We are seeing one simple economic trend the rising price of basic foodstuffs (and other commodities) have a ripple effect around the world. As I review the news media I see articles on North Africa and Arabia and the riots and revolutions and military crackdowns which are taking place. I see discussion of UK monetary policy increasing as our inflation continues its rise. Many other nations have joined China in raising interest-rates in response for example Vietnam has raised hers by 2% this week. Now I see that the International Monetary Fund is discussing it and the G-20 group of nations will discuss it this weekend. Unfortunately this is the same G-20 which flies across the world and travels in motorcades to warn us of the dangers of climate change! Hypocrisy are us you might say. However it is a wide ripple effect from one event. I am reminded of the image of throwing a pebble into a pond. There was a children’s programme in the UK which had the strapline “expect the unexpected” whereas most mainstream thought only expects the expected.
The possible far-reaching consequences of the rising price of cotton
Overnight has seen developments in the underlying cause. The Commodity Research Bureau foodstuffs index has reversed its recent dip and risen 4.72 to 489.71. Also I notice the fats and oils index rose by 4.08 to 540.66. So the heat is on again you might say. In addition we are seeing a move in what is another relatively basic staple as cotton is surging in price and is now over US $2 dollars per pound and indeed is at US $2.11 per pound this morning. This represents a limit up price which has been the situation since Wednesday. For those unaware of what “limit up” means this is a consequence of some exchanges having price limits when trading stops which may be for an hour or that day. For example US Treasury Bond futures have had limits and Japanese Nikkei futures have a 3% price limit. If you are an option trader called Shaun trying to hedge your position that can be inconvenient, although on the upside at least I got a break!
The basic fact is that cotton prices have risen by a concerning 45% this year. To give some further consequence of this until this surge the recent high was 80 cents per pound. Now I want you to perform a slight mental leap. What have been the driving forces of low inflation in the westernised industrial world? Well one of them has been cheap clothing often cotton based from the Far East. It would appear that not only is that now over but we are seeing the reverse and can expect price rises rather than falls from this area. A Japanese economist I exchange ideas with contacted me recently to say that she had been on a business trip to Bangladesh and such prices were rising quickly there which she expected to hit the UK over the next 6/9 months. If you do not believe it then take a look at the labels in your clothes. In the UK one company Primark has made a successful business out of using cheap cotton and clothing to undercut rivals and this business model has to be under question going forwards. I am sure international readers have their own equivalents.
On the subject of international readers I notice that I am getting some few readers in the Far East interested in my articles on Quantitative Easing and its consequences. Hong Kong,China, Vietnam and others. As I get only a small snapshot of detail on the total I wonder how much concern there is out there over the consequences of this continuing policy.
US Inflation:The Consumer Price Index (CPI)
If we look at the official US CPI one might be tempted to say “nothing to see here move along”. Whilst it climbed 0.4% in January the year on year rate remains historically low at 1.6%. However this is a seriously flawed index as I pointed out in my article on the subject back on the 2nd of July last year. One major issue is that housing represents some 41.46% of this index and that most of this is made up of rental costs. So in essence it is unlikely to rise much and whilst I believe that housing costs should be an influence on consumer inflation I believe that using an estimate of what home owners think they might get in rent if they rented their home out does not work well in practice. So it understates the US cost of living possibly substantially.
I am not much of a fan of the UK/European method of CPI but it at least if used for the US shows a higher levels of inflation. The latest figure for the US is out of date but in December it was at least 1.9% versus the official 1.5%. So not much but a little better.
If we link trends we see that US Consumer Prices for clothing rose by 1% in January in a trend we can expect to continue and perhaps accelerate if we allow for more recent commodity price rises.
The UK and problems with calculating inflation
I wrote this on Tuesday after looking at the UK consumer inflation statistics about a change which had taken place.
Perhaps nice for the figures for now but if cotton prices remain where they are this will misfire fairly soon! For those who have not be following their rise cotton prices have doubled since mid-2010.
The Bank of England mentioned this subject a day later in its inflation report. Here is its view on what has happened and the effect.
It is likely that the previous collection practices picked up the seasonal falls in prices during the winter and summer sales, but did not fully capture the recovery in prices after sales had finished
That suggests that true clothing prices were around 5.5% a year higher than measured in the CPI, equivalent to adding 0.3 percentage points to aggregate annual CPI inflation.
The changes to clothing price collection methods are likely to have a larger impact on RPI inflation than on CPI inflation……….The changes to price collection practices will increase the dispersion of clothing and footwear prices, and therefore the impact on RPI will be larger than the impact on CPI. In 2010, the contribution of the formula effect to the CPI/RPI wedge increased by 0.3 percentage points, entirely reflecting clothing and footwear prices.
Firstly I welcome this move. If you spot a mistake the correct course of action is to put it right as quickly as you can and then look to learn from it. However there are some consequences.
1. The under-recording of UK inflation may have contributed to the Bank of England’s apparent obsession with deflation and disinflation and the way it has dismissed inflationary trends. Although care is needed here as it may suit the Bank of England to exaggerate the effects of this…
2. Those who hold or have held UK index-linked government bonds which are linked to the Retail Price Index may well be enquiring as to whether they have been treated fairly. There is an issue here where the bonds will have been following an index which has been reported at what we know now is the wrong price. As I believe in transparency I will declare that I do have an interest here as my pension fund is “overweight” in such assets.
3. Those who have held UK index-linked savings certificates may be wondering the same thing. They may also be wondering if this is the real reason why there have been no new issues of such products recently.
I will contact the necessary bodies to find out what they plan to do in response to this and update when or perhaps I should say if they reply!
Confederation of British Industry report on UK manufacturing reports cost pressures
Reflecting strong cost pressures from rises in oil and other commodity prices, inflationary pressures remain intense for UK manufacturers in the February survey. A balance of +32% of firms predict they will have to raise prices over the coming quarter, following a similar expectation in January (+31%).
Dissent on the Monetary Policy Committee: Selling England by the Pound
Andrew Sentance who has been arguing against the consensus at the Bank of England since late last summer gave a speech yesterday whose timing can only be assumed was not an accident. He wanted to follow the Inflation Report with his own different views. He makes essentially three points which I highlight below.
The value of the pound on the foreign exchanges therefore needs to be one of the key areas of focus for the MPC as we seek to steer ourselves out of the current phase of high inflation…..
By raising interest rates sooner rather than later to help offset global inflationary pressures, the MPC can help reassure the financial markets and the great British public that we remain true to our inflation target remit and are not intent on “Selling England by the Pound”!
So to recap, I have highlighted three reasons why the “output gap” view that spare capacity would bear down on inflation might not have operated recently: the limited margin of spare capacity in the economy; the rebound in domestic demand growth; and a change in the pricing climate due to the accommodation of price and cost increases to ward off fears of deflation.
These interrelate and he feels that the “internationalisation” of the UK economy is a major reason why output gap theory has not worked. For those who have not followed this topic the consensus view at the Bank of England has been that the output gap will reduce inflation and then that it will eventually reduce it. At any point in time it is expected to work in 6 months time! Unfortunately so far it has not happened.
I entirely welcome some new evidence on new thinking at the Bank of England and whilst I feel the timing is late there is the cliché better late than never! Although to correct myself to a degree, Mr.Sentance is only espousing views which were in the past considered part of Bank of England orthodoxy. It would be interesting to get the opportunity to ask Governor King when he changed his mind on such matters as the answer (if I got a one) could only be revealing.
How dangerous is it that the consensus view is always to expect the expected?
I went to a lecture at the London School of Economics on Monday evening and the speaker suggested that reality for economics was represented by using reasonable assumptions to get one set of answers or a curve on a graph. I asked if the fact that expressing reality as a single curve ignores the fact that due to human subjectivity in reaction to events that there might be several alternative responses rather than just one. Accordingly this might explain why what are called Black Swan events or what I was taught as the serially uncorrelated error term keep catching mainstream economics out.
I would welcome readers thoughts on this issue.