Jeremy Warner's Outlook: Bank of England's gloomy prognosis

Surprising resilience of equity markets; John Thain joins the thundering herd
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The Independent Online

You'll be pleased to know that Mervyn King, Governor of the Bank of England, doesn't lie awake at night wondering whether the Northern Rock debacle has damaged his chances of a second term of office. Indeed, he as yet hasn't thought about a second term at all, or at least that's what he said yesterday. Mmm... Yet he is surely right to insist there are rather weightier matters to think about.

At his quarterly press conference yesterday to announce the Bank's Inflation Report, the Governor said the Monetary Policy Committee was facing some difficult decisions over the months ahead. He's right about that too, for, as things stand, the Bank seems as confused as the rest of us about where the economy is heading.

In the short to medium term, the Bank faces rising inflation and fast-slowing growth. Back in August, Mr King said growth would need to slow in order to hit the inflation target two years out. The credit crisis means the economy is slowing rather more dramatically than the Bank would have liked.

The implication of the Inflation Report is therefore that there will need to be at least two cuts in interest rates early next year to a little less than 5.25 per cent to restore growth. Even so, there will be a quite pronounced slowdown during the course of next year. With monetary policy easier, the Bank is relying on slower growth to bring inflation to heel.

Does this analysis seem sound? Most bankers and business leaders I've spoken to in recent weeks suspect that the Bank is being too optimistic on both growth and inflation, though few yet predict a recession. The continued boom in Asia ought to protect us from that. Yet many fear a return of "stagflation" to Western economies – a world where inflation is relatively high but growth stubbornly low.

Stagflation is a word that Mr King personally likes to avoid, for to him it brings back memories of the supply-side shocks and hyper-inflation of the 1970s. The new vogue word is instead "slowflation", an economic environment in which interest rates have to be kept relatively high in real terms to keep inflation under control, thus stifling growth.

Many might reasonably think that prices are already out of control, with the old measure of inflation – the retail price index – again above 4 per cent. The perception of still quite low rates of inflation is largely an illusion maintained by the Consumer Prices Index used for inflation- targeting purposes.

So far, retail sales and consumption have confounded projections by holding up well. Yet it is hard to find any British retailer who is optimistic about the outlook after Christmas. This may in part be down to the fact that previously they were all exceptionally gloomy about Christmas, which now looks as if it will be relatively buoyant. The gloom has become postponed.

Yet there is also good reason to think conditions will slow markedly in the consumer economy once the festive season is over. If people spend more freely than they should in the run-up to 25 December, then the post-Christmas hangover, when consumers rein in to pay down their credit cards, may be worse than usual. The credit crunch is also likely by that stage to be having a significant adverse effect on the real economy, with tightening credit conditions and significant job losses in the financial services industry.

The longer-term outlook is also for much less benign economic conditions than we have enjoyed for the past ten or more years. During that time, China and other fast-developing emerging markets have acted as a disinflationary force in the world economy, helping to keep prices and wage inflation low.

This phase of development has come to an end. China is now exporting inflation, not deflation. The terms of trade, which have been powerfully in Britain's favour over the last ten years, are turning against us. The relatively low interest rates and consequently quite high levels of growth we have experienced in the past may be drawing to a close.

Whatever he says, Mr King presumably does want a second term. Yet as he has often said, we may now be moving into a more challenging set of economic circumstances. To date, the management of monetary policy has been relatively easy. In future, it may be more difficult to deliver in the way the politicians and the electorate want. Mr King will soldier on given the chance, but he might be better off leaving it to someone else.

Surprising resilience of equity markets

No central banker would ever dare attempt a stock market forecast after Alan Greenspan's famous "irrational exuberance" speech, which was at least four years ahead of its time. The Dow nearly doubled before he was finally proved correct, and even then it never returned to the level it was at when Mr Greenspan said it was overvalued.

Even so, Mr King came perilously close to taking a view on stock markets yesterday by expressing some bemusement over the fact that the repricing of risk hasn't yet been reflected in equity markets. Western stock markets, he pointed out, remain broadly at the same level as at the beginning of August, while emerging market equities have since added 20 per cent.

A crash in equity markets, he intimated, was a rather bigger risk to the world economy than the sub-prime writedowns of Western bankers. The theme was taken up by Stuart Gulliver, head of investment banking at HSBC, during yesterday's third-quarter trading update conference call. Strip out the banking sector, he pointed out, and US stock markets were at an all-time high. This, in his view, was unjustified, in that it seemed wholly to ignore the damage the credit crunch would eventually do to the US economy and hence corporate America.

This seems to be very much the prevailing wisdom among bankers, yet it self-evidently isn't yet shared by the balance of investors. In fact, an entirely plausible case in support of equities can be made. If you'd been an investor in Western banks you would have found yourself in the midst of one of the most crushing bear markets of all time over the past few months. This has coloured and distorted views among those who cannot understand why others shouldn't be suffering the same degree of discomfort.

One reason for the relative strength in equity markets is simply the lack of viable alternative assets. When credit previously classed as triple A suddenly turns out to be valueless, normally "risky" equities start to look pretty attractive, and accounts traditionally regarded as opaque look like a paradigm of transparency against the mysteries of collateralised debt obligations. Liquidity which previously flowed into some of the more dangerous areas of the credit markets is now being invested in equities.

What's more, many US and European blue chips are these days as reflective of the world economy in its totality as the domestic economies where they are domiciled. This is particularly the case with London's mining stocks, where it would be hard to find a more direct investment exposure to the explosive growth of emerging markets. Where do these gloomy bankers expect people to put their money: under the mattress? That day may still come, but for the time being there is no anomaly in the relative strength of equity markets, which is only a reflection of the continued strength of certain parts of the world economy.

John Thain joins the thundering herd

When John Thain left Goldman Sachs to become chief executive of the New York Stock Exchange, his goal was to revive the fortunes of "a great American institution". The task complete, he's moving on to another one-time symbol of American prowess now sadly fallen on hard times – Merrill Lynch. The thundering herd no doubt thinks it is buying in the secrets of Goldman Sachs' success, but be warned. The unique ingredients of Goldman's achievement don't easily travel or get replicated elsewhere. Many have tried by poaching top Goldman staff, but no one has yet succeeded. Still, Mr Thain is quite a coup. If anyone can restore Merrill to past glories, he can.

j.warner@independent.co.uk

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