A world of deflation or one of renewed, if modest, inflation?
A world of deflation or one of renewed, if modest, inflation?
If anyone a couple of years ago had suggested that the oil price could rise above $50 a barrel without any significant rise in inflation they would have been thought a bit loopy. As a result, as it became clear that energy prices would remain high, the general assumption hardened that the world was in the early stages of a drawn-out rise in interest rates, with a peak perhaps some time in 2006. Of course, the actual level of rates and the timing of the peak would be different for the different monetary areas. The UK has moved earlier and more aggressively than the US, so might be able to cut earlier. The European Central Bank was stymied by the poor economic performance in Germany and so would delay any rise. Nevertheless, the perception was that the overall slope of rates would carry on upward for some time.
This view ran through into the early months of this year. In the past six weeks or so, quite a radical change has taken place in expectations. In a nutshell, it is that the peak will come much earlier than everyone expected. If this is right, it would fit in with a perception that, viewed globally, deflation is more of a threat than inflation - a view that would fit in with the astounding decline in long bond yields. What is happening, and why?
The minutes of the Bank of England's Monetary Policy Committee are not a bad place to start. The revelation that two members (including the Bank's chief economist) voted for a cut in rates at the last meeting was only part of the story. The other part was the evident general concern about the retail slowdown.
One echo to that, by the way, came yesterday from Dixons - the electronics business has slowed particularly sharply - and another from Mervyn King, the governor of the Bank, in his Mansion House speech. In that, he noted the slowdown in the high street, though he did contrast this with the reasonable sustained demand for services.
At any rate, the very idea that the next move in rates could be up has vanished and the expected date for the first cut is somewhere between August and early next year. The first graph shows some expectations for the UK base rate, together with those for the US and ECB equivalent rates, from Dresdner Kleinwort Wasserstein. DKW expects a cut before the end of this year, with another early next year, bringing the base rate to 4.25 per cent. The next graph elaborates this expectation, suggesting also that the market's expectation for interest rates remains too high.
That is interesting and, for what it is worth, squares pretty much with my own expectation of a fall in rates in October. From a global point of view, however, what the US and eurozone do is, of course, more important than what we do here. The US next.
The genius of Alan Greenspan has been to keep 'em guessing. The word used to describe the tightening of policy was "measured". People took that to mean that the rise would be pretty steady until rates were "normalised", wherever that might be. But whereas the presumption of a few months ago was that "normalised" would not be reached until well into next year, now it is that we are just about there.
You can see the expectations of DKW for Fed funds in the first graph and then, with the implications for money market rates, in the third one. It is for the rises to stop in September, with Fed funds at 3.75 per cent. I am not sure that could be considered "normal" because core inflation at a consumer level will be around 2 per cent, which would leave the country with quite low real rates for this stage of the cycle. It is also questionable whether this will be enough to slow the US housing boom, which, while less dramatic than the UK one, is nevertheless causing concern. But that is the expectation.
Now look at Europe. We have just had another inconsequential ECB meeting, plus calls for a cut in rates from Germany, and it seems that instead of tightening, the ECB will probably stay where it is at 2 per cent. That is also the view of DKW, though it thinks the market has got rate expectations wrong in the medium term (final graph). The main point here is that hardly anyone now expects a rise in eurozone rates.
If this is right then a number of conclusions logically follow. One is that this peak in the interest rate cycle will be the lowest in Britain since the 1950s. (People with long memories will recall that a Bank rate, as it then was, of 7 per cent was the crisis rate that historically signalled the peak of a cycle.)
Another is that the bond markets may actually be right in driving down rates to such low levels. Actually, I don't think that they are because governments will run excessively loose fiscal policies - and so issue lots of bonds - for the next five years. I think the market is right about inflation but wrong about the supply of paper.
Another is that there are such powerful deflationary forces in the world that the central banks could hardly create inflation if they tried. Or rather they can create asset inflation - they can pump up property prices - but they cannot create goods inflation or even, to any great extent, private sector services inflation. The downward pressure on world manufacturing costs from China and the corresponding pressure on many service industry costs from India is too great. Even the rise in energy prices cannot change this broad picture of a world that is moving inexorably towards price stability, something that it has not had (and then only briefly in the exceptional inter-war period) for 70 years.
Indeed, if you stand back, the world of finance looks much more like the world of a century ago than any period of living memory.
In the first five years of the last century inflation in the UK averaged 1.3 per cent - almost exactly the same as it has been under our new consumer price index in the first five years of this one. Gilt yields in 1904 were 2.8 per cent, which, all right, is a bit lower than the 4.5 per cent last year - but for us the memory of the great inflation of the last 40 years still lingers, whereas investors in 1904 had no experience of inflation at all. Short-term money in 1903 was 3.4 per cent, and in 2003 was 3.8 per cent.
We really have not got our minds round the implications of this. We still compare the present situation with the 1950s. Maybe the better parallel would be the 1870s or even the 1840s. All we can be sure about is that this is an interest rate cycle that is different to any that have occurred in our adult experience.Reuse content