Back in October there were 1.13 euros to the pound. Over the last few day the exchange rate has been rotating around 1.20.

On the last day of 2010 there were 1.54 dollars to the pound; as of Friday there were 1.60.

The pound has been rising, and according to Capital Economics, it is expectations that rates will be rising in the UK soon that are causing the rises.

It’s not helpful. If the UK is to enjoy an export-led recovery, we need sterling to remain cheap, which is why it was a tad odd when last week David Cameron seemed to join the cause of those wanting to see higher interest rates in the UK.

But there is one rather worrying trend we are seeing at the moment that may indeed force the Bank of England to up rates.

On Saturday morning, BBC Breakfast ran two stories in a row which illustrate the problem. The first story was on rising charges at car parks, the other on rising petrol costs. Both stories said prices are rising because of a combination of rising inflation and rising VAT.

In fact, the correspondent talked about prices going up 6 per cent, because that’s what you get when you add inflation to the VAT hike.

The story is daft, of course, because the VAT rate is already included in the inflation figures. VAT went up in January 2010 and it went up this January, and this has pushed inflation up.

To add VAT to inflation is double accounting, as you are adding in the same variable twice.

If unions were to adopt that philosophy, they might start striving for wage increases of 6 per cent. That really would be a concern.

People’s expectations of inflation matter. If we expect inflation to rise, our behaviour can make the very thing that we expect to happen actually more likely to occur. In short, our inflation expectations can be self-fulfilling. And the current media talk of rising rates is in danger of making that a necessity; that would be bad news for the UK’s indebted households, and bad news for our exporters.

Factors that pushed especially hard on inflation were airfares (between November and December this year they rose 41.8 per cent), fuels and lubricants (prices increased this year by 2.8 per cent, the largest rise for a November to December period since 1996), and food, (prices, overall, rose this year by 1.6 per cent, the largest ever rise between a November and December period.)

Of course another factor pushing up on inflation is VAT. VAT went up in January 2010, and went up again this January. In the year to December, CPIY (that’s inflation minus the effect of indirect taxes such as VAT) rose by 2.0 per cent, up from 1.6 per cent in November.

Many are now saying inflation is out of control, and interest rates must rise. We are not so sure, and many economists still agree.

Chris Williamson Director and Chief Economist at Markit said: “The data in fact do little to change the medium term picture, whereby the short-term factors that are currently driving up inflation should disappear, meaning inflation will fall next year. Most importantly, underlying domestic demand remains very weak with signs that economic growth slowed towards the end of last year and is expected to remain subdued in the first quarter. Falling real incomes, high unemployment and widespread job insecurity mean demand is likely to remain lacklustre for some time, and also suggests that higher prices will not feed through to substantially higher wages and salaries. Any rise in interest rates is therefore likely to have little impact on inflation itself.”

Yesterday, the ITEM club from Ernst and YoInflation is primarily being driven by temporary factors such as a rise in VAT, high commodity prices and past depreciation of the sterling. Stripping away these factors reveals that underlying price pressures remain low. Indeed CPIY (ie inflation excluding indirect taxes) was depressed at 1.6 per cent in November.

“We are of the view that the MPC should only respond with monetary tightening in the event that high inflation begins to become entrenched in people’s expectations reflected by unsustainable increases in wage settlements. However in the current context of a weak labour market with wage growth well below pre-recession levels, this seems unlikely. Therefore an increase in interest rates right now will be premature and is likely to dampen an already fragile economy.”

This morning, Jonathan Loynes, Chief European Economist at Capital Economcis said: “don’t forget that the headline rate reached 5.2% back in 2008, but was down to 1.1% just 12 months later. With fundamental drivers like spare capacity, wages growth and money growth all still pointing to considerably lower inflation in the medium-term, we continue to think that the MPC should – and probably will – hold its nerve and continue to provide the economy with the strong support it will need to withstand the coming fiscal tightening.”

However, while we still believe inflation will fall back later this year, and it is way too soon to up interest rates, we reckon inflation will become a problem in a few years time. The inevitable increase in the Chinese yuan and the rise in Chinese wages will mean a reversal of the conditions that led to low inflation in the noughties. The retirement of the baby boomers will also see baby boomers dip into savings to fund their retirement – this is also potentially inflationary. The era of low interest rates will be with us for a few more years, but by the midpoint of this decade we reckon that will change.

But the pressure on it to up rates is becoming stronger.

The latest BRC survey had food inflation rising 4 per cent in the year to December. Commodity prices keep going up, VAT is up again, petrol is becoming ridiculous, and if China really does appreciate its yuan, won’t that make China’s products more expensive?

But then again, think of it in these terms. Most UK households have mortgages, meaning they probably pay more interest on their debts than they receive on their savings. This means they are worse off if rates go up. But these people are already worse off anyway; wage growth is set to lag way behind inflation this year. So if rates do go up, we will be seeing a double blow on households.

Interest rates are meant to influence inflation through their effect on demand. Higher rates bring down demand, pushing prices down. But the forces that are pushing up on prices at the moment have nothing whatsoever to do with UK demand.

But there is one snag.

Yes, it is true that factors creating inflation are external at the moment, and therefore an increase in interest rates will just make things harder for households without dealing with the cause of rising prices. But wasn’t a similar argument, albeit applied to opposite circumstances, completely ignored by the Bank of England earlier last decade?

During the boom, inflation was low because of external factors – cheap manufactured goods from China, mainly. But the Bank of England said, inflation is low, so let’s cut interest rates. As a result, people who were already benefiting from cheaper products had the added benefit of lower interest rates. No wonder the economy overheated. Or is that understating it – no wonder the economy boiled over.

Of course, back in the boom years central banks got a tad arrogant. “Low inflation, consistent growth was down to us, aren’t we clever,” they said. Well, it wasn’t. Now they are saying higher inflation and lower growth isn’t down to us. Well, they are right – sort of. But then again, they can’t have it both ways.

And finally, before we leave this topic, there are a number of forces that are coming into play that could create a new bout of inflation in the decade to come. Firstly, over the next decade, or even longer, growth in demand from the developing world is likely to exceed growth in savings – creating higher interest rates and inflationary pressures. Secondly, it seems wages in China are set to rise; this may well have inflationary implications. Finally, as the baby boomers retire, they will dip into their savings, and spend money even though this rise in spending may not be matched by higher production from the diminishing labour pool. This too could have inflationary implications. See: Interest rates set to rise as economic tectonic plates shift – is this good or bad news?

See http://www.investmentandbusinessnews.co.uk/economic-growth/interest-rates-set-to-rise-as-economic-tectonic-plates-shift-is-this-good-or-bad-news/12136

For the time being, we would argue that deflation remains a bigger danger to the developed world than inflation. But this could change over the next few years – but the change will have nothing to do with quantitative easing.

 So, inflation using the consumer price index measure was 3.2 per cent in October, or if you prefer to measure your inflation in old money, it rose from 4.5 to 4.6 per cent by the retail price index.

Thankfully Mervyn King does not have to write a letter to the chancellor every time inflation is more than a full percentage point over target. He would be suffering nasty finger cramp by now if that were the case, but even so, today he will be knocking off his fourth letter of the year.

But here are three reasons why the inflation hawks are wrong, and one why they might have a point.

Reason number one: CPIY, that’s inflation minus the effect of indirect taxation (that‘s VAT, among other taxes) was still only 1.6 per cent, from 1.5 per cent the month before. Next year, VAT is going up, and so will inflation. But a hike in interest rates will do nothing to fix the underlying factors pushing up on prices. VAT is going up next year, and therefore so will prices regardless of what the rate of interest is.

Reason number two: average wages are simply not going up in tandem with inflation. Data out from the Chartered Institute of Personnel and Development (CIPD) yesterday revealed that employers are expecting to see wage rises of around 1.5 per cent next year. CIPD said: “Evidence from our members suggest that it will be some time yet before pay settlements rise consistently above 2 per cent – implying a sustained period of squeeze on real incomes given the current high rate of price inflation.”

For as long as wage rises are so modest, the chances of seeing an inflationary wage spiral are remote.

Reason number three: if interest rates were to rise, then the impact on households, which are set to see their disposable income fall next year anyway, would be catastrophic, sending the UK back into recession, and no doubt creating the conditions for a deflationary spiral.

The argument for the hawks is that quantitative easing is not really being that effective, and if anything, seems to be creating the risk of new bubbles forming in certain asset prices.

Investment and Business News is a succinct, erudite and informative roundup of today’s top news stories on business and the economy, with analysis thrown in. Sometimes amusing, frequently contrarian, often thought provoking, and always informative, Investment and Business News is free. To subscribe, click on the subscribe function at the top right hand corner of this page. By the way, did we say it’s free?

In the great inflation or deflation debate, an interesting new argument has come to the fore in recent days. At the risk of the author making himself seem to sound old, this piece will christen the argument as The Bananarama Theory, and it goes like this: it’s not what you’ve got, it’s what you do with it, and that’s what gets results.

We refer of course to the Bananarama theory of the money supply. And the theory says it’s not how much money there is in circulation, it’s how fast we spend it that matters.

Irving Fisher, a man who died some 35 years before the Bananarama hit, put it another way: MV= PT. Or the money supply, times velocity of circulation, equals the number of transactions times average prices. In other words, if the number of transactions rises, but the money supply or the speed with which we spend money stays still, we get deflation. If, on the other hand, transaction levels remain fixed, but either the money supply or velocity rises, we get inflation.

Transaction levels are more or less correlated with output. In other words, if spending rises faster than output we get inflation; if it’s the other way round, it’s deflation.

On several occasions this column has warned about the appalling growth in the broad money supply. Despite all this quantitative easing, in the US, broad money, or dollar M3, has contracted every month this year. In the UK we have seen modest growth, but nowhere near to the level economists seem to think is required to sustain the economy. It all boils down to lending. Broad money includes credit, so if the central banks create money, but the commercial banks don’t then go out and lend it, broad money does not rise.

But the lacklustre performance of broad money is not restricted to the UK and the US, it’s a global phenomenon too.

But suppose that while the broad money supply contracts, we go out and spend the money we have got that much faster. In other words, velocity of circulation rises, maybe at a sufficient pace to overcompensate for contraction in the money supply.

Velocity of circulation is measured by taking GDP, and dividing by the money supply. And since US GDP is growing, but the money supply is contracting, then by definition the velocity of money must be rising.

The big question, however, relates to why velocity is rising. Is it rising because the return on holding cash is so low that we are going out and spending it? Maybe velocity is rising because investors, and especially institutional investors, are ditching cash and moving into other assets. If this is the case, then, in theory, rising asset prices will mean we feel better off and spend. This will lead to faster growth, and as a result banks will feel more comfortable about lending, and then … well, at that point the genie might be out of the bottle, and central banks may need to hike rates fast and start reversing quantitative easing by selling bonds.

There is some evidence to suggest this is what is happening. Writing in the Telegraph, Simon Ward, chief economist at Henderson Global Investors, said: “Evidence of a ‘dash from cash’ includes record retail buying of mutual funds and a decline in institutional investors’ ‘liquidity ratio’ – the proportion of their portfolios held in money and short-term securities.

“Meanwhile, equities, bonds, housing, commercial property, commodities, art, antiques and fine wine have all appreciated, in some cases substantially, over the past year – strongly suggestive of surplus money rather than the Governor’s mooted shortage.”

The FT quoted Michael Saunders referring to “a run-down in cash held by pension schemes and life insurers.” He said: “Excluding these groups, broad money growth is about 3 per cent annually, roughly what it was when the UK last emerged from recession in the early 1990s.”

Well, it depends on how you define money supply. You could equally interpret Mr Saunders’ finding as suggesting velocity of circulation is growing.

This all begs the question, is this view right? Is inflation really being stoked up, not so much because QE is boosting the money supply, but because the combination of record low interest rates and QE is increasing the pace at which we spend it?

We are not convinced. The fact is, both Brits and Americans are saving more than they did during the boom. Thanks to the impending retirement of the baby boomers, they need to save a lot, lot more. The prognosis for house prices on both sides of the Atlantic is awful, meaning home owners will feel hard up over the next year or so, or maybe longer. In the UK, wage rises are lagging behind inflation, and many of us are worried about the public sector cuts. In the US, the latest data on US personal incomes indicated that personal incomes fell 0.1 per cent in September.

So while the rises in some asset prices may make us feel more confident and willing to spend, there are lots of factors pushing in the other direction.

But let’s wait and see. No doubt the nomenclature of “The Bananarama theory of the money supply” is not going to gain much traction, but one can be pretty sure we are set to hear a lot more about the velocity of money.

Investment and Business News is a succinct, erudite and informative roundup of today’s top news stories on business and the economy, with analysis thrown in. Sometimes amusing, frequently contrarian, often thought provoking, and always informative, Investment and Business News is free. To subscribe, click on the subscribe function at the top right hand corner of this page. By the way, did we say it’s free?

The picture may start to become clearer when you realise that the particular bonds that have seen yields fall into minus territory are index linked. The government pays out a dividend based on the rate of inflation. So, if inflation rises, the yield goes up.

Right now, the yield on US government bonds that are not linked to inflation is ridiculously low. Last night the yield on US ten-year bonds was 2.64 per cent.

But why are yields so low? If quantitative easing (QE) is shoring up problems for the future, and we are to see a nasty surge of inflation in a few years’ time, as some people keep saying, surely the yield on these bonds should be a lot higher. There are only two possible explanations. Explanation number one: the markets don’t buy the inflation argument and still fear deflation. Explanation number two: QE has distorted the market.

Now, consider bonds that are inflation linked. If you want a safe refuge for your money, and figure that US treasuries are the safest possible home, but you fear inflation, then you have a dilemma. Throw your money at treasuries paying a yield of just 2.64 per cent, then if inflation does surge, every year you will be losing money when measured in real terms.

By contrast, if you put your money in index-linked bonds, you know that as inflation rises, so will the yield.

Now, if the current yield you receive is negative, this means that as inflation rises the yield will rise too, but in real terms will remain negative. But, and this is the worrisome implication, markets may have concluded that although buying index-linked bonds at negative interest means the holder is guaranteed to lose money net of inflation, at least the loss will not be as great as that suffered by a holder of conventional bonds.

In other words, markets are worried about inflation, and see negative yields on index-linked bonds as the lesser of two evils.

This also provides ammunition to the gold bulls. If markets are looking for a hedge against inflation, then does it not make sense for those who are less concerned about liquidity to opt for the classic inflation hedge, gold?

On the other hand, the Fed wants to make bonds so expensive that markets will instead throw money at business and consumers.

The snag is, for as long as markets refuse to support investment, and instead throw their money at so-called safe havens, the chances of inflation remain unlikely.

Investment and Business News is a succinct, erudite and informative roundup of today’s top news stories on business and the economy, with analysis thrown in. Sometimes amusing, frequently contrarian, often thought provoking, and always informative, Investment and Business News is free. To subscribe, click on the subscribe function at the top right hand corner of this page. By the way, did we say it’s free?

PS: This all begs the question, how is this possible? Well, it all hinges on the time to maturity. The bonds in question were 100 dollar Treasury Inflation-Protected Securities that had five years to go until maturity, and carried a premium of half a per cent. Investors paid 105.50 dollars for them. This means that over the next five years the bond holders will receive 2.50 dollars in yield and then 100 dollars for the bond. So they will make a loss of 3 dollars. Of course, if inflation surges, then they will get more money for the bonds, netting a profit. But it will only be a profit in money terms. After allowing for inflation, bondholders will still be losing money, just less of a loss than if they had bought non-index-linked bonds – that is, just to reiterate, assuming inflation picks up.

There is a famous equation: PT= MV. Average price times number of transactions equals money supply times velocity of circulation of money. The thing is, the money supply has many different definitions. Maybe broad money is really MV, but that is just a matter of semantics. The fact is that it is broad money, not narrow money, that determines inflation; broad money has contracted in the US every month this year, and its growth in the UK is anaemic. See: Bank of England rate setting committee

But then again, it is clear why broad money is performing so poorly; it is because of low lending levels. The question is, will this be a temporary thing, and will lending return to old levels. If this happens, then all that extra money created by the Bank of England will multiply out, and we will have problems.

But, for a variety of reasons, we think this is unlikely.

First off, bank regulation, including the new Basel accord, is likely to keep lending lower.

Secondly, the boom in asset prices, and especially house prices, encouraged borrowing as people felt they could afford to borrow more because their extra borrowing was fundable from the growth in the value of their property. I think there are good reasons to believe it will be a long time before we have another property boom, hence demand for credit should remain low. This partly explains what happened in Japan 20 years ago; asset prices crashed, and we saw 20 years of deleveraging.

Thirdly, saving is coming back into fashion. Who knows how long this new fashion will last, but it will be a while before we return to the recklessness of the boom years.

Fourthly, during the boom Western markets were flooded with credit from Japan and China. The Japanese carry trade is over. If China does indeed consume more, then we should see the gradual end of that era of Chinese money propping up Western credit.

Fifthly, the twin forces of globalisation and technology have created a big leap in global capacity, and when capacity rises, the money supply must rise too, or we will get deflation. We may have seen an early example of this effect in the period that central bankers refer to as NICE.

But the sixth reason is the main factor. In fact, it makes the other points quite trivial, and it relates to demographics and the retirement of the baby boomers. The fact is, across the West, and indeed China where the population is ageing too, and very much In Japan, demographic changes mean it is essential we save more and borrow less. The demographic change is about 20 years ahead of us in Japan. This surely is the real cause of Japan’s 20 years of economic malaise and deflation.

Unless central banks can find a way of channelling quantitative easing into areas that will create wealth and promote business, i.e. venture capital, or more business friendly banks, it will be ineffective.

Investment and Business News is a succinct, erudite and informative roundup of today’s top news stories on business and the economy, with analysis thrown in. Sometimes amusing, frequently contrarian, often thought provoking, and always informative, Investment and Business News is free. To subscribe, click on the subscribe function at the top right hand corner of this page. By the way, did we say it’s free?

Actually, news that members of the MPC voted three ways at the latest meeting was no real surprise. The more interesting aspect lies in what the members sitting in the middle are thinking, and the latest minutes suggested they are leaning towards more quantitative easing.

Andrew Sentance, who has taken up the role of the MPC hawk, has been voting for rate rises now for several months. It would have been a real surprise if he had changed his tune this time around, so there was no surprise that he voted for a hike once again. Mr Sentance has been expressing fears that there is less spare capacity within the UK economy than was previously thought. His big fear is that the recession may actually have killed off some capacity permanently, and that a future rise in demand will be translated almost immediately into higher prices.

By contrast, Adam Posen has written extensively on how he believes the time is right for more quantitative easing. In the meeting held earlier this month, he voted for a further £50bn.

But perhaps of more significance is what the minutes said of the members who sat in the middle, voting for no change. Some felt that “the likelihood that further monetary stimulus would become necessary in order to meet the inflation target in the medium term had increased in recent months.”

Now, that is about as big a hint as you are going to get.

Of course, with inflation remaining stubbornly at 3.1 per cent, a position it has now occupied for three consecutive months, there is no shortage of those who believe that there has been some kind of secret pact with the government, and that actually the Bank of England no longer cares about inflation. Conspiracy theories aside, there is no shortage of people who feel the current levels of interest rates are a recipe for inflation down the line and that more QE would be an unmitigated disaster.

But on the other hand, average earnings growth including bonuses increased in the year to August 2010, by 1.7 per cent. Hardly the stuff that wage push inflation is made off, and which Andrew Sentance seems to fear. More to the point, in the year to August, pay growth (including bonuses) in the private sector stood at 1.2 per cent, compared with 2.9 per cent in the public sector. In other words, the main impetus for wage inflation this year has come from the public sector.

Now, lean in a little closer and we will let you into a secret. Keep it quiet now, won’t you. Here it is: the public sector may see wage inflation slow quite significantly for the next few years – there, said it. In other words, the one thing that has kept wage inflation up at all, is set to go into reverse.

And then there’s the money supply. The initial estimate for September’s money supply growth, and in particular broad money or M4, was out this morning. The Bank of England said: “M4 decreased by £5.5 billion (0.3 per cent ), compared with an average monthly increase for the previous six months of £0.8 billion. The twelve-month growth rate fell to 0.9 per cent from 1.9 per cent in August.” Now, a growth rate of M4 of just 0.9 per cent is incredibly low. “M4 lending,” says the bank, “decreased by £0.7 billion (0.0 per cent) in September. The twelve-month growth rate fell to 0.0 per cent from 0.7 per cent in August.” And finally: “M4 lending (excluding the effects of securitisations, etc.) decreased by £0.8 billion (0.0 per cent) in September. The twelve-month growth rate fell to -1.0 per cent from -0.4 per cent in August.”

The truth is, that despite all this QE, the money supply is barely growing at all, and the measure of M4 lending that the bank prefers is contracting.

The question over QE is not whether it is shoring up inflationary pressure, but whether it is doing anything much at all. QE will only be effective when the Bank of England starts buying bonds in banks that are more proactive in lending to business, ideally in the form venture capital, such as the new £1.5bn fund the banks have been threatening to form. If QE could be used to turn this £1.5bn fund into a £15bn fund, then it really would start making a difference.

Investment and Business News is a succinct, erudite and informative roundup of today’s top news stories on business and the economy, with analysis thrown in. Sometimes amusing, frequently contrarian, often thought provoking, and always informative, Investment and Business News is free. To subscribe, click on the subscribe function at the top right hand corner of this page. By the way, did we say it’s free?

NICE stands for non-inflationary, consistently expansionary. And the decade also known as the noughties, is often referred to as the NICE decade – except, of course, the ending was (to put it into central bankers’ jargon) simply beastly, and we eventually paid the price for all that naughty spending.

But now Mervyn King reckons we are entering a period of sobriety; or savings, orderly budgets, and equitable rebalancing … .
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Yuan. Yuan …
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Sorry about that, must have nodded off there.

How about this one: corrections, recessions and payback?

Investment and Business News is a succinct, erudite and informative roundup of today’s top news stories on business and the economy, with analysis thrown in. Sometimes amusing, frequently contrarian, often thought provoking, and always informative, Investment and Business News is free. To subscribe, click on the subscribe function at the top right hand corner of this page. By the way, did we say it’s free?

It all began last week when the President of the Bundesbank Axel Weber told a delegation in New York that he thought the ECB purchase of bonds drawn on the Eurozone’s more vulnerable countries “should now be phased out permanently”.

Then in an interview with the Italian newspaper La Stampa this morning, Jean-Claude Trichet, head honcho at the European Central Bank, was asked if he agreed with Weber’s comments. He replied that the “overwhelming majority” of ECB members were not in favour of discontinuing the bond purchases.

What makes the debate all the more interesting is that many have tipped Weber as the next president of the Eurozone central bank.

Germany is of course hugely resentful of the debtor countries within the Eurozone. The idea of bailing them out is an anathema to Germany.

And yet it is thanks to the problems in Greece and the rest that the euro is so cheap, which in turn is boosting German exports.

Germany may hate the way the Eurozone is bailing out countries that didn’t adopt its more prudent ways, but the alternative would be for it to leave the euro. This is what Nobel Laureate Joseph Stiglitz recently predicted.

See: Germany may pull out of Euro, predicts Joseph Stiglitz

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