2nd July 2010 by Shaun Richards
Yesterday again saw more equity market falls with European markets hit hard. The Dax,Cac 40 and FTSE 100 all had triple digit falls. Rather ironically BP was up so the FTSE 99 had a particularly bad day. In the event US markets rallied a little towards the close to stop a triple-digit fall there and the Dow Jones ended up 43 points down. Interestingly European markets are trying to rally this morning but so far it looks weak and feeble, perhaps they are waiting to see the US jobs report this afternoon. As one of the commenters on here pointed out there were strong currency moves yesterday with the Euro rising nearly 2.5% against the US dollar and the volatility continued in other currencies with UK £ rising by 2 cents against the US dollar as well. If you take a look at a chart of this it was an extraordinary move from 1.22 to 1.25 for the Euro/$ after some days of relative stability. In the world of machismo and political grandstanding it may well get forgotten that the fall in the Euros exchange rate was a market mechanism likely to help her problems as one of them was an over-valued exchange rate. One factor that has been ignored recently has been the slow improvement (and yesterday not so slow) improvement in the UK £’s exchange rate which on a trade-weighted basis has risen from 76.6 to 82.
American inflation figures, are they for real?
I have seen some interesting new research done on this subject by Simon Ward which questions the methods of calculation of US inflation figures. These are figures which commenters on here have raised issues about before but the answers from this analysis are intriguing as we shall see later. On the face of it America does not have much of an inflation problem with her Consumer Price Index being at 2% and the trend for this appearing to be down. This compares with the UK’s official inflation index which is was at 3.3% in May.
However this analysis looks at things differently and asks the question what would American inflation be if she calculated her inflation in the same way as the UK and the Euro zone do? So what we need is an American measure of inflation which is the same as the harmonized index of consumer prices” (HICP) which is the full name of the euro zone measure. Fortunately the US Bureau of Labor Statistics does calculate such a number and it was 3.2% in April and its calculation for the UK was at 3.3%. Looked at like this US inflation has been over 3% since December 2009 which is a worse performance that the UK. Makes you wonder does it not?
The Technical Difference
The main difference between the two inflation indices ( the official US consumer price index (CPI) and the European HICP) is that the latter excludes owner-occupied housing costs, of which the most important component is what is called “owners’ equivalent rent” or OER which is a notional payment by homeowners to themselves for accommodation. It is a sizeable factor because OER has a 25% weight in the American CPI basket and is estimated based on market rents to have fallen over the last year, and accordingly it has exerted a major drag on official inflation measures.
I find this OER intriguing on several counts. Firstly it is a notional artificial concept and it does not really do the job to my mind which should be measuring house price inflation. Rents may move with house prices but they may not. I am not going to forget that I believe that inflation indices should measure house price inflation as well as other asset prices but if you argue not unreasonably that OER is not a good measure of this then you are left with the bare figures. US and UK inflation are very similar and Euro zone inflation is considerably lower at 1.4% for the latest “flash” estimate.
The clear implication
There is something very important which follows on from this. American is scared of deflation and possibly disinflation at this time and some of this is based on her Consumer Price Index. Indeed some economists (not me) prefer measures of what they call core inflation which is at 0.9% and is dipping. However using this new methodology it rises to 2% which does not raise deflation spectres so much.
So there is a very clear danger of policy being inappropriate and a mistake being made. We have been here before, for example I believe that the Bank of England gave itself such deflation scares due to its output gap theories that it “over-responded” to the credit crunch in my view leading us to where we are now. This new theory suggests America may have made a similar error.
Now consider the US government bond market and look at the yields on there. Her ten-year Treasury Note yield of 2.94% did not look a lot before if you remove some of the deflation scares it looks much too low, and as for two-year yields at 0.63%? If this markets came round to this new inflation methodology there would be quite an impact.
The Bank of England
Recently members of the Monetary Policy Committee have been giving speeches which are not quite in the same form as before. I think that they feel that they are losing or have even lost the debate over inflation in the UK and wish to publically try to counter-act this. If they are trying to reduce inflationary expectations then of course they have a theoretical problem as so few people probably actually read their speeches we would have to be incredibly influential on public views to impact on inflationary expectations! I thank them for the implied compliment.
Of the speeches the most interesting was given by Adam Posen on Wednesday as it was about as honest as a member of the MPC is likely to get but it was also quite extraordinary in its (ill)logical gyrations. First let us have some welcome honesty.
Sometimes the simplest explanation is the best. It appears that actual inflation outcomes,
which have predominantly been overshoots of the Bank’s target for the last four years, are
contributing to a slow upwards creep in inflation trend.
I think this is as near as we are going to get to a mea culpa from the MPC. You may notice that the four-year period mentioned goes back to before the credit crunch so there is an implied admission for that period too. However then the logical contortions begin.
It is difficult to attribute the rise in inflation in the UK solely or even primarily to ‘one-off’ factors like VAT, past sterling depreciation, or energy prices
The issue I have with this is the “past sterling depreciation” which I believe has been a considerable factor in the UK’s inflation problems and can only think that this is being ruled out because it came mostly before the Quantitative Easing experiment and was therefore known and should have been allowed for. So I feel that this is an ex-post justification or put more simply an attempt to re-write history. In the past the Bank of England has expressed the view that changes in our exchange rate are a strong influence on inflation. However we do also get some more implied honesty.
The shorter the private actor’s perspective, the more consistently off target the Bank seems to have been – inflation has been above target 23 of the last 29 months since January 2008, and increasingly so on average. The MPC’s inflation forecasts in the Inflation Reports have seemed unduly sanguine ex post as well:
I like the phrase “seemed unduly sanguine ex post” which is a very formal and nice way of saying turned out to be mistaken and very wrong isn’t it? These (wrong) forecasts are important because the MPC sets its policy based on them so if the forecasts turn out to be wrong then the policy is likely to be too. However some more honesty is in the speech.
It is naïve or disingenuous for us on the MPC to pretend that such a sustained series of above target outcomes and forecast errors would have no impact
This section of the speech is quite welcome and in some ways refreshing. Unfortunately the speech loses its way as a piece of logic as having rejected sterling depreciation as a cause of inflation it ends up blaming private sector inflationary expectations as the cause of the inflation we have seen. So readers in the UK it was your fault. I hope that you all feel suitably admonished. The audience were not quite so convinced however and I am not surprised.
Tucked away in the speech was an interesting new view on QE ( I lost count of the new views on this from the MPC somewhere in the mid-20s) calling it “intentionally visibly aggressive” and thereby implying that it was at least partly enacted to influence expectations .
I do not wish to be too critical about this speech as I feel that there is more honesty in it than many others given by MPC members but there are clear failings in it which I have pointed out above. Perhaps an insight into his feelings is the talk of the recent inflation rise as “modest”. However towards the end of the speech we get the following disturbing statement.
……. in that state of affairs I would be only too happy to vote for an interest rate increase. If a majority of the MPC agrees at that time to tighten policy, I am fully confident that any inflation creep would be reversed, and that British inflation expectations would be totally reanchored
I have been following the UK inflation experience for 25 years now and have studied it back into previous periods and therefore cannot share his confidence as reanchoring inflation expectations has often proven painful,difficult and taken some years.
UK Money Supply
This week has seen some new figures for UK money supply and on first reading they appear to show that broad money growth is improving. There is an irony here possibly as the speech I quoted above has the MPC moving away from this as a main impact of QE! However one needs to be slightly careful with the figures as we are in a time of extraordinary moves in money markets around the world with serious issues for interbank lending particularly in the euro zone which can easily distort other figures.
The Bank of England’s favoured broad money measure which is M4 (excluding deposits held by non-bank financial intermediaries) has risen by a 9.2% annualised rate over the last three months. But breaking the numbers down M4 held by households and non-financial corporations only rose by 1.5% annualised over tha same period. In other words in an echo of what was called disintermediation back in the 1980s there may well be issues with the numbers as there is a lot going on the financial sector. Only time will tell.