UK Inflation and house price support - What is going on?

I will interrupt my commentary on UK government spending as there has been a string of news that is worth consideration.

There is a lot of excitement in the press at the moment about inflation in the UK (see here and here and here). I have already detailed elsewhere about why I am puzzled that our largest living expense (housing) is excluded from inflation. However, even if it was accepted that the inflation figures made any sense in the real world, why would the current inflation be any prompt for interest rises?

Interest rises are supposed to rein back inflation when an economy is at (or near) capacity, and where there are upward price pressures as a result. In other words, raising interest rates is there to restrain economic activity through a reduction in the money supply.

See the following quote from the Guardian (link above):

'The Bank has said global trends beyond the control of its nine-strong monetary policy committee have been responsible for the rise in inflation and has left the cost of borrowing at 5% since April after three quarter-point cuts in the preceding five months.'

On this rare occasion I am an 100% in agreement on the cause of inflation. It is not generated from within the UK, but is the result of wider global forces. In fact, were it not for such forces, it is very likely that (even on the inadequate measures used), that inflation would be falling in the UK with the economy contracting. Excepting government workers, who in the current climate will be risking high wage demands...

The Bank has warned that if it sees evidence that wage inflation is rising, it may be inclined to raise rates. (in the Telegraph report linked to above)

...and how on earth is the economy going to reach capacity? Shops are already reported to be slashing prices...businesses are already shutting down, unemployment is rising.....

The same Telegraph report suggests that the Bank of England is considering the contraction in the economy 'next year' as part of its consideration. However, this should be the only consideration, excepting government worker's pay.

This brings me to a central problem with the stance on interest rates and inflation.
What exactly is holding or raising interest rates supposed to do in the face of recession and global forces? I am genuinely puzzled, as I can only think of one mechanism that this might impact, and that is the value of the £GB. If interest rates are raised, this may have an upward effect on the £GB as it will attract money into the economy, such as 'Carry Trade' money. Now if the £ rises, this will have the effect of reducing the cost of imported goods, including foods. As such this mechanism will (to some degree) lower inflation in the economy (though I would think not by a great deal, as the £ can only be supported this way to some extent).

However, as the UK service industry goes into recession, the only hope of recovery is manufacturing, and export manufacturing at that. In such a situation, the rise in the £ will be fatal. Also, it will negatively impact the balance of payments, as imports will surge, it will damage tourism, and so forth. Furthermore, raising interest rates will increase the cost of business overall, and further lever down an economy rapidly heading into free fall due to strains on consumers, and the fall in house prices. It will accelerate these processes.

All of this just to try to overcome food price inflation that does not even originate in the UK? Furthermore, one of the inflationary factors has been oil, and the price is dropping. When we consider the reason for fighting inflation with interest rates, this makes no sense whatsoever. As such it is only possible to conclude that this is either an unthinking knee jerk reaction (macho economics? Being seen to be 'tough' on inflation?), or it is politically inspired. For the latter, it is hard to see what can be gained.

In summary, I am genuinely puzzled as to how the thinking on interest rates is playing out, even if we consider the inadequate measures that are used in calculation.

Having expressed puzzlement at the potential political motivation for interest rates, there is one are of the economy which is plainly a matter of political convenience, and that is help for the housing market. A Times article reports that the government is going to extend further support for the market as follows:

'The scheme allows banks to swap mortgage-backed bonds issued before the end of 2007 for much more tradeable Treasury bills that can then be used to raise funds in the markets.'

In short, the government is going to take on a pile of low grade debt, and swap it for high grade debt (though the government is claiming that the debt exchanged is all high grade - sound familiar?). Furthermore Darling is

'considering a more controversial multibillion-pound plan for the Government itself to guarantee temporarily high-quality mortgage-backed securities. This could help to create investor demand for the government-backed bonds, assisting lenders to sell on their loans and so increase the supply of finance for lending.'

All this on top of the Stamp Duty holiday. All in all, this smacks of desperation. The fundamental question to ask here is as follows:

On what basis do they think that the current house prices should be supported? In other words, are the current house prices the right price, too high or too low. If they are making these proposals they must have a reason as follows:

1. If they think prices are too high, then they are doing this to delay the day when prices fall.
2. If they think the prices are 'just right' then they are supporting prices to protect the right price. However, how would they be able to demonstrate that the price is 'right' now?
3. If they think that prices are too low, then the same question as above. How do they work out that they are too low? Do they have some magic formula to justify this. If not, then why not?
   

As is evident in the points above, there are some serious problems with each of these scenarios. The first is that the government has made a decision on what the correct house might be, but they have offered no evidence of how they could make such a calculation. As for trying to hold or boost prices artificially, how can this be sustainable in the long term? How can they keep prices from eventually correcting to a different level? The only thing such measures can do is delay any price adjustment. This raises the final question - at what cost?

The truth is that such measures will not do anything significant. Nothing is going to make the banks lend in the way they were in past years. In order to support the market, they need to continue with their dangerous practices of high income multiples for lending, self certification etc. The banks must do this if prices are to rise or stabilise, as the boom in housing was in part the result of an increase in the finance supply (see a funny view of wealth - the section on housing for a fuller discussion of this).

I am guessing, and it is only a guess, that Darling knows that the banks will not use the finance for new lending, but it will be used to shore up their battered balance sheets. In other words, with the exception of stamp duty, the measures look remarkably like the government trying to prop up the banking system. It looks like he realises that there is another credit crisis on the way, and is trying to forestall it.

Alternatively, he may just be incompetent, and responding to expediency in order to prop up the economy short term at the price of greater havoc later.

A quick post, and I will return to government spending soon. As a note, this is a quick review, as much more explanation could be given for why this is very odd behaviour.

Update Made on 14 August:

Just a quick note to mention that it seems that the BoE is not going to play ball on the idiocy that Darling is contemplating. Mervyn King says the following:

“We don’t guarantee lending to other forms of borrowing. There is no reason why in the long run you need any guarantee of lending to the mortgage market.”

Taken from the Times here....