Chinese inflation rises so she responds but the Bank of England prefers to ignore inflationary trends

There were developments yesterday in quite a few areas which affect the world economy which were much more significant than you might infer from the small moves in world equity markets. Perhaps the most significant was the news that emanated from China. Early in the day there were rumours that she would raise deposit reserve requirements and by the end of the day she had by 0.5%. However care is required as the move which took place as a temporary measure a month ago has now become permanent rather than there being a new move! We are back to the use of the word temporary again are we not?

The reason for this shift has come this morning as Chinese consumer price inflation has risen to 4.4% which is up by nearly a percentage point and is a 25 month high. Forecasts are for this measure to continue to rise and it could easily hit 5% early next year with current trends for commodity prices and oil. Accordingly the Chinese authorities have responded. Indeed we saw that they responded in another way too because the exchange rate of the Yuan or renminbi was allowed to appreciate as well. This rallied yesterday by 0.5% to 6.625 versus the US dollar for its strongest one day move for 5 years. To put the move into perspective I wrote about China’s abandonment of the fixed rate peg for the Yuan on the 21 st of June and since then it has revalued by only 3%. We will have to see if she is now willing to let it rise further to help with her inflation problems, however with the G-20 meeting coming up there is also an element of political convenience in the move. So before championing a new policy it might be best to wait and see after the meeting.

Fractional Reserve Banking

I am often asked about this subject which has become more topical since the MP Douglas Carswell introduced a Bill to try to end it in the UK. An interesting move particularly as we don’t really have it in the UK! However here is an example of a country China which does.So let us look at how it works in theory.

The increase in reserve requirements means that deposit-taking banks have to keep more of their money with the Central Bank. This means that it is not available for lending purposes and hence restricts credit and bank lending. To the extent that a bank “multiplies” its assets then it restricts that too. Therefore when an economy has too much credit it can help to reduce it. Sadly in practice it is usually applied much too late as if you think about it to work well it needs to be applied to the early stages of a boom in credit. Indeed this is what is happening in China as we see moves which are likely to be too little too late. This is one of the reasons many countries abandoned it although of course their newer measures did not work that well either or we would not be suffering form a credit crunch.

Inflationary Trends abound

The paragraph heading may come as something of a surprise as many parts of the media have closed their eyes to this. Indeed their behaviour often reminds me of a Monty Python type sketch as to my mind they seem to be imitating Mr. Cleese and his colleagues. However let us move from comedy to reality and look at the evidence.

The Oil Price has rallied strongly recently. If Ben Bernanke meant this to be one of the asset prices that he wanted his policy of Quantitative Easing to increase then he has succeeded, although I would like to see an explanation of exactly how this helps the US economy as to my mind it hinders it. The price of a barrel of West Texas Intermediate crude oil is now US $88.30 which is up 24% since the recent low on the 24th of August when it touched $71.32 per barrel.

Commodity prices have also been strong with rises at different times in food prices and metals meaning that they are up by around 25% over the past year. So we have a lot of basic inputs for industry and requirements for human beings rising in price. It is in my opinion one of the failings of economics to concentrate so much on so-called core measures of inflation which exclude food and energy prices. If you think about it the basic requirements of a human being go as follows.

Oxygen;Water preferably clean;Food;Energy; Shelter

Accordingly looking at core inflation excludes factors 3 and 4 in the list and to my mind its importance should always come with that caveat.

The Bank of England Quarterly Inflation Report

This was released yesterday and accordingly I took a look at what I thought of its previous report for some perspective. Back on the twelfth of August I suggested that the following issues were relevant,

This report was awaited on several fronts. The first was that revisions were expected to the Bank of England’s forecasts as they were out of line with general consensus views. The second was how the Bank of England would address the fact that its economic forecasting record has recently varied between poor and completely inaccurate. Thirdly would it address the fact that if its forecasts are wrong and it bases policy on the forecasts then its policy has been wrong too? Fourthly how long will it maintain official interest rates at the historically low-level of 0.5%.

Intriguingly and there is an element of groundhog day about this all of the points above still apply. Everybody was expecting yesterday an upward shift in inflation forecasts but the growth forecast had not been a triumph either as the last 3 months have way exceeded the Bank of England’s expectations. If you look at the Report you get this.

CPI inflation remained well above the 2% target, elevated by the restoration of the standard rate of VAT to 17.5% and the past depreciation of sterling. Inflation is likely to stay above the 2% target throughout 2011, given the forthcoming rise in VAT and continuing increases in import prices. As the impact of those factors on inflation diminishes, inflation is likely to fall back, reflecting continuing downward pressure from the persistent margin of spare capacity. But the timing and extent of that decline in inflation are highly uncertain. Under the assumptions that Bank Rate moves in line with market rates and the stock of purchased assets financed by the issuance of central bank reserves remains at £200 billion, the chances of inflation being either above or below the target by the end of the forecast period are judged to be roughly equal.

So there has been a slight shift with the use of “highly uncertain” and this is reinforced in their view on economic growth “”The outlook for growth is highly uncertain”. So rather than an admittal that their forecasting has been very poor we get a shift of the blame onto conditions. But it is something I suppose. Later on we also got this sentence which would have been much better placed in the headline paragraph above.

Prices of commodities and other traded goods and services have continued to increase, raising companies’ costs and inflationary pressure.

Sneaking this in later in the report does not make it any less true or the Bank of England’s ignoring of it any less embarrassing. However there was one other change in this report and that was the treatment of the output gap. For new readers this has long being the theoretical justification behind the Bank of England’s view that inflation would quickly return to target which it had previously clung too despite the mounting evidence to the contrary. The emphasis is mine.

many companies should be able to increase output significantly using their existing workforce and capital. But other signs, such as the modest margin of spare capacity reported in business surveys and the pickup in employment, suggested that their scope to do so may be more limited.

For those unaware of the significance of this point the Bank of England had estimated previously an output gap of around ten percent of UK economic output as its justification for its belief that inflation would fall back. Without any grand declaration this ten percent of UK economic output appears to have metamorphosed into a “modest margin of spare capacity”. To my mind this requires a substantial explanation and a mea culpa.

We also got a statement in the Report which is simply untrue.

Despite above-target inflation, measures of inflation expectations appeared broadly consistent with meeting the inflation target in the medium term 

They simply do not say that. For example the EU Commission published a survey on UK inflationary expectations towards the end of last month which showed quite a pick-up in inflationary expectations and there have been others including the Bank of England’s own survey which have hinted at a rise. Perhaps they are using “broadly consistent” as a euphemism and a get-out clause.

Comment

There is much that is familiar here in that as ever the Bank of England is forecasting that inflation will be on or about target in two years time. I would like to give a warning to anybody that might be tempted to rely on this that I cannot think off the top of my head of a forecaster with a worse record than that of the Bank of England on these matters. They have been consistent too.

Furthermore over the period of the credit crunch the Bank has always been wrong in the same direction because inflation has consistently been more than it has forecast. So as time goes by whatever credibility the Monetary Policy Committee has left is being eroded. Indeed it would appear that one of its theoretical benchmarks the output gap may be getting something of a downgrade. Whilst I welcome this I am afraid that following it has led the MPC to make a succession of policy errors and their tenure will be tarred by this. I suspect that the history books will not be kind.

As we move into 2011 there is a danger that they will prove to be wrong again as with commodity price trends we could see headline inflation rates for our Consumer Price Inflation index exceed 4% and for our old measure of RPI then we could see 6%. Of course trends can ebb and flow but our watchdog appears to be asleep to them.

Update 3:3o pm Ireland and Portugal

Both countries are being hit hard again today as speculation reaches an even more fevered peak. Day by day their government bonds have required a higher yield and inspite of the differences between them with Irish ten-year government bonds yielding 8.9% as I type whilst the Portuguese equivalent is around 1.5 points lower, their position is in overall terms quite similar in regards needing help.

The reason for me saying this is that Ireland has reserves to dip into whilst Portugal does not. Ireland can avoid having to issue new bonds until around June of next year whilst Portugal has borrowing requirements which are ongoing.

You could argue accordingly that in some respects Ireland is actually in a stronger position as it can ignore the strong economic winds hitting her as in the short-term some will feel that these yields are irrelevant. My view is different as Ireland’s breathing space is a mirage created partly because she has yet to reveal the full extent of her problems. For example I have been looking at some new information on Bank of Ireland today and as time goes by I expect it to be nationalised.

So both countries can resist calling for help for a while as hour by hour fluctuations can ebb and flow.However, I remain of the view that both countries should call in the IMF and ask for help and the sooner the better. I do not feel that they should call in the Euro zone rescue mechanism as I fear the design of that has been so shoddy that it may make things worse and not better.

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11 thoughts on “Chinese inflation rises so she responds but the Bank of England prefers to ignore inflationary trends

  1. Hi Shaun, thanks again. What does not seem to be analysed fully is the probability of stagflation – am I right. I dont see any analysis of the following scenario : spare capacity that there is ( which may not be much) is permanently lost, given the long timescale to recovery ; credit conditions worsen causing households and corporates to increase ( not decrease) savings, and therefore reduce consumption ; fiscal consolidation reduces final government demand further ; exports dont have time to take up slack; emerging market growth drives up commodity prices ; corporates protect margins whilst real wages are eroded by inflation. All these scenarios are jumbled up variously with side references to probabilities of each component individually. Shouldnt they be looking at currently apparent trends and anticipating their outcomes, rather than applying trends from past recessions..or perhaps do both. The BoE needs to take care of its stock of credibility.

    • Hi Shire

      I have written often about the dangers of stagflation. For some reason the media and many economists seem only able to think of the two polar extremes of hyper-inflation and deflation and ignore the middle ground alternatives. Inflation seems likely looking as far ahead as we can and our recently strong growth is unlikely sadly to persist. So stagflation is possible and to my mind still more likely than the two other outcomes.

      If so it will be a poor outcome for those who have invested in conventional bonds.

      • What confuses me a little here is that the monetary framework allows for the BoE not to take action on temporary blips under or over the target if the taking of action could cause volatility in output. That said, if actual inflation is running above target they are supposed to write to George Osborne to explain what policy measures they are taking to bring it back to target. They are unspecific as to when they predict it will return to target.They say it wont be before the end of next year. But, I dont here them saying anything about bringing inflation back to target. Current stance is to conduct policy to reinflate a predicted deflationary spiral. Isnt the truth here that the BoE dont have the tools to operate their framework, or that the framework is a nonsense.

  2. Hearing David Blanchflower on the radio yesterday saying that we should not worry about inflation but press on urgently with more QE was very depressing. He even said that if there turns out to be excessive inflation, it can be dealt with later. Well apart from the fact that the inflation is already with us, disguised by strange comments from his ex-boss about the discredited excess capacity theory and carefully crafted indices, our track record in dealing with inflation is miserable. We always leave it too late and suffer the consequences for several years in very high interest rates.
    I guess he and others have the hidden agenda that they think that more wealth must be shifted from the middle class downwards, and deliberate but denied inflation is their chosen method.

  3. You haven’t mentioned, so I will here, the MPC report admits the MPC is divided and this only gives the average of views. There seems to be little influence from Posen in the report, at least in the sense that it shows inflation clearly above target, which I feel is something.

  4. As ever a very interesting read however I have a question Shaun. I appreciate you can’t provide financial advice and as such I’m not asking for any. I also appreciate this is a personal question which you may choose not to answer. But where would you invest your money now, with things the way they are? You say conventional bonds look likely to suffer and equities seem shaky at best. Where do you consider to be the safest bet?

    • Hi Thomas
      Actually I have been thinking of this subject and have no objection at all to publishing my thoughts as long as it is made clear that they are my thoughts and opinions and are not investment advice in any shape or form. A friend and ex-colleague has sent me some charts and I will mull over them over the next day or two.

      As to conventional bonds it is my opinion that their current level in the UK is unsustainable. My only real doubt is to whether the MPC might buy more UK gilts and then support the price. As an aside my whole career in the City since I left university has been a conventional bond bull market in the UK if looked at over that period. There have been ebbs and flows of course but if I only knew that then! One cautionary note is like the dot-com boom of the last decade these types of bubble can persist for much longer than anyone might think.

  5. As your paragraph heading says, “inflationary trends abound”. So why can the MPC not recognise them? One wonders how a group of people, tasked with a very specific and measurable responsibility, can be so consistently wrong yet seemingly have no self awareness of their error!

    And it’s disappointing that opposing views, highlighting the MPC’s incompetence (frankly) in forecasting inflation, aren’t being given greater media coverage. Not least because the evidence points ever more strongly to the fact that those (often academic economists) warning of deflationary risks, and proposing ever more unconventional measures to combat it, are very wrong indeed. While they wring their hands over a theoretical possibility of deflation, back in the real world inflationary evidence abounds.

    The MPC’s birth and earlier years coincided with a disinflationary global secular trend. That UK inflation remained roughly on target during that period was predominantly a result of that secular trend rather than as a result of any actions the MPC took. Perhaps this period of benign low inflation led the MPC to believe it possessed powers which it sadly does not.

    Specifically, it seems to believe that it can jaw bone down inflation expectations. Unfortunately, msnsging expectations downwards requires credibility. As inflation continues way above target, and above the MPC’s benign forecasts, for month after month, its credibility has steadily declined. With their track record of failure, how can anyone now take their forecasts seriously?

    Furthermore, while jaw boning may help when the backdrop is a beneficial disinflationary one, the world is moving quickly to a very different, more hostile, environment. Where previously the developing world economies, through their vast pools of inexpensive labour and manufacturing capacity, provided a disinflationary effect, this beneficial period has largely passed.

    Today, with their increasing wealth, they have a voracious appetite for the commodities needed to build the infrastructure required by their rapidly expanding economies, And their raised standards of living means there is a far larger pool of people competing for the same limited supply of other scare resources with inelastic supply.

    The MPC seems to show little recognition of these dynamics at work. They are not one-off effects which will drop out of the numbers; they are trends in motion. Now, the MPC may wish to argue that interest rates are not a mechanism by which they can counter the effects of commodity or other imported inflation, but that’s not the course they’ve chosen to pursue. Instead, they are pretending these effects will magically abate, when in reality they’ll persist and worsen. And a weak currency policy magnifies their impact.

    Meanwhile, businesses and consumers operating in the real world see inflation, whatever its cause, and attempt to up their pricing accordingly, with little regard for the MPC’s perceived (now seemingly mythical) output gap. The Genie is well on his way to being out of the bottle.

  6. USA ActionNews relates that it was back on Friday, November 6, 2009, that a financial analyst prophesied that we would reach the point of today’s developing global currency war: The dollar will get “utterly destroyed” and become “virtually worthless”, said Damon Vickers, chief investment officer of Nine Points Capital Partners … Due to the huge wage disparities between the United States and emerging markets like China, Vickers said that may resolve itself in some type of a global currency crisis. …“If the global currency crisis unfolds, then inevitably you get an alignment of a global world government. A new global currency and a new world order, so we may be moving towards that,” he said.

    Today, November 11, 2010, a bear stock and bond market got fully underway as the currency traders fully declared a currency war on the world governments.

    I … Stephen Bernard, of the Associated Press wrote on Thursday November 11, 2010, from New York: Before the markets open that stock futures slipped as the world leaders attempted to come up with plans to strengthen a weak global economy and signs of rising inflation in China.

    The Group of 20, which encompasses leaders from major rich and developing nations, are meeting in South Korea and trying to hammer out plans to help support a global recovery that has accelerated in some countries like China while more developed countries like the U.S. have struggled to rebound.

    Currency manipulation, trade gaps and protectionism are the major topics the group is expected to discuss.

    Some countries criticized the U.S. last week after the Federal Reserve announced a bond-buying program that effectively cut the value of the dollar. The U.S. and others have criticized China for holding its currency artificially low.

    A weak currency helps a country’s exports because they become cheaper to sell overseas. That can lead to big trade imbalances and protectionist reactions from government’s trying to keep their own countries’ goods from being priced out of the world market.

    Leaders are trying to sort through those issues to avoid a string of currency devaluations that could stunt a global recovery

    The dollar, $USD, gained ground against the Euro, FXE, today, and was little changed again Japan’s yen, FXY. The Japanese government has flooded currency markets multiple times in recent months with yen to cut the value of the currency as it hovers near a 15-year low against the dollar.

    The Euro, FXE, has struggled in recent days because of fresh concerns about government debt problems, particularly in Ireland, EIRL.

    A steadily declining dollar over the past two months has helped funnel money into stocks and commodities as investors seek better returns

    The Euro, FXE, has struggled in recent days because of fresh concerns about government debt problems, particularly in Ireland, EIRL.

    A steadily declining dollar over the past two months has helped funnel money into stocks and commodities as investors seek better returns.

    II … Today, stocks fell sharply, effectively started a new downturn – debt deflation got strongly underway in stocks, ending a rally that began with the announcement of the EFSF Monetary Authority in early June 2010, and which for many insightful investors carried insight that the US would come out with QE 2 in its November FOMC meeting.

    Peak stock wealth has been achieved as stocks fell as follows:

    S&P, SPY, -0.4%,
    Russell 2000, IWM, -0.4%,
    World Shares, ACWI, -0.5%.

    A global bear stock market actually commenced on November 5, 2010, when World Shares, ACWI, fell from the November 4, 2010 rally high of 46.60 to the November 5, 2010 value of 46.51. Today’s fall to 48.85 simply put the nail in the coffin as European shares fell hard on Ireland’s and Portugal’s debt issues:

    Europe, VGK, -1.3%
    European Financials, EUFN, -1.5%
    Europe Small Cap Dividends, DFE, -2.0%
    Ireland, EIRL, -2.5%
    Italy, EWI, -2.0%
    Spain, EWP, -2.0%
    Sweden, EWD, -1.9%
    Austria, EWO, -3.1%

    Currency traders sold the world’s currencies against the US Dollar again today November 11, 2010, on news of Eurozone sovereign debt issues: a new and greater Eurozone Debt crisis has emerged with Ireland and Portugal at its epicenter.

    The currency traders actually commenced a global currency war on November 5, 2010 when the world currencies, DBV, peaked at a high of 24.10 and sold off on November 8, 2010.

    The European Financials, EUFN, in addition to the Interest Rate on the US 30 Year Interest Rate, $TYX, are the current focal points of the global currency war, which started November 5, 2010, as the currency traders have undertaken a plan to establish global corporatism and themselves as sovereign over humanity.

    Global competitive currency deflation, that is global competitive devaluation, has come at the hands of the currency traders, as concerns have arisen over the sovereign debt of Ireland and Portugal, and that the US Federal Reserve’s QE 2 purchases of US Government debt, constitutes monetization of debt.

    III … In the global currency war, the most indebted currencies are likely to be sold first and hardest by the currency traders: this means that Portugal, Italy, Ireland, Greece, Spain, The US and Japan are going to be ground zero for austerity and hardship.

    EuroIntelligence reports in article Ireland Going Down Irish 10 year yields hit 8.7%, and the spread with German bonds is now 6.5%; LCH Clearnet imposes larger margin requirements for Irish trades; the Greek adjustment programme is collapsing, as the projected 2010 deficit is now put at 9.3%, as opposed to a projected 7.8%; Papademos insists on no restructuring; an increasing number of market participants now believe that Greece and Ireland will eventually default, as they are beginning to digest the implications of the German crisis resolution proposals; Portuguese yields also rise/

    ECRM – its a new acronym. After the EFSF and ESRB, comes the ECRM, or will it be the EMF? After the proposal by Daniel Gros and Thomas Mayer for an EMF, comes the counter-proposal from the Bruegel team by Francois Gianviti, Anne Krueger, Jean Pisany-Ferry, Andre Sapir and Jurgen von Hagen, for a European Sovereign Debt Crisis Resolution Mechanism, or ECRM. Here is the link to the paper. In the introduction the authors characterise their main points thus: A procedure to initiate and conduct negotiations between a sovereign debtor with unsustainable debt and its creditors leading … in order to re-establish the sustainability of its public finances. This would require a special court to deal with such cases. … Rules for the provision of financial assistance to euro-area countries as an element in resolving the crisis. Should a euro-area country be found insolvent, the provision of financial aid should be conditional on the achievement of an agreement between the debtor and the creditors reestablishing solvency.

    Mervyn King’s warning of trade imbalances and current account imbalances are becoming increasingly apocalyptic. This was contained in an article on Alan Greenspan in the FT. It is not very interesting what Greenspan has to say, but the comment from Mervyn King is of a different order. “If we end up 12 months from now with countries taking protectionist measures, everyone will suffer. I think the absolute imperative for this weekend [at the G20] is a clear demonstration that every member of the G20 recognises that the imbalances are a problem . . . If we don’t do that then I fear the next 12 months will be an even more difficult and dangerous period than the one we have been through.”

    John Glover and Michael Shanahan of Bloomberg report Irish Bank Default Swaps Surge to Distress on Cost of Bailout. The cost of insuring the bonds of Irish banks soared to distressed levels amid concern that the government won’t be able to afford the cost of bailing out the nation’s banks.

    IV … The US Dollar, $USD, traded up 0.7% by the end of the day to close at 78.17. While Total Bond, BND, traded even on the day, the World Government Bonds, BWX, and the International Corporate Bons, PICB, traded lower so as to constituted severely damaged investments.

    The 1 to 3 Year Government Bonds, IEI, traded 0.2% lower; these are the very ones targeted for purchase under QE2 for stabilization. Quantitative Easing is a total waste of money: why attempt to stabilize something is inherently unstable, unless one have a secret motive.

    World government bonds, that is sovereign debt of the nations, BWX, traded 0.5% lower, falling from a head and shoulders pattern. Investing in sovereign debt is no longer a profitable investment opportunity.

    Emerging market bonds, EMB, traded 0.2% lower; and the chart pattern being similar to world government bonds, suggesting that it is unwise to invest in sovereign debt in the emerging markets as well as the developed world.

    Likewise international corporate bonds, PICB, traded 0.7% lower and has fallen from support as well. Bryan Keogh of Bloomberg reports: Company bonds in Europe are the riskiest compared with U.S. securities since May as concern rises that the euro-region’s most indebted governments will need a bailout, further damaging the economy.

    V … The currency traders have established themselves as sovereign over the governments of the world and over the world’s financial markets today November 11, 1010. The bond vigilantes and the currency traders have seized sovereign debt seigniorage authority from the world banks and world governments; and established themselves as the sovereign governing power in the world today.

    VI … A new global currency system will be implemented by a world leader and a world banker and they will oversee global governance in regions of global government, as called for by the Club of Rome in 1974.

    I believe that out of intensifying bond deflation by bond vigilantes calling sovereign debt, BWX, lower and bank debt interest rates higher, and greater competitive currency deflation at the hands of currency traders, the seigniorage of the European periphery countries will fail, and that they will default on their sovereign debt.

    Eventually I believe a Global Seignior and Global Sovereign will arise and institute unified regulation of banking globally, this as referred to, in the James Politi and Gillian Tett Financial Times article, NY Fed Chief In Push For Global Bank Framework, and that the Seignior will oversee all matters of debt and credit, and implement a universal currency system, that is a global currency system, that will likely first be used by Portugal, Italy, Ireland, Greece and Spain, as they will have lost their sovereign debt seigniorage and the ECB will have stopped buying their debt.

    Perhaps Robert Rubin, Co-Chairman of the Council On Foreign Relation, the CFR, or European Council President Herman Van Rompuy will rise to be the world’s Sovereign and institute global governance as he said November 9, 2010: ”We have together to fight the danger of a new euro-scepticism. … This is no longer the monopoly of a few countries. In every member state, there are people who believe their country can survive alone in the globalised world … It is more than an illusion: it is a lie!”, reports OpenEurope in November 10, 2010 Daily Briefing.

    One can read the full EU Press release of his speech here. And Mark Alexander provides the reference to the Daily Telegraph report: Euroscepticism leads to war and a rising tide of nationalism is the European Union’s “biggest enemy”, Herman Van Rompuy, the president of Europe has told a Berlin audience.

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