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.
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.