Outlook: Policy headache for Bank of England's MPC as sterling falls

Derivative Buffett; GlaxoSmithKline

Sir Edward George, Governor of the Bank of England, told the Commons Treasury Committee yesterday that the pound was approaching an "acceptable" level for euro entry. What he didn't point out was that over the last month the pound has fallen by more than the Bank of England was projecting for the whole of the next two years, as measured by an international basket of different currencies.

The significance of this statistic is that a falling pound has marked inflationary implications, giving the Bank of England's Monetary Policy Committee plenty to chew on as it meets to consider interest rates over the next two days. Look beneath the still subdued headline figure for inflation, and you see service prices roaring away as if in the midst of an inflationary boom. No sign here of Britain slaying the dragon of its inflationary past. The only thing that's keeping the overall cost of living down is deflating product prices, and a large part of the reason for this has been the relatively strong pound. That picture is changing fast.

It is extremely unlikely that the MPC will raise rates at this week's meeting, having so recently surprised the markets by cutting them. But if the pound continues to fall, then that moment will fast be upon us. It scarcely needs saying that the economy as a whole needs an interest rate hike like a hole in the head right now. Weaker data yesterday, with slowing house prices and retail spending, point to the need for lower interest rates still. The policy dilemma grows more acute by the day. Further interest rate cuts may be necessary to keep the economy growing, but that's just going to increase the pressure on sterling and inflation.

Paradoxically, then, the further the pound falls towards an "acceptable" level for entry into the euro, the further the interest rate differential with the eurozone may need to diverge. European interest rates need to fall a lot further. For Britain, on the other hand, we may already be at or close to the bottom of the interest rates cycle. This doesn't look like economic convergence to me.

So much for short-term interest rates. What of the outlook for longer rates? Again the pressure may be upwards. The International Monetary Fund was in truth a lot more sanguine in its annual assessment of the UK economy than the headlines would have you believe, but there is no doubt that the Chancellor's forecasts for both growth and tax revenue now look more than a little optimistic. Actually, they looked optimistic when he first made them in last November's pre-Budget report and they seem even more so today.

The text book response to economic stagnation is either to cut taxes or increase public spending to boost growth, and if you are President George Bush, you do both at the same time. Gordon Brown is raising public spending, but he is also attempting to raise taxes too so that he can safeguard his reputation for prudence with the public finances. From 6 April, you'll be paying an extra £254 a year in national insurance contributions on a salary of £30,000, and more than £1,000 a year on earnings of £100,000. These are not trivial sums. The Chancellor's problem is that eventually rising taxes become counter productive, because they stifle growth which reduces tax revenue.

Mr Brown plans to plug the gap by borrowing more. The more he borrows, the more gilts he will have to issue and the more it will push up long-term interest rates. All those wonderful mortgage deals you see advertised in the press will melt away like snow in summer and the housing market will slow accordingly. Mr Brown, with his eyes still firmly set on the job next door, might secretly wish the Prime Minister ill in his ever more lonely commitment to war against Iraq. But the truth is that the Chancellor needs a swift and successful outcome to these matters just as much as his next door neighbour.

Derivative Buffett

Far be it from me to say Warren Buffett, the investment guru, doesn't know what he's talking about, but, Warren Buffett doesn't know what he's talking about. One of Mr Buffett's favourite investment sayings is never invest in something you don't fully understand, and derivative securities seem to have entirely foxed him. In extracts from his annual letter to shareholders in Berkshire Hathaway, published in Fortune, Mr Buffett says he views derivatives as "financial weapons of mass destruction" and "timebombs".

When he and his right hand man, Charlie Munger, get through reading the footnotes detailing the derivative activities of major banks, the only thing they understand is that they don't understand how much risk the institution is taking. His remarks are classic Buffett and in some respects he's got a point. An awful lot of derivative activity is untransparent and, at the more complicated end, virtually impossible to understand to all but experts.

Rudi Bogni, former head of Swiss Bank Corporation's London operation, became so worried about his inability to comprehend what his traders were up to that he went off and did a PHD in advanced mathematics, so as better to understand the risks being run. Some of the more complex derivative products may be little more than fee-earning concoctions, and quite a lot of them are no doubt dangerous if bought by people without a proper understanding of their contractual obligations.

But the idea that derivatives collectively pose some sort of apocalyptic risk to the financial system is alarmist nonsense. You can understand why Mr Buffett might think that, because it has cost him a lot of money to close down the derivative trading offshoot of one of his businesses, General Re.

It is also the case that insurers and reinsurers have in general found themselves at the butt end of some hefty derivative liabilities, but that's their own fault for mismanaging their exposures in the first place. Mr Buffett is right in suggesting that those who don't understand the nature of the derivative risk they are taking are likely to end up with a bloody nose. That, on the other hand, is true of everything.

The reality of the explosive growth in derivative markets this past 15 years is that they have allowed much higher levels of growth than would otherwise have been the case, not just in the capital markets, but in the economy as a whole, by enabling banks and others to spread credit and other forms of risk across a wide range of participants.

Risk has certainly been shifted from one repository to another, but in the process it is likely to have been greatly dissipated. The fact that the business downturn has not been accompanied by the usual banking crisis is in large part down to the improvements in risk management that derivatives have allowed. Mr Buffett believes it all an illusion, but perhaps the Sage is simply wrong.

GlaxoSmithKline

Another day, another courtroom setback for GlaxoSmithKline in its attempt to defend patents in the US against the onslaught of generic competition. GSK's chief executive, Jean-Pierre Garnier, looks increasingly like King Canute attempting to hold back the tide. He's already in effect lost the battle with Augmentin. Now he seems to be losing it with Paxil too.

The extraordinarily fat profits big drug companies have historically enjoyed seem to be under attack on all fronts as governments and insurers attempt to pare down their healthcare costs. But what really keeps JP awake at night is the creep through internet sales and other distribution channels of low, low Canadian prices into the traditionally highly priced US market.

Combine this with the desert in new product discovery and it's easy to see why the GSK share price is close to a six-year low. The days of plenty may be over for good.

jeremy.warner@independent.co.uk