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!


The Bank: Inside the Bank of England: the 10 competition winners are…

The answer was the Bank of England’s Inflation Report cost £4 when it was first published in 1993, and now costs £3, deflation of 25%.

Congratulations to the ten winners picked randomly:

  1. Tim Cockram – Chetwood Wealth Management
  2. Simon Bird  – Brewin  Dolphin
  3. Alex Brandreth – Brown Shipley
  4. Robert Harper – Brewin Dolphin
  5. Ali Treharne -  SFP Plymouth
  6. Mark Dobson – Charles Stanley
  7. R Knight – from Altrincham Cheshire
  8. James Norman – Northern Bank
  9. Mark Jones – Brewin Dolphin
  10. Moyeen Islam – Barclays Capital

We’ll be in touch and you’ll receive your books soon. Thanks for all the entries.


The Bank: Inside the Bank of England by Dan Conaghan. Thoughts and a competition.

I’ve just finished reading Dan Conaghan’s newly published book The Bank: Inside the Bank of England.  It’s very good – and essential reading for all bond geeks.  We met with Dan a couple of weeks ago (he’s coming in for a lunch with a few clients next week) to talk through some of the themes in the book.  First of all it’s a big surprise just how little has been written about the Bank of England over the past couple of decades, especially given how much has happened over that period – independence in 1997, the credit crisis and the bank bailouts, and Quantitative Easing in particular.  Perhaps the best insight so far came in Alistair Darling’s autobiography, and like that book, the striking thing here is the criticism that Governor Mervyn King comes in for.  King comes under attack for both his refusal to take advice and his reliance on a handful of people within his beloved Economics Division, but more seriously for his slow and perverse responses to the UK banking crisis and in particular the Northern Rock bank run.

Elsewhere there are a few other things that caught my eye.  I hadn’t realised that in a late 2009 speech, Chief Economist Charlie Bean talked about one feature of Quantitative Easing being that it lowered gilt yields “so reducing the cost of financing a given deficit”.  I’ve not seen that benefit of QE – i.e. reducing the national debt burden – ever mentioned again (I saw a former German ECB council member talk today and he described QE type regimes as “fiscal dominance” of politicians over central banks).

And there’s Paul Fisher of the MPC being questioned by a Treasury Committee about whether the Bank of England could intervene in the foreign exchange markets to change the value of sterling to hit the inflation target.  “The exchange rate policy is part of monetary policy…the MPC can intervene in exchange markets if it thinks it is appropriate to help meet the inflation target”.  Again though, not something I’ve ever seen discussed since, but worth bearing in mind especially as the pound remains so strong (we could sell loads of freshly printed expensive fivers and set up a SWF!  We could put the proceeds together with the imaginary £28 billion that the government is getting from taking over the Post Office pension fund?).

Finally there’s a fair bit of debate about the next Governor of the Bank of England (Mervyn King’s term ends next year so there could be an announcement after the summer).  Following the failures of the Tripartite arrangements during the credit crisis (Michael Fallon MP to the Governor regarding the actions of the Tripartite during the credit crisis: “Who was in charge?”.  Mervyn King: “What do you mean by “in charge”? Would you like to define that?”) there’s a suggestion that an outsider like Lord Sassoon, commercial secretary to the Treasury might be the first external appointment for three decades.  I’ve no view on Lord Sassoon, but I would be disappointed if Paul Tucker, current Deputy Governor, didn’t get the top job.  I think markets would too – he has the right mixture of intellect, pragmatism and experience to cope with the future issues that the ongoing credit crisis will throw at the UK.

So a competition.  We’re giving away 10 copies of Dan Conaghan’s book.  The question is this:

It was first published in 1993 and cost £4.  It now costs £3, a fall of 25%. Which influential publication is this (clue: you can find the answer in the book…)?

Please see here for terms and conditions, and submit your answer here.


B(l)ank cheques

Rating agency Moody’s today downgraded a swathe of UK banks. The reasoning behind this was not the weakening of the economy, nor the fact that, according to Mervyn King, we are in possibly the worst financial crisis ever. It was due to the changing nature of the blank cheque that banks receive from their implicit support from the state.

The rating agencies have recognised that government policy has shifted and that state support for banks is becoming limited and dependent on their systemic importance to the UK economy. This is not new news and the increasing risk that bank bond holders have been exposed to is something we have talked about before and has been illustrated painfully by recent price movements.

However, some interesting comments and pointers come out of the Moody’s press release. They not only assign higher ratings to some banks due to their size, but assign these higher ratings also due to their complexity ie “driven by large cross-border trading and derivative books”. This seems somewhat perverse for the state. Surely it does not want to be on the hook by providing more support to banks that threaten the domestic system due to cross border activities and complex derivative books, which the regulator has respectively less control over and less understanding of.

Going forward, the UK tripartite authorities (the Bank of England, the Financial Services Authority and the Treasury) are going to aim, through implementing policies along those recommended by the Independent Commission on Banking, to reduce this subsidy for too big to fail and too complex to fail banks. The eventual implementation of such policy would logically result in further downgrades of UK banks by the rating agencies.

The bank checks of the tripartite authorities mean fewer blank cheques. It appears under this scenario we still have further to go in the deteriorating credit quality of many UK banks as conferred upon them by the rating agencies.


UK inflation falls, but potentially worrying signs

The good news was that UK CPI fell from 3.2% to 3.1%.  The less good news was that this was 0.1% higher than expectations and remains above the 3.0% upper bound (inflation hasn’t been below 3% since December last year).  The worrying news was that the Core CPI measure, which excludes food, alcohol, tobacco and energy prices, jumped 0.2% to 3.1%, and was 0.3% above expectations. Core inflation strips out the more volatile elements of inflation, and if you believe these elements are temporary in nature, then it provides a ‘truer’ picture of inflation.  This is the highest core inflation rate since records began in 1997, although it’s a rate that’s been equalled twice already this year.  This chart shows CPI versus core CPI since 1997.

 The reason for inflation coming in higher than expected was down to the services component (see chart), which is also a bit worrying.  Goods price inflation (currently 55% of the CPI bucket) had been the main driver of the UK inflation rate, with part of the reason likely to have been the lagged effect of sterling weakness (see previous blog here).  However, an increase in the services component (45% of CPI) suggests that inflationary pressure is beginning to come from domestic sources rather than international sources.    

This does seem to lend some support to the MPC’s chief hawk Andrew Sentance, who has today again argued that spare capacity in the economy is not as large as was previously supposed.  As explained from page 9 of his speech today, unemployment is lower than has been seen at this stage of previous cycles (and labour demand may be picking up), companies have adjusted quickly to lower levels of demand and are not reporting significant spare capacity, and wage growth has exceeded expectations.  “As spare capacity has not exerted much downward pressure on inflation so far, so there must be a high degree of uncertainty about its future impact”.

Does this mean that we can look forward to a series of interest rate rises soon?  Unlikely.  Andrew Sentance was the only member to vote for a rate hike in June, and in today’s speech, even he concluded that he is not in favour of a sharp rise in interest rates, favouring “a gradual rise in the Bank Rate which would be aimed to avoid destabilising confidence through a sudden policy lurch”.   The majority of MPC members also need to agree with Sentance, which may be tricky if the rumours that Mervyn King believes that the ‘Bank rate will stay low for four years‘ are true.  Furthermore, we have little idea yet how the UK or global economy will react to the huge fiscal tightening that is coming, which leads me to believe that even if inflation does rise further through the remainder of this year, UK interest rates are unlikely to rise until economic growth follows a similar trajectory.


Dear George…

Mervyn King introduced himself to George Osborne last night by writing him a letter, not to wish him luck in his new and frankly unenviable role, nor to advise him on just how much austerity is needed on 22nd June to keep the markets supportive of gilts, but instead to explain why he has again overseen a rate of inflation of more than 1% above the target rate of 2%. The letter states that the Governor should:

1. Explain why inflation has moved significantly away from the target.
2. State the period within which the Governor anticipates inflation to return to target.
3. State the policy action that is being taken to deal with it.

1. The CPI index rose to 3.7% year over year in April, up from a 3.4% rise in consumer prices the previous month, and not insignificantly 0.2% above the market’s expectations for where today’s number would be. The Governor blames oil prices, the VAT increase and the fall in sterling for the inflation miss (no mention of higher duty on cigarettes and alchohol!). He believes these three factors are temporarily boosting the inflation rate and expects that inflation will fall back over time to its desired level of 2% due to the output gap. We are sympathetic with the Bank’s argument that there is a significant amount of spare capacity in the economy at present and that this will likely see inflation fall in the future.

2. Mervyn King believes that it is likely that inflation will fall back to target “absent further price level surprises…..within a year”. What a nice performance target for the year, if you are an inflation forecaster (which, thankfully, Mervyn is not): he will hit his forecast unless he is wrong.

3. The Bank of England took unprecendented action in response to the huge contraction in demand at the onset of the financial crisis with the aim of keeping inflation near target in the medium term, by which I am referring to quantitative easing and near zero interest rates. The Governor today states that in this meeting the Committee felt it appropriate to maintain the current level of stimulus in the economy, citing an appropriate balance between downside risks (spare capacity) and upside risks (commodity prices, amongst others) to inflation.

So Mervyn’s seventh letter (now to his third different chancellor) once again explains that whilst inflation is substantially higher than where he and the MPC expected it to be at this time, and whilst inflation continues to come in higher than the market’s expectations, he and the Committee are happy for the extraordinary level of stimulus to remain in the economy for now, for fear of the fall-out that would result were stimulus to be removed too soon. This is a view we here have huge sympathy with. One only has to look at the panic in the Eurozone in recent weaks to realise that the current recovery is extremely fragile. On top of this, our new government has already announced an emergency budget for 22nd June, which will surely see fiscal tightening dampening some of the inflationary effects of monetary stimulus currently in the system.

So whilst there is sure to be some heavy criticism coming from the media and other commentators about the apparant ineptitude of the MPC to correctly forecast near term inflation, spare a thought for Mervyn. First of all, whilst the MPC has got near term inflation wrong (underestimating) for the best part of the last year, its remit is to manage medium term inflation, for which it has a strong record since its independence. My interpretation of the Governor’s citing the fragile balance between ‘upside’ and ‘downside’ risks to inflation is that it is actually a balancing of near term and medium term inflation, with the former on the one hand being boosted by extraordinary policy measures and the resulting global recovery, and the latter being justified by concerns about the recovery’s persistence and strength. Perhaps he realised that the MPC was too focused on short term inflation rather than medium term inflation when it left rates too low after the crash and then had them too high from 2007 as we approached the financial crash? This is a criticism that is surely all the more cogent when directed at the ECB?

Most importantly, though, give him credit for what he has achieved. Faced with collapsing global demand, a financial system in disarray, and a freezing and contraction in the velocity and quantity of money in the economy, extreme monetary and fiscal stimulus were a necessity. The fiscal stimulus and growth of the state that resulted from the crash has meant the UK’s and most of the western world’s levels of indebtedness have risen hugely too. And the very worst case scenario in a highly leveraged world is a deflationary spiral where prices for everything are falling whilst debts still have to be repaid in full. The lesser of two evils in this case is definitely some controlled or temporary inflation to reduce the real cost of a large debt burden (not to mention that the avoidance of deflation also enables monetary policy to maintain its efficacy). And on these terms, with positive growth, positive inflation, and a recovering housing market, perhaps it is time to praise, not criticise, the MPC for its decision to embark on quantitative easing? The range of decisions we face today as an economy are inestimably preferable to the ones we could have been facing now had we seen monetary policy inaction during the crisis. Well done Mervyn, inflation above a short-term target is a result.


Gordon Brown – a bit less keen on an independent Bank of England

At a time when the gilt market is desperately interested in the future of Quantitative Easing, the Prime Minister yesterday sent a shot across the bows of the Bank of England’s MPC by saying that ending QE would put the UK into a “very deep recession”.  Whilst his words were, on the face of it, aimed at the Conservative Party’s perceived reputation as Great Depression puritans who would remove all forms of stimulus as quickly as possible (see here for David Blanchflower’s view that the Cameron/Osborne plans would push us into a “death spiral of decline”), the remarks are unhelpful for the Bank of England.  “If we removed stimulus now, stopped the quantitative easing we would be back to where we were”, he said.  The Bank will decide on an extension, or end, to QE at the 5th November MPC meeting, and it must be remembered that this is a form of monetary policy delegated to the Bank in the same way as interest rate policy is.  Given some stabilisation in the UK’s economic indicators over the past couple of months (house prices, retail sales, business survey data) this decision is going to be a very tough call, and we still walk the tightrope between inflation and deflation.  Today’s CPI data came in at 1.1% year-on-year, just above the level where the Bank has to write to the Chancellor explaining itself – although this should edge up later this year as the base effects from lower energy prices fall out.  I can’t imagine that the Bank was pleased with this pressure, although Mr Brown did state in an interview on Bloomberg TV that QE is a Bank of England decision (shortly after saying that “the right time to do this is when we are absolutely sure of a recovery”, so no pressure there then).

Goldman Sachs surveyed its clients yesterday afternoon on the outlook for QE.  Only 21% thought that November would see the end of the programme, with the vast majority seeing a further extension (nearly 30% thought that the total would rise to above £250 billion, comfortably mopping up the entire predicted gilt issuance for this financial year, and more!).  No wonder gilts have been rallying over the past few days, and no wonder sterling is falling.

Elsewhere, we had a team outing to see the new David Hare play, The Power of Yes, at the National Theatre.  The Bond Vigilantes were “clocked” as evil City workers within seconds of sitting down, but made it out alive after some robust discussions with our fellow audience members.  The play itself gets a modest 6/10 – the first half is dull for anybody who’s read a paper over the last two years, but it does improve, and there are some interesting interviews with people close to the action (we learn that Mervyn King panics if there are transport problems when he’s travelling on business, and that Fred Goodwin had to be shocked into agreeing to apologise at his Select Committee hearing – the exact wording is not appropriate for a family bond market blog).  But bankers get the entire blame for the crisis, without any thought for the demand side of the credit expansion (i.e. our lust for flat screen TVs and buy-to-let mortgages).  The dealers are evil, and the addicts blameless.  The only time the role of the wider public is examined is when Hare examines the demutualisation of building societies into banks, which led to a change of role from piggy banks that lent to solid homebuyers into quasi-investment banks driven by growth.  This demutualisation wave was driven by a greedy public – a couple of thousand pounds of shares here and there (worthless now in some cases), and we lost our local, conservative lending institutions.  Mind you, the remaining building societies didn’t escape the rush into toxic assets (the Dumfermline BS had its assets split up by the authorities in March this year).  You can read real reviews here (The Telegraph and the Guardian).  If anybody else has seen the play, feel free to leave your comments below.


Mervyn loses his Talons

The Minutes from the Bank of England’s Monetary Policy Committee meeting of two weeks ago were released earlier today. They show that the motion to increase the Quantitative Easing program by £50bn was carried with a vote of six to three. Interestingly, Governor Mervyn King was one of the dissenters. Not too long ago one would have assumed that this would have been due to him worrying that inflation is about to pick up and that he would therefore be reluctant to increase the monetary stimulus further. In fact quite the opposite is true.  King and the other two dissenters (Beasley and Miles) actually voted against the £50bn, as they wanted to increase it by £75bn (which would have taken the total programme to £200bn). This is a quite a departure from the previously hawkish Governor, who, it was reported in the New Statesman, opposed the 1.5% rate cuts of late last year. I guess it remains to be seen if once again he’s a little late to the party or he has now managed to get himself ahead of the curve.  Bear in mind however that the increase in QE was announced before the unexpectedly sticky UK inflation data…


Save the banks, save 5130 lives

Our banking analyst pointed out this academic paper to us. The joint work by the Universities of Cambridge and California shows that banking crises cause a significant increase in deaths from heart disease. In developed countries the increase is 6.4%, and for poor countries 26.0%. The authors estimate that a severe UK banking crisis would result in up to an additional 5130 deaths. It concludes that the decision to bail out Northern Rock has saved many lives, although it wrongly attributes this boost to our national well-being to Mervyn King (who would have watched us all turn blue on the carpet) rather than those twin angels of mercy, Brown and Darling.

The Beautiful (expensive) Game

With all eyes on tomorrow’s inflation data (will Mervyn be forced to write a somewhat embarrassing letter explaining why inflation has breached its upper target ?) a report from the Virgin Money Group show football fans are suffering more than most. The Football Fans Price Index shows that the cost of attending games has risen 8.3% in the last three months and a whopping 17.1% in the last twelve. According to the survey it now costs a massive £91.29 to attend a Premiership game once you account for tickets, travel and other expenses. Having attended most of Liverpool’s away fixtures this season I cant say I’m surprised to learn that England tops the league for the most expensive average match ticket in Europe; what a shame we can’t transform that supremacy onto the pitch!

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