Tuesday, December 15, 2009

Inflation in the UK

The UK Economy

The doubts about the future of the UK economy have been multiplying of late, prompting one commentator to seek to defend the economy, arguing that there remain competitive advantages in the UK economy. Despite such positive framing of the discussion, the doubts still remain, as in the following excerpt:
That said, we are in a mess. In type, the position we face is not so different from the early 1990s, although the government's deficit as a share of GDP is going to be about double what it was then and the stock of debt is much higher. The UK's current account deficit, though, has not been as large, even when the economy was strong, as it was during the 1980s' boom, and it is now about the same as it was in the early 1990s.
Perhaps the most interesting news for the UK is that inflation is once again climbing. Input prices have been rising for manufacturers, and continuing weakness in the £GB will have an ongoing inflationary impact, much as I predicted long ago. This from the Telegraph:

The Consumer Prices Index (CPI) - the measure of inflation used by the Bank of England to set interest rates - was 1.9pc higher in November than in the same month in 2008. Economists had pencilled in a gain to 1.8pc. On the month, CPI climbed 0.3pc.

The Bank has already said that it expects inflation to breach its 2pc target and possibly rise as high as 3pc in coming months, as a combination of higher oil prices and the reversal of the cut in VAT - it will return to 17.5pc from 15pc on January 1 - push up prices across the economy.

Inflationary expectations are problematic for the Bank of England's policy of quantitative easing, as the threat of CPI deflation has been used as a fig-leaf for the policy. This report from AP:
"The MPC [Bank of England Monetary Policy Committee] has dished out many gifts to the economy throughout the year, so it was unsurprising that at its pre-Christmas meeting it thought it had done enough," said Stephen Boyle, head of RBS Group Economics. "These monetary policy presents, from low interest rates to quantitative easing, are gifts that will keep giving and will help get the economy back to its feet in the New Year."

Analysts now expect the bank to wait until its quantitative easing program, which boosts the money supply by effectively creating new money to buy assets, is completed in another two months before considering whether to expand the program.

"The scale of the program will be kept under review," the committee said. Detail on how the nine members voted will be revealed when the minutes of the two-day meeting are posted on Dec. 23.

The Bank of England's November inflation report makes interesting reading, with considerable caveats on inflation expectations. I will quote their discussion at length:
Inflation is likely to rise sharply in the near term, primarily reflecting the reversal of the VAT reduction, while sterling’s past depreciation continues to push up on inflation. Thereafter, downward pressure from the persistent margin of spare capacity is the dominant force. This pressure acts to bear down on CPI inflation, although it gradually fades as the economy recovers.

The extent to which CPI inflation will deviate from the 2% target is highly uncertain and depends on a number of factors. The degree of downward pressure from the weak demand environment will depend on the timing and strength of the recovery, the impact of the downturn on the supply capacity of the economy, and on the sensitivity of inflation to the degree of economic slack.

The profile for inflation will also depend on the extent to which companies need to adjust further to the higher import costs associated with sterling’s depreciation and on whether there are further substantial movements in energy and commodity prices. There is a range of views among Committee members about the relative strength of these factors. On balance, the Committee judges that, conditioned on the monetary policy assumptions described above, the risks of inflation being above or below the target are broadly balanced by the end of the forecast period. The outlook for inflation in the medium term is somewhat higher than in August, reflecting the stronger projected distribution for GDP growth.
Despite such caveats, the MPC chose to continue with the anounced asset purchases, otherwise known as quantitative easing (QE), or better described as printing money to purchase government debt. That this is a radical policy has been acknowledged by the Bank of England, and that it was to forestall deflation was the original purpose of the policy. The fig leaf of deflation is disappearing but the policy continues.

The problem faced by the Bank of England is a very basic one. There is a flood of government debt issuance around the world, and the UK is just one of many countries expanding borrowing at an astounding rate. However, as a county with one of the fastest rising government deficits, the UK is one of the higher risk governments for risk of default. Furthermore, the pre-budget report appears, as one commentator puts it, to rely on 'hope' for a future fiscal deficit reduction. The pre-budget report was widely seen as being wildly optimistic, and presented many fiscal holes, further eroding confidence in the UK:
Government spending on defence, higher education, housing and transport is likely to bear the brunt of sharp cuts planned over the coming years, the non-partisan Institute for Fiscal Studies said on Thursday.

The IFS estimated that based on Chancellor Alistair Darling's pre-budget report on Wednesday, departmental spending outside protected areas such as health, schools and overseas aid would fall by 5.6 percent a year between 2011 and 2014.

This would require 35.7 billion pounds of savings, equivalent to just over 1 percent of national income. Around 15 billion pounds of this had not been identified, the IFS said.

Moreover, 12 billion of the 35.7 billion pounds in savings are planned to be achieved by efficiency gains, despite evidence that three quarters of the efficiency gains claimed by the government earlier this decade were questionable or did not occur, the IFS added.

One of the most interesting reports is not directed at the UK alone, but is very applicable to the UK economy. Moody's is contemplating the impact of social unrest as part of the inevitable fiscal retrenchment that must take place in the 'stimulus' economies. The underlying point of the report is that there are doubts about whether governments might be able to press home any fiscal retrenchment, and such questions might be raised about the UK.

As if these headwinds against ongoing funding of government debt were not enough, concerns are growing about unfunded pension liabilities and the hiding of government debt through Public Finance Initiatives. These factors will no doubt be added to the mix when investors contemplate their confidence in the UK government.

As such, in an increasingly competitive environment for access to credit, the UK government looks to be uncompetitive. If the Bank of England ends the policy of QE, it is uncertain as to whether the UK can continue to finance the massive spending it has enacted. It is a question of who, in an increasingly competitive government debt market, might choose to fund UK fiscal deficits. There are no obvious contenders to absorb the record levels of debt issuance, and any pull back on Bank of England purchases might see the start of failed debt auctions. On the other hand, if the Bank of England continues purchases of government debt, they will support an unsustainable position, and allow government to continue with incontinent fiscal policy.

The Bank of England will be damned if they end QE, and damned if they do not. As the situation stands, the only foundation for confidence in the UK economy is the prospect of a change in government. However, the likely winners of the next election is the Conservative Party, and they are still holding back on plans that will substantially and credibly reduce the fiscal deficits. Hope for improved fiscal policy will therefore be a gamble for potential purchasers of gilts.

If the government fails to sell debt, then the crisis that will follow will be truly breathtaking.

On the other hand, if the Bank of England continues down the path of QE, the size and scale of any future crisis will be larger, as the government will be allowed to continue with irresponsible fiscal policy. Furthermore, with CPI rising, how long will it be before the fig leaf justification for QE falls off, leaving The Bank of England with no hiding place for their Zimbabwe like policy? As for reversal of QE, the selling of the Bank of England's gilt holdings, this appears as a very, very distant possibility.

The UK economy has been miraculously floating on air. How much longer it can do so largely sits in the hands of investor confidence in a future change of government, and with a change of government a substantive change in fiscal policy. As Liam Halligan, a Telegraph columnist puts it, current UK government policy is 'leading the UK down the road to sovereign default'. Can the UK economy float on air until the election? Such a hope is a poor foundation for an economy, but is all that supports the UK economy at the moment.

The $US - More Cracks in the Edifice

I would like to start this post with a quote:
The Gulf states remain divided over the wisdom of anchoring their economies to the US dollar. The Gulf currency – dubbed “Gulfo” – is likely to track a global exchange basket and may ultimately float as a regional reserve currency in its own right. “The US dollar has failed. We need to delink,” said Nahed Taher, chief executive of Bahrain’s Gulf One Investment Bank.
I seem to have been arguing a lonely position for a long time; that the $US as the world's reserve currency is fast coming to an end. As each month passes, the doubts about the stability and value of the $US multiply, and it is evident that some of the main actors in the world economy are starting the process of retreat from the $US. Whilst the move towards the 'Gulfo' does not constitute the end of the $US as a reserve currency, it is yet another metaphorical nail in the $US coffin.

My argument has been straightforward. A reserve currency must have a value created by wealth generation, and that issuance of a currency beyond the expansion in wealth generation will eventually see a retreat from the currency. This is what I had to say about the $US in August 2008:
As such, the dollar may rally for a while, but in the end it can only last for so long before economic reality trounces market sentiment. At some point there needs to be an economic justification for a stronger dollar, and force of habit is a poor justification.
In January of this year, I discussed the 'myth of the eternal status of the $US as a reserve currency'. I would recommend that you read the article, as it seeks to look at the underlying and fundamental reasons why the $US can not continue as the reserve currency. In an article for Trade and Forfaiting Review, I made the argument in a very simple and digestible way, saying the following:
Imagine a world in which there was no international reserve currency, but that an organisation was proposing that the US dollar ought to be the future reserve currency. Would you take such a proposal seriously?

Your response might be that the US dollar sits atop mountains of debt, a shrinking economy and you would point out that the US monetary authorities are printing money to fund record government borrowing. You might actually laugh at such a prospect.
It is very simple - if the $US were not already the reserve currency, who in their right mind would propose it as such? If the currency can not stand upon its merits, then there is only sentiment and habit as foundations. These are extremely fragile foundations for a reserve currency, and I would suggest are foundations that will not bear the weight of negative factors bearing upon the $US. The question is not 'if' it should lose the reserve status, but how quickly sentiment might shift. I once prematurely called the demise of the $US, and am therefore reluctant to place a firm date on the demise, except to say that it will be sooner than many people think.

Note 1: Sorry for the lack of response to comments, and also replies to my Yahoo email address. I am still pressed for time, but take an interest in all of the comments.


  1. As far as I am concerned if a government or company borrows by lending itself its own money to meet essential commitments, then it is already in default in real terms.

  2. Hi Cynicus,

    The guy who wrote this piece below has been pretty bullish throughout the Crash but no longer, he has become a bear. More and more pundits in the media are becoming cynical!

    I have started trimming my debt and equity positions and will move into foreign currencies in Q1 2010. Sterling could have a bounce in Q1 as strong prints on inflation and growth make the market think interest rate rises are on the way.

    Good fortune.

    Allister Heath at CityAM - 10/12/09:

    Britain is sleep-walking towards a fiscal meltdown

    ...Undoubtedly the greatest sleight of hand in yesterday’s pre-Budget report was its reliance on completely unrealistic growth forecasts. Last year was the worst for the UK since comparable records began in 1948; the 4.75 per cent fall in output was steeper than anything we saw at the height of the Great Depression. Alistair Darling is forecasting growth of 1-1.5 per cent in 2010, which is sensible. But he is predicting 3.5 per cent a year thereafter, which is impossible, especially given that the UK’s sustainable rate of growth will be permanently lower thanks to the punishment being inflicted on the City, the 52 per cent top rate of income tax/national insurance and the general erosion of incentives to work, save and invest. And without the growth, the deficit will be even larger, requiring even more drastic surgery.

    For all the talk of belt-tightening, the PBR forecasts still incorporate a surge in current expenditures: these are set to rise from £607bn this year to £729bn by 2014-15 (last year’ spending level was just £563.8bn; so much for restraint). If current spending were only to increase in line with inflation and therefore stop growing in real terms, then the total would be £665bn by 2014-15, a significantly more manageable number (I am grateful to Chris Watling of Longview Economics for the number-crunching). Chancellor Alistair Darling missed a great opportunity to slam on the brakes yesterday; no real Keynesian could sleep at night with a budget deficit predicted to hit £178bn in 2009-10 and £176bn in 2010-11 (both up by £3bn since the Budget).

    Much of the private sector has suffered lengthy pay freezes; regrettably, the public sector needs to take some of the same medicine to keep costs under control, rather than enjoy the relatively lenient 1 per cent cap on pay growth proposed yesterday. It is a matter of deep regret that the key area of government spending which Labour proposes to cut is the capital investment budget, which is set to fall from around £70bn this year to £45bn by 2013-14. All forms of government will unfortunately need to be cut – but it makes little sense to promote consumption expenditure over infrastructure spending, especially at a time when the UK is still suffering from a lack of a proper transport system. The PBR’s tax hikes, while substantial, were swamped by rises in spending: an extra £4.3bn in 09/10 and £4.9bn in 10/11, which as Citigroup points out is being driven by higher debt payments.

    The European Commission says that the UK’s structural fiscal deficit (stripping out the recession-induced cyclical component) will be over 10 per cent of GDP in both 2009 and 2010 – more than every other EU country. We are in deep trouble – yet yesterday’s PBR did nothing to stabilise our public finances. Unless we see a real change of gear after next year’s election, the markets will finally run out of patience and short the UK, with devastating consequences. Time is fast running out.



    Death to Bubble Addicts

  3. Not directly related to this specific post, but interesting nonetheless:



  4. Hi Cynicus,

    Just some thoughts:

    B is for Britain

    1997 - 2007: The Bubble of Britain

    ~Property bubble, consumer debt bubble, tax receipt bubble from the City, government spending bubble.

    2007 - 2010: The Battle for Britain

    ~Socialism (proto-communism) = Old Labour: tax and spend.
    ~Capitalism = The Tories: spending cuts, tax rises and targeted tax cuts.

    2010 - 2011: The Bust of Britain

    ~Q1 or Q2: perception of a hung parliament blows out the yield curve, currency weakens and base rates need to rise. Cost of financing the deficit rises and import inflation rises. Economy crashes.

    ~Q2: Old Labour win election - capital flight, capital formation is knee capped. Pound and gilts tank, base rates need to rise. Economy crashes.

    ~Q2: Hung parliament: pound and gilts tank, base rates need to rise. Economy crashes.

    ~Q2: Tories win with a majority. Emergency budget of tax rises and spending cuts, leads to a Double Dip early 2011.

    I think that in all of the above scenarios UK-centric shares will have a tough time and many will derated. The upside is pretty limited whilst the downside could be extreme. It looks probable that inflation will be more prevalent than deflation, this is already apparent in the official inflation figures. If the pound falls further and world growth leads to higher priced commodities this will heap more pressure on cash poor consumers. If interest rates have to rise to protect the inflation target and currency, then the Debt Junkies will experience another constraint on their cash flow and ability to consume; we enter the twilight zone of Stagflation.

    During the Bubble of Britain the growth in GDP was driven by debt:

    ~Property debt.
    ~Consumer debt.
    ~Trading debt in the City.
    ~Government debt.

    With a crippled banking system, a consumer drowning in debt and using a base rate of 0.5% as a lifebouy, plus a government balance sheet that is moving toward Event Horizon, how will growth be engineered in a stagflationary economy? How will the deficit be cut? How will UK-centirc shares thrive in such an environment?


    Death to Bubble Addicts

  5. "This would require 35.7 billion pounds of savings, equivalent to just over 1 percent of national income. Around 15 billion pounds of this had not been identified, the IFS said."

    If as Reuters quote 35.7Bn is only 1% of national income Marvelous Merlin King must be waving his magic wand a fair bit!


  6. I agree with Allister Heath's analysis but am concerned about the impact of all this on inter-generational wealth - that the build up of debt (both official and hidden, such as unfunded pension commitments) means that there will be a wealth-chasm between the older and younger generations which can only end in tears and maybe conflict. There is some discussion of this on recession.co.uk.


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