Lessons from Zimbabwe

Posted on 19 April 2013 by Nicolo Carpaneda

Stefan took some time off over Easter for a quick holiday in Zimbabwe and, as always, he remained on the lookout for economic insights.

As the only country to experience hyperinflation this millennium, Zimbabwe can certainly provide valuable lessons. From late 2008 its inflation was estimated to be running at a staggering 489,000,000,000% on an annual basis. The economy collapsed, and the population suffered food and fuel shortages, amid a mad dash for foreign currency.

Zimbabwe’s experience is particularly pertinent at a time when central banks are experimenting with unprecedented levels of monetary easing. At times, politicians may view inflation as a convenient way to reduce exorbitant debt burdens but inflation is a dynamic force and Zimbabwe’s cautionary tale teaches us to be careful what you wish for…

UK inflation: the Bank of England would have to generate significant disinflation in the majority of goods we consume to hit the 2% inflation target, killing any recovery. Food and administered price rises are the problems.

Posted on 26 March 2013 by Anjulie Rusius

With the UK’s 2% CPI inflation target having now been exceeded for 39 consecutive months, last week’s budget formally acknowledged the on-going situation and changed the Bank of England’s remit.

Although chancellor George Osborne maintains that medium-term price stability represents “an essential pre-requisite for economic prosperity”, the updated remit simultaneously introduces the concept of flexible inflation targeting in the short term, asserting that the Bank of England committee “may wish to allow inflation to deviate from the target temporarily” in exceptional circumstances, i.e. as the result of shocks and other disturbances. In short, inflation targeting looks like it will continue to take a back-seat to the pursuit of growth and employment with the chancellor accepting that inflation is likely to rise further and may remain above the 2% target for the next two years. It is also interesting to note that there is no restriction on how far inflation is permitted to deviate from its target, nor has any time limit been set for any such deviations.

Allowing more flexibility simply reflects the reality, and it can therefore be argued that this is probably based on the theory that whilst current inflation rates are hurting consumers, hiking rates to bring inflation down – by raising mortgage and loan rates – would hurt even more. Wage growth is only just above 1% per year, so the authorities perhaps feel that overshooting the inflation target is unlikely to create an inflationary spiral based on rocketing pay settlements.

Citigroup’s Michael Saunders has presented an interesting piece of research which he believes breaks down the root causes of inflation stickiness. The research shows that for most of the inflation basket, there isn’t a problem and for the 27% where there is a problem, it is not clear that hiking rates would be a solution.

The first graph demonstrates the inflation generated from demand-insensitive areas (e.g. goods that have relatively static demand curves, regardless of changes in the price) such as utilities, education, tobacco, food and alcoholic beverages. This part of the basket contributes to 27% of the overall CPI figure. In recent years, this proportion has persistently exceeded the Bank of England’s 2% target thanks to formulae on these prices which allow “inflation plus” rises, and in the case of food, volatile weather. The Bank of England explains this away by treating it as a one off shock; Michael Saunders argues that this portion of the CPI basket is seeing a consistent series of small shocks, and is therefore predictable. Therefore in order to compensate for the above-target growth in price level of these prices, the inflation rate of the remaining portion of the basket of goods would have to see much lower inflation to offset this and to meet the 2% target. The required adjustment is demonstrated by the green line in the second graph, while the actual inflation rate for this portion of the CPI basket is shown in yellow.

As you can see, Citigroup’s research shows that the actual inflation rate for the remaining portion of the CPI basket of goods must fall considerably ( from around 2% per year to around 0.7% per year) if the formal 2% inflation target is to be met. Indeed, in the aforementioned Bank of England remit, George Osborne himself concedes that the impact from both regulated and administered prices have together contributed to the persistent inflationary environment.

It is subsequently made clear that in the current environment of deliberately loose monetary policy and the ensuing departure from the inflation target, UK above-target inflation is baked into the cake unless the Bank of England tries to depress demand for the remaining demand-sensitive proportion of the basket. If this inflation overshoot is not curbed over time, this could potentially affect expectations of future inflation, calling the Bank of England’s ability to deliver medium term price stability into question. Therefore, despite champagne being removed from the CPI’s 2013 basket of goods, let’s hope that over time the Bank of England’s credibility is still something the UK can celebrate.

Wage inflation: Upward pressure on German labour costs in 2013

Posted on 13 March 2013 by Markus Peters

When I left Germany more than three and a half years ago, it was a good place to live. Germany’s polarising football superpower Bayern Munich had just failed to win the Bundesliga, horse meat was deliberately eaten in form of “Rheinischer Sauerbraten” and circa 40 million Germans were in employment. Despite all the bad news today – Bayern Munich has a strong lead in the Bundesliga table and horse meat is a basic ingredient in nearly every ready-to-eat meal available – Germany has not become a worse place to live. Employment is at record highs in absolute terms and the unemployment rate stands steady at 6.9%.

Although some of the peripheral countries have made some progress to lower their unit labour costs through harsh austerity measures (as projected by the Organisation for Economic Co-operation and Development (OECD)), Germany’s competitiveness still stands out as exceptionally high within Europe. Austerity is a tough medicine to take, so I doubt that the Greeks, Spanish and especially Italians (as the recent electoral outcome confirmed) are willing to take their prescribed doses all the way through until they reach a similar level of competitiveness to Germany.

For this reason, it is generally argued that the Eurozone rebalancing has to come not only through structural reforms in the periphery, but also through internal devaluation in the core of Europe. Unlike peripheral Europe which is attempting to reduce labour costs, in 2012, Germany’s economy saw annual real wage growth for the third consecutive year. Employees keep demanding higher salaries after cutting back for years. Hiring intentions and business confidence have not even dropped considerably after the economy’s slowdown in the last quarter. But most importantly, it’s electoral season in Germany.

At the start of March, the SPD, Greens and “Die Linke” (The Left) officially kick-started their electoral campaign around the topic ‘social justice’ (Soziale Gerechtigkeit). In Germany’s upper chamber (Bundesrat), where they now hold the majority of the votes, the three parties voted in favour of a statutory minimum wage of EUR 8.50/hour (or circa EUR 1,300 per month if we assume an average weekly working time of 35 hours for full-time workers).

Germany is one of the few countries in Europe which has not got a statutory minimum wage. The proposed minimum wage would roughly equal the minimum wage level of the United Kingdom and would be below the minimum wage of France, the Netherlands – and Ireland (looking at the below chart, I have been wondering if this is one of the reasons why we have not seen as many Irish people on the streets as Spaniards or Greeks). The proposed law is still subject to the approval by the CDU/FDP-led German Parliament though. It is very unlikely that it will be approved in its current form, but it puts considerable pressure on Angela Merkel to make concessions on this topic and to somehow set a floor level to German wages.

The main source for wage pressure in Germany though stems from expiring labour agreements between the powerful trade unions and industrial employers. It is estimated that labour agreements concerning up to 12.5 million workers, or around 30% of the German labour force, are subject to re-negotiation in 2013. Trade unions Ver.di and IG Metall represent the interests of around 9 million German workers alone this year. The wage negotiations with the biggest impact take place for compensation in the metal and electronics industries (concerning circa 3.4 million employees), in the retail industry (1.3 million), in the wholesale commerce sector (780,000), and in the main construction sector (650,000).

So what are they asking for? One of the very first renewed agreements was concluded last weekend. Labour union Ver.di and the public sector representatives agreed on a 5.6% wage rise throughout 2013 (+2.65%) and 2014 (+2.95%) for around 800,000 public sector employees. Furthermore, job guarantees were granted for all public sector trainees and a uniform holiday allowance of 30 days per year was agreed. Elsewhere, IG Metall currently aims at a nominal wage growth in the metal and electronics industries of 5.5% and IG Bau has demanded wage growth of 6.6% for workers in the construction sector. Beyond doubt, this could mean significant real wage growth for a considerable part of Germany’s 41.7 million labour force.

The power of German trade unions, particularly in electoral times, must not be underestimated. The German “blue collar” workers are the traditional voters of the left parties, so the social democrats will do everything to support the trade union efforts. Angela Merkel has to find a way to accommodate the unions’ demand for higher wages because she will not be able to afford an outright electoral recommendation for her competitors to 12.5 million blue collar workers.

Wage inflation is certainly on its way in Germany. And it might come at exactly the right time for the German economy. In an environment in which we can’t see Eurozone demand for German goods picking up and Chinese demand for German goods is increasingly likely to slow down, it strikes me as a positive development that German workers have more money in their pockets and can stimulate domestic consumption, making the German economy less dependent on the export sector. But the German economy clearly walks a fine line here. Excessive wage growth might decrease German competitiveness too much. We don’t see this danger stemming from the suggested minimum wage which seems to be too low to have a significant immediate negative impact. In the longer run, there is the risk though that the minimum wage level could prove to be an enticing lever for governments to please the electorate ahead of general elections.

In the shorter run, the impact on overall wage levels from labour union agreements might prove to be more considerable. The rigid Bundesbank models suggest that a 2% increase in real wages in the German economy would translate into a ¾% decline in the rate of GDP growth and a 1% increase in unemployment. The same models say that the effect for the peripheral nations from the decreased competitiveness of the German economy would be close to zero because of the structure of trade flows. So the net negative effect to European trade overall is attributable to what Bundesbank president Jens Weidmann phrases as the realisation that “Europe is not an island, but part of a globalised world”. In our opinion, it would be interesting to see what the models say when you feed them with a 30% Yen depreciation and 20% sterling depreciation against the euro and what the Bundesbank’s suggested reaction to such a scenario might be.

The bond vigilantes are being zombified, but the currency vigilantes are rampant

Posted on 12 March 2013 by Mike Riddell

We have written extensively on this blog in the last year about what we’ve termed ‘central bank regime change’ (eg see Jim’s article here from a year ago), where we have argued that in the years ahead, central banks would care less about inflation and more about growth and unemployment. We have since seen a number of examples of this playing out – the Federal Reserve has started targeting the unemployment rate, the Bank of Japan is trying to generate inflation, and the ECB has said it will do “whatever it takes to preserve the euro”.

More recently we’ve seen the Bank of England join the party, where 3 of the 9 members of the MPC voted for additional asset purchases despite forecasting that inflation is likely to remain above the 2% target for the next two years. And then last week we had the bombshell in the Financial Times that conversations are being had about changing the BoE’s remit, which looks suspiciously like a leak (again today it was reported that Carney has met with the Treasury to discuss remit change).

Richard wrote about the ‘currency vigilantes’ in 2010 (see here), where he discussed how QE was taming the bond vigilantes, how in the new topsy turvy world the highest inflation economies could have the lowest bond yields, and how the currency vigilantes will take the bond vigilantes’ place to enforce discipline. If you look at FX performance year to date then the currency vigilantes are clearly on the hunt – the world’s worst performing major currency at the time of writing is the Japanese Yen (-9.7% vs USD) and the second worst is the British Pound (-8.5% vs USD).

Meanwhile, QE has successfully turned the bond vigilantes into bond zombies. Market participants no longer appear to be forcing up profligate countries’ nominal government bond yields; they are instead buying up these countries’ inflation linked bonds. So in another topsy turvy development, it is becoming cheaper rather than more expensive for these governments to borrow. Cynics would argue that was the whole idea.

The result is that as real yields fall versus nominal bond yields, market implied inflation expectations are by definition increasing. One measure of market implied inflation expectations is the 10 year breakeven inflation rate, which is the gap between the 10 year real yields and 10 year nominal yields. The chart below shows that US 10 year inflation expectations are at the highs of the range of the last 15 years. Today the UK 10 year breakeven inflation rate hit 3.36%, the highest since September 2008. If you consider that the UK breakeven inflation rate is priced off RPI, and RPI is likely to be around 1% higher than CPI over the long term, then the UK bond market is still only pricing in a 10 year CPI average of just over the current 2% target. We think this still has a lot further to go – and we still hate sterling.

The Real Income Enigma

Posted on 12 March 2013 by James Tomlins

“The question isn’t at what age I want to retire, it’s at what income.”

George Foreman

The carry trade, the grab for yield – call it what you will, but this has been a persistent fact of life in today’s investment climate, especially as larger cohorts of the developed world join the ranks of the retired. As Mr Foreman points out above, the financial aspect of retirement isn’t really dominated by how much capital you might have, but how much income can be generated from your savings and various entitlements. Furthermore, safeguarding this income from the rapacious grasp of inflation is crucial. Real income is the goal.

While there is plenty of demand for real income, the supply of assets that can provide this is now dwindling. The chart below is a very simple one (and arguably too simplistic), but it paints a stark picture for income hungry investors. On the left hand side is the nominal income yield from various asset classes (dividend yield in the case of equities, yield to maturity for fixed income). The right hand side merely takes away the last inflation number to give you a snapshot of real income yields. This does not take into account the possibility of earnings and dividend growth from the equity markets (an important aspect) or indeed any changes in the inflation rate. For any income orientated investor, this essentially gives you the menu of options for generating inflation beating income in the here and now.

One thing that should come as no surprise is that cash and government bonds offer negative real returns on a buy and hold basis, but what is less obvious perhaps is that the number of asset classes that offer a positive real return has shrunk dramatically. Indeed, only high yield bonds offer a significant pick up above and beyond the inflation rate. (This pick up is there in part to compensate investors for the risk of default, volatility and lack of liquidity). Whilst we do not expect dramatic capital gains from high yield in the near future, absent a major negative shock for risk appetite, this context provides very powerful structural and technical support for the asset class. Investors, particularly those seeking income, ignore this at their peril.

Video – The new normal: the thin line between deflation and inflation

Posted on 4 March 2013 by Gordon Harding

Last week Jim took part in an Asset.tv masterclass. The panel discussion was hosted by the BBC’s economics editor Stephanie Flanders with the main theme tackling one of the big conundrums of the past few years – whether we’re heading into an era of deflation or inflation and indeed whether central bankers really care about inflation anymore. The video also covers a range of related topics, such as the efficacy of QE, currency wars and the implications for markets if and when central banks begin their exit strategies.

To view the video you will need to enter your Asset.tv registered email address. This is required by Asset.tv as part of the broadcasting rights for this masterclass. If you do not have an Asset.tv email address you can register on the Asset.tv website and then return.

Monetary policy and the electoral cycle

Posted on 7 February 2013 by Richard Woolnough

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.

Nominal GDP targeting for the UK, coming sometime, maybe?

Posted on 23 January 2013 by Jim Leaviss

This speech by Mark Carney, incoming Bank of England Governor, to the CFA Institute in Toronto, is potentially very important for UK monetary policy. He appears to suggest that targeting a level of Nominal GDP (NGDP) can be more powerful than an inflation target. Importantly he also emphasises the “history dependence” of such a policy regime, and that “bygones are not bygones”. Central bankers would be compelled to make up for past misses. Holes in growth, caused by recessions and slowdowns, need to be filled in.

George Osborne, UK Chancellor, has appeared to be warm to a discussion about a change in the UK’s monetary policy regime (and he appointed Carney to the Bank). But what would it mean in practice? Nominal GDP targeting means that monetary policy would aim to hit a combination of growth and inflation over time consistent with its trend. In the case of the UK this might be 2.5% real growth and 2% inflation, so 4.5%. But the wonderful thing about nominal GDP targets is that you don’t really care about the mix, so 4.5% inflation and 0% real growth is as good as 4.5% real growth and 0% inflation. Or at an extreme, a fall in real GDP of 10%, and inflation at 14.5%. I think that many of us would regard this indifference between growth (“good”) and inflation (“bad”) as strange. Is this an example of a policy that turns failure (having persistently higher than target inflation rates) into a triumph? Not even, I’m afraid as we haven’t achieved a 4.5% nominal GDP rate in the UK in recent times as real growth has hovered around zero.

I have some other issues about the proposed policy too. The estimation of the trend itself becomes very important. On this chart I show, in green, the level of UK nominal GDP. If we draw a trend line, using the period from 2003 to 2007 and project it forward, it appears that the level of UK growth is still significantly below trend. On my calculations it’s around 12%, but I’ve heard estimates (including from within the Bank) of 15-16% below trend too. You can see that given how weak real growth is in the UK (we may have gone back into recession), we would need to generate a significant amount of inflation to return to the trend level within the next couple of years. After all, the Bank would be “compelled to make up for past misses”.

But what if that trend rate of growth was too high? 2003 to 2007 was in the white heat of the credit bubble, and growth came from all directions, consumer spending and government spending. It seems very plausible that we were growing above our potential at the time, thanks to cheap money and leverage. If we show the same chart with a trend line from the period before credit exploded, say 1997 to 2003, we get a very different gap. In fact the yellow line here shows that the current level of Nominal GDP is bang on where we might expect it be. Perhaps this explains why the UK’s employment situation has been relatively strong in the period since the credit crisis, and perhaps it explains why inflation has been so sticky to the upside – maybe we are operating around full capacity already?

There are other objections of course – inflation data are never revised, whereas GDP numbers are, sometimes drastically. So central bankers could be aiming at a historical number that might change significantly (most economists expect UK GDP to be revised higher for the period since the credit crisis). But perhaps the greatest criticisms are reserved for the damage this might do to monetary policy credibility – does not caring about the mix of inflation and growth increase the risks of inflation drifting further away from 2%? And some have suggested that countries that have followed a NGDP regime have experienced higher volatility of both output and inflation compared to those that target inflation alone.

So on the face of it, I’m not a fan. But I am a pragmatist, and the debt to GDP ratios that we have now (or are baked in the cake for the future thanks to demographic trends) can only be dealt with by either above trend growth (are we going to see 4% real growth in the UK for any sustained period?), or higher inflation. No central banker will ever tell you that this type of regime change is taking place to erode the national debt. But if growth continues to stagnate, and politicians remain reluctant to take difficult decisions on pensions, tax rates and benefits, inflating the debt away looks to be the only option. Outright government bond defaults are unnecessary in countries with their own currencies – but subtler defaults will happen – against populations as we find that the promises made to us about our old age or child benefit no longer apply, and with inflation reducing the real liabilities of the government. This is Central Bank Regime Change, and you won’t like it.

Chinese housing market, not so magic – will the dragon run out of puff?

Posted on 18 January 2013 by Magnus Paterson

‘The ruin of a nation begins in the homes of its people.” – Ashanti proverb

In the last ten years, around the world, we’ve seen a series of housing led credit booms inflict heavy recessions on economies. We seem to be seeing the same thing happening today in parts of China.

Deutsche Bank’s excellent economist Torsten Slok has produced the following graph; which clearly shows how unaffordable house prices are becoming, relative to incomes, in some major Chinese cities.

While property prices in the rest of the world continue to adjust towards more fundamental valuations, China’s credit boom is allowing the opposite to happen.

Current property prices in major Chinese cities are unsustainable. Either they adjust (a bursting of the bubble) or real wages have to catch up (massive inflationary pressure).

The currently inflated dragon is unlikely to survive in its current form.

Judgement Day – RPI Damp Squib

Posted on 10 January 2013 by Ben Lord

Today has seen the release of the decision by the National Statistician about what to do with the Retail Prices Index. We were told of the consultation in September last year, and were presented with 4 options, ranging from 1) to do nothing, to 4) to make RPI as much like CPI as possible.

Our view was always that the consultation arose as a result of the desire to correct an error made in the clothing component of RPI in January 2010 see blog. This change had seen the ‘wedge’ between RPI and CPI anomalously and erroneously increase by close to 1% following its implementation. We therefore believed that it was perfectly appropriate for the National Statistician to correct this error, and so we were expecting to see Option 2 materialise, which most closely targeted correcting this source of the wedge.

UK linkers had noticeably underperformed other markets since the announcement of the consultation. The market had initially started to price in a 30 to 50 basis point reduction in the wedge of RPI over CPI in expectation of Option 2′s intention to rectify the error. However, as Judgement Day approached nervousness increased in the linker market as people started to worry that the more severe options could be implemented.

Were Option 4 to have been recommended today, the wedge of RPI over CPI would have been reduced by approximately 100 basis points. This would have been a severe and brutal change for the index linked bond market. All else remaining equal, this change would have seen breakevens on index-linked bonds fall by approximately 70 basis points (allowing for 30 basis points of underperformance already priced in). To put it another way, this would have see the price of the longest index-linked gilt, the UKTi 0.375% 2062s, fall from 107.7 to about 85, a fall of 21%. Today, things really could have got nasty!

But the decision today has been Option 1. No change. Whilst highlighting that “the RPI does not meet international standards” and recommending that a new index be published, Jil Matheson “also noted that there is significant value to users in maintaining the continuity of the existing RPI’s long time series without major change, so that it may continue to be used for long-term indexation and for index-linked gilts and bonds in accordance with user expectations”. For the release, go to this link.

All the lobbying that we – and some others – have been doing behind the scenes has been worth it. In the Financial Times today, Chris Giles (who was on the Consumer Prices Advisory Committee) stated that the ONS rejected the committee’s advice in the face of ‘overwhelming opposition to changes in the calculation of the RPI’. The market has recently opened, and is removing the expected reduction of 30 basis points or so from Option 2. Breakeven inflation rates at the moment are up by 37 basis points at the 10 year part of the curve and by 22 basis points at the long end. The 2062 index-linked gilt is up by 12 points in price terms, and the whole linker market is rallying in the relief that no change is being made…

…for now! We will soon see the creation of a new RPI index, called RPIJ. This effectively makes RPI equal to CPI through making the older RPI index more modern by removing arithmetic mean and replacing it with geometric mean. This will be run in parallel with the old, untouched index. But it suggests that this debate is not over forever. We could again see recommendations to move from RPI to RPIJ, but more likely, we will soon start to debate moving the index-linked corporate bond market from RPI linkage to CPI linkage. The creation of RPIJ does seem a little irrelevant, where a new index has been created that few people will care about given that inflation linked bonds will continue to be linked to RPI and the government is clearly dedicated to linking other forms of government compensation to CPI.

Ultimately, though, even if we had seen a brutal reduction in RPI today, I still think that the strong case could be made to want to own UK index-linked bonds over the medium and long term. And changing the calculation to option 4 could have saved the Treasury a whopping £3bn per year, so while the decision to make no change has been great for inflation linked bond holders, it’s not so great for the UK’s coffers. Finally, the strong opposition to the RPI changes gives you a good idea of how hard it will be to implement austerity measures, and if we aren’t going to get out of this debt crisis through austerity, then the likelihood of us getting out of it with the help of inflation has just increased a bit!

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