The Bank has to change its low inflation mentality to address economic reality
“Whole cities of pain. A continent of pain,” said the great, if eccentric, Wall Street money dealer Jim Cramer recently. He was talking about the economic pain spreading across the United States, of course. Until recently, the pain of the US housing market had not spread to our own fair land. Much of the economic data here has been, if anything, surprisingly healthy. But such figures are generally backward-looking and often look fine until suddenly they don’t.
Last week we saw a dramatic escalation in pain levels as one mortgage lender after another either withdrew home loans or raised the interest rates. The chart shows the growing divergence between the Bank of England’s official rate and interbank Libor rates that explains this.
This is the most concrete evidence to date that the esoteric “credit crunch” has moved out of the so-called “interbank money markets” and into the consciousness and pockets of the British people.
The Co-op Bank and First Direct said they had to shut their doors to new business because house buyers were deluging them with requests for favourable mortgage terms. Many who bought a two-bed flat in a city centre anywhere in Britain are now finding they can’t afford the mortgage repayments and the value of the property is dropping fast.
Perhaps Cramer should take a trip across the Atlantic to see more cities groaning under the pain.
Britons are also carrying record levels of debt. Figures last week showed a surprise jump in unsecured lending in February, mostly overdrafts.
A sign of continued consumer confidence, you might say. But it looks more as if consumers faced with greater difficulty in raising mortgage finance have simply let their overdrafts take the strain: it is a sure sign of consumers under stress.
That makes sense when survey after survey has been showing consumer confidence is very weak and people’s intentions of making a major purchase are vanishing. No wonder private car sales are dropping. Ernst & Young, the consultants, have warned that dealerships face a year of struggle.
The Bank of England’s credit conditions survey last week showed banks expect lending conditions to get worse, signalling more trouble ahead.
The economy has sailed resiliently through many shocks over the past 15 years, from the Asian crisis in the late-1990s to the dotcom bust of the early noughties. But it has not been hit by anything like this credit calamity for a very long time, if ever. This is the big one.
The idea that we can escape the impact of what is happening in America is just wishful thinking. There was some optimism in financial markets last week that the worst of the credit crunch might be over. These are the same markets that failed to predict the credit crunch and are the root cause of this misery, so their opinion, frankly, is not worth much.
The reality is that the economy has been pumped up and up in the past decade by the cheap and easy availability of credit. Now it is neither cheap nor plentiful and the fallout is hurting.
For one thing the housing market bubble – in a way we knew all along it was a bubble – has been pricked and is starting to deflate rapidly.
House prices are not going to drift quietly sideways over the next few years while average earnings catch up. They are going to fall sharply. I would be surprised if they don’t fall by a quarter or more over the next two years.
It is not just about the supply of credit, it is about mentality – the fear and greed syndrome. Who would buy a property, even if they could get a mortgage, if they thought they could wait another year and pay, say, 10% less?
Estate agents report they have stacks of properties for sale but simply can’t shift them. So supply is plentiful and demand has dried up. In most markets, that means prices fall. Why should the housing market be different?
Already, the construction sector has nose-dived, as witnessed by two surveys of the sector that came out last week. The much bigger services sector, too, looks as if it is running into trouble, according to a survey by the Chartered Institute of Purchasing and Supply last week.
The service sector is about two-thirds of the economy and has looked robust until now. Financial services employment has fallen sharply. The data is turning down.
All of which brings us to the policy response. What can the Bank of England do about interest rates? The growing risks to growth would normally call for sharp cuts in interest rates, following the Federal Reserve in the United States. The Fed has cut from 5.25% last autumn to just 2.25% now.
The Bank of England has been much more cautious, cutting from 5.75% to 5.25%. Part of the reason is that, until now at least, the British economy had held up well. But the other key element, as the Bank’s executive director, Paul Tucker, said last week, is that the monetary policy committee is not prepared to let the “inflationary genie” out of the bottle.
He hinted that slow, gradual rate cuts were in the committee’s mind rather than Fed-style emergency cuts.
Inflation has been pushed up to 2.5% – above its 2% target – by rising food and energy prices and is likely to rise quite a bit further.
Tucker acknowledged that a sharp slowdown in the economy would also put the brakes on inflation but it was not clear by how much.
But these are strange times for the MPC. In the face of such a shock to the economy as this credit crunch, it has to be wondered whether any of its forecasting models are of any use.
Models often use past performance to predict what might happen. But the past 15 years have been so stable for British growth and inflation that most models are likely to forecast that it will simply carry on. That is very unlikely, which means in turn that interest rates could be left too high for too long, just as happened in the US.
The rate cuts implemented by the Bank of England have probably already been cancelled out by the rising market interest rates that have pushed mortgage costs up. So interest rates are likely to be slowing the economy down, rather than boosting it.
The MPC is also conscious that for years, inflation was steady around the 2% target as high domestic inflation was offset by very low foreign inflation thanks to the strong pound and cheap Chinese imports. But now, rising world food and energy prices, combined with a falling pound, mean imported inflation has risen.
The implication of that is that domestic inflation will have to be much lower in the coming years than in the past decade. In turn, that means the economy will have to be run more slowly to keep domestic inflation in check. That’s why Tucker said last week that the MPC wanted to see some slack develop in the economy.
But the risk is that the economy might slow much more sharply than the MPC is expecting, possibly even follow the US into a recession.
In the face of such downside risks, which look to be much bigger than the upside risks to inflation, rates need to be cut, and fast, starting this week. There may not be much time. The pain is real, it is time to get the aspirin out.
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