Thursday, 7 March 2013

Avoiding the Q(E) at the Bank

Bank of England. Image: Adrian Pingstone
We are pleased to note inaction at the Bank of England after rife speculation that more QE would be announced. The pound’s 7% devaluation this year may have been the deciding factor and a greater focus on exchange rate stability would be advisable now.

If there has been a 'weak pound' policy then it really needs to be revisited. Sterling is 20% below its average for the ten years to 2007 and fell by 30% in 2008. Despite this there has been no exporters’ renaissance in the UK.

The positive trends for the UK economy, however, continue apace. Unemployment is falling, and the number employed is rising. Full time employment fell by a million between 2008 and 2010 but has subsequently recovered 579,000 jobs – nearly 200,000 in the final quarter of 2012 alone. Wage growth, however, has been weak.

Inflation or deflation? That is the question…

Much of the world’s inflationary funk at the moment stems not from a wage price spiral but from administered inflation. In Europe, government withdrawal of subsidies on things like university fees, together with higher consumption taxes have caused inflation to be higher than desired.

There is some scope for eurozone states to shift the tax burden from direct to indirect taxes (eg income tax to VAT), as a means to achieve an internal devaluation in a fixed exchange rate regime, but in general the scope for tax hikes to restore fiscal responsibility look to be passing behind us.

The other source of inflation, particularly for the UK, has been currency weakness. The devaluation of sterling in 2007, and 6% trade weighted devaluation this year, continue to exert an upward pressure on prices.

The combination of these factors in the UK has caused inflation to consistently exceed targets, following an initial post-crisis deflationary pulse. Cumulatively prices are now seven percent higher than the Chancellor had intended when the most recent (CPI) inflation target was incepted. That overshoot has all accrued in the years since 2008.

The painful nature of this rise in prices has been compounded by the background for real wages. In the UK, wage growth has grown ahead of inflation at a reasonably fixed pace for around forty years. That all stopped, however, following the financial crisis.

Now following a period in which taxes have increased and imports have risen in price, and wages have stalled, UK workers are earning around 9% less than they were in real terms in April 2009. The historic trend would have seen them earning around 3% more over that period. Against this background there is perhaps little surprise that the growth outlook has been problematic.

The inflationary outlook remains meaningful and while we would agree with the views of the governor that many of these inflationary forces are deflationary in nature (suppressing demand), there appears to be quite a surprising failure to acknowledge the Bank’s complicity in weakening the pound and thereby raising external prices.

It is true that the UK’s marginal demand for food and energy may not be hugely influential in setting global prices, but it is also true that policy impacts the exchange rate. Foreign exchange dictates the sterling price of those imports. The debate to be had is whether the UK will start to benefit from the depreciation of sterling or whether, in fact, more attractive terms of trade (a stronger currency) would be beneficial.

The benefits of weaker sterling operate with a j-curve effect, a lag during which the depreciation makes things worse before they get better.  That lag is due to higher costs for consumers and producers alike. These make it difficult to expand business domestically.  As a natural precursor to expanding internationally, weak domestic growth may be what’s holding exports back.  Historically there appears to have been little sympathy on the MPC for the view that the UK would benefit from an exchange rate-driven increase in disposable incomes.

So despite little evidence that the UK export sector can respond briskly to improved competitiveness, there appears to be a significant push towards a more expansionary monetary policy. Why?

There has long been a suspicion that 'governments' will try to inflate away their (our) debts. The counter argument to this is that, in the world of independent central banks, the responsibility for price setting is independent of the responsibility for fiscal management. Recent years are in danger of shattering that illusion.  But it would not make sense for the central bank to try to inflate its way out of inflation while the government is still running such large deficits. In the current situation, inflation just increases the future debt burden.

There is, of course, a feedback between the fiscal and monetary policy. If government borrowing rates rise, implied government deficits rise, and, all other things being equal, fiscal policy will have to tighten, which will be deflationary. The banks, it would appear, are simply pre-emptively targeting that deflation.

We might assume this policy was forcing insurance and pension funds into higher risk assets, and it may be, but their pace of gilt accumulation has remained fairly constant. Instead the surplus of new issuance has been met by increasing demand from the central bank and more materially by the increase in demand from foreign central banks and 'private sector overseas' investors.

Guy Foster
Head of Portfolio Strategy

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