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....

House Prices - The Expert Predictions

I have been a consistent and long standing pessimist on house prices, most often in the face of experts asserting otherwise. By chance I recently came across 'Financial Outlook 2008' in the Telegraph online edition. The most interesting thing about this is that, with remarkable honesty, in addition to current predictions they provide a link to the predictions made in January of 2008. It makes interesting reading and illustrates perfectly why I am so cynical about the experts. The link for the predictions can be found here.

You can compare what I have predicted with the experts. Whilst I was predicting a housing crash, and a drop into deep economic disaster, and the UK falling off an economic cliff, you can see the somewhat sunnier picture of the experts (I will paste in my prediction made in November 2007 at the end).

On the house market we have the following samples from the experts:

Stuart Law, chief executive, Assetz says ''Professional investors will generally take a medium to long-term view of the market, and reasonable predictions forecast good growth over this longer time frame, making any short-term price wobbles irrelevant'. He suggests that over 2008 house priced will stabilise, rents will go up, and inflation will be stable. His recommendation in January is to buy into the market for buy-to-let. Happily, this person whose advice is so wrong does not appear in the more recent financial outlook section. However, I would gamble that this 'expert' is still in his job and still getting it wrong. Despite writing something which is fundamentally wrong, Assetz have the following on their website; 'Assetz® is a group of well known and successful property investment advisers'. I wonder how they define successful advice?

To Stuart Law's prediction we can add CML who predicted a 1% rise, though they at least acknowledged that the credit crunch would have an impact (there it is again, the magical beastie the 'credit crunch'). The only remotely sensible prediction was from the Halifax who suggested that transactions would fall back, but then (at that time) I guess that they would have known this as a result of their own internal policy discussions (as they would have known that they were about to severely tighten lending criteria). However, they only predicted a 'softening' in house prices, and even then focused on some regions, not the whole market. Most of the forecasters justified their predictions through suggesting that housing supply constraints would help to maintain prices.

Not all predicted a sunny year, but all were a long way from predicting the carnage that is taking place in the housing market at the moment. I strongly recommend following the link provided and taking a look at the predictions. This will be a real education on why you should be careful of the so-called experts.

As for my prediction, made in November, in 'A Funny View of Wealth' see below:

'The slow fall in house prices will accelerate into a full blown crash, with February or March being the months where the falls really start to accelerate. In the six months that follow prices will drop by an average of 20 - 25%, as buy to letters panic and sell into a falling market. In part this will be a response to the fall in house prices, in part it will be due to increasing difficulty in renting their properties (though this factor will lag the price drop)'

I quote myself here, not to be smug at being correct (I would rather have been wrong) but to point out that all of the information was 'out there', even for a non-expert such as myself. So why did so many get it so badly wrong? I do wonder whether the problem is not just that these experts follow a herd mentality, and never actually think for themselves. This does create one puzzle - who is leading the herd? Or is it more like the flocking behaviour of starlings, where each bird just looks to the bird beside them, and reacts to their movement?

In either case, we should treat the opinions of these experts with extreme caution. For example, the Economist magazine gives a forecast for various parts of the economy every week (at the back of the magazine), based upon a poll of forecasters, or the Economist Intelligence Unit. I happen to have the June 21-27 2008 issue next to me so will use this issue, and note that the prediction for UK GDP for 2009 is +1.4. Compared with even a couple of months ago this is very pessimistic, but still shows no acceptance of the depth of the severity of the current crisis, let alone managing to see that the root of the crisis is structural. It is also a great indicator that these so called experts are largely reacting to current events, rather than understanding the underlying causes of economic change/activity.

This lack of understanding is rather puzzling, as all of these economists will have presumably hold doctorates in economics. I really can not see how they can not see the structural flaws in the economy - unless they are following the same herd/flocking behaviour that I have mentioned earlier. At present, if we accept the flocking principle, the flock appears to be moving towards the point of view of a quick shallow recession. I wonder when the shift of the flock to accepting that there is a crisis will occur? Probably when the economy is already on the floor......

A note: I just remembered a conversation I once had with an estate agent over prices a couple of years ago. I remembered this whilst reading about 'supply constraints' being used as a justification for prices remaining stable. The agent (no surprise) was basically saying that there was no upper limit on house prices, on the basis that people would always need somewhere to live. I then painted a scenario for the agent (something like) as follows:

'Imagine a situation where there is no free health care, and no medical insurance. Imagine that you have a fatal heart condition, and that the fee for correcting the condition is £1 million. You have no more money than you have now, and have no potential to earn more money than you have now. Will you buy the operation to fix your heart?'

The answer, of course, is that even if your life is at stake the price is simply unaffordable. In other words, however necessary it is to have somewhere to live, if you can not afford to live in a house because they are too expensive, no amount of saying it is necessary will allow you to afford something that you simply can not afford.

The agents thinking process seems to illustrate perfectly how unsupportable bubbles grow.

















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