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Stamping down on foreign flows into UK property could be sterling suicide

So now we know what the Bank of England intends to do about the UK’s housing market, a market that Governor Carney has previously referred to as the biggest risk to financial stability and therefore to the economic expansion (the IMF and the EC had similar warnings).The answer, in short, is not much at the moment – while Carney is not “happy” with the buoyant UK housing market, he is willing to “tolerate” it.

Before wondering what to do – and what not to do – about the housing market, it’s worth asking whether the UK housing market is in a bubble. It’s not as crazy a question as you might think – in real terms (i.e. adjusting for inflation), UK house prices rose by just +1.2% per annum from 1974 to the end of 2013, and by 2.2% per annum from 1974 to the end of 2007. It was the early noughties when things got crazy, as UK real house prices saw double digit returns in four consecutive years from 2001-2004 – strip out these years, and UK real house price growth has actually been negative in the last four decades*. But even including 2001-04, if you consider that the UK’s productivity growth since the mid 1970s has averaged about 1% per annum, and that UK population growth has averaged 0.3% per annum over this period, then small positive real house price growth doesn’t appear hugely alarming.

That said, 40 year average price changes don’t tell the whole story. The performance of the housing market in the past year is remarkable – UK house prices were up 11.1% in nominal terms in the year to May according to Nationwide, which is still a long way short of the 2001-04 bubble years, but is the fastest pace since then. Meanwhile data from the ONS shows that nominal London house prices rocketed 18.7% in the year to April. These rates of growth are well in excess of inflation, and well in excess of wage growth.

What is causing the recent jump higher in house prices? By definition the answer is an excess demand versus a lack of supply, although almost all commentary on the UK housing market seems to focus primarily on the latter rather than the former. Public debate about UK housing has been strongly influenced by then MPC member Kate Barker’s government commissioned 2004 review of housing supply, where she argued that ‘the long-term upward trend in house prices and recent problems of affordability are the clearest manifestations of a housing shortage in the UK’, and that the UK needed to build up to 260,000 new homes per year to meet demand. In the decade since the report was published, less than half this figure has been built, suggesting a shortfall of 1 million houses has accumulated.

But is the spike in house prices really all down to supply? As Fathom Consulting have pointed out, if there was a housing shortage then why haven’t real rent costs jumped higher? The chart below plots nominal wage growth versus UK rent costs back to 2001 – rent costs were actually increasing at a slower pace than wages pre-2008, and have only been running fractionally above wage growth more recently. If there was a supply shortage, then we would expect to see real rent costs increasing quite sharply as people become forced to spend more on housing as a percentage of their income, but this isn’t the case.

Slide1

The next chart suggests that the pick-up in house prices that began last year is much more likely (as always) to have had more to do with demand, namely lower mortgage rates and easy mortgage availability. The left hand chart is from the Bank of England’s recent Financial Stability Report, and shows the loan to income ratio on new mortgages advanced for house purchase. Around 10% of new mortgagees are now borrowing at a loan to income ratio at or in excess of 4.5 times income. Over half of home buyers are now having to borrow at 3+ times income, which is a ratio about 5 times higher than immediately before the UK housing market crash of the early 1990s. It’s striking how closely correlated loan to income ratios (left chart) are with house prices (right chart). It suggests that limiting loan to income ratios will also serve to limit house price appreciation, although the correlation doesn’t necessarily imply causation. It could be that a jump higher in house prices forces buyers to take on more debt, since only additional debt will make it possible to get onto the bottom rung of the housing ladder**.

Slide2

The other growing source of demand for UK property is likely to be overseas investors. When sterling collapsed post the 2008 crisis, the assumption was that the UK would see an export-led recovery thanks to a huge improvement in its competitive position. Unfortunately, this didn’t really happen, because the UK’s big export – financial services – was in little demand post crisis. UK exports did initially pick up, but today are only 10% higher than at their peak in 2008, and have moved sideways since 2011. Spain’s exports, in contrast, are almost 30% above 2008 levels in euro terms, despite the euro strengthening against sterling over the period.

Sterling depreciation may not have resulted in a surge in exports of UK goods and services, but it does appear to have led to a pick-up in a new kind of export – London’s housing stock. Savills, an estate agent, estimates that overseas equity into just prime London residential property was above £7bn in 2012, and presumably it was higher still in 2013. Overseas buyers have always been involved in London property thanks to market transparency, liquidity, political stability, a clear rule of law, decent education, and low taxes versus countries such as France or Spain, but the 2012 inflows were twice the amount seen in 2008 or 2009, and about a third higher than in 2006.

It’s easy to see why overseas buyers have taken a shine to UK property from the chart below. British houses feel far from cheap in local currency terms, but they look considerably cheaper from the perspective of all the traditional foreign buyers, with the exception of Russians. From the perspective of Chinese investors, London house prices are still 17.5% below their 2007 highs when measured in Chinese Yuan.

Slide3

The Bank of England’s strategy for reducing domestic demand for UK housing via macro-prudential measures such as limiting loan-to-income ratios should be the primary way to tackle the destabilising effects of housing related indebtedness, and the Bank of England arguably could have done more. Stemming foreign flows into the UK housing market is much more attractive politically, but could be very unwise.

Data from last week showed that the UK’s current account deficit improved slightly in Q1 2014, but Q4 2013 was downwardly revised to 5.7% of GDP and Q3 2013 to 5.9%, a worrying new record. Of the so-called ‘Fragile 5’ emerging market countries, only Turkey had a bigger deficit in Q4.

A current account deficit is a broader measure of a country’s trade balance. The UK’s large deficit can be attributed to various factors (e.g. a sustained trade deficit, a deteriorating income balance which may partly reflect an increase in foreign companies taking over British companies, and sustained budget deficits), but generally speaking a chronic current account deficit is indicative of competitiveness problems. The chart below shows that a large and deteriorating UK current account balance has historically preceded a sterling crisis, where a sharp depreciation in sterling subsequently restored the UK’s competitiveness, and hence its current account balance. If you consider that foreigners buying new build houses in London is little different to foreigners mass buying Scotch Whiskey in terms of its effects on the national accounts, then proposals to tax foreign buyers of London property is the equivalent to taxing your own exports! Not a very clever thing to do with such a precarious current account balance. Note that taxing exports is considerably worse than protectionism, which typically involves taxing imports.

Slide4

Macro prudential controls are a positive step and should help curb some of the local mortgage excess that has built up over the last couple of years. However, those pointing to supply-side factors as the primary reason for higher prices aren’t viewing the whole picture. UK property is cheap from an overseas perspective and will likely remain in demand to foreign buyers looking for solid returns in a low-yielding world. And beware the clamour of calls to stem foreign inflows into the UK housing market, which is turning into one of the UKs most in-demand exports. Of course, if macro prudential measures fail to take some of the heat out of the market, the Bank of England could always raise interest rates (if only they could remember how to….)

*This is calculated using UK RPI and the UK Nationwide House Price Index. Given there are methodological issues with both RPI and Nationwide data, it’s worth treating the calculation slightly cautiously – for example, UK RPI has averaged 0.9% higher than UK CPI since 1989, so real house prices appreciation is an additional 0.9% p.a. on a CPI basis.

**The recent nudge higher in both house prices and the move higher in first time buyer loan to income ratios is likely to have been assisted by the help to buy scheme (or the ‘help to sell scheme’, as we called it at the time), although given that as at the end of May, only 7313 houses were sold under the scheme with the total value of mortgages supported by the scheme at £1bn, there are other forces at play.

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Who is to blame for shrinking real wages in the UK? Nobody?

The squeeze on UK consumers through falling real wages has been regarded as a significant factor in the (until recently) anaemic economic recovery.  Employers have taken a good share of the blame for this – but is that fair?  Have employers deliberately kept earnings below inflation as a means of boosting their own profitability, or was this an unintended outcome of upside inflation shocks?

If we look at Eurostat’s nominal wage growth series in the UK since the credit crisis, it’s only in the last couple of years that nominal wage growth has been well below the Bank of England’s inflation target of 2%.  In 2008 nominal wage growth was 6.1%, 2009 1.8%, 2010 3.6%, and 2011 2.1%.

It’s only in 2012 that Nominal Wage Growth fell way below the BOE’s inflation target

And yet over those same years, Labour Productivity per Hour Worked (again Eurostat) was awful.  -1.2% in 2008, -2.3% in 2009, +1.1% in 2010, and +0.7% in 2011.  In other words companies appear to have, ex ante, attempted to compensate their workers for expected inflation, assuming that the Bank of England hit its inflation target, and have overcompensated them, ex post, for improvements in productivity.

Labour productivity has been very weak – and often negative

So has the problem for earnings been the unexpected inflation overshoot (since the credit crisis started CPI has been above the Bank’s 2% target in all but 6 months, in 2009), not the wage setting behaviour of companies? Had inflation come in at, or above target, workers would have been better off in real terms until 2012, and certainly better off than you might expect given the historically strong relationship between wage growth and productivity.  I’m not sure I’m blaming the Bank of England here either – to achieve the 2% inflation target, rates would have had to have been inappropriately high for the domestic demand conditions and the distressed balance sheet of the UK public and private sectors.  And productivity is weak in part because employment has been unexpectedly strong relative to the weakness of the economy.  So a low inflation, high productivity UK economy sounds nice – but in the circumstances would likely have only have been possible with a much deeper recession and higher unemployment rate.

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Winners of our @inflationsurvey competition. The M&G YouGov Inflation Expectations Survey for 4Q 2013 will be released next week.

Beginning of November, we published a blog announcing the release of our Q4 YouGov Inflation Expectations Survey for early December. We are now in the final stages of collating and analysing the survey results and will publish the full report in the coming days on Twitter (@inflationsurvey) and our bond vigilantes blog. For those of you who are not aware (where have you been?!), the survey was created by M&G’s retail fixed interest team in partnership with YouGov. We ask over 8,000 consumers from the UK, Europe, Hong Kong and Singapore what their expectations are for inflation over the next 1 and 5 years. This has grown ever more important as central banks have sought to manage interest rate expectations through forward guidance.

The results of the Q3 Survey published last September as well as previous surveys are available here.

So congratulations to the 15 winners listed below, who were chosen at random amongst all our @inflationsurvey followers and who will each receive a copy of Frederick Taylor’s “The Downfall of Money”. We will DM each of you asking for your address so we can send you the book.

Simon Lander @simonlander01
Britmouse  @britmouse
Ian Burrows  @ian_burrows
Richard Lander  @richardlander
Iain Martin ‏  @_IainMartin
Morningstar UK ‏  @mstarholly
Brian Simpson ‏  @simpsob1
Amir Rizwan  @amirriz1
Tim Sharp ‏  @tm_sharp
Leanne Hallworth ‏  @leanneha41
Kevin Fenwick @kevinfenwick
Nico  @nicolocappe
qori nasrul ulum  @reme_dial
Alexander Latter  @AlexanderLatter
Ace AdamsAllStar  @AceAdamsAllStar

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Competition: follow @inflationsurvey on Twitter to have a chance to win one of 15 copies of The Downfall of Money by Frederick Taylor

At the end of October, the Citigroup Inflation Expectations survey showed a record jump in UK inflation expectations. The medium term expectation for UK inflation rose from 3.3% in September to 3.9%, and the number of people expecting inflation over 5% also rose significantly. Inflation expectations have become increasingly important in the UK because, as part of Bank Governor Carney’s new forward guidance regime announced in August, the Bank can raise rates even if unemployment remains high if inflation expectations become “unanchored”. Of course the period when the Citigroup survey was conducted was one where the major UK energy suppliers had announced annual price hikes of around 10%, and this spike in inflation expectations may well not persist. But it will have worried the Bank, and the gilt market fell on the release of the data.

Whilst UK inflation was making the news for its potential to surprise on the upside, Europe faced a very different scenario. October’s euro area CPI reading came in at an annual rate of 0.7%, down from 1.1% in September and below the market’s expectations. A Taylor Rule would suggest that with inflation so far from the ECB’s target of 2%, the central bank should be aggressively easing monetary policy (beyond today’s 25 bps cut, and beyond the zero bound to include QE?).

The next M&G YouGov Inflation Expectations Survey for the UK, European and Asian economies will be released in December. These M&G YouGov surveys are based on the best practice methodology discussed by the New York Fed (for example asking people about inflation rather than “prices of things you buy” as that sort of question tends to make people think solely of milk, bread and beer). We also have a bigger data sample than many of the other inflation surveys. Finally we also ask some interesting supplementary questions on issues like government economic policy credibility. As inflation expectations become increasingly important to central banks we think that we need to pay more attention to them – to date they have been well anchored, despite money printing through QE, but if this changes then so will central bank behaviour.

The Q4 M&G YouGov Inflation Expectations Survey will be released through Twitter. Follow @inflationsurvey to get the release time and date, and also to access the detailed report in December. The feed will also tweet on other inflation surveys and measures of inflation expectations. We hope you find it useful.

To encourage you to follow @inflationsurvey and be first to get the survey results, everybody who does so (and existing followers) will be put into a draw to win one of 15 copies of Frederick Taylor’s The Downfall of Money. This is the story of Germany’s hyperinflation of the 1920s, where the Reichmark fell to 2.5 trillion to the US dollar, and the economy collapsed – arguably sowing the seeds of the Second World War.

9781620402368

Click here for terms and conditions.

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In search of satisfaction – our analysis of the BoE press conference

Listening to the Bank of England Quarterly Inflation Report press conference – the first with Mark Carney steering the ship – a song immediately sprung to mind. The song was written by a former student of the London School of Economics, Sir Michael “Mick” Jagger with his colleague Keith Richards in 1965. There is no better way to analyse the current thinking of the Bank of England than through one of The Rolling Stones best songs, (I Can’t Get No) Satisfaction.

I can’t get no satisfaction

The new BoE Governor began with the positive news that “a recovery appears to be taking hold”. This wasn’t news to the markets, as more recently we have seen a remarkably strong string of economic data. However, the very next word in Mr Carney’s introduction was “But…”. What followed was, in my opinion, the most dovish sounding central bank policy announcement since the darkest days of the financial crisis.

Carney firmly announced his arrival as the global independent (excluding BoJ) central banking community’s uber-dove through the acknowledgement of a broadening economic recovery in the UK, and then making explicit that the BoE remains poised to conduct more, not less, monetary stimulus. Until now, these two conditions were considered by bond markets to be pretty much incompatible.

’Cause I try and I try and I try and I try

Carney told us that the BoE will maintain extreme monetary slack (in terms of both the 0.5% base rate and the £375 billion of gilts held) until the unemployment rate has fallen to at least 7%. He went even further than this, stating the MPC is ready to increase asset purchases (QE) until this condition is met. However, there are two conditions under which the BoE would break the new, explicit link between monetary stimulus and unemployment: namely, high inflation and threats to financial stability. Did the new governor have to put these caveats in place because other members of his committee would only agree to the announcement if they were mentioned?

Supposed to fire my imagination

The new framework announcements were broadly in-line with what we were expecting. In that respect, the Governor’s major announcement was not too much of a surprise. The market agreed and there was a relatively muted response. Carney was supposed to fire our imaginations, so the question is – did we learn anything new? The “yes” and “no” arguments are outlined in the below table.

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When I’m watchin’ my T.V. and that man comes on to tell me how [the economy should] be…

The market suspected Mr Carney would bring in some forward guidance, but I think the most interesting implication of this announcement today is that he felt the need to do something, but did not feel the need to increase asset purchases through QE. Mervyn took on the first part of Friedman’s equation, the supply of money. This was not inflationary as the transmission mechanism was broken, and the cash was hoarded and not released into the real economy. Could Carney be the governor to focus on the second part of the equation, money velocity? Forward guidance is designed to give individuals and companies the confidence to borrow in order to spend or invest. If they do, velocity will return as the transmission mechanism repairs. I believe we are considerably less likely to see an increase in QE under the new governor.

If forward guidance does not have the consequences Carney intends, and my belief that he is more focused on the transmission mechanism than his predecessor, what might Carney do next? At that point, he might increase schemes akin to Funding for Lending, and hand banks cheap funds at the point at which the banks release the loans to borrowers. This way, banks are heavily incentivised to lend at levels that are attractive to individuals and companies.

He’s tellin’ me more and more, about some useless information

Carney told us that if and when unemployment reaches 7%, policy will start to tighten. But then he stated that if inflation exceeds 2.5% on the BoE’s shocking 2 year forecast (is this a rise in the inflation target?), or if inflation expectations move beyond some unannounced bound, or if financial stability is under threat, then he might have to break the newly explicit link between unemployment and monetary policy. And then he stated that even if unemployment hits 7%, this will not trigger a policy change, but a discussion around one.

I don’t think we actually got pure forward guidance, but a pretty muddled variant thereof. Bond markets are rightly unsure as to how to react, and have struggled for a satisfying interpretation. All we can really take from the BoE is that they will need to be sufficiently satisfied that the UK economy has reached escape velocity before hiking rates or reversing policy.

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The King speech

Today is the last inflation report for Mervyn King, Governor of the Bank of England. He has served the bank for many years and has been the key figure at the bank for the past eight years.

King’s abdication (retirement) is a time to reflect on his achievements at the top. A keen football fan who happily uses soccer analogies, King would probably recognise his time as Governor has been a game of two halves.

The first half was great, with no apparent need to interfere with a perfectly balanced, strong growth, low inflation economy. The second half involved a great deal of stress and the need for intervention as the economy was weak, the inflation target was constantly missed, and he faced the financial equivalent of Chernobyl, as the banking sector began to meltdown.

King is not only a football fan but is also a regular sight at Wimbledon. Rudyard Kipling’s poem ‘If’ is the guide to how players should play on its perfect English grass courts. It is fair to say that King has appropriately treated success and failure in the same way.  I would argue that his failures were in the first half of his term and his strength and ability shone through in the second half of his term. Although his critics may say that the seeds of the financial crisis were sown under his watch.

I think the seeds of the UK financial crisis were as follows:

Inappropriately low interest rates in the USA following the tragic events of September the 11th.

The removal of bank supervision from the Bank of England by Gordon Brown.

The need to hit a rigid inflation target when the world was enjoying low inflation because of world trade and productivity growth meant the use of over stimulative policy, causing a boom to keep inflation on target.

The euro creation resulted in an unstable financial system in Europe.

The first three of these have been resolved with the passage of time, a change in UK banking regulation back to the old ways, and a move around the world to more flexible inflation targeting. The last – the issue of banking in the eurozone – remains unresolved, but there are strong signs that potentially successful attempts are underway to solve the dichotomy of banking support from sovereign states within the eurozone.

We are avid watches of the inflation reports, and will be watching it today. The journalists get to ask questions. If I was there these are the three I would like to ask:

1. What do you think of the euro as an economic concept?

2. How close were we to financial Armageddon?

3. How does QE work?!

Sadly I think Mervyn will be as discreet as always in the press conference. Let’s hope that when he is allowed to speak freely, we get to see a little less candour and more transparency and insight into what has been an exciting time to be at the bank.

I think history will show that Mervyn King did a good job in handling the crisis. After all, that’s what central banks were created to do as lenders of last resort. From an economist’s point of view, what does his leadership prove? Well, Goodhart’s law was again proving itself to be correct. You aim to be a boring central banker and look what happens!

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Funding for Lending – has the scheme achieved its goals?

As has been widely reported, last week the Bank of England and HM Treasury extended their Funding for Lending Scheme (FLS). The FLS was originally launched in July last year with the intention of stimulating lending in the real (non-financial) economy. Under this scheme a bank or building society borrows UK Treasury Bills and hands over eligible assets as collateral. The fee they are charged (effectively the interest rate) and the amount they can borrow are determined by how much they have increased their lending. The bank or building society can then either repo their T-Bills for cash or, more cheaply/likely, just use them to replace cash in their liquidity buffer. The more they lend the more they can borrow at the lower rate.

The BoE and HM Treasury have hailed the scheme as a success. But on what measure?

Today we received news that mortgage approvals had another weak month in March, increasing only slightly to 53,500. Mortgage approvals have been flat at around 50,000 per month since early 2010 and, considering last week’s extension to the programme incentivises SME lending more, it doesn’t look like the cheaper funding has spurred the desired increase in lending.

UK mortgage approvals chart

Further, with the average mortgage rate in the UK at around 4% and banks able to borrow at what the Bank of England estimates to be 0.75%, the lower rates clearly aren’t being passed on to the man on the street either. Assuming banks’ net interest margins aren’t the measure on which this programme is judged I think it’s fair to say it hasn’t been a huge success.

Unless that is, you happen to be an investor in asset backed securities. The UK Residential Mortgage Backed Securities (RMBS) market has rallied significantly since the FLS was first announced. Granted, most risk assets have rallied since last summer – partly down to Mario Draghi’s now famous speech – but I think that the UK RMBS sector has had an extra boost from the FLS.

Rather than issue RMBS, the banks and building societies have preferred to pledge their mortgage stock with the FLS which has provided a technical support for the market. The graph below shows the spread on an index of short dated, AAA, UK prime mortgage deals. As you can see they began their rally last summer and have been hovering around 50bps since the autumn. The lack of supply – we haven’t had a new public deal since last November – has certainly been supportive for spreads.

UK Prime RMBS chart

The Bank of England and the Treasury claim that the scheme has been a success mainly on the grounds that things would have been worse without it. Clearly we’ll never know. Whether things are better or not the FLS appears to have done almost exactly the opposite of what it set out to do. It was established to provide support to the non-financial sector, but as far as I can tell, to date it has actually made the financial sector marginally healthier and better off.

 

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Old Lady sells her bonds

Back in 2009 the Bank of England (the Old Lady of Threadneedle Street) began buying a portfolio of investment grade bonds to provide funding to UK corporates, to aid liquidity in the corporate bond market and to supplement their QE purchases of gilts. Last Friday this investor sold its last corporate bonds.

This has been a great success from a profit point of view. The attached chart shows the total return of an index of non-financial corporate bonds over the period of the bank’s purchases and sales as well as an indication of their total holdings.

I believe its actions helped stabilise the corporate bond market in the UK by providing a backstop bid, therefore helping to reduce the cost of funding at the margin for issuers, and would have added to the effects of QE. However, empirically measuring these effects is hard to do – corporate bond markets that experienced no domestic support from their central banks appear to have performed similarly, and the debate on the true effectiveness of QE remains.

What is the primary lesson we have learned? I think it is that state intervention can work where markets are priced inefficiently. This is illustrated by the large profits the bank has made by buying an out of favour asset class from the private sector. It is probably a good base to have the state intervene where markets are inefficient, for example in areas such as healthcare, defence, law and order, and infrastructure. The danger comes when the state interferes to the detriment of an efficient market. From an economic point of view, aggressive trade barriers are the first thing that comes to mind where there would be a great deal of consensus from the left and right side of politics. Other actions may depend on your economic or political view. The best current example of this is the single European currency experiment. Does it aid a free market via price transparency and low transaction costs, or does it hinder efficiency by having one single interest rate and exchange rate for such diverse economies ?

The Old Lady’s portfolio of corporates has served her and the UK well because she bought them at cheap levels from distressed sellers. Unfortunately, this investor has a significantly bigger portfolio of gilts. The carry and mark to market on these looks great. However, turning this unrealised gain into a realised profit still remains a challenge. If she comes to sell, her position is likely to drive the market against her.

old lady blog chart

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Monetary policy and the electoral cycle

When deciding economic policy, the buck, so to speak, is left with a combination of the chancellor and the Bank of England. This arrangement exists as politicians should have the final say in a modern democracy, but a modern democracy needs to have a brake on populist politicians, hence an independent central bank.

Today those worlds publicly collide, with Mark Carney, the next governor of the Bank of England, appearing in front of the Treasury Select Committee. This will hopefully give the markets and politicians a flavour of his approach to dilemmas the Bank of England currently faces given the UK’s current economic malaise. What kind of policy will Carney follow? Is he a natural dove or a hawk?

Well at a guess, he has been appointed by a chancellor who wants economic recovery for the benefit of the country, and from a political point of view, an economic recovery that will keep him and his party in power. It would therefore be fair to assume that when interviewing for the position, any respected German central bankers’ applications would have been put straight in the bin.

One can therefore assume that Carney has been chosen to reflect the need at this point of the electoral cycle for a bit of an economic boost. Indeed, yesterday Osborne was calling for a more dovish stance from the Bank of England.

Politicians in the UK have played loose with fiscal and monetary policy over the years. Did we join the ERM in 1990 to drop interest rates to help the conservatives retain power in 1992? A tightening of monetary policy by the creation of an inflation targeting Bank of England in 1997 aligned the economy to the electoral cycle in Tony Blair’s first term. The amendment of the CPI target by Gordon Brown in 2003 brought a handy monetary stimulus ahead of the 2005 election. Given the election is a couple of years away and monetary policy works with a general lag of 18 months, what is the chancellor to do two years ahead of the election this time?

It is an ideal time for him to meddle with monetary policy. With the changing of the guard at the Bank of England he will be able to liaise with a new governor to undertake reforms to make the economy work better, and therefore increase the chance of re-election. The simplest way to boost the economy in the short term is to change the inflation target. This can be explicit, or disguised amongst the current statistical reform of RPI and CPI measures.

The surprise for the markets over the next year could well be a combination of a flat economy encouraging a politically motivated chancellor, and a new central bank head keen to make an impression in his new job, working together to engineer higher growth and higher inflation via an explicit loosening of the inflationary target in the UK.

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Do Central Banks tell us too much for our own good?

I read in The Times last week that the Shadow Monetary Policy Committee (a panel of economists and Bank of England alumni) thinks that the Bank of England should announce a freeze on UK rates for an extended period of time. The Federal Reserve also had this policy (now replaced by even more explicit guidance about the unemployment rate and inflation levels), as did the Bank of Canada. In the past few years the Fed has spent weeks debating its communications strategy. Elsewhere we get monthly press conferences (including in Trichet’s time as head of the ECB the use of the explicit codewords “strong vigilance” which meant “rates going up next month”). We also get Inflation Reports and Financial Stability Reports, fan charts and GDP forecasts from which market economists pronounce that the Bank’s two year ahead projection means no more QE just yet. I wonder though whether we’re being given too much information, and that in telling us exactly what they are going to do, central banks risk either a) having to not change their policy even if economic circumstances mean that they should (for example if economic growth comes back strongly yet they’ve promised to keep rates on hold for years), or b) lose face, credibility and trust with the market by going back on their promise. Each of these actions has a cost, and should lower an economy’s potential GDP rate.

Is the promise of low rates forever fuelling the return of those Four Horsemen of the Bondocalypse – CLOs, PIK notes, CCC rated high yield issuance, and mega – LBOs? Does it lead to complacency in investment? To schemes that can only survive if rates don’t ever rise? Is current central bank policy generating asset bubbles? And what are central bankers left with, without the ability to surprise and shock? Worse still, what if “low rates forever” has the opposite effect than intended? Does it say “doomed, we’re all doomed”? Perhaps central bankers should realise that keeping us guessing is their most powerful tool (OK maybe QE Infinity is their most powerful tool, but still).

The clip below is of Diego Maradona, scoring against England in the Mexico World Cup finals in 1986.

I was reminded of it when I picked up a copy of Steve Hodge’s autobiography The Man With Maradona’s Shirt in the sales. Maradona was fortunate enough to swap shirts with Nottingham Forest legend Hodge after that game. Anyway, back in 2005 Bank of England Governor gave a speech in which he said the most interesting thing a central banker ever said.

“The great Argentine footballer, Diego Maradona, is not usually associated with the theory of monetary policy. But his performance against England in the World Cup in Mexico City in June 1986 when he scored twice is a perfect illustration of my point. Maradona’s first “hand of God” goal was an exercise of the old “mystery and mystique” approach to central banking. His action was unexpected, time-inconsistent and against the rules. He was lucky to get away with it. His second goal, however, was an example of the power of expectations in the modern theory of interest rates. Maradona ran 60 yards from inside his own half beating five players before placing the ball in the English goal. The truly remarkable thing, however, is that, Maradona ran virtually in a straight line. How can you beat five players by running in a straight line? The answer is that the English defenders reacted to what they expected Maradona to do. Because they expected Maradona to move either left or right, he was able to go straight on. ”

If Maradona had put out a press release and a booklet explaining exactly what he was going to do, it could never have happened. But by keeping the England team guessing and by shifting his weight from left to right (the footballing equivalent of raised eyebrows) he scored the greatest goal of all time.

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