EEF blog

Today’s producer prices data reflect what surveys such as the PMI have been pointing to for the last few months: input price rises are starting to ease. 

Although prices were still up by over 14% in the year to October, this was the lowest annual increase since December 2010. What is more, between September and October prices actually fell back a little, mainly reflecting price falls in crude oil, imported metals and home produced food.

This will provide some comfort for the Monetary Policy Committee, which has argued that consistently above-target inflation has been largely caused by external pressures that should start to abate in the next twelve months.

Based on this view, the MPC announced yesterday that it would keep the base rate on hold at its record-low level of 0.5% and continue to add to its stock of asset purchases up to a value of £275bn over the next three months. This loose monetary policy also reflects the MPC’s belief that demand – at home and abroad – will be so weak as to risk inflation falling below target in the medium term.

But these arguments are disarmingly similar to those we have heard from the MPC from some time. And inflation has remained high. In December inflation will have been above the MPC’s target rate of 2% for two years.

Ahead of the Bank’s Inflation Report next week, here is a quick overview of what’s kept inflation above-target:

Two years of temporary factors

1) VAT

The two increases in VAT, in January 2010 and January 2011, both had a year-long impact on the figure for CPI. This effect will fall out of the figures in January 2012.

VAT has a significant impact on consumer prices

12-month % change in CPI and CPIY (CPI excluding indirect taxes)

Source: ONS, 2011

2) Exchange rate depreciation

Though its impact was less marked this year than in 2010, the depreciation of sterling which started in mid-2007 added significantly to the cost of imported goods, thereby feeding through into consumer prices.

In the past year sterling exchange rates have been much more stable, and though high levels of uncertainty in Europe mean that this could change, there is no particular reason to think that sterling will drop significantly in value, as most commentators now believe the currency is closer to its true value.

3) Commodity price rises

As I have pointed out, pressure on producer prices has started to abate in the last few months. Weaker global demand would point to this trend continuing.

Although previous energy price-rises meant that energy providers have recently passed on big price rises to their customers, even this should work its way out of the inflation statistics by September next year.

Producer prices have stabilised in recent months

Producer Prices Index, Input Prices (2005=100)

Source: ONS, 2011

Back when the “credit crunch” started, we all suddenly started talking about Libor (the inter-bank lending rate). We saw Libor shoot up, and cause all sorts of liquidity problems for banks. A rapid series of rate cuts by the Bank of England ameliorated this to some extent, and in last the year or so Libor has been broadly stable.

But this is an indicator which wasn’t stay out of the limelight forever. As the Guardian flagged up yesterday

The key measure of financial stress in the British banking system - Libor, the London Inter-Bank Offered Rate - rose again this morning to within a wafer of 1% for the first time since the 2008 financial panic.
…
the banks are [now] charging each other almost twice as much as the Bank of England's base rate of 0.5% to borrow money for three months. 

Libor starts to creep up
Spread between 3-month inter-bank lending rate and Bank of England base rate

Source: Bank of England

The spread between Libor and the base rate is only part of the story. With the base rate still at 0.5% the actual Libor rate of 1.03% is markedly lower than the rate of 6.85% the measure hit in September 2007. But the fact that Libor is starting to creep up suggests that Eurozone fears may be spreading to the British banking system. A worrying sign: Libor is a measure to watch.

This is the backdrop as the Monetary Policy Committee announces its latest monetary policy decision. Having announced a four-month program of asset purchases last month, it is unlikely that the MPC will go further today, though as uncertainty spreads, further monetary easing in the next few months cannot be ruled out.

Charlie Bean, deputy governor of the Bank of England, gave a speech earlier today in which he laid out “why the [Monetary Policy] Committee’s view of the outlook has shifted so dramatically” compared with earlier in the year, when the recovery seemed to be broadly on track.

Bean is at pains to point out that slowing growth not confined to the UK. Growth in the Eurozone still appears to be weakening, and recent signs of improvement in the US are still vulnerable to domestic and global events. Even emerging economies are slowing as a result of policy designed to avoid over-heating.

Bean believes there are two key reasons for slowing growth:

1. Heightened tension in financial and bank funding markets associated with the twin euro-area banking and sovereign debt crises, which has damaged confidence and caused businesses to hold back on investment. (see our blog on why what happens in Europe matters)
2. The substantial rise in energy and commodity prices during the latter part of 2010/early 2011 which has added to the squeeze consumers were already facing on their incomes.

Despite the fact that inflation has hit household spending – and therefore contributed to lower growth – Bean thinks that the outlook for weaker UK growth in the next couple of years means that the level of inflation will undershoot its target in the medium term without monetary intervention.

The Bank releases its quarterly inflation report on the 17th November, this will be a chance to see a little more on how their forecasts have changed. But one thing is clear: next Thursday's announcement on the MPC's latest decision is likely to reiterate the ongoing need for  loose monetary polucy.

This is a summary of the MPC minutes - you can find the full version here. 

Financial markets

• Increased stress in financial markets associated with euro governments and banks is reflected in volatility in asset prices and a reduction in liquidity across a range of markets.

• Stresses on short-term funding markets are driving up costs for European banks, including UK banks. Domestic lending in the UK could be affected if higher costs persist.

International economy

• European activity indicators have weakened, particularly in the periphery, but indicators even for France and Germany suggest flat output.

• U.S. indicators mixed with encouraging signs of investment in quarter 3 like to be short-lived as business and consumer confidence are weak. The passage of Obama’s $450 billion stimulus bill through Congress looks uncertain.

• Some gradual slowing in activity in China. The rebound in activity in Japan following the earthquake and tsunami also looks to be short-lived with weak prospects beyond 2011q3.

Money, credit, demand, and output

• The latest revisions to national statistics have revised up the contribution of net trade to growth from the onset of the financial crisis through the recession and into the recovery. This is now more in line with what was expected given the depreciation in sterling.

• Business surveys suggest weak growth in 2011q3 in both services and manufacturing sectors.

• Mixed evidence on the weakening of external demand for UK exports with CIPS/Markit PMI suggesting falling demand but other surveys suggesting this is holding up, particularly to markets outside Europe.

• Credit conditions have remained tighter since the financial crisis but no sign yet that recent financial market turbulence has tightened conditions still further.

Supply, costs, and prices

• MPC expected inflation to rise above 5% in the short term [as it has, to 5.2%] before falling back sharply in 2012 as VAT and oil price rises fall out of the series.

• Inflation expectations as measured by surveys of households remain unchanged while implied expectations through financial markets have fallen somewhat – though such implied expectations are volatile in times of financial stress.

• Excluding the impact of bonuses in some sectors, recent data suggests wage growth remains modest.

• The degree of slack in the labour market is a key factor in determining how much additional downward pressure there will be on  inflation.

Immediate policy decision

• The main upside risks to inflation in the medium term are expectations of higher inflation becoming embedded in wage and price-setting behaviour, lower spare capacity in the economy than thought, and another rise in commodity prices.

• No recent data suggest any strengthening in the upside risks.

• The main downside risk to inflation in the medium term is weak demand being unable to absorb the spare capacity in the economy.

• Ongoing problems in the eurozone area and the strains these are putting on financial markets have increased recently and the outlook for the UK economy had weakened.

• The MPC voted unanimously for Bank Rate to be maintained at 0.5% and also unanimously to finance a further £75 billion of asset purchases (QE).

The Governor of the Bank of England believes inflation is heading down. And, as Chris Dillow’s article on Investors’ Chronicle today points out,

It’s highly likely that inflation will fall a lot next year. Basic maths tells us as much.

He’s referring to the statistical composition of the inflation data, which means that over the course of the next year the impact of VAT and energy price rises will fall out of the measure and bring inflation down.

There are other – non-mathematical – reasons to believe that inflation might fall in the coming months too. Global economic weaknesses are likely to hold down the demand pressures that would ordinarily push up prices.

But, as Dillow points out, there is an alternative view that inflation could still rise. As Jeremy Warner over at the Telegraph notes:

The problem with inflation, repeated historical experience has demonstrated, is that once out of the bag, it is extremely difficult to put back in. There is only so much wage erosion through inflation that people will take before they start to demand compensating pay rises.

Also – as both writers add – in the medium term inflation is likely to be pushed up by the recent extension of quantitative easing.

The question remains: which of these factors is likely to play a bigger part? We will know the Monetary Policy Committee’s view of this when they release their minutes tomorrow morning.

Tomorrow morning ONS will release the figure for CPI annual inflation in September. CPI inflation is widely expected to come in at over 5%, as energy price rises start to hit consumers.

As our forecasts show, this should be the peak for inflation, and recent comments from the Governor of the Bank of England suggest that inflation is now likely to fall below its 2.0% target in the medium term.

CPI inflation likely to edge over 5% in September, before falling back
Forecasts for annual % change in consumer price index  

In interviews following the bank’s latest interest rate decision, the Governor said he believed that the rate of inflation should fall back as temporary factors such of the VAT rise fall out of the measure, and weaknesses in the UK and global economy continue to weigh on demand.

There are still upside risks to inflation, though, particularly if increased inflation expectations begin to feed through to pay settlements, but the minutes from September’s MPC meeting suggest that this is less of a concern while the economy remains weak.

What to watch:

• There will be more information on the MPC’s latest thinking on Wednesday, when the minutes from the October meeting are released.
• We will also be releasing our Pay Settlements survey this week, which will give an indication as to whether industry is being affected by higher wage expectations (see last month’s press release).

On Monday, Chancellor George Osborne announced at the Conservative Party Conference that his officials were working on options for credit easing. Since then there has been intense speculation about precisely what he means by this.

Yesterday the Governor of the Bank of England, Sir Mervyn King, did a round of interviews explaining the MPC's decision to start QE again by voting to extend its asset purchases facility by £75 billion. The focus for the purchases will very much be gilts (rather than a riskier range of private sector assets).

This morning, the Chancellor was again speaking, this time on The Today Show to discuss QE and his own announcement. Some interesting thoughts came out of this.

The Chancellor repeatedly stressed that both he and the Prime Minister have been consistent since they were in opposition in saying that the current situation called for fiscal prudence but monetary radicalism. Like Monday he again seemed to be pushing the idea that his credit easing policy was in the monetary sphere of macroeconomic policy.

But he also noted that it was the bank's domain to expand the volume of credit (via QE) but the government's to steer it to where it needed to go in the economy, including to SMEs (via CE).

Asked further what credit easing meant, the Chancellor said there were several options being explored. He mentioned the relative size of the UK's corporate bond markets compared with those in the U.S. In the UK minimum corporate bond issuance seems to be £100-200 million. In the U.S. as little as $25 million can be raised in these markets.

This has been an issue floating around 1 Horse Guards Road (HM Treasury) since at least July 2010 as it was included in the government's access to finance green paper as a weakness in the UK funding environment that may need strengthening.

No doubt this is a weakness worth looking to strengthen. But I wonder if it is the priority. SMEs (say firms with turnover of up to £25 million) are consistently reporting the worst access to finance. Even if corporate bond markets could be made as accessible tomorrow as in the U.S., this isn't going to help SMEs.

So this suggestion seems to me more about having a meaningful outcome from the government's current Mid Caps Growth Review than targetting the most important problems afflicting the flow of credit to SMEs.

The government action is a little unclear too. Are they going to create demand by buying these bonds - with fiscal implications? Are they going to try to bring down some of the hurdles companies face to issuing bonds - such as fees from ratings agencies? And how quickly will this influence change, even were the government sitting ready to buy billions of corporate bonds tomorrow, will companies be in a position to issue them?

On the one hand:

QE could support growth (the Bank of England's Quarterly Report suggests that it does)

But on the other:

QE could cause the “wrong kind of inflation” as it pushes up CPI and RPI (through exchange rate effects) without necessarily increasing domestic prices charged and wages paid.

This means government expenditure has to go up (as benefits and other payouts are uprated with CPI/RPI inflation) but tax receipts linked to profit and income might not rise to compensate for this.

I wouldn’t be surprised if the Chancellor starts looking for a one-handed economist…

Osborne's announcement today that his officials are working on ways to introduce 'credit easing' has certainly created a lot of buzz.

He said in his speech that it was similar to the national loan guarantee scheme that the Conservatives had cooked up in opposition. But he also said it was another example of 'monetary activism' - a policy stance favoured by himself and Mr Cameron.

In other countries, notably the U.S., credit easing has meant the central bank changing the mix of assets it holds to include riskier, private sector assets as well as top-rated govt securities. The idea is that by buying private assets, like corporate bonds, directly, banks are freed up to lend more (and perhaps more riskily) directly to businesses.

If this credit easing were to happen at the same time as the central bank expanded its balance sheet (quantitative easing) the idea is the transmission could be more direct to the real economy, rather than relying on the portfolio effect of central bank demand for government securities encouraging financial institutions onto riskier assets.

By contrast the national loan guarantee scheme seemed to be an amped up version of Labour's Enterprise Finance Guarantee Scheme (which itself replaced the Small Firms Loan Guarantee Scheme). Here the government provides partial guarantees on loans made by commercial banks in return for fee. The coalition opted to extend the scheme in 2010 rather than bringing in the national loan guarantee scheme.

So which is it? Lot's of speculation already doing the rounds.

I think Osborne means the central bank getting involved in buying a wider range of assets. He was apparently glad-eyed about Adam Posen's  speech on alternative ways of doing QE a couple of weeks ago. The credit easing here could go in tandem with creating a securitising entity - like the 'Bennie' Posen proposed.

Plenty of questions about how credit easing might work:

• How well placed is the govt to assess risk of private assets?
• Does the risk of private assets turning bad create a fiscal liability that HMG must reflect?
• How quickly can an entity securitising loans to SMEs be created?
• Is the additional risk any kind of threat to the govts fiscal credibility?

Frenzied build-up to the Autumn statement begins now...