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Inflation
The monster is out of the box - but for how long?
It's easy to look on the down side right now just ask Mervyn King.
"There is a feeling of chill in the economic air" remarked the Bank of England Governor in a press conference yesterday.
The air is likely to get distinctly chillier as we look ahead towards the autumn.
If inflation alone was the only problem in the economy, this could easily be rectified by simply raising the base rate a few basis points to keep the unpredictable menace in its box. But what happens when the lid is jammed open by something equally damaging like the credit crunch?
This is a continuing dilemma for the Bank of England and UK citizens anxious about jobs as well as rising fuel and energy costs. Ominously the tone of the inflation report paints a gloomy picture of more pain to come. Britain and most of the rest of the world are sailing into uncharted waters on the anniversary of the official start of the credit crunch - an unhappy milestone no one is celebrating.
Since last year we have become all too familiar with words like "sub-prime", "house price crash" credit squeeze etc... to add to the return of the old 70s favourite - "stagflation". The torrent of bad news has continued as newspaper headlines predict even more gloom to come in 2009 with a recession looming menacingly on the horizon. Yet the accepted wisdom is we are not technically in a recession until two consecutive quarters of negative growth- but it certainly feels like one.
Everywhere you look the system appears to be unraveling alarmingly, banks have continued to announce heavy losses - a record £700 million in the case of RBS. The UK property market is being held in the vice like grip of a negative feedback mechanism, held down by tight lending conditions on one side and a slowing economy held back by rising inflation on the other.
This week also revealed unemployment figures surging higher in July than at any time since 1993; worryingly around the time of the last recession. The official unemployment rate now stands at 5.4% and no matter where you look, all sectors of the economy appear to be being sucked down the plug hole of a deep recession.
A chill in the air there may be, but inflation has become too hot to handle for the Bank of England, who have no choice but to keep rates on hold at 5% seemingly indefinitely. The value of sterling has plummeted as a result, falling to a 2 year low of $1.90 this week.
All this of course means less money in our pockets, surging energy and food bills and the money we do manage to hold onto steadily being eroded away. With these factors in mind, it is no surprise there is less to spend on property. First time buyers initially thought to be the main beneficiaries of a falling property market have virtually been frozen out altogether by the huge deposits required by banks for mortgages.
Freezing stamp duty is unlikely to improve the situation either, why not wait and see house prices become even more affordable and mortgage deals improve?
The death of the 100% mortgage as a result of the sub-prime crisis also marked the start of an accelerating slump in the property market which has yet to reach rock bottom. The situation has been compounded by the governments' dithering over suspending stamp duty, which has brought the ailing housing market to its knees this month.
So is there any good news to find amidst all of this?
Yes indeed there are if we look beyond the current turmoil. There are a few glimmers of hope to be found as the smoke clouding the future begins to clear.
Firstly we have seen a dramatic decline in the price of oil from its peak of $147 a barrel in July at the height of the tension in the Middle East triggered by Iran's missile testing. Oil fell as low as $113 this month, a fall of 23% even though threats to global supplies have actually increased, notably this week with Georgia's short-lived war with Russia.
Despite the Russia's invasion of South Ossettia and the threat to Georgia's oil pipelines, the oil price continued to decline providing a clear indication that it has already passed its peak. Even so the shock news came this week that UK inflation now stands at 4.4% with this month's inflation report hinting that we are likely to see a further rise to more than 5% in the coming months - a figure that would push inflation above the base rate for the first time since 1981.
While less than ideal, the bank of England's gloomy response is a predictably more an honest reaction to the situation we are in right now. Alastair Darling as he has done all year would at least play on some of the more optimistic signals emerging. For instance the inflation figure relates to July when oil surged to $147 a barrel, therefore inflationary pressure will almost certainly ease in August.
Further news from China this week painted an equally gloomy scenario of China's economy with Chinese government holding a meeting in July to discuss slowing growth, rising inflation and a serious decline in exports to the US and European markets. Demand for oil will almost certainly fall as a result, which will see prices fall even further in the coming months.
This will combine with a slowdown in the UK as the economy slowly grinds to a halt, this will unfortunately push unemployment even higher through 2009. While this will compound the misery for many, a slowing economy will eventually bring inflation back under control allowing the Bank of England to cut the base rate to stimulate growth long term.
There was even some more positive news arising from the housing market this week with the RICS monthly survey finding a small decrease in the number of its members reporting lower house prices - down from 86.9% to 83.9%.
A crumbs of comfort maybe, but in these troubled times good news is hard to find.
By Brett Tudor
Decision Time on Base Rates
Still a case of out of the frying pan into the fire?
This week will be another important one in the battle against inflation and the looming prospect of a major recession in the US and UK. Monetary policy committees on both sides of the Atlantic and mainland Europe will once again decide which is the greater threat to recovery - inflation or slowing economic growth...
In the UK, the Bank of England continue to procrastinate as base rates remain frozen at 5%, yet there is a growing need for decisive action one way or the other to clear a path to recovery. The same is true in US where rates have been held at 2% since April this year.
In the Gulf of Mexico, tropical storm Edouard, the fifth tropical storm of the Atlantic hurricane season is threatening to whip up into a hurricane that could disrupt production on many of the Gulf's major offshore oil and gas platforms.
Something has to give and with oil prices declining rapidly from their recent peak, it appears we may see oil prices rally, which could well influence the committee's decision on Thursday if inflation is perceived as the main threat.
The pressure on the Bank of England to quell the threat from inflation is growing just as the economic outlook becomes gloomier by the day. The effects of the credit crunch are still working painfully through the system, which is likely to prolong the agony for many well into 2009.
Until now the BOE's policy has been largely one of keeping rates on hold while keeping an eye on inflation which came in at 3.8% in June, a whisker under twice the target rate. Huge increases in utility charges as a result of rising oil and gas prices threatens to drive inflation up as high as 5% this winter.
The conflicting pressures of worsening growth prospects and rising inflation left the majority of the committee trapped in a sandwich between committee members Tim Besley, who has been pushing for a rate rise since June and the dovish David Blanchflower, who viewed inflation as less of a threat than the prospect of recession in last month's meeting.
So can we really expect any movement this week?
This all depends on the long term outlook for inflation and the committees' view on the direction of the economy, which is the same dilemma they have faced all year. The UK economy is teetering precariously on the brink of recession with official growth figures released last month indicating that GDP growth has slowed to just 0.2%, part of a steep decline in growth which began mid way through 2007.
The sharp slowdown in productivity this year has been due to the housing slowdown and its effect on the construction industry. Output from this sector fell 0.7 % in the second quarter of 2008 as falling demand for property began to take its toll. Major housebuilders Redrow were the first to announce cutbacks in May with the announcement that they would axe 15% of their staff when the usual spring upturn failed to arrive. In July alone, 5,000 jobs have been lost in the building sector leading to desperate calls for a loosening
of lending terms to revive the ailing sector. The worst is yet to come as we approach the traditionally slow autumn period.
The retail sector has also fared little better; sports retailer JJB announced plans to close 70 UK stores as early as March and the shops windows across the country are filled with the ominous red of early sales banners. There is no escaping the reality that the economy is contracting at an alarming rate and this will intensify the pressure on the Bank of England to make this bitter pill easier to swallow in the longer term into 2009.
One chink of light amidst the gloom has been the steep fall in commodities, and more importantly, oil prices which began in July. Since its July peak of $147 driven by Iran's refusal to toe the line on its nuclear ambitions and supply disruptions in Nigeria due to sabotage by militants, oil has fallen back to $120 a barrel at the time of writing.
These threats remain, yet it is widely perceived that the great commodities bull run is over and it has been no coincidence that investors made what's known as a "crowded exit" from the oil sector. But how sure can we be that the oil price will continue to fall and more importantly how will the MPC view the recent decline?
Oil has proved particularly vulnerable to supply shocks as supply levels have been stretched to breaking point, but with speculators now switching their attention to banks we may well have already passed the peak in July. Whether or not it is all downhill for oil from this point on will depend on two major factors; global demand and the situation in Iran. The former depends on the depth of the slowdown in Western economies and the knock on effect this will have on the emerging economies of India and China.
Taking this into account, a falling oil price will ease inflation worries, however it may also spell further trouble ahead if it is due to global demand falling and economies contracting further. Such external influences will halt any prospect of recovery in the UK no matter what the MPC decide about the base rate. The Bank of England can only plan for future recovery and there is more room for maneuver here than across the Atlantic.
A rate cut would ease the pain in the short term and provide. Unlike in the US where further rate cuts are now firmly off the agenda, there is nothing to lose (apart from a weaker pound) and a rate cut might just restore some optimism while breathing a little life into the construction sector - assuming that banks follow suit by loosening their lending criteria.
However, my guess is the Bank of England will continue their holding policy of 5% on Thursday while recession remains more a threat than a reality.
Rising inflation and slow growth render central banks powerless
The week's big news has centred on minutes released by the Bank of England and the Federal Reserve. Both paint a rather gloomy picture of the months ahead, with rising inflation and slowing growth dominating thinking among committee members on both sides of the Atlantic.
The Bank of England committee noted that the UK economy is slowing with GDP growth falling from 0.6% to 0.4% in Q1 2008. Industrial production also fell by 0.5% in March which was said to be "a weaker figure than that embodied in the original GDP estimate". There are equal concerns for the housing market, with house prices falling 1% in April. The growth in mortgage lending is likely to slow further with banks still not reaching "the end of their balance sheet adjustments" according to notes, or in simple terms the credit squeeze is likely to be with us for some time yet.
In the US, the Fed committee's statement noted that the outlook for economic activity had
weakened further; growth in consumer spending had slowed, and labor markets had softened. The outlook for the housing market was also bleak, the minutes also noted that financial markets remained under considerable stress, and that the tightening of credit conditions and the deepening of the housing contraction were likely to weigh on economic growth over the next few quarters.
The next policy meetings in Europe are due on the 5th of June and the committies are virtually certain to vote for a hold on base rates at 5% in the UK and 4% in Europe.Those controlling the purse strings around the world are currently paralysed by oil prices at record highs. Until inflationary pressures ease and the dollar strengthens they have little room for manoeuvre.
Extracts taken from the minutes of the BOE policy meeting released on the 21st May
On the UK economy...
"Even if money market conditions did improve further, lenders still had much to do to adjust their balance sheets to reflect a more realistic evaluation of risk. That meant credit availability was unlikely to improve in the short term."
"Further evidence had accumulated during the month that the UK economy was slowing.
According to the preliminary release, GDP growth had been 0.4% in 2008 Q1 compared with 0.6% in the previous quarter. More recent data suggested that industrial production had fallen by 0.5% on the month in March - a weaker figure than that embodied in the preliminary GDP estimate."
On the US Economy...
"Indicators of the United States economy had generally been less weak than financial market participants had expected."
"There had been no signs of a turnaround in the housing market, with foreclosures rising rapidly. And consumer confidence was fragile. The latest Senior Loan Officer survey from the Federal Reserve confirmed that banks had continued to tighten credit supply."
Oil Prices...
"According to the Bank's market contacts, speculative purchases did not seem to be the prime cause of the recent increases in the oil price. More fundamental demand and supply factors had probably been at the root of its steep rise during recent months, and there remained considerable uncertainty about the oil price outlook."
On the UK housing market...
"The housing market had weakened further. House prices had fallen by just over 1% in April, according to both the Nationwide and Halifax indices."
"Growth in mortgage lending was likely to slow further, as banks had not reached the end
of their balance sheet adjustment."
"Many existing homeowners had built up a sizeable amount of housing equity, but a weaker housing market and tighter credit conditions would make it harder to access this collateral to finance consumption."
On deciding to hold the base rate at 5%...
"In setting Bank Rate, the Committee continued to balance the upside and downside risks to inflation at this horizon. On the downside, a sharp slowing in the economy associated with weak growth of real disposable income and the tightening supply of credit could pull inflation below the target."
"The contraction of credit supply had been intensifying and, coupled with the erosion of real incomes, was likely to depress demand."
"The upside risk to the inflation outlook over the forecast period was that the period of above target inflation in the near term would, by affecting the expectations of those setting prices and wages, have a greater tendency to persist than had been assumed in the central projection. Reducing inflation from persistently high levels had in the past required prolonged periods of subdued economic growth."
"For most members, a reduction in Bank Rate this month would make it more difficult to keep inflation expectations in line with the target. CPI inflation was already at 3% and the Committee expected it to rise further in the near term. Although economic activity was likely to slow, the Committee had judged that some slowing in the growth rate of output was likely to be necessary for inflation to settle close to the target around two years ahead."
"For one member it was, however, particularly important to look through the short-term spike in inflation. The factors pushing inflation up - oil and other commodity prices - were beyond the MPC's control and, with pay growth remaining subdued, this period of above-target inflation would have little tendency to persist."
The Heat Is On
Just when the future was starting to look a little rosier, the UK was rocked by CPI figures of 3%, one percent above the target set by the treasury. This figure was higher than expected and a whisker below the level at which Mervyn King would need to write a letter explaining why.
This higher than expected increase from 2.5% shouldn't have come as much of a shock to anyone given that food prices are up 6.6% and energy 8.3% higher than a year ago. So what can the Bank of England do about it? Well nothing, it seems, as cutting interest rates further would exacerbate the inflation problem and raising the rate in the next meeting would only serve to plunge the country into a deep recession.
With all eyes on Crewe and Nantwich this week the government made a dramatic U-turn this week on the 10p tax rate ahead of a byelection which is taking on increasing importance. The Prime Minister has also been on a charm offensive, to bolster support for his battered party.
Looking elsewhere the 3-month libor rate the UK's key interbank lending rate has quietly increased, meaning looser lending conditions among banks are still firmly off the agenda.
This will of course feed down into the housing market via fewer mortgages being granted, which in turn will slow demand among those looking to buy property. This situation should at least benefit the rental sector with increasing numbers of people choosing to wait until the market recovers.
While it's been the hottest week of the year so far in the UK the economic gloom continues...
Breakfast with Brown
Will this be a full English breakfast or a continental? Whatever happens it will take more than a few extra rashers of bacon to force open the door to the coffers of high street banks.
There are signs that the banks are willing to pass on at least some of the of the recent interest rate cut to customers, however we are still a long way from seeing confidence return.
This morning's meeting will take place in Downing Street as a result of growing concern for the UK economy. While the prime minister has rejected any suggestion that this is a crisis meeting, it is evident that the economy is on the slide. Brown will be anxious to avoid following America into a property market crisis with plunging house prices spreading into other sectors of the economy including jobs.
He will need to ensure that banks have no more skeletons hidden in their closets and urge them to loosen their purse strings by repairing shattered confidence. The importance of this meeting cannot be understated as the solution to recovery from the slowdown rests on a loosening of credit conditions.
Recently nationalised Northern Rock will be among those banks he will need to convince. With those alarming queues around the block still fresh in the memory, the bank still have their standard variable rate under review even after April's base rate cut.
Will he succeed in convincing them? Has the recent base rate reduction been successful in restoring confidence?
What do you think? have your say
Credit crunch brings good news for students
As I write this, the Bank of England has yet to make their decision on the UK base rate. The only way as predicted on this site is down owing to the impact of the credit crunch; however, whether or not the decision is to cut or hold, it will at least help debt laden students.
We are all about to suffer the fallout from what is turning out to be one of the worst financial storms since the 1930s and there is little in the way of good news to lighten the gloom. However it turns out that with base rates odds on to fall today, students will be reaping the benefit. The introduction of student loans has been the curse of many students forced to graduate with a minimum £12,000 mill stone hanging around their neck. Debt is a depressing reality for many in the UK particularly graduates who are forced to choose between getting on the housing ladder and paying off their loans.
The silver lining, if there is one, for graduates now is that in times like these it can actually be the poorer members of society who stand to benefit.
The student loan tracks the base rate; therefore each successive cut will go some way to lightening the load. It has to be said they'll still struggle to afford a property with average starting salaries for many graduates currently at £13,000, but with a house price crash looming; maybe there is further good news on the horizon...
What do you think? have your say
How many Base Rate cuts will it take to restore banks' confidence?
A typical mortgage now costs £216 more a year than it did just three weeks ago. The recent rate cut and rumours of a further rate cut, have so far failed to have any effect on bringing mortgage rates down, on the contrary, they are actually rising - and fast...
Once again it is the average homebuyer who will be absorbing the fallout from the credit crunch, itself caused by Banks' irresponsible lending in the first place. Those who have chosen to borrow beyond their means are not to blame, houseprices have risen so high in the past decade that first-time buyers have been prepared to borrow more than 4 times their salary just to buy a decent sized home. The availability of mortgages at these levels has been a disaster waiting to happen, banks desperate to gain a greater slice of the mortgage market pie have actively encouraged irresponsible lending. For such large sums of money restrictions were incredibly relaxed.
So now with fixed rate deals coming to an end, those people will need to find new products, yet they will find there options becoming more and more limited. With banks now withdrawing some mortgage products and upping their new fixed rate deals, many will face a hard time meeting payments. This will be very damaging for the housing market, making a crash a virtual certainty.
It is deplorable that banks that banks could potentially profit from their own recklessness.
Availability of credit is one of the key drivers of a healthy property market, yet the banks are choosing to up rates and withdraw products even though the BOE is cutting the base rate in an attempt to rescue the situation, a trend which is certain to continue. When will the banks realize that the sector of the market they are squeezing the most happens to be the most dynamic? There are people who think correction is a good thing, but try telling that to the people losing their homes this year.
The banks have now turned their attention to the long neglected area of saving to try and bring some stability to the industry, yet with the base rate falling this will become even less attractive to savers. We may yet see the same aggressive base rate cuts seen in the US in the next 12 months before banks loosen their grip. Watch this space...
What do you think? have your say
Bank of England base rate policy
A recipe for disaster?
After a particularly turbulent there are signs of the dust settling over in the US after successive cuts in base interest rates. It remains to be seen whether successive base rate cuts will help the US economy in 2008, with the spectre of inflation looming large on the horizon and house prices still in freefall. The question is should the UK follow the US into base rate cuts to kick start the slowing economy and combat the threat of falling house prices?
The BOE pursued a policy of raising interest rates last year in response to house price inflation reaching unsustainable levels. This policy has worked, but there are signs now that the policy may have worked a little too well. The brakes are now firmly jammed on the housing market, it is steadily grinding to a halt and there is the very real prospect prices sliding into reverse. House prices have fallen to their lowest level of increase since the mid 1990s.
Of course no-one could have predicted how deep the current credit crisis would be last summer, but there is now the very real prospect that those interest rate rises last year have bitten back. The twin impact of the credit crunch is widely reported on - mortgage applications are down and first time buyers are unable to capitalise on cheaper housing with the disappearance of 100% mortgages impacting heavily. But what about the effect of those high interest rates? This made mortgages more expensive to begin with which made people less inclined to re-mortgage.
The expectation now is for another cut in the base rate in April, however it will be some time before this has any effect on the housing market with the spread between the Libor (the rate banks lend to eachother) and the base rate having widened. This is passed onto customers in the form of higher interest rates on their mortgages. The Nationwide for example have just added 0.6% to their fixed rate and tracker mortgages. A further cut is unlikely to have any real effect on the housing market ailing housing market.
An interest rate cut in April will also raise the prospect of inflation with consumers already hit by the rising price of food and fuel which has risen significantly more than the current measure of inflation. People will be less inclined to go out and buy non essential items with the cost of daily necessities growing ever higher and the prospect of their homes falling in value.
Wage growth is likely to slow too with the very real prospect of a recession on the horizon. In the 1990s recession companies will be less willing to negotiate higher salaries with their employees in difficult market conditions.
A cut in the base rate will do little repair the damage and could make things worse at this stage. The best decision would be to hold rates and wait for the current financial storm to blow itself out, the last thing we need in the UK now is an increase in inflation.
What do you think? have your say
