King fails to convince the Treasury Committee

Mervyn King is again trying talk down inflation. He told the Commons' Treasury committee that "inflationary pressures [will be] pretty much back to target by around the middle of this year".

King confirmed that the Bank's counter-inflationary strategy is unchanged. It will try and wait out what it regards as a series of one-off shocks such as higher taxes and oil prices. By the summer, these effects will have fed through into consumer prices and gradually fade out thereafter.

However, he had to concede that inflation will rise at a seasonally adjusted annualised rate of almost 7 per cent this quarter. He also had to acknowledge that the inflationary outlook could deteriorate if the political situation in Middle East went pear-shaped, leading to a further increase in the cost of oil.

He also had to admit that the Bank had under-estimated the impact of both the commodity price inflation and the persistent effects of the exchange rate depreciation.

So to summarize; the bank believes that inflation will fall all by itself; there are alarming downside risks to the inflationary outlook and the Bank has accumulated an uneviable record of under-estimating inflationary pressures.

That settles it; no need for a rate rise.

Andy Sentance explains why a rate rise is necessary

Andy Sentance lays out the case for a rate rise in a recent speech entitled - Ten good reasons to tighten:

The MPC is accountable through its mandate to keep consumer price inflation at 2%. The mandate acknowledges that fluctuations will take place due to factors outside the MPC’s control. However, such factors causing deviations of inflation from target might be expected to be temporary rather than persistent. That has not been our experience, though.

Inflation has been above target for most of the time I have been on the MPC and some of the upward deviations have been quite significant. This creates a much stronger platform for tightening monetary policy than if we had experienced simply a “one-off blip” in inflation. The average CPI inflation rate while I have been on the MPC – since October 2006 – has been around 3% and over the past three years it has averaged 3.5%. In January it was 4.0%. In addition, CPI inflation is expected to rise higher in the short-term before falling back.

Indeed, since 2009, when the MPC put in place the current policy settings, inflation has persistently run ahead of the official forecasts set out in the Bank of England Inflation Report.

It is a must-read speech....

Rates must go up

Andrew Sentance, MPC member, again called for higher rates in the face of growing inflationary pressures:

"The time has come to increase interest rates. We should increase them gradually and slowly if we can. But the risk of delaying interest rate rises too long is that this gradual approach may cease to be an option in the future."

Six months ago it might have been possible to gradually increase interest rates. Unfortunately, the Bank of England is so far behind the curve that only a sizable rate hike will have a significant effect on rising prices.

Events in the Middle East have cruelly exposed the 'wait and see" stance of the more passive members of the committee. The sudden surge in oil prices will inevitably push inflation towards the top end of the Bank's inflation projection, at least in the short run. While a fall in the oil price is likely over the medium term, this decline won't come before inflation hits five percent. Indeed, if uncertainty in the oil market is protracted, then inflation could easily hit six percent by summer.

An earlier movement on rates, coupled with an unwinding of quantitative easing, would have put the Bank in a better position to deal the the recent commodity price shocks.

Now, the Bank must make up for the mistakes of the past. Delay will only make the evitable adjustment more painful. Rates must go up.

MPC are quoting writers instead of hiking rates

The monetary policy committee has started to communicate in aphorisms. Both David Miles and Adam Posen cracked open a dictionary of quotes in order to spice up recent speeches on the state of UK monetary policy.

David Miles, External Member of the MPC used the following quote from Milan Kundera, (Testaments Betrayed) in a speech to the CEPR in London:

"Man proceeds in the fog. ....... Yet when he looks back to judge people from the past, he sees no fog on their path. From his present, which was their far-away future, their path looks perfectly clear to him, good visibility all the way. Looking back, he sees the path, he sees the people proceeding, he sees their mistakes, but he doesn't see the fog."

Yes, David, we know that. The future is confusing and the past is clear. Nevertheless, decisions have to be made about the future path of monetary policy. Moreover, the mist seems to be clearing. Recent CPI data has strongly signaled that inflationary pressures are growing.

Adam Posen was a lot more obscure. He gave a recent speech on inflationary expectations and lifted the following gem from Walter Bagehot.

“A democratic despotism is like a theocracy: it assumes its own correctness.”

I can't see the immediate connection with interest rates. Is he hinting that while there is democracy within the MPC, there is no political accountability. Therefore, the UK monetary policy framework is like a democratic despotism? What does "assuming its own correctness" mean? Of course, I know what the words mean, but I don't see the relevance.

Enough of this pretentious nonsense, in monetary policy there is only one quote that matters. It is from Milton Friedman. It comes from his 1970 book The Counter-Revolution in Monetary Theory:

"Inflation is always and everywhere a monetary phenomenon."

If the MPC had remembered this quote, the UK inflation rate wouldn't be four percent and rising.

What is the trigger rate that finally forces the MPC to act?

At what rate of inflation would the monetary policy committee feel compelled to raise rates? It is certainly not four percent. We are there already and rates remain firmly fixed to the floor. Would it be five percent? Seven? Eleven?

There must be a number - a trigger inflation rate - where the MPC would finally act; a point where the costs of rapidly escalating prices are greater than any gains from protecting the banks and trying to revive the economy with cheap money.

Whatever the answer, the MPC have to deal with a rather unpleasant consequence of a near zero bank rate. The higher that trigger rate of inflation, the further the bank rate must travel before they can bear down on rising prices. If, say the inflation rate were cruising at a steady 7 percent a year, then a 25 basis point increase is unlikely to make much of a difference. The adjustment, if it is to be effective, is likely to be very nasty. There is always a cost for delaying the inevitable.

The crisis in the Middle East isn't giving any comfort to the MPC that it can avoid the trigger rate question. The oil price is swinging around violently with each political shock. Nevertheless, the trend seems unmistakable. Oil is at a two-year high. Today, Brent crude prices in London hit $105 a barrel today. If that price were sustained, then the Bank of England's central forecast of 5 percent will end up being a tad too optimistic.

It wouldn't be the first time that the Bank's optimism has led it to under-estimate external pressures on the CPI. Indeed, recent bank inflation forecasts have exhibited a strong bias towards under-predicting inflation. A cynic might suggest that these biases play a key role in rationalising the low interest rate policy stance of the MPC. The forecasts tell a pleasing story that lower inflation will eventually arrive, so long as everyone is prepared to wait out these recent external shock.

Instead of hoping for the best and pretending that inflationary pressures are temporary, the Bank needs to be looking closely at downside scenarios. For example, how would UK consumer prices react to political unrest in Saudi, with its inherent risks of disrupting oil supplies. What would happen to inflation if wage pressures in China were to increase?

Such scenarios cry out for a higher bank rate. They would also starkly illustrate that the magnitude of the interest rate adjustment will have to be large, thus exposing the MPC to the charge that it should have raised rates much sooner.

In fact, pushing rates down to zero was an over-reaction, largely driven by panic. It had a certain theatrical quality. The MPC acted like a magician, hoping to dazzle the audience with an unexpected trick.

With inflation now heading for five percent and possibly higher, the MPC might need to pull out their top hat and cape and prepare to play another trick with interest rates. How does a 300 basis point rate increase sound? Not shocking enough? Would 500 basis points be sufficient to have us gasping for breath?

Playing catch up

"We (the monetary policy committee) would be better placed to head off the upside pressures on inflation which are now apparent if we had taken earlier policy action.

And the risk is that when policy tightening does start, it will be overdue and the MPC will be playing catch-up – which is not a good scenario for recovery prospects."

Andrew Sentance, external member of the Bank of England's monetary policy committee

The monetary miracle is over

One should never underestimate the importance of luck. For almost a decade, the Bank of England proved to be very fortunate. It managed to simultaneously keep interest rates low, dramatically increase the money supply, and at the same time meet its inflation target.

How did it pull off this monetary miracle? The chart above provides a comprehensive explanation. It breaks the CPI inflation rate down into two components; the rate for services, which are mostly produced domestically; and rate for goods, which are almost entirely imported into the UK.

As the chart illustrates, prices for domestically produced services have grown fairly consistently at between three and four percent a year. This is far in excess of the Bank of England's inflation target. Prices of goods, on the other hand, were falling between 2000 and 2006, exerting powerful downward pressure on the aggregate inflation rate.

The reason for this negative inflation rate for goods is well understood. China industrialised, and exported huge quantities of clothes, footwear, and electronics. Prices for these items fell massively. In contrast, domestically produced prices increased rapidly in response the the extraordinary surge of Bank of England inspired monetary growth.

For many of us, this inflationary dichotomy between its goods and services will ring true. Anyone who regularly hired an accountant or chose to educate their children privately will be familiar with the four percent a year price hike.

So, it is fairly easy to see how the Bank of England got away with loose monetary policy and low inflation. Nevertheless, there is a more intriguing question embedded in this chart. To what extent did the surge in goods prices trigger a financial crisis?

To see how the turn-around in import prices might have precipitated the crisis, it is worth remembering how monetary policy worked in the past. In previous decades, rapid credit growth would have quickly fed through into prices. Eventually, interest rates would have increased, credit growth would have subsided, the economy would have slowed, and eventually inflation would have moderated.

This didn't happen in a decade before the crisis. Credit exploded while the overall inflation rate remains subdued on account of cheap imports. The Bank of England didn't feel obliged to raise rates, and the credit bubble just kept on growing.

Unfortunately, the old trade-off, like an unwelcome relative, returned in 2006. Inflationary pressures were building in the East,and import prices began to increase.

There were tentative signs of trouble in 2005. The Bank of England made a half-hearted attempt to raise interest rates to stem inflationary pressures. But the monetary policy committee took fright when it saw the property market weaken. Rather than tackle the growing inflationary menace, the committee buckled, reduced the bank rate and gave the housing bubble a new lease of life.

This weakness before the inflationary enemy resulted in renewed price pressures. In the early months of 2007, the Bank of England and its sister institutions in the US and Europe, were belatedly hiking interest rates.

This changing policy stance was sufficient to expose all the poor lending practices and financial sector abuses that had built up through the previous decade. Many banks, particularly small ones like Northern Rock, had cut interest margins to the bone and jacked up their leverage ratios. The slightest perturbation of interest rates and the financial system was in deep trouble.

The rest of the story you know.

So here we are - four years on from the crisis - and inflation has hit 4 percent, and it is likely to go higher. The Bank of England now believes itself to be trapped. It fears to raise interest rates on account of what it thinks a rate hike might do to the frail recovery. As for dealing with inflation, it has no strategy. There is no plan, just a vague hope that somehow things will turn out alright in the long run.

In fact, there never was a plan. The only thing that kept inflation down for ten years before 2006 was luck and a flotilla of Chinese cargo ships packed full of goods.

Watch out Mervyn, the press are starting to turn....

The UK press are starting to question Mr. King's competence...


The Guardian

His letter to George Osborne had a familiar ring about it. Yes, inflation remained well above target, but that was due to the weakness of sterling, rising commodity prices and the increase in VAT. For some in the markets, this explanation is wearing thin, and has become as unconvincing as the boy who tells teacher that the dog ate his homework.

The Telegraph

Cheap money has thus not only fuelled inflation, but has created a climate in which talk of any rate rise triggers concern that we may be tipped back into recession. Stuck in this vicious circle, it is no surprise that Mr King openly acknowledged yesterday that the MPC is split on the future direction of policy.

BBC

Mervyn King's 10th letter to Number 11 Downing Street is similar to many of the other ones he's written. In his view, the 4% rise in the CPI in the past 12 months is unfortunate - but temporary, and almost entirely driven by factors beyond the Bank's control. He insists that the MPC has not "lost control of inflation".

The Spectator

Now that today’s inflation figures are up, to a predictable and predicted 4.0 percent on CPI and 5.2 percent on RPI, we can expect the usual response. Nothing from the government (even though the declining standard of living will eclipse cuts as the no.1 problem of 2011); plenty of shocked news stories; and, then, the round of commentators saying that Mervyn King should “hold his nerve,” and not increase the absurdly low base rates of 0.5 percent. Inflation is temporary, he says, and should be okay again this time next year (that’s what he said about the start of 2011).

A good day for senior management at Barclays; a terrible day for the rest of us

Yesterday, the consumer price index was published, showing that prices are rising at 4 percent a year. The governor the Bank of England tried to explain this outrageous number by suggesting that higher prices are due to temporary factors. He must have forgotten that UK inflation has been consistently above the two percent target since 2006. Perhaps Mr. King operates on another temporal dimension, but nearly five years of above target inflation doesn't sound that temporary to me.

Under normal circumstances, a responsible central bank wouldn't hestitate to raise interest rates in the face such an appalling degeneration of the inflationary environment. However, nothing is normal about current UK macroeconomic policy management. Yet, even as the inflation numbers deteriorate at an alarming rate, Mr. King continues to resist the idea of raising interest rates.

His reluctance stems from a belief that protecting the UK banking system is more important than confronting inflation. Banks are undercapitalised and keeping interest rates low boosts their profitability. Banks can now borrow funds from the central bank at 0.5 percent and buy a government bond for 4 percent. Making money has never been easier.

With such a benign monetary regime, it might be reasonable to think Mr King should expect some reciprocity from commercial banks. It would be helpful if banks shared his concerns about undercapitalisation. Profits could be pumped back into banks to strengthen their balance sheets.

Today, Barclays had an opportunity to respond to all that love and kindness from the Bank of England. It published their end of year results. What did Barclays do? They gave their staff a huge pay increase. Last year, staff costs increased by an astounding 20 percent.

As our collective living standards are slowly crushed by higher prices and stagnant wages, we can ponder on the delicious irony of that extraordinary pay increase. Our central bank has engineered a rapid increase in inflation, either by accident or design, so that Barclays bank can increase salaries, in real terms, by 16 percent.

How cheap dresses and fancy shoes led to the financial crisis

Fashion has never been cheaper.

Since 2000, the ratio of clothes and footwear prices to hourly earnings fell by almost 60 percent. Around half of that decline was due to the direct effects of lower prices; the other half came from higher nominal wages.

This chart illustrates this spectacular fall in the real price of clothing. It also demonstrates the extraordinary structural change that has occurred in the world economy over the last 10 years. There was a time, and it wasn't so long ago, that Britain had a textile industry. That industry has all but disappeared. Instead, all our clothes are produced overseas, mostly in East Asia, particularly in China.

This chart doesn't just highlight the disappearance of a single British industry and the rise of China as an economic superpower. It also explains how the Bank of England made some profound errors in the conduct of monetary policy. The bank wasn't looking too closely at the sudden profusion of style around Threadneedle street or the meteoric rise of Jimmy Choo. If they had noticed, they might have avoided the greatest economic and financial disaster for generations.

As clothing and footwear prices fell, it should have provided powerful downward pressure on the overall price level. Yet throughout the last decade, consumer prices continued to increase.

Until 2006, that increase was around 2 percent a year. Although this inflation rate doesn't sound too serious, it obscured huge shifts in relative prices. If clothes prices were falling sharply, other items had to be going up in order for the overall inflation rate to be two percent. In reality, cheap Chinese imports were hiding a lot of inflation.

Low headline inflation lulled the Bank of England into a false sense of security. It chose to ignore the fact that cheaper imports were distorting true underlying inflationary dynamics. Since the headline inflation rate was within its mandated target of two percent, all was well with the world. Therefore, the only sensible thing to do was to reduce interest rates to historically low levels.

This provoked a borrowing frenzy. The primary destination for cheap credit was the housing market. The Bank of England couldn't fail to notice the double digit increase in house prices. However, it argued that it wasn't the job of a central bank to target asset prices. The CPI was the thing that mattered, and that was under control.

Despite this neat excuse, the borrowing frenzy wasn't just confined to the bubblicious real estate sector. Lower interest rates also encouraged households to fund consumption expenditure with a huge increase in personal debt. Flat screen TVs, new cars, home extensions, and extravagant holidays to Asia were all funded by cheap loans from high street banks. Behind all this debt accumulation was the Bank of England, with its low interest rates, and a belief that inflation was under control.

Then, it all fell apart. There is no need to recycle the sequence of events that led to the financial crisis. It is suffice to say that from 2007 onwards, banks failed and households either could not or would not continue borrowing to finance consumption. Aggregage demand crashed, and GDP fell through the floor, taking a sizable chunk of tax revenues with it.

As the crisis unfolded, the Bank of England impotently tried to revive the economy with lower interest rates. Despite the dramatic cuts in the bank rate, the UK economy dived into the deepest recession since the war. The Bank of England was also suckered into resuscitating the banks, who quickly sucked in huge amounts of taxpayer’s money. Before you could say "Clements Ribeiro makes nicer dresses than Georges Chakra" every major economic indicator was pointing in the wrong direction.

What was it that drove Britain into this sorry mess? Superficially, it looks like interest rates. Search a little deeper and we see that for 10 years the Bank of England ignored the fact that clothing and footwear prices were falling in absolute terms. Instead, they focused on the aggregate price index and an inflation target that was almost certainly too high. This negligence gave them the justification for excessively low interest rates.

This chart has a twist. Since the beginning of 2009, clothing and footwear prices are no longer falling. In fact, over the last year, clothes and footwear prices have increased by two percent. While this is lower than the overall level of inflation, it points out that the Bank of England can no longer rely on low wages in China to keep UK inflation down.

Those days are over.

Looking through inflation

I enjoyed reading these paragraphs in Philip Aldrick, and Emma Rowley piece on inflation, which appeared in the Telegraph:

For the past three years the (Bank of England) has got inflation consistently wrong. Just last year, it predicted the current quarter's inflation figure would be 1pc. When the ONS publishes a figure four times that level on Tuesday, it will only aggravate concerns.

The Governor and his cohorts have a formula for dealing with overshoots now. The Bank needs to "look through" inflation, King says. Shear off the one-off events, oil price spikes, poor harvests that lead to food price rises, the inflationary effect of the pound's devaluation and the VAT rise. Strip all that out and domestically generated inflation in the past four years has been "close to zero and obviously well below the target", King said in Newcastle last month.

"Looking through inflation" - as if we couldn't see it every time we enter a supermarket.

Aldrick and Rowley’s article hints at some deeper problems of monetary policy management. Over the last quarter of the 20th century, a consensus developed that price stability should be the primary focus of monetary policy.

In order to deliver low and stable inflation rates, a parallel consensus emerged. Central banks should be independent of political control and receive a unambiguous mandate for which they are then held accountable.

In order to make this mandate operational, Central banks needed a data-based standard. This meant choosing a single price index, which was compiled independently of the central bank. A third consensus developed. The Consumer Price Index was to be that benchmark, and it was to be produced by an independent national statistical office. (As an aside, I always thought that this was the wrong benchmark, because it excluded house prices. But let’s leave that objection at the cloakroom for fear that it might obscure my central argument. )

In summary, modern monetary policy had arrived that three points of agreement:

• Monetary policy should be directed towards price stability:
• Central banks should be independent:
• The CPI should be the metric for measuring the central bank’s success in meeting its primary objective.

Unfortunately, the Bank of England failed to abide by this social contract. Instead of maintaining price stability, it has chased growth with paltry results and kept the banking sector afloat at the cost of higher inflation.

This race for growth has compromised its independence. Today, the monetary policy committee looks more like a gaggle of incompetent and unelected politicians rather than a group of competent, rational, data-driven bankers.

As for the transparency of the CPI benchmark, the Bank has tried to detract our attention from it by a litany of self serving excuses about global shocks, oil prices, VAT and whatever else seems convenient to put forward as an explanation for unacceptably high inflation.

It is all rather disappointing. There was a time when I though an independent central bank was the answer. Perhaps, this explains my anger what has come to pass as monetary policy. The consensus could have worked, if only the MPC had understood what it had signed up for - keeping inflation under control.

It is time to close this farce down

One should always be suspicious of simple solutions to complex problems. For a least four decades inflation bedevilled the UK economy. In the early 1990s it was fashionable to believe that an independent central bank would resolve the problem. If we simply handed over monetary control to a hard-nosed banker, inflation would more or less disappear. Monetary policy would be determined by a rational consideration of economic data. Political factors would have no influence on interest rates.

Gordon Brown was a believer. As soon as Labour were elected in 1997 he made the Bank of England independent. He created a monetary policy committee and told them to keep inflation under 2 percent. He also promised that the government would not interfere in monetary policy decisions.

Roll forward 14 years, and the independent Bank of England has given up the fight against inflation. Apart from a few lucky months, it has missed the inflation target consistently since about 2006. It irresponsibly kept interest rates low for over a decade and provided the necessary conditions for an unprecedented asset price bubble. When the bubble burst, the financial system teetered on the brink of total collapse.

Since the bubble evaporated, the Bank has ignored its remit to keep inflation under control. Instead, monetary policy has been directed towards recapitalising the banks at the expense of savers. The consequences are now apparent in prices. Inflation is rising and there is no prospect in sight of any remedial action by the monetary policy committee.

Despite some appalling inflation numbers in December, this week the MPC decided to keep interest rates fixed at near zero. Like clockwork, the appalling inflation numbers keep coming. Today, the ONS published producer and output price data. Output price inflation rose 4.8 per cent in January 2011, while input price inflation rose 13.4 per cent.

It is time that the denial stopped. The Bank of England is incapable of maintaining price stability. It is time to close the show down. It is time to disband the monetary policy committee and re-establish political accountability. If the government again managed interest rates, they would be answerable for their decisions at the ballot box. In any event, they could do no worse than the Bank of England.

We will find out next week

We will have to wait until next Wednesday before we learn of the mental contortions of the monetary policy committee that led them to keep interest rates fixed while inflation accelerates.

The Bank of England’s Monetary Policy Committee today voted to maintain the official Bank Rate paid on commercial bank reserves at 0.5%. The Committee also voted to maintain the stock of asset purchases financed by the issuance of central bank reserves at £200 billion.

The Committee’s latest inflation and output projections will appear in the Inflation Report to be published at 10.30am on Wednesday 16 February.

An explanation would be nice.....

From the Telegraph....

The Bank of England topped up Governor Mervyn King's pension pot by £1.4m after deciding to award him an early payout in 2008.

The deal was settled shortly after Mr King negotiated a second five-year term at the Bank following a fraught reappointment process in the wake of the Northern Rock crisis. In his final 16 months as a member of the generous final-salary scheme, the Governor's pension pot grew by a third from £3.95m to £5.36m. By comparison, in the prior 12 months, it rose by £378,700.

Once he leaves the Bank, when his current term expires in 2013, Mervyn King will be eligible to draw an annual pension equivalent to £198,200 today The Bank could offer no explanation as to why the Court of the Bank decided to bring the Governor to full pension accrual before starting a second term, though it may have been for administrative purposes. Once he leaves the Bank, when his current term expires in 2013, he will be eligible to draw an annual pension equivalent to £198,200 today.

Talent must receive its just reward, even when it has been farmed off to Eastbourne.

Why are we so unhappy?

So why is there so much unhappiness about inflation at present?

The answer is clear. The three factors I described – higher import and energy prices and taxes – have squeezed real take-home pay by around 12 percent.

Average real take-home pay normally rises as productivity increases – money wages normally rise faster than prices. But the opposite was true last year, so real wages fell sharply. And given the rise in VAT and other price rises this year, real wages are likely to fall again.

As a result, in 2011 real wages are likely to be no higher than they were in 2005. One has to go back to the 1920s to find a time when real wages fell over a period of six years.

Speech given by
Mervyn King, Governor of the Bank of England
At the Civic Centre, Newcastle
25 January 2011

It wasn't me says the Governor

A sign of genuine leadership is a willingness to accept responsibility. Sadly, Mr. King's recent speech in Newcastle was an unconvincing exercise in blame displacement.

As Governor of the Bank of England, his primary task is to ensure a stable price level. However, UK inflation is spinning out of control. So how does Mr. King deal with this seeming contradiction.

In his speech, he offered three explanations for the recent rise of inflation. The UK economy has suffered from three shocks; higher import prices, higher energy costs, and higher VAT rates. He implies that neither he, nor the MPC, bear any responsibility for these developments.

Of course, this isn't quite correct. Let us start with import prices. The reason that import prices are higher is because sterling has depreciated. The exchange rate is the relative price of a currency. If a central bank increases the supply of its currency, then the price will fall.

This is exactly what the Bank of England did, and explains why Sterling is worth so much less than three years ago. Therefore, the Mr. King and the MPC are directly and uniquely responsible for higher non-fuel import prices.

What about fuel prices? Surely, Mr. King is innocent. Sadly not. He must bear some responsibility here. While it is true that the monetary policy of the UK has only a minimal effect on world energy prices, it is not true of the aggregate behaviour of all central banks. If each of the major central banks decide to loosen monetary policy and inject massive amounts of cash at a global level, then world energy prices will rise.

The Bank of England, along with the Fed, the ECB, and the BoJ, all simultaneously loosened monetary policy in the autumn of 2008. This wasn't an innocent coincidence; this was a coordinated effort. Two years later, inflation is picking up, just as monetary theory would predict. The BoE, along with other central banks, are therefore responsible.

Mr. King's responsibility for the VAT hikes is more indirect. The Bank of England was negligent throughout the decade prior to the crisis. It acquiesced to a massive asset bubble, that eventually burst and nearly brought down the financial system. Unwisely, the government responded to this crisis with wide, short-sighted changes to VAT rates. While Mr. King was not directly responsible for these policy vacillations on VAT, he was responsible for creating the permissive environment that allowed politicians to behave so badly.

Whatever excuses Mr. King may furnish for past mistakes, one thing is clear, the jig is up. Inflationary momentum is increasing, and there is only one way to pierce the boil - higher interest rates. The time for excuses are over. The time for leadership has arrived. Mr. King needs to step up and do what has to be done.

How well has the Bank of England forecasted the inflation rate?

How have the Bank of England's recent inflation forecasts compared with actual out-turns?

Before that question gets an answer, we need to acknowledge that economic forecasting is extremely difficult. So we shouldn't be too hard on the Bank simply because it can not precisely forecast the inflation rate 24 months ahead.

The Bank of England present their forecasts with a considerable degree of modesty. In addition to their central forecast, they also publish upper and lower bounds that indicate the degree of uncertainty that the Bank attaches to its forecast.

Therefore, one shouldn't place too much emphasis on whether the forecast is right or not. Instead, it is much better to think of the forecast in terms of what it reveals about what Bank of England is thinking and how it views recent macroeconomic developments.

So what do recent forecasts reveal? The chart above illustrates the Bank's forecast between May 2008 and February 2010, along with the actual out-turn for inflation. Ironically, the most accurate long-term Bank forecast is the oldest. The May 2008 inflation forecast was rather pessimistic. The Bank expected inflation to remain above the 2 percent forecast for several years ahead. Although this forecast missed the slowdowin of inflation in 2009, it wasn't too far off for 2010.

From November 2008 onwards, the Bank sharply revised their forecasts. They began to expect a sharp deceleration in inflation. They got this right; inflation did come down sharply. In September 2009, it was just 1.1 percent.

Then things went off track for the Bank's forecasters. Inflation picked up sharply in the closing months of 2009. It is given a further boost with the resumption of the higher VAT rate in January 2009. Curiously, the VAT hike was pre-announced, so it was surprising that the Bank didn't capture the uptick in their forecast during the early part of last year.

However, the most revealing forecast is the one from February 2010. By then, the Bank had caught up with the VAT shock, and managed to get the q1 forecast more or less spot on. Thereafter, things start to go wrong. The Bank expected inflation to fall, very much as it had in the winter of 2008. Instead, the rate went the other way.

In forecasting terms, this was a near term miss. In other words, the recent surge of inflation caught the Bank of England completely by surprise. The normal response to such situations is to completely rethink one's assumptions. The next inflation rate will make particularly interesting reading as the Bank struggles to explain this divergence between their recent forecasts and the inflation out-turn.

So what does this tell us about UK monetary policy? Two things; a further round of quantitative easing is now extremely unlikely and an interest rate hike is coming sooner than previously expected.

UK inflation is spinning out of control

December’s inflation number wasn’t just bad, it was horrific. In just one month the headline CPI rate went up from 3.3 to 3.7 percent. The retail prices index now stands at 4.8 per cent.

To give the December number some context, the CPI rose by one full percent in just one month. This was a record increase. Between 1996 and 2008, the 1-month change between November and December has varied between a fall of 0.4 per cent and an increase of 0.6 per cent. So, the latest number was off the scale. Moreover, this number does not include any of the recent VAT increase. That will hit the index next month.

Notwithstanding the unprecedented nature of the December number, the further deteroriation in inflation should not come as a surprise to anyone. Over the last three years, the Bank of England cut interest rates to near zero, and then followed up by printing billions of pounds. This increase in the money supply has pushed sterling down against all major currencies.

Over in Whitehall the government is running a double digit fiscal deficit, while public sector indebtedness has exploded. It has vacillated over indirect taxation, first cutting the VAT rate and then increasing it twice. Furthermore, these measures were undertaken when oil prices have doubled, and food price inflation is surging. If ever there was a recipe for inflation then this is it.

The standard line to justify this chaotic catalog of policy initiatives is that the financial system has suffered a terrible blow and that these interventions were needed to prevent a 1930s style depression. While it is true that lending activity has slowed, the decline is very much in line with previous post-war UK recessions. Unfortunately, policy makers were far too prone to hyperbole when describing the reasons for their hysterical attempts to keep growth buoyant.

The near-term prospects for inflation are awfully bleak. Without a spectacular change in monetary policy, inflation is going in only one direction. Growth is now picking up, price expectations are rising, and all we need to put us into double-digit inflation territory is a further oil price shock, a renewed surge in food prices, and a marginal acceleration of wage growth.

The monetary policy committee is now cornered. There are no excuses left. There are no more stories to tell about the output gap and how higher unemployment will eventually bring inflation down in the medium term. Without a policy response inflation will quickly slip into double-digit rates in a comparatively short period of time.

There is an understandable concern about how higher interest rates might impact growth. At this stage, a darker scenario is lurking in the corner - capital flight. If investors start to believe that UK inflation will go higher, then either long-term rates rise accordingly, or investors go elsewhere.

This dilemma is likely to manifest itself first in the government bond market. If long rates start to rise, then debt servicing costs will increase as well. Rising long term government bond rates was the trigger that pushed Greece and Ireland over the edge into a full-scale fiscal crisis.

There is one glimmer of hope. The coalition has announced a fiscal consolidation plan that appears to be credible. This has bought the UK economy some time. However, the clock is ticking and that credibility could evaporate as long term interest rates start to rise, putting pressure on a vulnerable deficit position.

The options facing the monetary policy committee are difficult. However, the dangers inherent in a passive approach are exceedingly unpleasant. Whether the MPC likes it or not, the time for a rate hike has come.

Learning from our mistakes

It is a sad fact that in the last 40 years, Britain has suffered from four separate housing bubbles.

The first occurred in the early 1970s when Ted Heath was Prime Minister. He liberalized the banking sector, reduced interest rates, and tried to keep the economy afloat with a huge fiscal deficit. He also antagonised the unions and drove the UK to the edge of hyperinflation. House prices rose and fell in parallel with Ted Heath’s opinion poll ratings.

In the late 1970s, Jim Callaghan tried the same trick. He had less success than Ted. House prices didn't skyrocket in quite the same dramatic way. Nevertheless, his departure from office coincided with a house price crash.

Mrs Thatcher was a little slow in playing the housing bubble game. It was well into her second term as prime minister before she engineered the conditions for a hyperventilating property market. Nevertheless, it was a spectacular one. And when it crashed the whole economy sank with it.

John Major never got the chance to inflate the housing market. He spent most of his wretched time in office cleaning up the mess that Mrs Thatcher made. By the time he was shown the door, house prices had stabilized. This was good news for the next occupants of 10 and 11 Downing Street. The UK economy was ripe for another bubble.

Tony Blair and Gordon Brown produced perhaps the greatest bubble of them. When it finally burst in 2007, it did more than just send the economy into the longest recession since the war. It nearly destroyed the UK financial system. The UK economy came within a centimeter of Armageddon.

Have we learnt anything from these experiences? I am afraid not. As soon as this bubble has finally unwound, and the banks have recovered, the British people will be ready for another round of property market monopoly.

Deep down inside, we love it too much. We would miss those greedy conversations about how much price appreciation is now embedded in our homes. The illusion of wealth, it might be an imperfect substitute for being truly rich, but it will do for most of us.

However, there are others who look upon our experiences with unbridled horror. Having seen the harm that speculative bubble can inflict on an economy, the Singapore government introduced a series of measures designed to cool down their housing market.

The government announced its intention with extraordinary clarity: “The government’s objective is to ensure a stable and sustainable property market where prices move in line with economic fundamentals.”. Could you imagine a British government ever committing itself to that kind of sanity?

• It raised down payment requirements for second mortgages. Individuals with more than one mortgage can only borrow up to 60 percent of a property’s value, down from 70 percent.
• It extended the period homeowners must hold properties to avoid a sales tax. Sellers will now have to pay a stamp duty for all homes and land sold within four years of purchase.
• Singapore’s homeowners who sell a property within a year of purchase will have to pay a tax of 16 percent.

Earlier, the government barred interest-only loans for some housing projects. It also barred developers from covering interest payments for apartments still being built.

House prices in Singapore are rising rapidly. The risks to the financial system and economy are serious. Nevertheless, in contrast to our sorry history, the Singaporean government understands the dangers of permitting unbridled property speculation. Although, we cannot learn from our own history, there is some comfort in the fact that others can see the dangers that we cannot.

Rhetoric and reality

Reading the Bank of England's internet site always makes me laugh. There is a wonderful disconnect between rhetoric and reality. The bank talks a good game when it comes to inflation. Here is what they say about their principal objective:


A principal objective of any central bank is to safeguard the value of the currency in terms of what it will purchase. Rising prices – inflation – reduces the value of money. Monetary policy is directed to achieving this objective and providing a framework for non-inflationary economic growth.

This week, they had a chance to put their rhetoric into action. The monetary policy committee could have raised interest rates. Instead, they chose to do nothing, despite the growing and incontrovertible evidence that UK inflation is accelerating.

The reason for the decision is well understood. The monetary policy committee would like to keep commercial bank funding costs low. They would like to increase the difference between the interest rate banks pay to depositors and the rates banks receive on their loans. This is known as the fat spread strategy. Its purpose is to recapitalise the banks surreptitiously by imposing the costs on savers.

The absurdity of the situation is amply demonstrated by a simple thought experiment. Suppose that the financial crisis had never happened and that the Bank of England was faced with the same inflation data. What would be the most appropriate interest rate response to an inflation rate that has been above target for 40 out of the last 48 months? It would be a rate hike, of course.