Hopeful indications for the world economy lead to equity rallies but the UK is in danger of letting the inflation genie out of its bottle

Firstly let me welcome everyone to 2011 and wish you all a Happy New Year. As I have written before I expect it to be a very busy one on the economic front and one which will be subject to quite a few influences several of which are contradictory. As not everywhere takes as long a break as the UK it is already plain that equity investors were not happy with the pre-Christmas gains of the “Santa Rally” and used the first trading day of 2011 to push equity prices higher. The US Dow Jones equity index closed up some 93 points at 11,670 and if we add the fact that it closed at the end of November 2010 at 11,006 we can see that since then it has rallied by 6% which is slightly more than it had managed in the rest of 2010 put together. Even one of the laggards in terms of equity markets in 2010 the Chinese Shanghai Composite index has rallied some 44 points to 2853 this morning. The net effect of all this is that the UK FTSE 100 has followed the nursery rhyme of the Grand Old Duke of York as after dropping 71 points on New Years Eve today it has rallied by just over 100 points so that it has for now regained 6000.

Possible Causes

Purchases of US government bonds by the US Federal Reserve Bank

The Fed was out early in the New Year and purchased some US $7.8 billion of US Treasury Bonds (government debt) in the 7 to 9 year maturity range yesterday. Various people have tried to establish a direct link in terms of correlation between these purchases and equity market rises but the truth is that the situation is more complicated than that. So it comes down to opinion about indirect effects and I can help the feeling that the asset purchases under the so-called QE 2 programme are supporting equity prices but it is also true that this is very difficult to prove!

US Economic News: ISM Report

The Institute for Supply Management reported yesterday and whilst there is always debate over whether a report meets economists expectations what cannot be argued is that a reading of 57 for December 2010 on a scale where a reading above 50 indicates expansion is good news for the US economy and in particular for its manufacturing sector. The new orders index was even better at 60.9. The report goes on to say.

The manufacturing sector continued its growth trend as indicated by this month’s report. We saw significant recovery for much of the U.S. manufacturing sector in 2010. The recovery centered on strength in autos, metals, food, machinery, computers and electronics, while those industries tied primarily to housing continue to struggle. Additionally, manufacturers that export have benefitted from both global demand and the weaker dollar. December’s strong readings in new orders and production, combined with positive comments from the panel, should create momentum as we go into the first quarter of 2011.

So a strong report which the ISM itself suggests is consistent with an economic growth rate of some 5%. I think that one should be careful of such hyperbole and if we break the report down we see that according to the ISM then US manufacturing is doing well but the housing sector is not doing so well. Looked at like this we are back, in my opinion, to the picture of the US economy that we have had since late summer. That is of economic growth but at a level which is not yet sufficient to make much,if any,of a dent in US unemployment levels. The employment level in the ISM report dipped to 55.7 from November’s 57.5 so growth in manufacturing employment is slowing which only adds to the uncertainty for 2011.

One matter did not escape my attention which is that if you read further down the report you get a very long list of commodities prices which have risen but only one (natural gas) which had fallen.

Foreclosuregate: Bank of America

Tucked away in the news was a report that Bank of America had reached an agreement on this subject with the two main state subsidised mortgage companies in the US which glory in the names of Fannie Mae and Freddie Mac. For those unaware of this scandal it has created quite a cloud over the US housing market. The reason for this is that banks and loan servicers used false documents and signatures to justify hundreds of thousands of foreclosures or what we in the UK call repossessions making them in effect illegal. The scale of these actions made it unlikely that these were a coincidence and there was an instance of one person completing thousands and possibly tens of thousands of these, of course there is now some uncertainty over whether this person was also a fiction. So the US foreclosure situation was grim as many states simply stopped allowing them.

As you can imagine fears were high for the US banking sector and accordingly news that Bank of America had settled by paying some US $ 2.8 billion  to Freddie Mac and Fannie Mae was perceived as good news in this context.However care is needed as the deal is a cap for exposure with Freddie Mac it is not at its sister agency Fannie Mae and of course there are plenty of private insurers still to settle with. So I suspect that the euphoria may well be somewhat short-lived and the story is not yet finalised.

European Purchasing Mangers Index

Figures from this area were also quite firm with the index rising to 57.1 in December from the  55.3 reported in November which indicates that Europe’s manufacturing industry ended 2010 growing strongly on a scale again where over 50 indicates expansion. This was not a new figure but was a revision up from the previously reported 56.8. As ever the expansion was driven by export-led growth from Germany which recorded a PMI of 60.7.

Greece

Unfortunately the PMI  for Greece was again disappointing with the number slipping back from 43.9 in November  to 43.1 in December. There had been a slowdown reported in the contraction of the Greek industrial production figures recently so I have read this figures closely to see any evidence of an improvement. Unfortunately we see the following.

Business conditions across the Greek manufacturing sector deteriorated at a faster pace in December, as domestic demand remained lacklustre and new export orders fell markedly (having broadly stabilised in November). Weaker market demand primarily reflected poor financial and economic conditions, as well as bad weather, in Greece and parts of Europe. Although a sharper depletion of backlogs prevented output from falling as steeply as new work, the latest drop in production was nonetheless substantial. Meanwhile, employment continued to fall and input price inflation accelerated further.

So just to rub it in input prices are rising which is likely to be our old friend commodity price rises again, and in a report devoid of any good news to cling to we see that January’s figures are likely to be affected by strikes in Greece.

Comment

I notice that Basil reports that the cafes and shops of Greece were, in his personal experience still doing decent business which is something of a counterpoint to these figures. Regular readers will know that I was always troubled by the danger of a spiral downwards for Greece resulting from the austerity regime in a similar way to what happened to Latvia when she was also under an IMF led austerity regime and I still worry that this is the most likely outcome.

The UK Economy

PMI

One hopeful sign is that the UK’s own purchasing managers index has come in very strong this morning at 58.3 which according to Markit who produce the figures is a sixteen year high. Part of the improvement came from net exports which is particularly welcome as we have not managed to take much advantage so far from the reduction in our exchange rate which took place in 2007/08.

However it did not escape my attention that the following was also reported.

Cost inflationary pressures continued to build in December, as average input prices rose at the fastest rate in the nineteen-year survey history………..Part of the increase in purchase prices was passed on to clients in the form of higher selling prices in December.

Care is always needed with survey results and this applies to all of the reports I have discussed today. However a picture os a strong UK economy with growing price pressures is consistent with other signals. Personally I see it as good and bad in the same report. I welcome the signs of growth but am also concerned by yet another report of rising inflation in the UK economy. The simple truth is that the Bank of England is starting to look a along way behind the curve on this subject and whilst members give us hyperbole by claiming that their influences are “inflation,inflation,inflation” to quote Spencer Dale they seem to forget that words need to be followed by deeds.

Inflation in the UK: Institutionalised Inflation

One subject that will occupy a lot of space in media coverage today will be the fact that the rate of Value Added Tax ( a sales tax) has risen overnight from 17.5% to 20%. For serious economic commentators care is needed as this will not directly raise inflation as we had an increase of the same amount this time last year. However with an economy which is beginning to show some signs of overheating on this front concerns are rising about possible price rises being slid in and hidden with the VAT rise. We will have to wait and see what happens on this front as the picture is somewhat confused and muddy. To give an example of this I have just listened to a member of the UK retail industry on the radio tell us that prices will not rise although there might be some increases! The current situation is littered with other examples of such verbal incontinence I am afraid.

However 2011 has already seen several examples of what I call institutionalised inflation in the UK. Commuters have been hit by rises in rail fares of approximately 6% which sits oddly with our political leaders supposed commitment to public transport but perhaps they themselves with their still somewhat friendly expenses regime do not notice such changes personally. Also tucked away on New Years Day was an increase in fuel duty of 0.76 pence per litre which now will be edged higher by the increase in VAT. For those unaware of fuel prices in the UK there had already been rises in the period leading up to Christmas and in the garage around the corner from me the price of a litre of diesel is now 130 pence.

Conclusion

There has been a hopeful start to 2011 for the world economy in most places but whilst this is also true for the UK the combination of a possibly overheating economy with signs of institutionalised inflation pose concerning signs. After suggesting (correctly I believe) that interest-rate rises were needed at this time last year I feel now that it would be just as important for a member of our monetary policy committee to battle institutionalised inflation as I expect more of it in 2011. In my view a risky game is being played……

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12 thoughts on “Hopeful indications for the world economy lead to equity rallies but the UK is in danger of letting the inflation genie out of its bottle

  1. Hi Shaun and a happy new year. As a non economist I am confused by the concept that a VAT increase would not directly increase inflation. Obviously not products are standard rated and there may be some margin smoothing,timing issues and the like. However surely if like today unleaded fuel went from 125p to 128p that feeds to RPI?

  2. Andy,

    Inflation is a moving annual total which means that the price increases between December 2009 and January 2010 will drop out of the figure as the increases between December 2010 and January 2011 are added in.

    VAT went up 2.5% last year and that increase will drop out just as the current one kicks in – net effect, near but not quite zero (as the base will be higher).

    Of course, that doesn’t mean that prices won’t rise by 2.5% or more: just that the inflation rate may be below people’s worst fears and price rises can be hidden by blaming retailers: smart huh?

    • The month on month figures dropping out of RPI are
      Dec09 0.6% Jan10 n/c Feb10 +0.6% Mar10 +0.7%

      As those figures where against a background of weaker commodity prices eg crude in the $70-$80 range, I wonder whether a relaxed approach to VAT and RPI will be jusitied.

      • Hi Andy
        Chris has already replied on this issue but in essence there are two points. One is that for the monthly figures there will be a rise as Januarys prices will be higher than Decembers due to the VAT rise. However the annual figures have an equal sized rise in VAT falling out of the calculations…. So we wait to see the net effect as to whether other price increases will be added to it or whether firms will accept a margin reduction. Some firms did raise their prices in advance to clain that they are swallowing the rise now so the picture is complicated even before we try to allow for other price rises such as rail fares and fuel duty! Indeed some price rises do not cause inflation in a purist sense as the strict definition of inflation is a continuous rise in prices but I am afraid it is virtually impossible to fully allow for that in another conflict between theory and practice.
        Personally I would have raised it for the new tax year in April.
        As to a relaxed policy well the Monetary Policy Committee would struggle to adopt a more relaxed policy than their current one although of course Adam Posen feels that it is appropriate…

    • Hi Graham
      Thanks for the link. I have been following the decline in retail sales through the year and would just like to add that I think ESEE/Kathimerini has forgotten the impact of inflation on retail sales in Greece. A nominal fall from 52.8 billion Euros to 51.6 billion is a lot less than that indicated on the data so far by EL.STAT. So unless there was a real rally at the end of the year as EL.STATs data is only up to the end of October the difference was probably caused by inflation which is just under 5%.

      Put like that an outright nominal fall even with inflation of 5% does not look pretty does it?

  3. Hi Shaun, a very Happy New Year to you and your readers. The last MPC minutes made interesting reference to an indirect tightening of UK monetary conditions in terms of an appreciating exchange rate and increasing gilt yields- protective of inflation? I wonder if the policy here is to push the cruise-control and let things coast. More news as to how UK banks can replace SLS and CGS funding without tightening credit or raising its price would be helpful.

    • Hi Shire
      The Bank of England used to have some rules of thumb for the impact of changes in the exchange rate (essentially comparing a certain % move with a 1% base rate move). However certainly some members of the MPC have given speeches which have said they now longer hold this to be true and the most explicit references have come from Adam Posen who feels that the effect has weakened. You can spin that several ways as the old formula (if you take the depreciation we had in 2007/08) meant that the MPC was responsible for a larger amount of monetary easing than otherwise which does not suit Mr.Posen’s case. However just to complicate things the 5% fall in the official base rate has had less of an impact than some some might have expected particularly those whose reading had never extended to reading about the dangers of a liquidity trap.
      In short therefore a small appreciation in sterling’s exchange rate and a rise in gilt yields should have some economic effect but will it operate where we want it to? For example an increase in fixed-rate mortgages may weaken our housing market which already has problems rather than help to trim inflation. I feel that one of the dangers of 2011 is inflation in some areas and the opposite in others. Either way neither is a direct policy tool although the bank could easily raise gilt yields by announcing some sales of its holdings! Of course this is very unlikely from a group of people who seem to think that no exit strategy will ever be required.
      I too worry about your implied question about the possible effect of a credit squeeze on smaller companies and feel that it is a risk in 2011 that the Bank of England appears determined to exacerbate. As ever in the world of imbalances in which we live I was watching a report yesterday on CNBC which said that large companies were awash with cash!

  4. Shaun, happy new year and i continue to look forward to your prescience blog every evening which remains streaks ahead of the mainstream newspaper commentators

  5. Hello Shaun, happy new year!

    Judging from the comments I’ve made vs. the comments Basil has made, I’d call Basil a bit too optimistic – or perhaps unaffected by the “crisis” on his own, tending to view things through rose-tinted spectacles elsewhere.

    Let’s see:

    Several businesses, citing legitimate or less than legitimate reasons, have decided not to pay their employees for December, or January, or both. Most of them, however, did pay the “Christmas bonus” payment (and at this point I would like to remind to read readers that the Greek system uses 14 yearly payments to make up a yearly salary, in lieu of 12 in most other countries, but this is no “bonus” per se), because not paying this carried legal ramifications that could lead up to temporary imprisonment of the legally appointed company representatives.

    This includes the company where I work at, which let us know that we will get paid January’s salary after May, since they decided to use January as a “pot of money” in order to proceed to certain mass redundancies (which are costly in many cases as per Greek employment laws). Effectively, we did not get any “Christmas bonus” at all, and will get it later in the year. Our primary shareholders are international funding groups, but it appears that the spirit of the times catches up even to these “financial giants”.

    I should note that in our company’s case, the whole idea is to restructure to the better, since for the last few years we’ve been plagued by, among others, a near total lack of skilled salesmen and / or commercially minded people in the respective divisions, so the above moves have been largely expected for many months now…

    …But others have not been so fortunate, having to wait for random amounts of time to receive their legal pay, without any actual “restructuring” taking place.

    As you may understand, measures such as these mean that people affected (me among them) bought exactly NADA for Christmas. Maybe coffee shops and restaurants are quite full (and with Athens being a city of 5 million people, it’s not that astonishing, especially considering the Greek habit of having coffee for 2-3 hours at a minimum in afternoons, effectively taking up a table for so much time with “only” a beverage per person seated).

    I did note, however, markedly decreased traffic after New Year’s Day midnight – I even found a free cab on the street within 5′, something unprecedented for previous new year’s eve days, when it was “either radio taxi by appointment, or nothing”. It seems that a majority of people elected to gather to friendly houses for a drink and some cards, instead of spending proportionally more money to celebrate outside.

    Personally, I believe that the Greek solution is closely bound with the European solution, since it’s quite apparent that while Greece may take the blame for a long of things, it’s not the only “culprit” in the crisis. It will be very interesting to see whether Spain and Italy will meet their crazy Q1 2011 funding needs. I don’t suspect they will, at least not easily. Eventually, I think that something “Euro-bond-ish” will be born, in return for a gradual financial union of the Euro area (perhaps leading up to a model of federal government a la Germany of the Euro area – After all, Germany seems to be the center of everything these days).

    Once again, my best wishes for 2011 to all! I will keep you updated regularly.

    • I will admit that I prefer to see the glass half full than half empty. However, it is certain that Greeks spend less than they used to do (they used to spend too much though at least for my standards) and it will become worse not better. However, I have noticed that non-Greeks friends seem to believe that Greece has become a terrible place to live and I just do not see this at the moment (especially away from Athens). I do not see major and dramatic changes in the daily life of my Greek friends (of course less money to spend and apprehension about the future, but still the vast majority of people that I know in Greece continue to lead a rather pleasant life at the moment albeit with less money). As to the comment that I am not affected by the crisis, it couldn’t be further away from the truth.

      • Keep in mind that I did not mean the “not affected by the crisis” comment in a derogatory sense. Someone, for instance, living in Greece, having suffered no tangible reduction in his income (save inflation effects) and somehow being safe from redundancies in a company, would be deemed “not to be affected from the crisis”.

        Your input is right, though: Greece is not a terrible place to live in, but in Athens / Attica in particular where most everyday prices are far higher than in other areas of the country, things are more “squeezed” at the moment for sure.

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