Jeremy Warner's Outlook: Cautious King unwilling to claim soft landing

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The Independent Online

Don't get me wrong, Mervyn King, Governor of the Bank of England, seemed to say yesterday: there are still plenty of risks on the upside. But the balance is now firmly on the downside. There could scarcely be a clearer indication that short-term interest rates have peaked. The Governor was careful to leave himself a long ladder down which to climb. Higher oil and factory gate prices, a weaker currency, and a sharp uptick in private sector earnings growth all meant that it was impossible to be certain where the future path of output, inflation, and hence interest rates might lie, he insisted. Yet his message was clear; employment, housing, and the economy in general had all slowed more quickly than the Bank had expected.

Don't get me wrong, Mervyn King, Governor of the Bank of England, seemed to say yesterday: there are still plenty of risks on the upside. But the balance is now firmly on the downside. There could scarcely be a clearer indication that short-term interest rates have peaked. The Governor was careful to leave himself a long ladder down which to climb. Higher oil and factory gate prices, a weaker currency, and a sharp uptick in private sector earnings growth all meant that it was impossible to be certain where the future path of output, inflation, and hence interest rates might lie, he insisted. Yet his message was clear; employment, housing, and the economy in general had all slowed more quickly than the Bank had expected.

The danger Mr King runs in warning of downside risk is that the moment everyone realises that 4.75 per cent is as high as it gets - barely conceivable even six months ago - they'll all be dashing off to the estate agents to put a rocket under the housing market once more. We've now had two months of falling house prices, but it is far from clear that the psychology of the housing boom has been broken. We won't know that for sure until after Christmas, which marks the start of the peak selling season.

Yet even on this front, the Bank of England has become remarkably sanguine. Going back a year or two, the big fear was that unless the Monetary Policy Committee acted against soaraway house prices, it faced the possibility of a nasty demand shock further down the line when heavily indebted consumers were squeezed by higher interest rates. The stitch in time principle has instructed much of the present phase of monetary tightening. That work now seems to be done. Indeed, according to yesterday's Inflation Report, the MPC has for the first time begun to forecast a fall in house prices - albeit a modest one. Previous forecasts have all had house price inflation falling to zero, but no further. A little bit of an overshoot now seems to be developing.

Even so, if the MPC's central projections are anywhere near correct, the Bank has already engineered the hoped for soft landing. The economy is a little bit weaker at present than foreseen in August, but grows more strongly later on. The same goes for inflation.

The House of Lords Economic Affairs Committee plans to summon Mr King for an explanation of why he's undershooting the inflation target by so much, yet the truth is that the MPC is still broadly on track in meeting its twin aims of producing low inflation growth. Better that inflation should undershoot than that policy should get itself into the position adopted by the Bank of Japan in the late 1980s, which did very well in meeting its inflation objectives but failed utterly until it was too late to do anything about the debt-fuelled equity and property bubbles that low interest rates had stimulated.

It can safely be said that the Bank has not made that mistake, and now even housing doesn't seem to hold the same ghoulish connotations for Mr King as it used to. In its latest Inflation Report, the Bank highlights a perhaps self evident but previously overlooked trend - that the once close correlation between house price inflation and growth in consumption may have been broken. In the past five years consumption has grown only in line with earnings even though house price inflation was much higher. Previously, consumption and house prices tracked each other much more closely.

The MPC draws much comfort from this phenomenon, for it may mean that demand and growth are no longer as sensitive to the ups and downs of the housing market as they used to be. If consumption growth has remained stable during a prolonged period of rising house prices, it should be relatively unaffected by a period of falling prices too. Why the disengagement? The Bank attempts to explain it thus.

Because in a rising housing market, the outlays necessary to buy become ever larger, it doesn't in aggregate make householders any wealthier. Any gains realised from trading down, equity withdrawal, or exiting the housing market entirely, are cancelled out by the extra outlay required of first-time buyers or those trading up. The reason why in the past the correlation between house prices and consumption was stronger may be that they were both influenced by the same factors. Improved economic prospects would have led to both increased spending and greater demand for housing.

So there you are. Economic nirvana finally achieved. Put like that it is no wonder Mr King is so keen to caution on any over optimism. Abolition of the economic cycle is a boast reserved only for chancellors. Invariably it ends up being dashed.

Cable & Wireless

If bamboozling the stock market with initiatives is the way to a higher share price then Cable & Wireless succeeded big time yesterday. A veritable smorgasbord of delights came with news that the company has returned to profits - from a 10 per cent hike in the dividend to a £250m buy-back, £50m of further cost savings, a management shake-up which sees the chief executive, Francesco Caio, take hands on control of the UK business, and the out of town relocation of head office to Bracknell. We mean business, the statement was intended to say. The shares duly celebrated with a near 6.5 per cent rise.

Yet the reality is that the stock price remains quite a long way below where it was little more than six months ago and business remains a terrible struggle. Moreover, it is only now, nearly two years after Richard Lapthorne was parachuted in as chairman to save the company from oblivion, that the new management team seems to be getting a proper grip on the UK operation, which is after all the core business asset. With £1.4bn net cash still on the balance sheet, the buy-backs look worryingly mean.

OK, so the cost of getting out of the US once threatened to gobble up the whole of C&W's cash pile. In the end Mr Caio managed to exit for only £220m. All the same, the wisdom of holding so much back, presumably for the eventual purpose of acquisition making, is open to question given C&W's track record.

The company's strategy for the UK business continues to look confused. With its acquisition of Bulldog, it was late into the "unbundled" broadband market, and while this seems to be about the only growth area of fixed-line telecoms left, it is already extraordinarily competitive.

Mr Lapthorne readily admits that even on a five-year view, top line growth is going to be next to impossible. It is in revenue mix, and in network and outpayment costs, currently running at £1bn a year, that he expects the progress to be made. Yesterday's statement together with the dividend increase was intended to send out a message of renewed self confidence in the company's future. But though we can perhaps be certain nowadays of the company's survival, it has still properly to articulate a way forward that rises above the humdrum of all legacy telecom networks.

Strange to think that as the arteries of the New Economy, these businesses were once thought so valuable. Today they struggle to achieve even a utility rating, for at least a utility usually has a monopoly. No such luck in this line of business, where prices continue to fall faster than the traffic can grow.

US rates hike

The US Federal Reserve reckons that with the Fed funds rate at "even" 2 per cent, its policy stance remains accommodative. What's the level at which it would become neutral or unaccommodative? No one really knows, but as in Britain, it's plainly a lot lower than it used to be. US long-term interest rates have risen since President George Bush was re-elected, but the yield on US Treasuries remains a long way below where conventional economic modelling suggests it should be given the weakness in the dollar, the size of the budget deficit and the renewed strength of the economy. Perhaps more so than any other major monetary authority, the Fed remains in uncharted waters.

jeremy.warner@independent.co.uk

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