Jeremy Warner's Outlook: Inflation limits Bank's scope for rate cuts
King urges UK banks to recapitalise; New round of Rock brinkmanship
Thursday 14 February 2008
There are a number of messages to take from yesterday's Inflation Report and the Governor of the Bank of England's accompanying quarterly press conference. One is that if interest rates are cut as the markets expect over the next year all the way down to 4.5 per cent, inflation will remain stubbornly above target for the whole of the two-year forecasting period and beyond.
Another is that, notwithstanding these inflationary forces, the Governor continues to think the balance of risk in the economy is to growth rather than prices. One thing the Bank will certainly not be doing is whacking up interest rates in the manner required to address the immediate inflationary threat.
To do so would be to plunge the economy into an unnecessarily steep decline. In these circumstances, the Governor is already reconciled to having to write another letter of explanation to the Chancellor on why inflation has been allowed to rise more than 100 basis points above target. This time it will be doubly embarrassing, for he will be doing so against a backdrop of falling interest rates. Last time, rates were at least rising by the time the letter was sent.
We are also told that there is quite unlikely to be a recession, or at least not a serious one. On the technical definition of recession – two quarters of negative growth – a very mild contraction is just about consistent with the Bank of England's new central projection this year. But a big one implying perhaps six quarters of quite serious negative growth of the type we saw in the 1970s and early 1990s is considered highly improbable.
Let's hope he's right about this, for the Inflation Report's over-riding message, reinforced by the Governor's comments, is still marginally hawkish in tone. If the economy is heading for hell in a handcart, the Governor certainly doesn't seem to recognise it. Yes, interest rates are headed lower to address a pronounced slowdown in the economy, but perhaps not as rapidly or pre-emptively as some in the markets would like.
The Governor invites us to discount the prophets of doom in financial and property markets, whose London-centric view he thinks is largely instructed by the crisis in the capital markets and not yet backed by hard evidence from the real economy.
Move outside London and you discover a more nuanced message, with little of the data pointing to the economic calamity that those in the thick of the credit crisis fear. Actually, this is still broadly the consensus view among economists, though it struggles to get heard amid all the lurid headlines. A pronounced slowdown, yes, but not a deep recession, with growth recovering to trend towards the middle of next year.
There is obviously something to be said for this point of view. Outside financial services and certain areas of retail, many business leaders continue to see relatively sunny skies with few signs yet of impending economic gloom.
This relatively sanguine view of the outlook relies on the idea that the present crisis in banking provides a necessary adjustment to some self-evident imbalances in the British and world economies, but has arisen soon enough in the cycle to prevent it causing an economic rout. It is hoped that policy action will underpin this benign outcome, allowing a reasonable chance of a soft landing.
The more pessimistic view, which the Bank may be underestimating, is that debt overhangs of the type we have seen in the US, Britain and elsewhere nearly always culminate in quite serious recessions – and there is little reason to believe it will be any different this time.
In the short term, the Bank may succeed in staving off a more serious downturn, but eventually the now obvious inflationary pressures building up in China, India and beyond will force a level of interest rates that will cause the UK economy to stumble badly.
This is not a certain outcome, or even the most likely one, but it is a wholly realistic possibility. For Labour's electoral strategists, it is also the nightmare scenario, for it means that, although economic pain may for the time being be delayed, it will be biting hard by the time the Government is forced to go to the country in late 2009 or early 2010.
King urges UK banks to recapitalise
For the second time in three weeks, Mervyn King has warned that UK banks need urgently to take action to restore their capital position. You would have thought that by now they would have got the message, but that's not the mood music coming out of any of them as the banking season gets under way.
If the disaster of results from Bradford & Bingley is anything to go by, UK banks are now at least reconciled to revealing the full extent of their losses from the present credit crisis. In its trading update a few months back, B&B said its exposure was relatively limited.
Now it admits to impairment charges which have virtually halved profits. Having sold a part of its mortgage book last year, the capital position has actually improved a bit, but prospects moving forward, with a mortgage book heavily dependent on buy-to-let and self certification, hardly look rosy. The problem is not so much lack of capital, but, as with Northern Rock, worries about continued access to funding.
As a comparatively small UK mortgage bank, B&B is hardly a proxy for the rest of the banking sector, yet nor are its problems unique. Of the other UK banks, only HSBC can reasonably be regarded as well capitalised. In the round, all the rest comfortably meet UK solvency requirements, which may explain why managements still believe that with a few asset disposals they will be able to muddle through without the need to cut dividends.
Yet by US standards, most of them would be regarded as critically undercapitalised and would already be under intense pressure from regulators to raise significant quantities of new capital. This is particularly the case with Royal Bank of Scotland, but applies to most of the others, too.
The danger that RBS runs by doing nothing is that if the credit crisis further spirals out of control, causing more write-offs and a full scale breach of capital requirements, conditions would by then be so bad that it wouldn't be able to mount a rescue rights issue or make a major asset disposal.
The margin for error in a lot of these banks is now wafer thin. The difficulty that boards have in grasping the nettle is that the City will undoubtedly require a scalp for the humiliation of a rescue rights or sovereign wealth fund capital injection. Recapitalisation may not be comfortable for shareholders or managements, says Mr King, but it will be healthier both for the banks and the UK economy. Quite so.
New round of Rock brinkmanship
More brinkmanship over Northern Rock, with the Government suggesting that Virgin must better its terms to get round EU rules on state aid and that, in the absence of such improvement, it may have to nationalise.
This is disingenuous. Given the degree to which the European Central Bank is propping up the Continental banking system, particularly in Germany and Spain, with emergency funding, it seems to me quite unlikely that the Europeans are going to complain about unfair state aid. They wouldn't have a leg to stand on if they did. The ECB insists that its funding is completely different from that being provided to the Rock, but for the life of me I can't see how.
Rock shareholders are in any case determined to block the Virgin proposal, which they think dilutes them too heavily, in favour of a management rescue that the Treasury says it dislikes even more than Virgin. It's hard to figure out who is taking the bigger gamble – the Government in risking having to push the nationalisation button, or the shareholders in possibly salvaging nothing at all from the wreckage. One of them must blink first, but it is still impossible to say which.
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