Inflation in the UK surges again making the Bank of England look ever more out of touch with reality

Last night I watched the press conference after the meeting of Euro Zone ministers and officials that had been called to discuss their so-called “shock and awe” rescue fund. This is the package that was launched with much hyperbole by Spanish Finance Minister Elena Salgado  back on the 10 of July last year and was supposed to amount to 750 billion Euros. Unfortunately the boasting that accompanied the launch has been followed by the realisation that rather than of shock and awe size it is in fact too small! Back on the 25th of June I pointed out a rather inconvenient truth.

So far so relatively simple however the EFSF plans to have a buffer of 20% which it feels will be sufficient to get it as an institution a Triple A rating from the credit rating agencies. So this means that it will in fact have some 365 billion Euros available to help any euro zone sovereign nation were to get into funding difficulties.

Unfortunately the structure of the plan was that as the Euro Zone contribution shrinks so does the one from the International Monetary Fund as the ratio between the two was set at two to one. So the shrinking of the European Financial Stability Fund from 440 to 365 billion Euros reduced the IMF package from 250 billion Euros to 213 billion. Adding in the component from the European Union of 60 billion then got us to 638 billion Euros. But is did not stop there as there was an even bigger flaw in the plan and it was one which showed considerable incompetence. You see each nation guarantees its own section of funds for the EFSF. So those in trouble fall out of the equation but also those in danger fall out of it too. They can hardly raise money to rescue themselves can they? So we are left in my opinion with a useable EFSF of more like 200/250 billion Euros. This means that the total rescue package has ended up with a maximum size of 450 billion Euros.

Does this matter?

When you look at the size of the rescue packages required for Greece and Ireland the numbers have another inconvenient truth. The bailouts are proving more expensive than expected. For example whilst we get all sorts of promises neither Greece nor Ireland looks remotely saved as we stand. I would not be surprised if the bailout for Ireland ends up being increased and neither bailout has any sort of exit strategy apart from hoping for the best. So a smaller fund collides with more expensive than expected rescues and leaves me with the conclusion that there is money to rescue Portugal but not enough for Spain should Portugal fail first. This is the crux of the matter.

Even worse than this is the feeling that is emerging is that the so-called rescues are not looking like rescues at all. The interest-rate charged to Ireland of 5.8% left her looking profoundly insolvent a fact which has suddenly occurred to her Finance Minister Brian Lenihan who is trying to renegotiate it. Unfortunately for the Irish government there was plenty of time to negotiate this as it was plain for quite some time before she called for aid that she was going to need it. I suggested they should call in the IMF in mid-September of last year and they did not call for aid for quite a while after that. But it would appear that in another outbreak of incompetence no planning was done.

So there were two matters for the Euro Zone to discuss. A lack of funds for their rescue package and the fact that a plan to help insolvency charges an interest-rate which guarantees it!

So What Happened?

In essence the can got kicked down the road until February or March as Herr Juncker did not seem quite clear about dates. In fact in a slightly bizarre intervention the English translation told us this.

To prove that the Euro does not have a problem we will issue a commemorative 2 Euro coin in 2012.

Whilst I was still scratching my head as to what this proved we were then told of Ireland and Greece.

Everything is on course as was supposed to be

I do not know about you but if their situation is on course I would hate to be off-course as it must be truly dreadful! And just to complete the let them eat cake atmosphere we got this from Commissioner Oli Rehn on the bank stress tests which were.

Very rigorous,even adverse

This is the same set of tests which passed Ireland’s banks.Their collapse shortly afterwards has put Ireland in a rescue package and put the credibility of the stress tests needing its own rescue package. So in essence there you have it apparently everything is fine which of course is a cover-up for the fact that they do not know what to do. Sooner or later financial markets will examine this uncertainty and they are unlikely to be kind.

Meanwhile at the European Central Bank

 As the Securities Markets Programme transactions which settled last week were of a volume of EUR 2,313 million, the rounded settled amount – and the intended amount for absorption accordingly – increases to EUR 76.5 billion.

So whilst the politicians dither it has had to expand its operations and bond-buying. I pointed out last week that the bond auctions in Portugal looked like they had received a lot of financial backing from the ECB and these numbers confirm this. I also pointed out that the ECB with the size of its purchases is creating a false market and that if anyone else did this then it would be ruled as a false market. Unfortunately for us and the ECB (as the SMP has all sorts of bad implications for it) the continuing failure of the Euro Zone to agree a strategy means that it is likely to be in effect a buyer of last resort for some time.

UK consumer inflation disappoints yet again

This morning we have received an update from the Office for National Statistic on the consumer price inflation position in the UK. Consumer Price Inflation is represented by CPI and Retail Price Inflation is represented by RPI.

CPI annual inflation – the Government’s target measure – was 3.7 per cent in December, up from 3.3 per cent in November…….In the year to December, RPI annual inflation was 4.8 per cent, up from 4.7 per cent in November…….RPIX inflation – the all items RPI excluding mortgage interest payments(our previous inflation target) – was 4.7 per cent in December, unchanged from November.

Regular readers will not be surprised to learn that food and fuel prices contributed to the rise and they were joined by air transport costs. The weighting of air transport costs has recently been increased in the CPI which is one of the reasons it rose by more than the RPI. There was also an increase in the gas price component which is recorded separately from fuels.

There is another reason why our two inflation measures diverged slightly this month and that is that houses depreciated in December. You see the RPI includes an effort to allow for house prices and CPI does not. I draw attention to this because in my view this makes RPI a superior measure of inflation for the UK to CPI in a country where the rate of owner-occupation is high. I do not think that the way the RPI does it is perfect merely that it at least tries whereas the CPI ignores such matters. Accordingly,in my view, its introduction was a retrograde step.

Comment

These figures confirm a pattern for 2010 which is troubling for UK inflation. Under the system we have the Governor of the Bank of England has to write to the Chancellor when inflation as measured by CPI exceeds its targeted level of 2% by 1% or more. We now know that it did this for every month in 2010. The Governor’s protestations that the rise in inflation has been due to “one-off” effects and will be “temporary” is contradicted more and more by the evidence as each month goes by. Even worse than this if we go back to the Bank of England’s forecasts for 2010 we can see that they underestimated inflation in 2010 by a considerable amount. This continues the Bank of England’s forecasting record which is now so poor in this area it is abject. This is important because it has based its economic policy on this and this policy with base rates at 0.5% and an asset purchase programme of some £200 billion is extremely expansionary. This policy looks less and less appropriate.

As we look towards 2011 we can see that there are dangers of inflation ahead. There are pressures worldwide from increasing commodity and oil prices and these will have their impact on the UK. Furthermore there have been signs that expectations of inflation in the UK are rising as the Bank of England’s own surveys have suggested this and more recently a survey by YouGuv for Citibank said that they had risen in December to 3.5%. As expectations are likely to lag the official figures this trend is worrying. There are dangers of inflation continuing to pick up in 2011 and if they do our  supposed guardian will be left well off the pace. It is in danger of repeating the mistakes made when we had politicians setting our interest-rates of initially doing too little to late and then following it with a bit of panic and raising them too much creating a boom bust cycle.

My View

My contention is that we should have raised our interest-rates some time ago. Here are my views from the 14th of December 2009.

Accordingly I remain of the view that raising interest rates to 1.5% will be a beginning in us negotiating our way out of our current difficulties.

As both inflation (which I expected) and economic growth have been higher since then I feel that events have backed up this view. Furthermore I would now be considering edging interest-rates up to 2%. However care is required here and many in the media do not take care. If you take the view that a neutral level for UK interest-rates is around the 4.5% level then my policy remains expansionary simply less so than the current one. This is not quite the way proposed interest-rate rises have been represented. Also if you look at the effect of the 5% cut in interest-rates we had back as the credit crunch exploded it was a disappointment in economic terms. I feel that one of the reasons for this was explained by Keynes some time ago when he talked of a liquidity trap. My nudges higher in interest-rates would take us out of this. Specifically I wonder if the cuts in interest-rates below 2% had much impact at all on our overall economic situation and I will explain this more fully in future posts.

2011 will be a year of many influence on us and the inflationary ones will be joined by deflationary ones too. We need to be ready for both and in my view currently policy is biased too much towards the deflationary influences and accordingly I feel that we need a re-balancing.

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12 thoughts on “Inflation in the UK surges again making the Bank of England look ever more out of touch with reality

  1. lets be honest here – the BoE is not going to raise interest rates because its only house inflation they care about . The banks are scared that the house market will collapse and therefore their balances will go south – raise interest rates and that can certainly happen!

    another bail out will be needed – but can we afford it ?
    IMHO no we can’t but it certainly seems like the banks own us and are the real power here.

    I agree with you that the CPI is a sop – I call it the ” creative price index” but use of this figure is purely political and not financial .

    RPI = Real Prices Index

    Forbin

  2. If cuts in interest rates below 2% had little impact on our overall economic situation, why should raising interest rates from 0.5% to 2% have any greater impact ?

    So far as rising prices are concerned, raising interest rates would probably tend to reverse some of the depreciation of sterling and tend to reduce the sterling price of imported commodities and may therefore reduce RPI/CPI. As someone in fuel poverty using heating oil which has increased in price from 46p per litre to 57p per litre since November, I’d be quite happy! I doubt whether our exporters would though.

    Presumably an increase in interest rates would tend to slow economic growth, increase still further unemployment and so reducing HMG’s tax take and increasing social security payments thereby making the budgetary deficit even worse.

    • Hi Paul and welcome to my blog.
      I will return to the liquidity trap situation in future articles but I have some points to add to my explanation/analysis today as I try to keep the posts to a reasonable length and accordingly on days like this some things get omitted.

      I understand that many will think I am proposing a solution which may add to the problems facing us so let me try to explain at least part of my thoughts. Firstly it is by no means a cure but it is part of a solution I believe for the following reasons.
      1. I discuss a range of interest rates because although many only discuss shorter-dated ones ( if you take it literally the MPC only controls overnight rates). Accordingly for me I might raise rates at the shorter end to hopefully help prevent rises in longer-term ones. I discuss longer-dated interest-rates in my articles regularly and find that they are rarely reported on in the mainstream media which is disappointing because they are at least as important as the base rate.
      2. The credibility of the MPC would have been improved rather than reduced.
      3. I would combine it with a campaign against the way that many interest rates faced by consumers and businesses have no relationship to it. For example I feel that banks are being allowed to profiteer at this time.This might mean that for some rates would fall, for some borrowers I hope it would. A side effect would be to reduce bank profits (and bonuses) some of which are being earned too easily.
      4. It would rebalance the situation to some degree between savers and investors.
      5. The borrowing situation has been distorted with those on longer-term tracker mortgages in great shape financially whereas those who want one now may not get one at all. It would help here
      6. Money markets would function more efficiently as we move out of what Keynes called the liquidity trap.
      7. It would help end us having an emergency interest-rate when we are no longer in an emergency.
      8. It would aid a rebalancing between savers and debtors.

      So it would be part of a step by step strategy and if you look at events since I proposed it at the end of 2009 I feel that inflation trends (which I expected) and economic growth trends (which have been higher than I expected) have backed it up. It would require other things such as reform of our banks which I often call for. Instead they get bailed out again and again.

      But it would not help with oil or commodity price rises in themselves…….. There is, in my view, no magic bullet merely that some choices are better than others

  3. I’ve heard economist friends talk about something called “revealed preference”. If you look at what the MPC has done and its outcome, their revealed preference is for a CPI of 3%. In fact, if you assume they have been targeting 3% since December 2008 their record does not look bad at all.

    Of course, if they have been doing that they should be prosecuted for the common law offence of misconduct in public office.

  4. Hey Drf

    I’ve just looked at the link you’ve posted. Personally I found the whole thing a scare essay, with many things I didn’t understand, perhaps due to explanations of what the data points on the graphs meant, the omission and clarity of nomenclature etc. However, on a positive note the decline in retail takings is good news, in that we hear a lot of how bankers are siphoning away the national wealth, but the large retail outlets are getting away with it too, that is to say, they import £billions of cheap Chinese rubbish every month.

    Banks should be seen as occupying forces that are a threat to national security, and large retailers made to pay higher taxes on items bought from countries that have an existential threat to the EU.

    • Hi Friedman is a Nazi (I hope you are not really), I only suggested that this link was “interesting”. I did not suggest any academic authority or validity concerning it.

      It is all very much about horses for courses these days. A young Economist I was talking to recently (who had just completed his Masters degree) as an professional Economist stated to me, “If the supposed Economic experts in control of things in the West actually knew what they were doing and if modern Economics actually worked we would not be in the present economic mess which we are in!” I found myself having to tend to agree with him.

      I think there are number of present issues which perhaps should make most of us quite scared, so a “scare essay” may not be so much of a bad thing?!

  5. If the base rate is increased by anything more than 0.25% the UK economy will quite simply implode. Economic activity is already low, and about to get lower,(because of increase in VAT and fuel duty not to mention the rise in commodity prices) but it would just freeze.

    The interest rates actually paid by borrowers is far higher than base rate because they did not go down in line with the base rate. Only the banks have gained from the low rate (as was presumably the intention) and if the base rate goes up retail interest rates will rise. Many borrowers will be unable to meet their interest payments, and default. The lenders will be unable to realise their security because there will be no buyers (because they cannot get finance to buy)-result meltdown.

    • Hi Mick and welcome to my part of the blogosphere.

      I have already replied explaining more of my views and why I think what I do to past questions/comments so let me give a reply which I have just given to Paul

      I understand that many will think I am proposing a solution which may add to the problems facing us so let me try to explain at least part of my thoughts. Firstly it is by no means a cure but it is part of a solution I believe for the following reasons.
      1. I discuss a range of interest rates because although many only discuss shorter-dated ones ( if you take it literally the MPC only controls overnight rates). Accordingly for me I might raise rates at the shorter end to hopefully help prevent rises in longer-term ones.I discuss longer-dated interest-rates in my articles regularly and find that they are rarely reported on in the mainstream media which is disappointing because they are at least as important as the base rate,
      2. The credibility of the MPC would have been improved rather than reduced.
      3. I would combine it with a campaign against the way that many interest rates faced by consumers and businesses have no relationship to it. For example I feel that banks are being allowed to profiteer at this time.This might mean that for some rates would fall, for some borrowers I hope it would. A side effect would be to reduce bank profits (and bonuses) some of which are being earned too easily.
      4. It would rebalance the situation to some degree between savers and investors.
      5. The borrowing situation has been distorted with those on longer-term tracker mortgages in great shape financially whereas those who want one now may not get one at all. It would help here
      6. Money markets would function more efficiently as we move out of what Keynes called the liquidity trap.
      7. It would help end us having an emergency interest-rate when we are no longer in an emergency.
      8. It would aid a rebalancing between savers and debtors.

      So it would be part of a step by step strategy and if you look at events since I proposed it at the end of 2009 I feel that inflation trends (which I expected) and economic growth trends (which have been higher than I expected) have backed it up. It would require other things such as reform of our banks which I often call for. Instead they get bailed out again and again.

      But it would not help with oil or commodity price rises in themselves…….. There is, in my view, no magic bullet merely that some choices are better than others

  6. Assuming China and India standards of living are rising, ours will fall as wages must align in a global economy. This will be done through inflation and currencies, inflation will rise for many years to come and real wages will fall in the west.

  7. Notayesman,

    thanks for your response.

    I’ve followed your blog for a while now and generally agree with you (from a very amateur viewpoint).

    I agree with you on this as well but the caveat is getting the banks to bring down retail interest rates-I don’t think it can be done. The best chance would be a new bank being founded with a more long term view-that hasn,t happened and I think is unlikely.

    Anyway, great site-keep going!

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