Wednesday 19 January 2011

No UK interest rate rise in 2011

To build on a theme started at the weekend, there is clearly an inflation problem building in the UK with CPI at 3.7% yesterday. The morning papers today are full of doom and gloom about interest rate rises. With UK rates at -3% due to Quantitative easing then it would seem sensible for the Bank of England to act.

There are two complicating factors though, first is the impact of global commodities, whose price is in a speculative bubble and are not a good determinant for long term inflation (see 2008 spikes in Oil etc which quickly tailed off). Secondly is the presence of Quantitative Easing by the Bank of England. The Bank of England has a helpful pamphlet explaining QE to the masses; I note it does not have a similar one explaining how this wondrous mechanism can be unwound. Charlie Bean of the Bank of England last year said that the bank has a choice in either raising rates or removing Quantitative Easing first. This was to allay fears in the Gilt market about a bond glut as the Government continues with its record breaking PSBR.

So the Bank, assuming it decides to ignore commodity prices is left looking at the UK economy for some guidelines as to whether to raise rates, leaven them or undo QE. Some of the recent figures in monetary terms make for poor reading too. The November MQ, M2, M3 and M4 measures of money in the economy all fell - not consistent with strong growth in the economy and we have had a harsh winter since then too.

City Analysts too are stuck as to what to suggest, although The FT has quotes today from a number of City economists, amongst which there is a great divide but one has some answers on the Bank of England current thinking:

"Philip Shaw, economist at Investec, is far from convinced that the UK economy is yet robust enough to withstand rate increases. He suggests that one solution to the MPC’s dilemma could be to keep interest rates steady, but to start to reverse some of the “quantitative easing” asset purchases undertaken through 2009 and 2010.
“This would represent a change in the MPC’s exit strategy, which is to move interest rates up to a certain level first, and then to start selling gilts – but we think this would be a way of maintaining its credibility while capping the downside risks to the real economy.
“The MPC could quite easily reverse £25bn-£50bn over a three-month period, which would give it some breathing space.”

The Bank has a big dilemma though, raising rates slows private sector borrowing down, reversing QE pushes long term market rates up as gilt yields rise as the price of gilts falls due to over supply in the market. Both kind of achieve what the bank wants; but both also reduce the velocity of money in the economy which does not seem sensible if the monetary base of the Country is falling; an economy can't grow if there is no new money being created.

As such, the Bank will leave rates and QE unchanged for a few more months yet. Then as Phillip Shaw says the temptation to slowly unwind QE will be big. Firstly it can be done in small amounts and secondly it is more PR friendly and 99% of people don't understand what it is anyway. Finally, QE is very distorting to the economy and so reducing it will be a good first step to normalising the UK economy (not good for CU's share portfolio though!).

My guess is that this will take place in the Spring and Summer and at the same time the Bank can see whether its inflation predictions are right or wrong as usual. What this does mean though is that interest rate rises on a big scale are very unlikely. There maybe one 0.25% or so to show willing but nothing more.

I am not panicking today because the paper are talking about 175 basis point rises; it just won't happen that way in this financially crashed economy.


Old BE said...

Does not the very suggestion that rates might have to rise/QE wound in go some way to achieving a less inflationary environment?

The pound has firmed up a bit, hopefully taking the heat out of those commodity rises and people might rein in their discretionary spending in preparation for a fall in net cash.

On a technical note, does a falling money supply point still to deflation rather than anything else?

measured said...

Just like I was saying.

Still it will leave the graph looking as if the B of E did not react fast enough to rising inflation so pundits in five years time, and five years after that, and five years after that... can bleat "The Bank never reacts quickly enough and should be raising interest rates NOW".

Tip: Always look for the underlying cause. ;-)


Budgie said...

I agree with your analysis, CU, but then I would since I predicted: "Bank rate held at 0.5% for most of year, rising only towards the end to 1%".

The BoE will give Osborne a clear run at least to, and a couple of months after, his budget.

Anonymous said...

I think rates will rise .25% about June.

There will be many headlines

It will provide a sheen of credibility in fighting inflation

Not many people/organisations will be highly impacted

QE will be unwound when the banks can make a chunky profit from the process and the govt wants them to do something they are resisting.

Bill Quango MP said...


Well..I reckoned it will go higher. Inflation and rates.
Purely on commodities.

1. China and India boom continues.
2. Latin America boom is sustained in many countries.
3. USA posting low, but sustained, growth figures, indicating a recovery.

Food:Asked farmer friend today. He supplies supermarkets.
Potatoes sold at £50/ton in 2010
Potatoes are selling at £200/ton 2011. That, and similar prices are continue.

Will the freak weather go away in 2011? unlikely.
Another poor harvest, floods, heatwave will just further force cotton/grain etc higher.
China has ALREADY released its grain reserves to try and combat inflation in their food prices.

And fuel energy prices.
Will they come down. No.

Even all the Euro crisis hasn't moved stirling higher than its rally of early 2010.

Rate Rises look to be on the cards.

James Higham said...

There are two complicating factors though

Three - don't forget the BofE and BIS too plus the monetary authorities we're beholden to.

jaffa said...

You are assuming that the growing concept of the MPC not being relevant will have no effect.

It may incense the MPC so they raise by 0.25% to show they can. this will have no effect anyway.

Or the political rumblings may cause pressure to bear on job security for MPC members, who will as always bend over to please. Just depends who pushes hardest banker buddies or government worried about election prospects.

KoR said...

Spot on, I would say. The Boe will want, rightly, a bit more data on the effects of public sector cuts and the VAT increase before giving a token signal.

Steven_L said...

Do MPC members have to declare if they are on tracker mortgages in a register of interests?

If CU is right there might be some tasty trades on short term interest rate futures for March, June and September.

One of my more long term observations is that since the Reagan/Thatcher years, the UK seems to coordinate monetary policy with the US, kind of like a weapon in a trade war.

Anonymous said...

We've had inflation for years but its been camouflaged by cheap chinese manufacturing of our consumer goods.

Its been an illusion, and as soon as their currency revalues we will have a real problem.

Anonymous said...

I'm not sure this post is spot on tbh..

You mention global commodities, whose price is in a speculative bubble and are not a good determinant for long term inflation.?

Well I thought oil had not broken its inflation adjusted highs from decades ago?

I know for example wheat used to be £120 in the early 90's, it spent most of its time since then around £90 ish, even when everything else was going up including fertilizers, sprays, fuel etc.
Its now at £200 ish, which is what it should be compared to the prices rises of everything else.
Is that a bubble?
Food producers prices have been depressed, there is surely a lot of scope for them to have legitimate rises.

I personally don't believe it was a bubble in 2008, it was a change that was a long time coming, which was then set back because of the economic crisis, but now it is resuming.

Steven_L said...

Of course, if they stopped paying farmers not to grow crops in the west, and got people who know what they are doing back on the farms in places like Zimbabwe...

Interesting US/China press statement. Obama seemed to be saying 'revalue your currency or suffer more inflation'.

Anything that happens to the UK is just collateral damage. If things get really bad there is $750bn at the IMF waiting for us to draw on.

Since most of our debt is internal, the defaults will be too, it's already started too, pensions and benefots from RPI to CPI etc.