Mervyn King's Speech: Complacency rules ok?

20th January 2010 by Shaun Richards

After yesterdays much worse than expected inflation numbers there was an opportunity for the Governor of the Bank of England to give us his thoughts on the matter last night in his speech at Exeter. The market had already given us a view as the UK government bond market fell, at the 10 year level by just under 3/4s of a point. As our need to finance our governments budget deficit is high such falls have become more important as should they be sustained we will need to issue bonds at higher yields which the UK taxpayer will have to finance in the end. In my analysis of Greece’s financial situation I have introduced the concept of comparing 10 year bond yields with the German bund as a benchmark. Using that at the end of last week we were at +0.67%  and +0.76 at the close last night,so a small deterioration. I use this measure because it takes general moves across government bond markets out of the numbers and shows how a country is being priced relative to its peers. In case you were wondering Greece is now at +2.65% . This is a warning to the fiscally profligate!  

The Governor’s Speech  

Mr. King spoke about global trade imbalances and the need for a rebalancing. He used the analogy of a game of Sudoku to help explain this. Those of you who have followed my analysis of Japan and its problems will now that I have been calling for this too. For example we need domestic demand in Japan to rise (one of the problems of our time is that there is little or no sign of this). He also gave himself a slap on the back as he praised the Bank’s Quantitative Easing Programme.   Apologies for the way the quotes are copied into here and the font changes I have made improvements since my first effort.

“The unprecedented actions of the Monetary Policy Committee to inject £200 billion directly  into the economy – described by some as “quantitative easing” – have averted a  potentially disastrous monetary squeeze.”   


After praising himself he then gave us a clue as to his thinking on QE.  

“Rather like the MPC, the owners of Quantitativeasing, winner of all three of his races in 2009, have yet to decide how many outings he will have in 2010. They are waiting for race conditions to become clearer”  
What was most revealing was his section on inflation. You might have expected him to say that the Monetary Policy Committee is on the case and considering action. This was not what he said. He said that UK households are going to have to take the strain and that whilst inflation would be high in early 2010.  

“The patience of UK households is likely to be sorely tried over the next couple of years.There is little scope for growth in real take-home pay, which may remain weak even as output recovers. It is clear that inflation is likely to pick up markedly in the first half of this year, a message reinforced by this morning’s news that CPI inflation reached 2.9% in December. The continuing pass-through of the earlier significant depreciation of sterling, while part of the necessary rebalancing of our economy, is offsetting to some extent the downward pressure on inflation from the large amount of spare capacity. And the rise in VAT back to 17.5% means that CPI inflation is likely to rise to over 3% for a while, or even higher for even longer were energy prices or indirect taxes to increase further. Although such price level effects do not constitute a continuing source of inflation, and hence should be temporary, they remain in the official measure of inflation for a full year.Provided monetary growth remains well under control – and remember that at present it is undesirably low – inflation should return to target in the medium term. I hope you will all remember that in both of the past two years inflation picked up as a result of temporary price level factors and then fell back, as the MPC had predicted.”   


I love the bit “they remain in the official measure of inflation for a full year” so I thought I would make sure you hadn’t missed it.  


Having agreed with the Governor on his analysis of the world trade and savings analysis I feel that his analysis of the UK is flawed. The economic history of the UK is littered with inflationary pick-ups dismissed as temporary and I love the idea that it is inconvenient that they remain in the measure not just for a year but a full year!An inconvenient truth perhaps? His analysis misses the fact that the Monetary Policy Committee in the last 18 months have indulged in a massively expansionary monetary policy because they thought that we in for a period of defaltion and disinflation (negative inflation). It is the disinflation that has proved to be temporay so far. So by his own logic he should be looking through this period. But he is not.  

What this speech tells us is that our guardian against inflation is going to have at least one eye closed and maybe both as we progress through 2010.  


I do not have a crystal ball and so inflation in 2010 may yet take several different paths. For example exchange rates and oil prices are notoriously difficult to predict. However the surge in inflation in early 2010 is now likely to be higher than expected even a month or two ago. In the economic history of the UK there are many examples of this leading to raised inflationary expectations and hence to further inflation. Should this happen the Governor is telling us that the Monetary Policy Committee will delay any response as its priority is economic growth. So if they do act it is likely to be too late and therefore will have to be a more severe policy response. Should we end up in a double-dip recession will this be how we get there?  




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