No rate rise

If not now, then when?

The MPC again ducked out of the difficult but necessary task of raising the bank rate. It is not obvious what they are waiting for. Inflationary pressures have grown considerably stronger over the last six months. The MC have just sat there in their oak panelled meeting room, watching passively as the rest of us have inflation hit five percent.

Wishful thinking won't deliver price stability. Talking tough doesn't do it either. The only known cure for rapidly rising prices is higher interest rates.

Great shot

Libya's main oil terminal was in flames on Wednesday night after Muammer Gaddafi's airforce bombed the complex, in an escalation that pushed the cost of the benchmark Brent above $115 a barrel

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Libyan oil wasn't the only thing destroyed by Ghaddafi's planes. The Bank of England's inflation forecasts also took a direct hit.

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.

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

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).

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.

Inventory? What inventory?

Does the lack of movement in published grain stocks invalidate any claim of a connnection between monetary policy and food price inflation?

New York journalist and one-time economist - Paul Krugman - thinks so. He doesn't see an "accumulation of inventory." Higher inventory would suggest hoarding, an important "signature" or marker of speculation. This point about inventory is mostly directed towards wheat, which has seen an extremely sharp run-up in prices.

Since Krugman lives in New York, it is perhaps understandable that his knowledge of farming is a little limited. There is no such thing as data on inventory. The USDA produces a time series called grain stocks.

This number is not the same as inventory, at least not in the sense used by Mr. Krugman. This stocks number has very limited coverage, focusing mainly on government holdings of grain. The USDA produces these estimates largely by looking at grain reserves in the US and reading reports produced by other governments.

Most countries run strategic grain reserves, and there is some limited data for what governments are holding. However, these reserves are disbursed across many sites across the world. Often there is wastage, theft, and misreporting. To put the issue in perspective; does anyone really think that the grain supply numbers coming out of say, Chad are accurate? Undoubtedly, the Chadian authorities are doing their best, but gathering comprehensive data on grain storage is not as easy as New York journalists might think.

In some parts of the world, grain markets are subject to government intervention, and price controls. This increases the incentives for corruption and misreporting. In more than one country, grain reserves have mysteriously disappeared, especially when food prices have suddenly accelerated. We should never forget there are some very powerful incentives at work here.

To make the point more forcefully, does anyone really think they know how much grain the private sector are holding? If private wholesalers are hoarding grain, I doubt very much that are reporting their stocks accurately to government officials. If prices are going through the roof, the incentives to hide grain are very potent.

Just to be clear, I am not saying we know nothing about grain stocks. I am sure the numbers coming out of the US, the EU and Canada are reliable. But strategic grain stock numbers from Russia, Kazakhstan and Ukraine? There I pause for a moment and wonder. Maybe, these numbers might be in the ballpark of the truth, but I would treat them with caution. As for private sector holdings of grain, only the Almighty knows that number.

There are estimates of production, which are partly taken from satellite imaging, and assumptions about yield per hectare. There is an obvious relationship between amounts produced last year and likely stocks this year. It is helpful, but I would feel uncomfortable about relying on those numbers.

Furthermore, when I hear that the USDA project a 5 percent decline in production, I am inclined to believe it. Nevertheless, reported harvests have been very good over the last few years. Even a five percent decline still puts the projected 2011 harvest up there in the top five years over the last two decades or so. However, none of this tells me very much about the true underlying level of world inventories.

Nevertheless, we shouldn't take too seriously any argument suggesting that speculation in food markets is implausible, simply because there is a lack of inventory build-up. It is the sort of argument that city folk make. Country people know better.

We must rely on what we can see; prices. We need to make a judgement about whether prices have deviated from long run fundamentals. As my last post indicated, prices seem to have jumped a long way from trend. To me, this smells of speculation.

Yes, food prices are increasing because of speculators

World food prices have become highly politicised. Two views are battling it out. First up; the supply-siders, such as Paul Krugman and Ben Bernanke, who claim that prices are up because of global warming, declining harvests and world population growth.

Then, there is everyone else, who claim that it is the fault of speculators.

Here is how Mr. Krugman put it:

"What’s behind the surge in food prices? The usual suspects have made the usual claims — it’s all about the Fed, or it’s all about speculators. But I’ve been looking at the USDA World supply and demand estimates, and what stands out from the data is mainly that we’ve had a huge global harvest failure."

He also said:

"..it sure looks like climate change is a major culprit. And it’s not just the (Former Soviet Union): extreme weather elsewhere, which again is the sort of thing you should expect from climate change, has played a role in bad harvest around the world."

Lets dispense with the climate change issue first. World wheat supply fell by 0.1 percent in 2010, and it is projected to fall by 5 percent in 2011. As the chart below suggests, there is nothing unusual about recent supply developments. In fact, projected 2011 wheat production is the fourth highest since 1995.

The World supply of wheat jumps around every year. This is due to fluctuating weather conditions. Anyone with a passing knowledge of farming knows that. Is the recent fall due to climate change - absolutely not. Linking recent food inflation to climate change is just absurd.

However, climate change point was merely an addendum to Krugman's argument. What about the more substantive point linking food inflation to a supply shock?

All speculative bubbles start with some kind of supply or demand shock. It is part of the pathology of speculation. The more substantive issue is whether originating shock can fully explain the subsequent price movement. In other words, can a 5 percent reduction in supply generate the following price movements?

Wheat prices are up about 50 percent in six months. The supply decline during that period was 0.1 percent. However, the anticipated decline in supply for this year is over 5 percent. That sounds a lot like speculation. Buy now on the expectation of higher prices in the future.

Low interest rates facilitates speculation in wheat. Suppose a speculator can take out a loan at 1 percent, buy a few tonnes of wheat at $200, stash them away in a warehouse and sell them six months later at $325. Does that not sound like a familiar wheeze? Here is a clue; think houses, dot.com companies, and currency futures.

Meanwhile, the rest of the world pays more for their food. Moreover, there is a kicker. The greater the amount of inflation, the greater the incentive for commodity dealers to speculate. More speculation means more hoarding, which in turn, creates more inflation. There is only one thing that can stop this cycle - higher interest rates.

For a liberal like Mr. Krugman, this is a very uncomfortable chain of events. He argued vociferously for lower rates. He believed that looser monetary policy would reduce the interest burden on US borrowers and prevent a further deterioration in US economic activity.

However, those low rates are now facilitating a speculative binge that is seriously hurting the world's most economically vulnerable people. At the risk of being excessively emotive, low interest rates may have protected debtors in the developed world, but at the cost of high food prices in the developed world. It is just one more miracle of Globalization

Input prices in the service sector rise sharply

The ONS have developed, on an experimental basis, a price series tracking services producer prices. As the name suggests, this series captures the cost pressures confronting firms in the service sector.

Recent movements in the series tell an interesting story. First, prior to the crisis, the service sector was facing mounting inflationary pressures. Second, once the crisis took hold, prices came crashing down. Third, in 2010 cost pressures have again emerged.

The services producer price inflation rate is far lower than that facing the manufacturing sector. There, the recent surge in energy and commodity prices has been a major driver of higher producer price inflation.

Nevertheless, the sudden reappearance of inflation in the service sector is further evidence that pricing pressures are building in the UK.

The interest rate hike is on its way

A rate hike is looking more likely. Here is Martin Weale, the newest member of the Monetary Policy Committee, writing in the Guardian.

As we cast our votes at the January meeting of the Bank of England's monetary policy committee – ahead of last week's GDP figures – I saw a compelling case for an increase in the bank rate.

My concern is that, if businesses and pay-bargainers come to regard an inflation rate of 3%-4% as normal, it will become more costly for the MPC to keep inflation close to the government's 2% target.

The longer inflation stays above the target and the further it rises, the greater the risk that inflationary expectations will become built in.

A rate hike at the next MPC meeting looks very likely.

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.

This, however, is not a blip

For at least a year UK producer prices have been rising by around 4 percent.

Are there any inflation-deniers left?

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.

Eurozone inflation creeps above the two percent target in December.

In December, the Eurozone inflation rate crept above the 2 percent target. Higher food and energy prices were the primary reason for the above target out-turn. However, if these items are extracted from the Eurozone CPI, then inflation was broadly flat at around 1 percent

The Eurozone is facing an existential crisis. The Irish and Greek governments are unable to finance their fiscal deficits and are now dependent on EU financing. Nevertheless, the crisis has not derailed the ECB and its efforts to maintain price stability. Over the last two years, it has maintained a consistent track record keeping inflation under control. This stands in stark contrast to the sorry efforts of the Bank of England. With lamentable regularity our central bank has failed to meet its inflation objective.

While the ECB's consistent and credible commitment to keeping prices stable means that it is in a better position than the Bank of England to deal with the growing threat from rising food and fuel prices. True, this may seem like cold comfort when the Eurozone itself is threatening to fall apart. Nevertheless, the stability of the Eurozone would be in further doubt if inflationary pressures were higher.

Nevertheless, inflation momentum is growing. The ECB faces the same uncomfortable trade-off as the Bank of England. Should it raise rates to keep inflation under control, or should it maintain low rates to protect the Eurozone banking system?

US Household wealth: where did it go?

Where did all that housing wealth go?

In the last four years, US home equity - the difference between the market value of homes and the outstanding stock of mortgage debt - has fallen by half. In terms of wealth destruction, there have been few parallels outside of war. The nominal value of housing wealth today is now at the same level it was back in the late 1990s. In terms of wealth accumulation, it is as if the US housing bubble had never happened.

This chart tells the deeper story than just simple post-bubble wealth destruction. During the bubble years, US homeowners remortgaged and extracted billions of dollars that was spent to sustain personal consumption. Lurking beneath the crazy house price appreciation of the last decade was a lethal accumulation of household indebtedness.  Households might have thought they were becoming richer. In reality, they were promising away their future incomes.

Here lies the treacherous asymmetry between home valuations and mortgage loans. House prices are ephemeral, flighty and fundamentally subjective. Debt, on the other hand, is merciless and exact. It must be paid.

Crashing household wealth also goes a long way towards explaining the ferocity of the recent US recession. There is a rough and ready empirical rule relating household consumption to wealth. Most economists agree that if wealth increases by one dollar, personal consumption increases by three or four cents.

If household wealth isn't fluctuating by much, then this wealth effect is quite muted. If, on the other hand, household wealth crashes by 50 percent, then GDP is going to take an almighty hit. So when house prices are racing upwards, the economy booms as everyone thinks they're getting richer. But when they crash, a recession is inevitable.

There is nothing new in any of this. Economists have understood the relationship between economic fluctuations and household wealth since the 1950s. The really interesting question is why would policymakers, in particular the Fed and the Bank of England, allow house prices to continue to rise, knowing the risks inherent when they inevitably crash? They can not plead ignorance.

Stopping a housing bubble isn't difficult. It can be done in one of two ways; raise interest rates or impose lending restrictions on banks, preventing them from writing mortgages to fuel the bubble. All that is needed is the will to do so.  However, bubbles are great while they last, and the pain they create is marked down for payment somewhere in the distant future. 

If this restatement about the dangers of asset bubbles seems a little too retrospective, take a look at food or oil prices today, which are now beginning to rise sharply. Also, examine recent developments in certain property markets in continental Europe, for example, Paris or Vienna. We still live in a world of asset price bubbles. Interest rates are too low, and we're bouncing from one crisis to another. We never seem to learn, or rather they would prefer to accrue the short run benefits of asset appreciation, and leave the consequences to the future.

Sterling crashes

It is down 13 percent this month alone.

Does anyone see a problem here?

Is this a good time to cut interest rates?