Tuesday, 19 March 2013

Government wealth warning

The situation in Cyprus remains fluid and uncertain. As I type the Cypriot parliament is scheduled to debate the deposit appropriation at 1600 GMT Tuesday, and banks are due to reopen on Thursday but, by the time you read this, all that may have changed. The uncertainty over how and whether this tax will eventually be implemented risks becoming a bigger issue than the initially proposed tax. In fact it provides an opportunity to see quite abstract finance textbook examples in practise.

The money illusion relates to the fact that individuals focus on what is happening to the nominal value of their wealth and not the real value of their wealth. Since the financial crisis struck in 2009, inflation has remained ahead of the Bank of England’s target to the extent that prices are now 7% higher than policy would dictate. That relates to a 7% real decrease in wealth for UK savers – eerily similar to the 6.75% nominal reduction likely to be foisted upon Cypriot savers and yet with much less sympathy.
Source: ONS/Brewin Dolphin

I am, of course, being slightly facetious. Cypriot inflation hasn’t been that far behind that of the UK and, as I mentioned before, the deposit tax may be the most initially shocking feature of the Cypriot bailout, but the island’s poor prospects thereafter seem more concerning as austerity bites and the finance industry shrinks. But it is important too because today saw the release of inflation figures in the UK. Rising to 2.8%, they remain above target. The Bank of England’s own projections suggest inflation will stay above target for two years and will breach the 3% level at some stage this summer.

New Governor Mark Carney might have to write his first letter to the Chancellor explaining persistently high prices early on in his Bank of England career. Unless at tomorrow’s budget the Chancellor changes the mandate for the Bank of England to permit higher prices. If so it’s unclear whether this ought to imply higher inflation still or just a sanctioning of the financially-repressive policy pursued so far.

Guy Foster
Head of Portfolio Strategy

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