The long-term future for Ireland and my view on inflationary trends in the UK and US

As we come to the end of a week what has had quite a few developments and issues it is time to try to take stock and look at where we stand. If one looks at the developments in China than after falls of 10% in the Shanghai Composite index over only 4 trading days we have seen closes of up 0.9% and 0.8%. So on a closing basis we have a bit of stability albeit at lower levels for the index,however, within the day there was still a fair bit of volatility. There will be ebbs and flows in this situation but the theme of inflationary pressure affecting China is unlikely to go away. There is also something of a feedback loop between China and commodity prices which can make the situation hard to assess at times as falls in China lead to falls in commodity prices. However as we stand commodity prices as measured by the Commodity Research Bureau spot index I follow are still up by 20% on a year on year basis, and this is after something of a setback for them.

The Irish Problem

This situation seems to be going on and on although in truth it is only this week when real negotiations have begun to take place. This in itself I consider to have been a failure because as the problem was plainly building for some time the relevant bodies should have had a generic plan ready and before inception only minor details should need to be sorted. A plan should have been ready for Sunday night and announced on Monday morning.

Moving onto actual details then the issue of Ireland’s low Corporation Tax rate (12.5%) seems to have become something of a stumbling block with Ireland wishing to keep it and both Germany and France wanting it to be raised. Of course as I have written before many organisations which include both Google and U2 use Ireland as a way of paying much lower tax rates than even the headline 12.5%. But the fundamental problem is that Ireland is asking for help from some countries which on a per capita basis are poorer than her whilst poaching international businesses from them with a lower tax rate. That must stick in some craws in the poorer countries in the Euro zone.

Going Forwards for Ireland

If we assume that at some time in the near future Ireland accepts an aid package from the IMF/EU/ECB one then has to face up to the problem of what happens next? My suggestion is that the most favourable route as I first argued on the 19th September is for the IMF to take primacy and I would to that with the thought that the IMF can help by ending the Croke Park Agreement. An outside body is likely to have more success in breaking down the cronyism that Ireland has suffered from than Ireland’s own politicians who have been a disappointment in this respect.

However even if we assume a favourable outcome we then hit a problem. Handing something of the order of 80 billion Euros to Ireland will help her in the short-term with her liquidity problems and help her oil the waters of her troubled banking system. As we look further forward we come to the issue of longer-term solvency  and a bailout does help this but only marginally. If you look at the numbers you still come to the conclusion that Ireland looks insolvent in the longer-term. The only possible answer would be a quick return to Celtic Tiger levels of growth which as they were based on increases in debt which are now unfeasible seems unlikely.

Accordingly the aid given is likely to have to be for the longer-term and it is quite plausible that it will become permanent.

The UK and Irish aid

I was asked yesterday how we would finance lending money to Ireland. As the UK is heavily in debt and our own borrowing figures disappointed then we would have to borrow the money via our gilt-edged or government bonds. If you take my view that the aid may remain a feature of the economic landscape then it would be logical to borrow the money over a longer time period than the 3 years so far usually assumed by the Euro zone. If we borrowed at out current ten-year rate then it would cost us some 3.4% per year to borrow the money. We would then have to decide what to charge Ireland. If we charged her a similar rate to what the IMF is likely to charge then we might even make a small loss so I do not see that as viable. So perhaps we could charge around 5% and in effect make an annual profit. For Ireland currently there would be a considerable saving on the 8.1% her ten-year bonds yielded at last nights close.

The real danger for us however is the very real possibility that Ireland may be unable to ever pay the money back and this is one of the reasons I would be very cautious on this front. Put another way an interest rate of 5% may yet prove too high for Ireland’s longer-term future.

Inflationary Trends

There has been new information on this front in both the United States and the UK this week and I would like to address them. I would have done so before but I have judged the Euro zone crisis to have been more of a priority.

Inflation in the United States

This matters because the US central bank the Federal Reserve has said that one of its objectives is to raise the inflation rate to what it considers to be a more normal level. It has embarked on a large monetary expansion scheme called QE2 to help achieve this. It would appear that the objective of the US Federal Reserve is to raise the US Consumer Price Index inflation measure to around 2%. Accordingly there were implications from the fact that the numbers for October were up 1.2% on a year on year basis. It is likely to mean that the Fed. will continue with its plans. Indeed its eyes my have fallen on this section in the report from the Bureau of Labor Statistics.

Over the last 12 months, the index for all items less food and energy has risen 0.6 percent, the smallest 12-month increase in the history of the index, which dates to 1957.

This is what economists call the core inflation level and some use it as an indication of future price trends. At this point I just wish to point out that I feel that the importance of core inflation measures is over-stated. However I show it because I believe that it is an influence on thinking at the US central bank which is not only likely to feel that this justifies its current policy but may also consider an expansion if such numbers are sustained.

My View

I wrote an article back on the 2nd of July explaining my views on what I feel are some of the problems with the way that America measures inflation. I feel that her CPI measure is unsatisfactory. This acquires a new significance when raising it has become a policy aim. In that article I pointed out that numbers are calculated for a harmonized index of consumer prices (HICP) which is the full name of the Euro zone and UK measure. It is published with more of a delay but the September figure was  1.8%. As the CPI measure rose this month then probably so did this one raising the prospect of it being 2%. If that should be so then rather than new measures to achieve the inflation target we would already be there.

On such a view the future path of US Federal Reserve policy would look quite different and the QE2 could sail back to port.

UK Inflation

This has been a problem for some time and the figures for October were no exception to this trend. This is in spite of that fact that the Monetary Policy Committee of the Bank of England keeps telling us that rises in inflation have been caused by temporary factors.

Consumer Price Inflation or CPI rose to 3.2% on an annual basis in October. This is 1.2% over its stated target and meant that the Governor of the Bank of England had to write yet another letter to the Chancellor of the Exchequer explaining why this is so. He appears to have forgotten that the letter is supposed to include what the MPC intends to do about it as his mantra of “inflation will fall in the medium-term” has less and less credibility as time passes.Those who remember the Retail Price Index of which the RPIX was our inflation target until 2003 will no doubt have spotted that the situation here is even worse as it was running at an annual rate of 4.5% in October which exceeded its target by some 2%.

Inflation for older consumers in the UK: The Silver RPI

There has been some debate on this subject and the charity Age UK has combined with Fathom Consulting to come up with an inflationary index for older consumers in the UK. It concluded the following.

The Silver RPI shows that since the beginning of 2008, those aged over 55 have experienced price rises at almost two per cent above that suggested by headline RPI figures. This rises to four per cent above headline RPI for those over 75. The gap between real and headline inflation over that period has cost the average 60-year-old £620 a year, rising to over £700 for someone aged between 65 and 69.

Should such a situation persist then those over 75 are currently suffering from an inflation rate of around 8.5%. In case you are wondering the main influences were as follows. Older people have benefitted less from the falls in mortgage rate because at their age they have often paid them off. In terms of their consumption patterns they tend to consume more of the following holidays,household insurance,utilities and intriguingly sugar and preserves! So they have a sweet tooth!

Comment

I think that this offers some food for thought. Now Age UK certainly has a vested interest in producing such numbers but I feel that this research should be looked into further as there does appear to be some basis to it. I would have expected there to have been more of an influence from medical costs (which escalate at an alarming rate) but perhaps there is some influence here from the role of the NHS.

What this does do is directly challenge the claims of the UK government which is going through a process of trying to tie increases in pensions to the CPI index of inflation and trying to claim that it represents pensioners.The significance is that CPI is lower than RPI.

UK Producer Prices

In October UK Producer Prices rose as follows. Output prices rose by 4% and input prices rose by 8%. You might if you had followed them feel that there has been an improvement. However you are in danger of being misled as they have been rebased. According to the Office for National Statistics.

Figures for PPI this month are the first based on Standard Industrial Classification 2007.

This seems innocent enough but I have looked at the numbers for 2010 and this is its impact on the headline output number for produced price inflation for the months of this year so far. They are -0.3%,-0.4%,-0.5%,-1%,-0.5%,-0.7%,-0.8%,-0.5% and -0.6%.

If I allow for this as best I can then in fact on the old basis output producer price inflation did not fall in October it probably rose to 4.6%. The input measure has been more volatile but was probably 8.8% rather than 8%.

Comment

I will let readers decide for themselves on the likely impact of this move concerning producer price inflation. I am also intrigued by the new research on a “Silver RPI” which on the face of it directly contradicts official UK government policy. I will point out that month after month our inflation figures disappoint and that rather than falling as the Bank of England has promised we have seen a rise again. I make no apologies for repeating my suggestion for improving the situation. 

 

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 six weeks now and should my Member of Parliament do me the courtesy of replying to my suggestion I will let you know.
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9 thoughts on “The long-term future for Ireland and my view on inflationary trends in the UK and US

  1. Morning Shaun.. fabulous article as usual. I could’nt agree more with this: “As we look further forward we come to the issue of longer-term solvency and a bailout does help this but only marginally. If you look at the numbers you still come to the conclusion that Ireland looks insolvent in the longer-term”. For me, I fail to see how a state can continue to borrow five of every eight dollars it spends for long, nevermind the social consequences of this. One cannot solve a problem of debt with more of it, even if the IMF believes it to be so.

    My question to you is in regard to a comment where a poster mentioned that should Ireland default, RBS and possibly other UK banks would be at serious risk.. could you comment ? Thanks

    • Hi Mr.K
      There are a lot of cross-currents in this area so I do not think that it is possible to come up with one number and say that it expresses the situation. For example UK banks were active in Ireland and it seems as though the two banks which are part-nationalised were the most active by this I mean RBS and Lloyds Banking Group ( presumeably mostly via its ill-fated merger with Halifax Bank of Scotland). However there are other influences.
      1. Cross-currents on the UK Commercial property market. For example estimates of the assets in the Irish bad bank settled on 21% being so far on mainland GB and 6% in Northern Ireland. If this carried on this would mean in total some 22 billion Euros of distressed assets in the UK by the time NAMA is finished. This has implications for the UK Commercial Property market which is showing signs of slowing anyway.
      2. Some UK banks are active in Northern Ireland which is bound to be affected by its southern neighbour.
      3. The UK residential property market appears to be turning down on its own which affects UK banks.
      4. Uk banks were also active in the other peripheral Euro zone nations. If you add them all up and include Ireland then according to JP Morgan via the FT you get RBS as the 3rd most exposed European Bank, lloyds as 6th and Barclays as 7th. In case you were wondering Credit Agricole were the most exposed. Now care is needed as in my opinion it looked like the German banks were under-represented but it does give some sort of clue.

      So I think that some of the UK banking sector is looking at possibly several problems at once which is the real danger to my mind. And of course there is a danger of an agent X in the way that somewhat unexpectedly Lehmans turned out to be more important than one might have thought.

  2. Hi Shaun, I completely agree with you regarding the ‘aid’ to Ireland – this sort of ‘bail-out’ does nothing to address the real issue, i.e. solvency. My interpretation is that this is: 1) a delaying tactic (of course!), and 2) laying the ground work for spreading the losses around at a later date. I do not think that the UK et al. should assume they will ever see any of their bail-out cash again.

    Regarding the US and UK rates of inflation and monetary policy, I think only a minority of people regard official CPI inflation statistics as providing an honest, unbiased measure of price pressures in the economy (and by extension, a reliable metric on which to base monetary policy decisions). At the risk of being a repetitive bore, I still think monetary policy makers are using statistics to justify their decisions, rather than basing their decisions on the statistics. For example, I came across an article in the FT from Wednesday in which Donald Kohn as good as admits that a lower dollar is seen as a means to an end (see paragraph about half way down, where he discusses a lower dollar and lower interest rates):

    http://www.ft.com/cms/s/0/4ba13af2-f285-11df-a2f3-00144feab49a.html#axzz15jhcVjgU

    A weaker dollar will eventually force China into revaluation – they are clearly struggling with the inflation created by QE1 and 2. Furthermore, the Fed and BoE are still hell-bent on bailing out the financial system, and seem to think that they have the tools to combat any inflation that arises as a consequence.

    PS. I may have missed it, but who do you see electing MPC members? The Treasury Select Committee? Lords Economic Affairs Committee? If you asked the general public, they’d probably stuff it full with even more doves than the Labour Party!

  3. Hi Shaun
    On the timing of the panic over Ireland I was wondering whether,following rating downgrades, Irish bonds ( sovereign and other) satisfy the ECB asset eligibility criteria of the Securities Markets Programme. Are the credit qualities of Irish assets compliant with the ECB’s laws?

    • Hi Shire
      Actually the criteria of the Securities Markets Programme is in essence the other way, it ends up buying what by definition nobody else wants (at that price anyway). So it ends up full of poor quality assets maybe very poor. This is one of the reasons Axel Weber was against it.

      As we stand Ireland is above the requirements for ECB repos etc. which I suspect is the question you meant to ask. But she must be in danger of downgrades by the various agencies. They too are probably waiting for the bailout. However as we no longer have 12 month ECB repos the importance of this has declined although it will be interesting to see if the ECB can continue to exit such measures or will be forced to return to them.

      The figures from Allied Irish today were disturbing and will not have helped, although its share price was rising earlier which I have to confess surprises me.

  4. Hi Shaun,

    Thanks for another thought provoking post. Whilst I have the upmost respect for your blog I have to question some of the statistics used.

    The first is the use of the Nikkei – Dow split. Given the volatile nature of the indexes I feel I do not gain much from the analysis of the split between the two. If I have my facts right, the dow is a measure of 30 companies, the Nikkei of 225. As companies come and go they must affect these measures in different ways.

    Whilst you are not placing much emphasis on it I would also question the Silver CPI measure. I have no confidence in the ONS CPI at all. The own brand goods distort this measure. In my opinion I could buy Supermarket own brand beans but I would not have the same quality of product as if I had purchased a well known brand. So the inflation that I see is not being measured in the CPI. I am also conscious of the fact that consumer goods exist in the basket, such as DVD Players. Whilst people will at times purchase these items they have a naturally deflationary effect and as soon as Blueray players are added to the basket they are re-based at 0 and so this continues.

    The silver CPI is supposed to show the inadequacy of the CPI measure for pensions. I agree with the principle, not necessarily with the measure. Although a weighted CPI reflecting household spending on food, clothes etc may be useful.

    I would not ask you to justify your use of measures. I would ask if you could explain what you read from the Nikkei – Dow split and if you agree that the silver CPI is a special interest measure?

    • Hi Mike
      It’s no problem I am happy to justify them.

      If we start with the Nikkei-Dow spread then one has to start with the fact that it many respects it is not a spread at all but it can be a guide. So I am not looking for a move of say 3% and saying that this is of note. My point is that it has moved much more for example from when they were level earlier this year the spread moved to 20% or so which I think is of note. Recently it has moved in by around half that which again I feel is of note. From the time I spent in Japan I believe it will have been noticed in Tokyo.

      As to weaknesses it has some too, in fact virtually any equity index comparison has issues for example if we stay in the US the Dow and the S&P500 have quite different bases and calculations. In Japan there are considerable differences between the Nikkei and the Topix on ebeing the representation of the banking sector although its woes have narrowed that a bit…As to the number of constituents that is less of a problem as of the 225 most days say 40 may not trade and another 40 will trade very little and so on, so it is in fact less of a problem than may first appear.

      So it has uses but is by no means a panecea.

      As to the Silver RPI I did say “Now Age UK certainly has a vested interest in producing such numbers but I feel that this research should be looked into further as there does appear to be some basis to it. I would have expected there to have been more of an influence from medical costs (which escalate at an alarming rate) but perhaps there is some influence here from the role of the NHS.” So I feel at a time when inflation indices are having their credibility questioned I think that some new thoughts help even from a vested interest,especially as they poses questions for the government which has claimed the opposite. So I regarded it as food for thought and further investigation.

      I hope this helps.

      • I had also been wondering about the Nikkei-Dow. Though this shows performance since June it would be interesting to reset this since the maiden voyage of QE2.

        Also when you class under performed I reckon(I could calculate it) if you take into account currency changes the Nikkei would have been a safe bet for US citizen as the dollar has fallen.

        • Hi Fletch
          Your analysis is perfectly valid as it is useful to look at such moves in the respective currencies and from the point of view of overseas investors. As someone who spent many years in the derivatives/futures world where one usually trades with little currency involvement my natural inclination would be to discuss such matters without the currency effect. So I would consider the currency effect later or separately.

          But the underlying point that one can add value by considering the effect on investors in other currencies is often helpful and I sit down and calculate the gold price in other currencies for that reason every now and then.

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