19th January 2011 by Shaun Richards
Yesterdays disappointing inflation data from the UK which continued a long series of similar disappointments was not the only story in financial markets on the day. For example holders of UK shares had a good day with the FTSE 100 ending at a new post-crisis closing high of 6056. International shareholders also had a good day in general with the US Dow Jones equity index also closing at a new post-crisis high of 10837 up 50 points on the day. It is a moot point as to the overall impact of inflation on equities but in the case of measures of UK equities with so many of the companies in the FTSE 100 (particularly if measured by share of capitalisation) either being essentially foreign companies or doing a lot of business abroad you might argue that for many of them the level of UK inflation is of minor importance.
Moves higher in international long-term interest-rates are affecting the world economy
For those who have not been following this matter we have seen falls in government bond prices and rises in yields on them since the latter period of 2010. This means that longer-term interest-rates have been rising and to give one example of an effect of this it has led to increases in many mortgage-rates particularly fixed-rate ones. This impact was first seen in the United States and is also now occurring in the UK. There will over time be similar effects on corporate borrowing as companies tend to borrow over longer-time periods where interest-rates are invariably correlated with government bond yields be it implicitly or explicitly. To put some flesh on the bones of the impact the US mortgage provider Freddie Mac tells us that the average 30 year mortgage rate was 4.23% in October 2010 whereas the latest rate in the markets is 4.85% approximately 0.6% higher.
We can see that as time goes by there will be an impact from this on the housing market. Of course this is exactly what the US housing market ( and indeed the UK one) does not need! But it is what it is getting. If I may refer to my policy prescription for the UK where I suggest a rise in short-term interest-rates one of the reasons for this is to help reduce an expected rise in longer-term interest-rates. The mainstream media obsesses with short-terms interest-rates and often ignores the fact that longer-term ones have at least as much impact. As we go forward into 2012 and 2013 the importance of longer-term interest-rates is likely to rise as over this period be it sovereign or corporate there is a lot of borrowing that is going to have to be done and it will not be free.
If we look at the crises which have brought both Greece and Ireland to their knees then they happened in spite of the fact that the official short-term interest-rate of the European Central Bank is 1% and that you can in effect get as much short-term money as you want at that rate. Indeed the amount borrowed at this rate has been extraordinary with Ireland’s banking system borrowing an amount pretty much equal to her country’s Gross National Product. It was the rise in longer-term interest-rates which broke the camels back.
Yesterday’s move in longer-term interest-rates
After the move in US longer-term interest-rates that I described earlier you might feel that in the ebb and flow of markets there might be a recovery. At the longer end measured by the yield on the US 30 year or long bond there has been very little improvement and it now sits at 4.56%. This is around 1% higher since the lows of late August 2010. There had been more signs of improvement at the 10 year maturity but yields here rose to 3.36% yesterday which is just under 1% higher than the lows. There was a short-term rise above 3.4% but this looks like a panic response to a “fat finger” trade where the wrong amount was input.
This is also being felt elsewhere if we look for a benchmark for Europe and the Euro zone we look to Germany. The benchmark 10 year yield here fell below 2.2% in late summer 2010 whereas yesterdays rise took it to 3.11%. Now there are several implications from this. Firstly this is bad news for the countries in distress as their longer-term interest-rates are often discussed as an amount over Germany’s and if it has ones which are rising so it is likely that their’s will. Another possible influence here is the increasing scale of aid/rescue packages being operated in the Euro zone which in effect is mostly being financed by Germany’s credit rating. One could add to this that markets are likely to be beginning to price in future financing for say Portugal or for the mooted increase in the Euro zone “shock and awe” rescue package and accordingly changing Germany’s future prospects and interest-rates.
Portugal returns to crisis mode
Here is an example of a country that is currently being brought low by rising long-term interest-rates. The Euro zone press conference I watched late on Monday evening with Herr. Juncker and Oli Rehn involved some crowing about the improvement in Portugal’s government bond yields. This example of hubris did not even survive Tuesday as at the end of the day her 10 year government bond yield was 7.07%. If we return to her last government bond auction which was lauded in some quarters as a “success” we need to remember that issuing 10 year bonds at an interest-rate of 6.71% would leave her insolvent fairly quickly which is not quite my definition of success.
But to continue today’s theme if we move on from the obvious impact of these bond yields on Portugal’s government and its fiscal position then lets us look at the wider economy. Firstly it will be impacted by the governments austerity programme to reduce its deficit. Then think of its mortgage market where rates will be based on high longer-term yields and then her corporate borrowing market where the same impact will be felt.This is before we look at the fact that Portugal’s banks are struggling to fund themselves in financial markets and instead are relying on the European Central Bank. This means that not only is the price of credit likely to be high but that the supply of it is likely to be restricted. If we think of the impact of these factors on Portugal’s economy they are likely to grind it down and send it back in recession if they persist for any length of time,and yet short-term interest-rates are officially 1%….
The UK’s situation.
We too have suffered from increasing longer-term interest-rates. Our 10 year government bond yield rose to 3.66% yesterday which is around 0.9%higher than the lows of last year. There have been moves higher across our maturity spectrum which are affecting mortgage and other interest-rates. As an example of this the Skipton building society increased its mortgage rates yesterday by up to 0.7%. Now individual lenders rates ebb and flow as to how much business they want but the trend is clear and other lenders have also raised mortgage rates recently.
This increase in longer-term interest-rates will be acting as a brake on world economic activity. It is something that ordinarily acts in the background as there are few who look at it and I have always assumed that it is something the mainstream media does not understand and therefore ignores. We have seen in recent times how Ireland and Greece have been pushed over the edge by it and that Portugal is on the brink. However it is not often discussed that in the spring/summer of 2010 it was an expansionary influence on the world economy as in general terms rates fell but that since then it has been a contractionary force.
Looking at the UK and its inflation problem the move in longer-term interest-rates will help with our inflation problem. However if we analyse it the 10 year yield is still below our inflation rate as published yesterday! If we move to a more sophisticated analysis where we compare bond yields with the expected inflation rate then as our inflation expectations are rising this may put further upwards pressure on bond yields. So the situation is not simple. As the pound’s exchange rate against the US dollar has risen to around 1.60 we may get a little relief from this route (as many commodities are priced in US dollars and so a rising exchange rate makes them cheaper) also although exchange rates are volatile and can reverse course quickly.
As you can see I feel that the situation is more complex than often presented and there is much more to battling inflation than raising short-term interest-rates and it is in response to such a situation that I recommend raising them to 2%.
CPI-Y or Consumer Price Inflation excluding indirect taxes
As we have seen rises in indirect taxes in recent times with Value Added Tax having just risen to 20% some make the argument that we should follow CPI-Y which in theory ignores such effects. For example Adam Posen, a member of the UK Monetary Policy Committee argued this in a speech a month or so ago. Unfortunately if you look at how CPI-Y is constructed you can see an example of theory not being matched by reality which is a familiar theme. If we look at the Office for National Statistics manual on the subject ( a riveting read…..) we see this.
The calculation of CPIY assumes that duty changes are passed on immediately and in full.
Unfortunately in reality this is not what happens as the Office for National Statistics researched what happened when Value Added Tax was reduced back in December 2008 from 17.5% to 15% and this research indicated pass-through of only one-third. So we have a miss-match between theory and reality and an indication that at this time CPI-Y was calculated incorrectly. This leads to the question is it being calculated incorrectly now after a VAT rise? To which the answer is Yes.
This is unfortunate for those who have advanced the theory that we should be looking at CPI-Y because usually they have been those who argue that the VAT increases will not be passed on in full! There is therefore a logical trap in their argument as the more they argue that the full move is not passed on the higher CPI-Y must be.
I have always felt that most of the increase in VAT will be passed on so my suggestion is that the real rate of CPI-Y is probably 2.5% rather than the 2% published yesterday by the ONS. Estimates of the impact vary as Simon Ward who has also looked at this area estimates 2.8%. Of course this also makes one wonder if Adam Posen understands this and if he does why he did not point it out in his recent speech.
Unemployment and Inflation
I notice another example of economic theory in the media yesterday as it goes as follows. There is a choice between unemployment and inflation and accordingly permitting higher inflation now will help to keep unemployment down.This is based on the work of a New Zealand born economist William Phillips (as I have readers down there I thought I would point this out!) which has been influential. Unfortunately this appears to be only true in the short-term if at all and in the modern era there are more examples of rising inflation causing unemployment than there are examples of Phillips curve type analysis. So we are back to the theme of people attempting to impose theories which simply no longer fit the evidence.