this month as CPI but managed to drop slightly from 4.7% to 4.6% although this was above the consensus expectation of 4.4%. The RPI-X which excludes mortgage costs was also at 4.6%.

Comparison with targets

The CPI at 3.1% is some 1.1% above its target whereas its predecessor RPI-X is at 4.6% and is accordingly some 2.1% over its target. This situation has persisted all year which seems to be something of a re-writing of the meaning of the word “temporary.”

Other Inflation Signals

Unfortunately for the UK economy measures of consumer or retail price inflation are not the only signals which are giving us a warning. Only on Friday I reported this.

The British Retail Consortium produced some estimates for the behaviour of shop prices in September. Overall shop price inflation increased marginally in September to 1.9% from 1.7% in August, taking it to the highest rate for five months. Food inflation increased to 4.0% in September from 3.8% in August.

These are not entirely unfamiliar trends and yet again make me wonder about the Bank of England’s definition of the word temporary. Just to add to this we have received producer price numbers for the UK this morning and according to the Office for National Statistics we got the following.

Output price ‘factory gate’ annual inflation for all manufactured products rose 4.4 per cent in September.

Input price annual inflation rose 9.5 per cent in September compared to a rise of 8.7 per cent in August.

And back on the 27th August I reported this.

There is one further implication of today’s figures,further down the report we get figures for the annual implied GDP deflator which in many ways is the best indicator of price inflation that we get as it is a wider measure than just consumer or retail prices and according to the ONS.

The GDP implied deflator rose by 4.1 per cent compared with the second quarter of 2009, up from 2.9 per cent in the previous quarter

So as one can see that it is far from only consumer prices that are showing a disturbing trend and makes me wonder if we are in danger of a move upwards rather than downwards. Obviously there are many factors at work as matters like exchange rates and oil prices can move very quickly in both directions.

A Response from the Monetary Policy Committee

A member of the Monetary Policy Committee David Miles is giving a speech today in Dublin and you might like to hear his views on our inflation prospects. He would have been aware of today’s figures.

UK inflation now sits uncomfortably above the target. But I believe that this tells us rather little about the cyclical position of the economy or where inflation will be in future. Underlying forces that were created by the financial crisis and that would have kept inflation low have been offset by other factors that have kept inflation above target for much of the past year.

I think somebody should make him aware that inflation rises are always caused by imbalances in downward and upward forces. Perhaps a course in mathematics and statistics might help. Indeed a course in asset price behaviour might also help as we also get.

Using monetary policy to reduce variability in asset prices is not likely to be effective.

You see this sentence which looks rather innocent on its own is the way the Bank of England absolves itself from responsibility for the run-up to 2007 and the problems that the boom in property prices and debt have caused. Many MPC members have slipped such references into their speeches,so often in fact that I wonder if they feel it is a type of absolution or perhaps that if they repeat it often enough someone might actually believe it.

I am also reminded looking at the speech of Mr.Miles’s attachment to “output gap” theory. Indeed if you re-read the quotes above it is plain that in a choice between reality (as best we can measure it) and theory he chooses theory. In my experience history is often rather unkind to such people.

My suggestion for the Monetary Policy Committee

Also I have a further thought and it does indicate quite a change. As the role of the Monetary Policy Committee has changed and expanded more than could have been forecast when it was introduced in 1997  there need to be new checks and balances on its power. My suggestion for a change is that MPC members should stand for election as they are currently much more powerful than many of our elected representatives.

Regular readers will be aware I have been suggesting this for a fortnight now and should my Member of Parliament favour me with a reply to my suggestion I will let you know.


23 thoughts on “UK inflation disappoints yet again whilst long-term government bond interest-rates are in a liquidity trap

  1. so the reality is that the MPC will not take any action on intrest rates – no matter how high the CPI figure is ?

    I though keeping inflation was their reason for exsistance ?

    this is seriously looking like a period of stagflation for the UK


  2. This is my first comment on this blog having been a long time reader.

    I think we all know now for certain (if it were ever in doubt) that the MPC are committed to an attempt to inflate away the public and private debt mess this country has got itself into.

    As a 35 year old that has seen the past 15 years dedicated to seemingly endless attempts to keep the British public in a form of debt based slavery, the past couple of weeks have been the final straw for me.

    Successive government policies have sought to prevent my family and I from ever owning our own home, and it seems that policy now is to protect those that indulged in taking on reckless amounts of debt by inflating it away, destroying the savings of those that refused to play the game in the process.

    The final insult is to be told that as someone who is “rich” (i.e. just falls into the higher tax bracket) I should be expected to contribute more tax in order to ensure I remain priced out of owning my own home.

    I’ve always previously ruled out emigration as I have young children and their grandparents would miss them terribly, but I can’t stay here any longer.

    The current economic policies of the BoE are a recipe for total disaster.

    • Have you narrowed down any of your options for emigration Nick? We are currently looking into Australia but unfortunately they look like they are in their own housing bubble at the moment and the £ to Oz $ would make renting whilst finding our feet quite hard.

      • The company I work for has an office in Newfoundland, Canada so I’ve been talking to people about Canada. I’m looking at the possibilities of Ontario or Alberta, though certain parts of Alberta are in a bubble of their own due to the oil sands boom out there.

        It’s going to be a big wrench to leave the fasmily behind but things are only going to get worse here.

        The Browne report is already the free market-isation of the HE sector. Next we’ll be being told that those that earn over £30k pr year should contribute top up fees to childrens education and healthcare.

    • Hi Nick and welcome

      There are a lot of problems but I firmly believe there is a way out. The reason why it is not being taken is in essence our politicians and many people of influence in our system have lost touch with reality. In a way output gap theory is a synonym for our times where a theory which is plainly struggling (I am being polite here….) is preferred over reality.

  3. “Temporary” has two senses: (a) lasting for a relatively brief period of time; (b) not permanent. They want us to understand (a). If put on the spot, however, they would point to (b). The ability to deceive without being caught lying is essential for any politician. The MPC members seem to have that ability, so they have no reason to object to your proposal that they stand for election.

  4. Hi Shaun,
    David Miles had more to say about the combination of high leverage colliding with asset price falls. Globalisation synchronised this horrendous crisis across markets, with banking solvency relying on 2% real equity at 60 times leverage ratios. Now, I share your worries about inflation ( in the context that in the decade to 2007 David Miles says monetary policy only hit the target 50% of the time). Since 2007 he points to it being only hitting target 30% of the time- a very poor outcome. If you are right about the liquidity trap and money lending is paralysed due to insolvency of the financial sector, I fail to see how raising short term interest rates is going to combat import and commodity-led stagflation aggravated by indirect taxation unless you think sterling should appreciate more rapidly.Isnt this all telling us that short term interest rates are an ineffective tool for controlling inflation in a credit-crunched, consumer-driven,debt-laden,deleveraging,regulator-run open economy?

    I have more of a gripe with Mr Miles BoE colleagues in the Financial Stability Department and the Tripartite Authority for allowing financial sector leverage to explode on a sandy foundation of securitised assets and short term money market finance. Did the heralded LSE so-called Financial Markets Group set off the alarm.Dont let sponsored academia off the hook, is my view.

    I would like to speak to a guy called Hyun Song Shin who wrote the following paper for the BoE in 2005 : Liquidity Risk and Contagion
    ….just to find out what was done with his paper…

    • Hi shireblogger
      I think we face quite a few issues at this time. I thought at the turn of the year that there were inflationary dangers in our system and a rise in interest rates might help. This was a judgement call which whilst so far has been right could yet have dangers as the full impact takes say eighteen months and so far we have had 9 or ten.

      However I also believe that short-term interest rates are also in a liquidity trap scenario and a rise to say 1.5% might help to alleviate this. I would not have cut rates below 1.5%/2% because i always believed this. Indeed it is one of the reasons for starting this blog as in I felt I was and am right but had no record of it! I believe that as one approaches the ZIRP behaviour of the monetary system changes. One situation which would only have been guessed before the event by someone who was incredibly cynical has been the way that the banks have been allowed to expand their margins. I remember arguing back at the turn of the year that a rise in interest rates needed to be combined with a new reform policy for the banks and if necessary instructing the ones that we own…

      You raise some valid points about the weakness of short-term interest rates as a weapon plainly they are far from a panecea but to get ourselves out of this will involve a multitude of small steps I feel. This is one of my arguments against QE that it is a search for a type of magic bullet when we need to slowly step by step reform things.

      Put another way a cut of nearly 5% in short-term interest rates should have had an enormous effect but it has not and perhaps the size of the cuts and the speed influenced things.

      Rather ironically if I had a vote right now I would not necessarily vote for a rise as I would wait for developments as we are at a nexus in my view. Put another way I feel that timing can be as important as what you do.

  5. It is like watching a car crash in slow motion. Giving cheap money to institutions who will use it to speculate on commodities to drive up prices (and so keep inflation above target). Meanwhile the private sector is deleveraging, the public sector is soon going to start doing that and so everyone needs to export more and import less: competitive devaluation.

    Long term interest rates are predicting problems that are no less serious than inflation. But dividend yields make UK equities look under-priced in comparison to gilts.

    Who gets it right most often holders of gilts or equity investors?

    Let’s watch and see.

  6. Its the 1970’s all over again, one assumes the MPC members dont really believe what they say more they are doing the only thing left for them to do. If they really do believe they can affect output through printing money when their inflation credibility is shot then they are in for a nasty surprise. If they are simply of the view that the only way out is to inflate away the debt but cant tell folk about it in case they riot then they are on the right track.

    More interesting is the US looking to devalue but China stopping them, raising rates each time the US gets out the printers. Where will it end?

  7. In case you’ve missed it there’s new book launch on Thursday. Written by leading hedge-fund managers no less:

    It appears to argue contain:
    “a collection of essays looking at the serious possibility that the recent financial unpleasantness was just an amuse-bouche for the main event – the really ghastly crash that awaits us all when governments start debasing the currency, when stock and bond markets go into extreme meltdown, when sovereigns themselves go belly-up”

    Seems to directly relate to the discussions on this blog.

    • Hi Burak,

      Indeed – the Great Depression MkII, but this time not in any way an accident,; due entirely to unbelievable incompetence and delusion at the top!

      • Hi Drf,

        The very troubling part about this is, if it weren’t for the artificial/huge/unconventional intervention by the central banks the world economy would already be devastated by now. Quite literally, the financial system would’ve collapsed and the economy be in a halt.

        To add a part-joke comparison, I think the credit crunch was a ‘Matrix moment’ when (aptly named) ‘Neo’ should’ve died but didn’t, kissed by the central bank. We still have to find and face up to Agent Smith…

        That aside, it looks more likely to be a ‘Plaza Accord’ situation, this time China in Japan’s seat. But back then Japan was already rich, whereas China isn’t. Japan was democratic and a defeated US ally, China isn’t. Moral of the story, I think a lot more is to come..

  8. I think your idea of elected MPC members is worth considering in principle, but who would the electors be? Hardly the “man in the street”. Could you flesh out a brief mechanism or series of mechanisms as how it would work?
    I think that China’s suggestion that some form of world currency with its concomitant controls is also an idea whose time has come. I realize that the US would kick up merry hell at having to meet its cheques, but it has shown itself to be motivated by self interest alone, and its time has probably come anyway.

    • Robert your suggestion that the time for a World Currency has come is either a) Very naive or b) Put here to see how much this blog’s reader’s really know.

      The banker’s who OWN the USA Federal Reserve and the other private Central Banks around the World are trying to get this exact outcome so they can control the whole World via the IMF’s SDRs or the more recently leaked Bancor name. Why would they do this you ask?

      I would suggest you go watch Zeitgeist The Movie to have your eyes opened and download the 220 page pdf too with this quote by James A. Garfield, 20th President of the United States particualrly revealing when talking about the Federal Reserve

      “Whoever controls the volume of money in any country is absolute master of all industry and commerce.”

      • Hi Graham
        You are getting caught up in the spam filters with a lot of your posts and are making them from a lot of email addresses which makes them look suspicious. If you are frightened of censorship then apart from slander, libel and profanity there isn’t any here but you are making it hard work. So please stick to one email address and make your points.

    • Hi Robert,

      There would be a number of practical problems with the concept of election of MPC members as I see it:

      1) The MPC was set up only to control inflation.

      2) It has failed dismally and continuously in this task.

      3) If its members were to be elected how would they be selected and nominated initially, and how could it be ensured that they were really qualified and competent for the job? How could bias be avoided? I fear any scheme would end up becoming just like the present election of politicians. We would end up with the most unsuitable incompetent idiots sitting on the MPC. In other words nothing would actually change and it could be worse!

      4) Who would be the electorate and how would they be enfranchised?

      5) If the MPC has failed to do its job then why do we need it any more at all? Surely the best action is just to abolish it and save the costs from Public funds? In the days when the Chancellor used to set interest rates and undertake fiscal control with the BoE things did not get any worse than now. In fact they never got as bad as they are now? Is the proof of the pudding not in the eating?

    • Hi Robert
      I have replied to FTG with some further thoughts on a later post. And actually I do think the man in the street should vote. It might seem unsatisfactory in some ways but in my opinion our so-called betters have done a dreadful job and we need to move them onto pastures new in my view. I have views on other institutions which I will be offering up as time goes by but a theme will be to reduce the power of our political class…

  9. I may well be naïve, but I don’t believe in conspiracies of the level you are suggesting. Is that the President Garfield who helped oust Tilden the Democratic winner of the election in 1876? And I should believe his utterances now? But assume you are right, then shouldn’t we try to control it on a world wide basis rather than let a coterie of American citizens control us willy nilly. I see it as exactly the same problem as the author sees the election of MPC members. The question really is: How is it to be done?

  10. Hello Shaun Richards,

    When elected officials controlled monetary policy the inflation record was often even worse than now.

    My thinking would be, “you can’t polish a turd”. The central bank framework should not be reformed, it needs instead to be abolished. In short, if the value of our money were protected by a self correcting mechanism because money was backed by something of intrinsic value (something like the gold standard but it doesn’t have to be gold, could be a portfolio of assets like land, mineral rights etc) an overpaid committee of plonkers wouldn’t be able to inflate away our savings and wages to bail out their privileged friends.

    If you must insist on retaining the existing fiat money system, how about changing the inflation target range to -3 to 0.5 % (i. e. maintain a gently falling or hardly rising price level), contracts of employment for MPC members allow NO pay rises and NO indexing of pensions (unlike now, they would get no protection from inflation, nice way to bake in a bit of self interest for keeping inflation under control, eh?) and failure to hit the inflation target subject to sanction of dismissal from the committee, NOT some lame “oh well, never mind” writing of a letter to the Chancellor!

    • Hi FTG

      I think that you are comparing my proposal with what happened in the past and they are not the same. For example when a political Chancellor of the Exchequer set interest rates there were a lot of variables here.
      1. They are politicians with a bias.
      2. They are elected on a lot of issues and deal in a generic rather than a specific manner.
      3. The Chancellor may have had no real interest at all in economic affairs. For example the current Shadow Chancellor Alan Johnson has openly admitted he has taken no real interest in economics and 2 candidates who have were rejected.

      So in essence politics has always triumphed over economics and led to accusations that interest rates were set to a political cycle.

      My suggestion is for a one issue election where people can stand. Often it would be economists but there is no reason why others should not stand. They would campaign on how they would set interest rates and also deal with our foreign exchange reserves although we havent used them for some time. There would also be a debate on extraordinary monetary measure like QE.

      I would also add a mandate as to what they should achieve and look to start a debate on what they should aim for to stop the Gordon Brown inspired debacle in 2002/03 when an inferior measure of inflation the CPI replaced the superior RPI.It was a plain weakness that no-one had the courage to resign at this point, I would have done.

      So the MPC would get its own legitimacy and would have to submit to re-election which I think would stop a lot of the current complacency. It would also work against the trend of what should be an independent body becoming just another arm of government whcih took just over ten years in my view..

      • Hi there.

        “So in essence politics has always triumphed over economics and led to accusations that interest rates were set to a political cycle.”

        And wouldn’t a democratically elected MPC have its own political cycle to deal with and therefore be subject to the same temptations?

        You can’t reform our monetary system, it needs to be torn down and rebuilt. Fiat money is the problem. If you’d left a pound under a mattress in 1800 and spent it in 1900 its buying power would have INCREASED over those 100 years. Your money would have more than preserved its value, during a period of explosive economic growth!

        If the existing monetary framework remains in place, how much do you think a pound will be worth in 2110?

        • Hi FTG
          There would be differences with the old system. For example the political cycle existed because politicians had a lot of things to deal with at any election and in essence wanted a short-term economic environment/boost often to cover up different issues. By contrast an elected MPC would have a specific mandate to be judged against. An MPC member would be judged against it whereas often by the time a general election comes around there is a different Chancellor….

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