A turning point?

One of the hardest things in life is to recognize a turning point. Identifying trends is always easy, but knowing when the world is about to move in a different direction is so much more difficult.

Over last 18 months, the path taken by the UK economy has been easy to make out. After August 2007, financial markets froze up. Credit conditions tightened, large seemingly invulnerable banks unexpectedly failed, and in due course the economy slipped into a recession.

Some observers took this trend and followed it all the way to the bottom, suggesting that the credit contraction would be so powerful that consumer prices and asset values would to fall in absolute terms. In other words, the UK economy was on course for deflation.

For a time, the deflation story was tracking the data nicely. Inflation has moderated somewhat in the last few months, coming off a 16 year high in September. Asset prices, particularly equities took a battering, and house prices fell by just over 20 percent.

Nevertheless, recent data has gently pointed in a different direction. While the real economy continues to weaken, there are now compelling reasons to think that the risks of deflation, in the sense of falling consumer prices, were overstated. Has the UK economy approached the turning point? Will inflation begin to re-emerge? There are at least eight reasons to think so. Some of these points you have seen from me before in previous posts, but it never hurts to repeat them.

The FTSE had a very good month in March, with the headline index now over 4000. Equity markets have stopped believing in deflation.

The spread between the BoE bank rate and government yields remain surprisingly high. After dipping down slightly, as the Bank of England began its much anticipated quantitative easing, rates promptly rose again. The bond market doesn't seem terribly convinced by deflation.

February CPI data was a serious blow to the deflationist case. The 12 month rate rose by 0.2 percent, with many of the underlying sub indices rising alarmingly. Declining utilities prices were the only thing that kept the February inflation rate from looking positively ugly.

Commodity prices are creeping up. Gold is on an upswing. Oil prices are up 25 percent since February. While recently, the oil price has given back some of its recent gains, the general direction seems clear.

Unit labour costs for the fourth quarter of last year were disturbing, rising at almost 5 percent. Again, it is another example of a key sector of the economy, this time the labour market, taking a skeptical view about deflation.

Mortgage availability improved in February. True, lending volumes are a long way from the heady days of 2004, but the Bank of England and the government have put in place a series of measures that have made it impossible for a bank to lose money on the housing market. There is a real danger that mortgage lending is about to explode.

House prices increased in March. I know, it's just one month, and in historical terms, house prices still look overvalued. Nevertheless, the March number does not look out of place in relation to improving mortgage availability. Moreover, houses have always proved to be an effective hedge against inflation. It pains me to say it, but I wonder if house prices might be close to bottoming out. Believe me; I would love to be wrong here.

The money supply is growing at 17 percent. I know, you've heard this old song from me before, but that doesn't make it any less true. Since early winter last year, monetary growth began to accelerate. Sooner or later, a larger money stock always means higher prices.

So what is the counterargument? Well, there's no denying that the world economy is spinning into the worst recession since the 1930s. Every indicator points in that direction. At the same time, monetary policy across the world is extraordinarily expansionary. There is no reason to think that a devastating recession cannot comfortably coexist with rapidly rising inflation. This was, after all, the great lesson of the 1970s.