End of his tether

Fund Strategy - 4 April 2011 | By Tomas Hirst

Just like the census that fell through our letter-boxes in recent weeks, macroeconomic statistics offer a snapshot of an economy at any given time.

They are, by definition, indicators of what has occurred rather than a clear window into an opaque future.

Strange then that supposedly forward-looking equity markets have of late been swung by news of unexpected rises in American unemployment, or disappointing fourth quarter GDP in Britain. The question that this poses more than any other is whether investors are relying too much on a crystal ball approach or if the figures really do offer a way to predict prospects for the medium term.

As Britain’s inflation figures have made for headline grabbing news in recent weeks it is appropriate to take these as a case study. While the consumer prices index (CPI) has remained above the Bank’s 2% target for most of the past six years, consensus expectations are weighted towards disinflationary pressures winning out suggesting that the figures may be masking the underlying drivers.

There is plenty of evidence to support this theory. In November 2009 consumer prices inflation was below the 2% target and the Bank of England forecast suggested that the balance of probability suggested it would remain so through 2010 and 2011.

Already, however, the Bank was preparing itself for a short-term pick-up in inflation pointing to “higher petrol price inflation and the reversal of last year’s temporary reduction in VAT” in its Inflation Report.

Sure enough, CPI picked up over the next few months but by May 2010, when the fan chart had predicted that weakened consumer demand and excess capacity in the economy would have begun to shift the trajectory downwards, inflation remained more than 100 basis points over the Bank’s target. (Cover story continues below)

This resilience of price pressure prompted a rethink by the Monetary Policy Committee (MPC) with Mervyn King, the Bank’s governor, suggesting in the opening remarks to the May Inflation Report that CPI was “likely to remain above target throughout 2010”.

Despite the revision even this has proven to be a conservative estimate with the Office for National Statistics (ONS) suggesting CPI was 4.4% in February, or 2.4% above target. Indeed the MPC has been forced to concede that it has become deeply divided with “real differences of view among the committee about the likely path of inflation in the medium term”.

Stephen Nickell, a former member of the MPC and a member of the budget responsibility committee of the Office for Budget Responsibility (OBR), says there is good reason why the figures are unable to predict imported inflation.

“Commodity forward curves are usually quite flat suggesting future prices will be around current levels. This means sharp commodity price rises or falls are almost impossible to predict.”

An inability to predict sharp rises in commodity prices has proven particularly problematic in recent years as it meant the Bank failed to anticipate the sharp oil spike and subsequent crash of 2008 as well as the current commodities bull market.

As suggested above, inflation like other macroeconomic statistics is a lagging indicator that shows the rate of change in a basket of goods over a given period. With oil and food price spikes the full impact is only felt if companies are able to pass on higher input costs to end consumers, resulting in a short-term increase in the rate of price changes but a longer-term rise in actual prices.

“When people look at rising oil prices they think it increases inflation over the short-term but then fades away. It does have a direct effect on gas, petrol prices and things like that, but then there’s a follow-on effect,” says Patrick Armstrong, managing partner at Armstrong Investment Management. “Companies don’t raise their prices immediately based on their higher input prices so manufacturers and so on, incorporate their price rises into their next round.”

Short-term spikes, as their name indicates, involve not only a rally but an equally severe fall in quick succession. Over the longer term, therefore, the Bank’s inflation calculations are relatively well buffered from these sorts of price movements.

If, however, the rally is evidence of a structural shift in global markets and not the result of speculation in markets, as some would contend, then this poses larger problems for the reliability of the Bank’s forecasts. Some economists have seen creeping inflation as evidence that the growth of emerging markets, as not only commodity producers but major consumers, is starting to push the prices of goods higher.

As evidence they point to the fact that last year CPM, a metals research consultant, announced in its Gold Yearbook 2010 that in 2009, for the first time in 20 years, central banks turned from being net sellers of gold to net buyers. The report said that official gold demand resulted in net buying of 15.1m ounces (470 tonnes), the sector’s first net addition since 1988.

Extraordinary policy responses from developed market central banks have exacerbated the supply/demand fundamentals. In particular the jump in money supply as a consequence of asset purchases under the policy of quantitative easing could provide a huge boost to the nominal price of ­commodities.

“Over the long term the amount of goods is fixed and the amount of money chasing it determines the price,” says Armstrong. “With 10% money supply growth a year over the last 30 years you would need a huge amount of economic productivity gains to not create inflation. We had that last decade with outsourcing keeping costs down but this decade the emerging markets’ productivity is becoming an inflationary pressure with countries actively competing for resources.”

So what now?

Irrespective of what should happen according to the Bank’s parliamentary approved mandate, what is likely to happen is inflation will remain above 2% and rates will stay at historical lows longer than many expect.

The corporate recovery that took off so spectacularly in March 2009 was welcomed warmly across the world as a sign that extraordinary policy action taken by central bankers had averted catastrophe. Much of that optimism was deserved as there is no doubt things could have been dramatically worse.

At its core, however, has been the recovery of credit markets. That is not to say total volumes of lending are anywhere near pre-crisis levels but that with Federal Reserve, Bank of England and European Central Bank base rates at historical lows the cost of credit has been much reduced so that larger corporates have been better able to refinance themselves.

It is no accident that the bottom of equity markets came four days after the Bank dropped interest rates to 0.5% and announced the first £75 billion to be spent as part of its quantitative easing programme.

This is obviously on a sliding scale. London Interbank Offered Rates (Libor) may appear low (benchmark three-month Sterling Libor is about 0.8%) but only a few companies are able to borrow at that level. Many smaller banks, for example, have had to pay a premium of as much as 100 basis points to gain access to credit while small businesses and households with little equity have also struggled to gain financing.

Nevertheless, large blue-chip companies have found credit markets flush with newly printed money and debt issuance has met with plenty of demand. In many cases these companies have found refinancing an easier task than their sovereign hosts after the debt transfer from private to public sector during the crisis.

Low rates have also had a direct effect on banking profitability. While the Bank’s base rate has remained at 0.5% since March 2009 mortgage rates have been slow to come down. The large spreads effectively represent a wealth transfer from borrowers, who are unable to gain access to cheap sources of credit, to institutions who can.

Returning the banks to profitability has been a key priority for policymakers, not least because the British taxpayer is a major stakeholder in some of the largest financial institutions. This, however, has created perverse incentives as a large percentage of this profit margin has been leveraged off the spread between what these same taxpayers are paying in interest on their borrowings.

The problem is exacerbated by the pick-up in headline inflation. With CPI running at 4.4% in February and RPI, which includes mortgage costs, at 5.5% the cost of living is going up appreciably. In contrast wage growth for both top and bottom earners continued to decline from 2008 levels.

Indeed, the jump in RPI since November 2009 has pushed the rate of inflation well above wage growth. In effect this means that real incomes are being eroded by the rate of inflation. According to the ONS this is “only the second time that growth in the RPI has increased above the rate of growth in the top and bottom deciles of the earnings distribution since 1997”.

This is not a new story, however. Real incomes have been falling every year since 2005 which is the longest continuous streak since the 1920s. Mervyn King, the governor of the Bank, said in a speech at the Newcastle Civic Centre in January that falls in the standard of living was the “inevitable price to pay for the financial crisis and subsequent rebalancing of the world and UK economies”.

Consumer facing companies in Britain may also struggle with significantly above target inflation. Falling real incomes combined with rising unemployment, which increased to 2.53m at the end of January, will put pressure on the British consumer and take pricing power away from smaller British retailers. Even businesses like grocers that have traditionally been able to pass costs through to consumers relatively easily in the past are likely to struggle.

The consequence of this could be to intensify the refinancing problems of small and mid-cap companies as profit margins become squeezed and the outlook for British household spending worsens.

That executives within the financial sector itself have had a relatively softened blow will no doubt be an issue that returns to the debating table if inflation persists as expected. While it may prove a concern for the government, however, it is primarily a political debate weighing the relative merits of levying punitive taxes to cover part of the cost of the crisis against the much fabled brain drain from Britain if the measures are deemed too harsh.

Under the most optimistic of analyses, above target inflation is a blessing as it reduces the cost of outstanding debt. As overall price levels rise the value of money falls and likewise the value of sterling-denominated debt. In a 2009 article by Joshua Aizenman, a professor of economics at the University of California, Santa Cruz, and Nancy Marion, a professor of economics at Dartmouth College, the authors claim that their model suggested ­inflation of 6% in America could result in a 20% reduction in the debt/GDP ratio within four years.

Willem Buiter, then professor of European political economy at the London School of Economics and currently chief economist at Citibank, joined many others in expressing his concern that such a concept risked spooking the bond market. He said central banks threatening to erode the value of debt risked feeding inflationary pressures into interest rates at maturities of five years and longer.

So far, however, this problem has failed to materialise with British 10-year gilts yielding 3.53%, significantly below their long-term average.

If we are to take the Bank’s official position, however, this is far from the desired policy. Charles Bean, deputy governor for monetary policy at the Bank, repeated the mantra in his speech at the Association of British Insurers’ Economics and Research Conference last month that excess capacity in the economy should draw inflation back towards target over the medium term.

“The risk of inflation staying above the target into the medium term needs to be weighed against the downside risk to growth and the prospect of a persistent margin of unused resources in the economy. Allowing inflation to come back gradually towards the target would allow the margin of spare capacity to close more rapidly.”

While raising rates might be a boon to savers, who have seen little return on their cash, it would also represent either a levy on bank profits or a further hit on smaller borrowers. A half-point jump would take rates to 1%, still far short of current loan and mortgage rates, which would either be pushed upwards by similar levels or absorbed by allowing spreads to shrink. It would also increase the borrowing costs of the banks in Libor markets.

As the Bank is already worried about the ability of financial institutions to replace some £400 billion of wholesale funding maturing over the next two years it is unlikely that either outcome would be considered desirable at this point.

Appealing to short-term pragmatism is probably King’s best course of action. Faced with growing division in the MPC it will be difficult to hold back the calls for some tangible sign that the Bank is taking its inflation target seriously. Bean acknowledges that inflation may prove even more persistent that presently represented in the projections.

As Buiter suggests, at its most simple the central bank is playing a game of dare with the perception of its credibility in markets. Although Britain’s austerity package appeared to temporarily reassure the market that policymakers are taking rising government debt seriously, history suggests the only way to reduce the debt/GDP ratio is through economic growth and/or inflation.

That bond markets have yet to respond to the pick-up in inflation by demanding higher yields suggests the Bank’s claims that inflation will return to target over the medium term are so far being accepted.

King said in January:

“Central banks, though, do not set policy or react according to headlines. They simply do their work…Credibility was not earned in a year, and it will not be lost in a year. It is the result of experience over a number of years.”

Unfortunately, credibility is a much easier thing to lose than it is to gain, and especially difficult to regain if trust is lost. Policymakers will be hoping that imported inflation from rapidly growing emerging markets proves less sticky than some fear or else they may find themselves having to look for new definitions of medium term.

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