IT never rains but it pours. While the credit crunch hangs over the economy
like the grim reaper, food prices have jumped to their highest since 1945
and oil came within a whisker of $120 a barrel. Faced with the twin perils
of recession and inflation, policy-makers are earning their money.
Tim Bond of Barclays Capital puts it neatly in a paper called “Out of the
frying pan”. Conditions are slotting into place for a gradual easing of the
credit crunch this year, he argues, but this will be followed by a
reacceleration of global growth next year, putting upward pressure on
prices. The credit crunch will give way to an “inflationary crunch”, he says.
If he is right it does not look pretty. Central bankers would be damned now if
they did not respond to the credit crunch, but they will be damned again if,
because of that response, they let the inflation cat out of the bag.
Two decades ago, too many interest-rate cuts in response to the October 1987
stock-market crash were partly responsible for the inflation of the late
1980s.
This time, of course, it feels different. The Bank of England’s £50 billion
(or more) special liquidity scheme will either be seen in the coming months
as doing the trick in helping to get markets moving again or a desperate
last throw of the dice.
The scheme, which has the backing of lenders large and small, and will have
their participation, deserves to succeed, and was not intended as a rescue
operation for the banks or the housing market. Rather, if the economy is to
come through the credit crunch, money needs to keep flowing and a downward
spiral avoided. The Bank is acting as banker to the system.
That was also part of the spirit behind Royal Bank of Scotland’s £12 billion
rights issue. RBS is not battening down the hatches for recession but
ensuring it has the capital base to keep lending flowing for growth. As Sir
Fred Goodwin, its beleaguered chief executive, put it: “Were we not to have
done the rights issue it could have impacted on our ability to continue
doing business at current levels, and that in turn could have made the
economy less good, which would in turn make our problems and other people’s
problems more acute.”
How serious is the potential inflationary shock? One curiosity in recent
months has been that as economic gloom has deepened with the credit crunch,
weakening global-growth prospects, oil and commodity prices have surged.
Sure, the world’s population is growing and eating better – those who can
afford to – but we did not discover that over the past six months. Yes, the
global oil supply-demand situation is tight and the producing countries,
including Saudi Arabia, no longer seem interested in a stable price. Again,
though, that is not new.
So while there are fundamental factors that explain the end of the age of
cheap food and energy, the suddenness of the rise in recent months points to
a significant financial explanation. Investors have piled in.
Does that mean prices will reverse as quickly as they rose? The International
Monetary Fund (IMF) looked at this in its world economic outlook this month
and concluded that prices were likely to decline but only modestly, except
in the event of a global downturn that spread significantly to emerging
economies. Financial flows can, however, change rapidly.
The IMF also ascribed the weak response of oil supply to high prices to the
politics of Opec (the Organisation of Petroleum Exporting Countries) and
caution by the oil companies in increasing investment because of earlier
episodes of very weak prices.
How big a problem are soaring commodity prices for Britain? One of a trio of
Bank speakers in recent days, monetary policy committee (MPC) member Tim
Besley, who voted against this month’s rate cut, noted that “the world does
appear to have become a more inflationary place of late”.
All countries are experiencing the food and energy effect. Britain’s inflation
rate, however measured, remains low, including in comparison with the rest
of Europe.
Besley’s charts demonstrated that the relationship between commodity-price
rises and general inflation is much weaker than it used to be. One reason is
that the industrialised economies have become less industrial. Another is
that tax and processing make up a high proportion of the final price. So,
while the crude-oil price has doubled over the past year, petrol has risen
by an average of 16% (diesel by a heftier 23%). Food prices, properly
measured and weighted by the Office for National Statistics, have risen by
6%.
Another potential inflationary effect, from a weaker pound, was highlighted by
Besley’s equally hawkish MPC colleague, Andrew Sentance. The Bank, he
insisted, had not abandoned sterling, which was still an important element
in monetary policy.
The key issues were whether any rise in import prices led to so-called
second-round effects on wages, and whether consumer spending remained
subdued enough to contain firms’ pricing power. The evidence on wages is
encouraging, though consumer spending, on the official numbers, is probably
too strong for the Bank.
What should we deduce from all this? Taken together with the minutes of the
Bank’s meeting this month, it is clear the MPC does not think it has lost
control of inflation. Those who voted to cut (seven out of nine) were
concerned that to not do so could lead to an inflation undershoot in the
medium term. Those are not the sentiments of a central bank quietly
abandoning its inflation objective.
Besley drew the distinction between previous episodes when commodity booms had
spilt over into high inflation and the recent period. Back then, most
notably in the 1970s, central banks allowed real (after-inflation) interest
rates to turn sharply negative. The US Federal Reserve has negative real
rates now but the Bank does not and doesn’t want to.
That is why the markets were right to interpret the Bank’s announcements and
speeches in recent days as signalling a slower pace of rate cuts in future.
But rates will fall further, and the first-quarter slowdown confirmed in
official figures on Friday made room for them to do so.
Another speech, from the Bank’s chief economist, Charlie Bean, talked of
walking a tightrope between the credit crunch and inflation. Doing so, there
is always a risk you will fall off in either direction. The best way of
avoiding this, it seems, is to avoid sudden movements.
PS: How much does media coverage affect the economy? Can we “talk
ourselves into recession”, as business people often suggest to me? Coverage
of the credit crunch’s consequences migrated from the business pages to the
front pages some months ago. Whether every reader understands the
intricacies, they know something is up. The sense of unease is widespread.
There is a bad-news bias, because that’s what sells. But when the IMF talks
of the biggest financial shock since the Great Depression, the Bank takes
unprecedented action to provide liquidity, and the prime minister and
chancellor hold emergency meetings with banks, it is hard to pin all that
much blame on the media.
In the end, reality is what matters. If people decide in a few months the
gloom was overdone they will respond accordingly in their spending
decisions. That happened 10 years ago after the last big financial crisis,
when the Asian, Russian and hedge-fund crises came together.
Once people decide it is right to be gloomy, however, that mood can be hard
to shift. Long after the economy came out of recession in spring 1992 it was
thought to be still in it.
Years into the “miracle” of low inflation and continuous growth, the economy
was reported as being in trouble and the government disintegrating. Does any
of that sound familiar?
Our interest rates are still well above the Eurozone rates so there is still room for further cuts; the main thing is to avoid recession at all costs.
john, milton keynes,
Inflation has been running high for the past decade, its just that the extra money has been used to purchase property. Now that that asset bubble is deflating, other commodity bubbles are taking its place: oil, rice, wheat ... only a tightening of the money supply can bring these prices down.
Paul, Coventry,
I think you are missing something. Where is the money flowing ,not simply commodities. Emerging countries/regions. The more flows there the less is available here.Why ? because rates here are too low to afford a real return.No, ? my inflation is well above 4%.Imagine I'm not alone.
SC, Preston,
When you look at the data inflation is clearly a current problem
which is being reflected in industrial unrest as people are comparing rising prices to what they earn.
Given that why do so many economists and the media keep screaming for more interest rate cuts? ?
James, NI, UK
Magnanimity, you infer, was not far away from Sir Fred Goodwin's £12 billion rights issue. The measure will indeed shore up the shaky capital adequacy of RBS. Yet the money has to come from somewhere. If several more banks have rights issues, a short term financial 'crowding out' effect could ensue.
Nigel Grimshaw, Cambridge,
If markets thought a global recession was likely, prices ex the $ effect would be falling. Given no lag for commodity production to catch up with increasing global demand, rip-roaring inflation & collapsing bond prices & a more severe recession than than the one we're trying to avoid are on the way
steve bloom, eastbourne,
Can you spell "hyperinflation"?...it is the expectation of inflation that has destroyed the bond markets, not the sub prime excuse that has been reported by the media.
the bellevue banker
scott alden stabler, bellevue, wa, united states