Archive for January, 2011

Conflicting Messages

It is not often that the UK economy makes national headlines, but this week’s GDP data saw that it did. Last quarter’s contraction of -0.5% took everyone by surprise – including, it seems, the Office for National Statistics, which stated that this preliminary release would be “more liable to revision than usual”.

Even taking this number at face value, however, the comments made the same evening by Bank of England governor Mervyn King were just as worrying. Not the fact that he reckons standards of living are to fall faster than at any time since the 1920s (something that has been clear for some time), but the mixed messages he gave on the way the Bank is apparently interpreting its mandate.

As stated on the Bank’s website, this is as follows:

The Bank’s monetary policy objective is to deliver price stability – low inflation – and, subject to that, to support the Government’s economic objectives including those for growth and employment. Price stability is defined by the Government’s inflation target of 2%.

Those subsidiary aims might come as news to many who see the UK’s central bank as a straightforward inflation targeter. But the speech he gave on Tuesday demonstrated that Mr King has not forgotten them. Indeed, what is worrying is that he might no longer even view them as subsidiary. For while he averred that inflation was the biggest “threat” faced by the MPC (as opposed to the “choppy” economic recovery), he also had the following to say:

“If the MPC had raised the Bank Rate significantly, inflation might well have started to fall back this year, but only because the recovery would have been slower, unemployment higher and average earnings rising even more slowly than now,” he said.

Hmm. On the face of it, that looks like an explicit admission that the Bank is prioritising growth and employment over price stability.

And again:

Mr King said he was unable to offer any imminent hope [to savers] of a rise in interest rates in coming months because of the poor economic outlook.

What about the inflationary outlook?

When it comes to real wages, it is the UK’s unusually high inflation (relative to its developed-economy peers) that sticks out. Nominal wages are growing at a similar, rather sluggish, pace elsewhere too. A central bank with a focused inflationary mandate would be seeking to contribute to living standards only by reducing inflation – not by chancing higher prices as a risk worth taking to secure a higher rate of nominal wage growth.

Let’s take an example. During the difficult first years of the euro, some European politicians worried that the ECB was setting rates too high in the context of a world economy that was slowing in the wake of the dotcom / tech bust. The ECB responded by observing that growth in real wages, assisted by its acting to contain inflation, would ultimately boost confidence and secure economic growth.

That’s how a central bank with a genuine inflation target looks at its support function to the wider economy.

As for the Bank of England, there is no better summary than that given by another member of the MPC, Andrew Sentance, in a speech he gave a day before that of his boss:

“The lack of a substantive policy response to persistent above-target inflation… enhances the risk of a loss of credibility in the inflation target itself and a loss of belief in the commitment of the MPC to achieving it.”

Following Mr King’s speech, the lack of such a commitment does not seem like a matter of belief. Perhaps his Bank’s gamble with UK prices will pay off, but it should worry us that he is taking it at all.

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28/01/2011 at 10:48 am

In The Balance

What an interesting week. In China, stock market nervousness intensified, with the Shanghai Composite off 3% on Monday, up just under 2% over the next couple of days, down 2.9% again on Thursday and 1.4% better today to close the week down 2.7% overall. Underlying this skittish behaviour were familiar worries about the threat to growth posed by monetary policy tightening in the face of higher inflation. Familiar too was the spillover of anxiety into other markets, with equities in general enduring patchy declines.

At the same time, yesterday saw the release of upbeat labour market figures in the world’s largest economy, with US unemployment claims continuing to fall. Figures on US housing came out too, with existing home sales much stronger on the month. Now one month’s data does not a summer make – especially for the housing series, which has been volatile in recent times and hit record lows during the second half of last year. But as readers of this blog will know, this data is of a piece with reports on the mortgage market and results from US banks that suggest the worst of the subprime crisis is now behind them.

In other words, it looked this week as if the market was ignoring further signs of recovery in the US and focusing on potential trouble in the Far East instead.

It may appear that this can be justified by reference to the growth contribution of China, and developing economies in general, over the last couple of years. Using the IMF’s most recent (October) estimate, for example,  2010 growth was forecast at 4.8% for the world as a whole, with developed country growth at 2.7% within that and growth in emerging economies powering ahead at 7.1%.

Let us turn to the US and China specifically. Real US GDP in the third quarter of last year was 3.2% above the same quarter in 2009 – a rate of growth exactly in line with the post-war trend. In China, the third and fourth quarters of last year saw annual GDP growth in real terms of 9.6% and 9.8% respectively. On the face of it, this would appear to justify the markets’ seeming view that a Chinese slowdown carries more weight than a US recovery. Given the relative sizes of the Chinese and American economies, however – roughly US$5.5trn and US$14.5trn – these rates of growth translate into similar values of production in dollar terms: $539bn for China and $464bn for the US.

Another way of looking at this is that a return to the lowest rate of growth experienced by China in the recent recession (6.5% p.a.) would be balanced in terms of aggregate world output by an increase in the rate of US growth of 1.2%.

There is no certainty that either of these things will happen in practice. US growth did run at about that level above trend following the recession of 1982, but picked up a lot more slowly after the (much milder) recession of 1991. Nor is there anything to indicate that a policy-driven slowdown in China would be sufficiently severe to take growth down by over 3%. And there are of course interactions to consider between the two economies: any growth in the US would likely soften the impact of slower domestic demand in China by boosting exports.

It is nonetheless worth bearing in mind the relative sizes of these (and other) economies when we are looking at the outlook for world growth, as well as the different relative rates. Should the US gather itself for an above-trend performance this year that would go a long way to balancing out the effects of a policy slowdown in lesser economies – even one as big as China’s.

Of necessity this has been a brief look at a complex area, but on the face of it the one-sided direction of equity markets this week could turn out to have been unfairly skewed.

21/01/2011 at 3:15 pm

Emerging Questions

2011 has begun nervously for markets. Shares are struggling to hold their ground, major bond markets have drifted lower and commodities are treading water too.

This morning’s policy tightening by the People’s Bank of China has added to worries that emerging economies, which have accounted for most of the world’s growth since the financial crisis, will put the brakes on that growth as they seek to contain inflation. There is already a belief in some quarters that the recent barnstorming performance of emerging markets has left them too highly valued. Could tighter money trigger an unwinding?

It has to be said that developing economies have dashed investors’ hopes repeatedly in the past. Latin America in the 80s; the fall of the Asian tigers in the 90s, then the Russian default – emerging market investment has been characterised by frenzied optimism followed by savage loss time, after time, after time. Has the moment now arrived for BRIC to hit the wall?

Let’s look at some facts.

According to Bloomberg, the p/e of the MSCI Emerging Market Index has averaged just under 17 since 1995. Over the last ten years (excluding the late 90s bubble), the average was 14. The level now is hardly out of line at 14.6, and arguably cheap on a longer term view. (It also looks cheap relative to a number of developed markets.)

Furthermore, monetary policy alone was not a good predictor of returns last year. In Brazil, the central bank’s target rate was hiked by a total of 2% and the stock market performed rather badly, with the MSCI Brazil Index up only 4%. In India, by contrast, the target rate went up 2% and the MSCI India Index up 15%.

Finally, the balance sheets of emerging economies look a lot sounder than those of most developed countries nowadays. Brazil’s budget deficit is smaller than Germany’s. Russia has more than twice as many international reserve assets as the eurozone. The spread of emerging market bond yields over their government benchmarks – a key market measure of sovereign risk – has collapsed from over 8.5% at the peak of the recent crisis to a mere 2.4% today.

In a nutshell, then, while prices have undeniably risen, emerging economies are fundamentally sound, their market valuations are not stretched, and policy tightening is an unreliable guide to performance. On that basis, further funk over the machinations of the PBoC would look to present more of an opportunity than a threat.

14/01/2011 at 3:01 pm


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