The British economy: inflation or deflation?

James Ferguson - Fri 16 Jul, 2004

...Is it inflation or deflation that most threatens the British economy? For most of the last three years, there was no such disagreement...

Investors have every right to feel mighty confused right now. Economists are famously incapable of agreeing on the solution to any problem. But you would hope that they might agree on what the problem is in the first place.

Is it inflation or deflation that most threatens the British economy? For most of the last three years, there was no such disagreement. Collapsing equity markets were pushing down asset prices, and China and India were pushing down the prices of finished goods and services respectively. With the lesson from Japan’s “lost decade” of deflation fresh in central bankers’ minds, the policy response was clear...

Cut rates to super-low levels, and increase public spending to bridge the gap until asset prices recovered and pricing power returned.

The British economy, inflation or deflation: Interest rates

But the policy may have worked too well. Over the last six months, a consensus has emerged that interest rates around the world were kept too low for too long. As a result, the global economy now faces a potentially dangerous inflationary spiral.

The case was most provocatively put in a recent cover story in The Economist. “Suppose a Martian returned to earth today, a quarter of a century after his last visit,” the magazine said. “He would note that America’s economic slack is disappearing fast, that its nominal GDP has risen by 7% over the past year and that inflation is around 3% and rising. From this he might guess that short-term interest rates should be around 4% - ie, positive in real terms. Tell him that America’s interest rates are currently 1% [they have since risen to 1.25% of course] and he would probably jump on the next plane back home.”

This view is shared by Anatole Kaletsky, The Times’s formidable economics commentator. He reckons the current US combination of an “ultra-lax” monetary policy and a falling dollar is reminiscent of the conditions that triggered the great inflation beginning in the mid-1960s. America today, says Kaletsky, is guilty of the seven deadly sins - of easy money, lax fiscal policy, devaluation, war, protectionism, high oil prices, and spiralling public spending.

In normal times, any one of these might be sufficient to push up inflation. “All seven operating together would be a sure-fire recipe for prices to take off,” says the Times’ man. “The Fed is doing too little, too late,” he concludes “to keep US inflation under control.”

Here in Britain, the most high-profile inflation hawk is undoubtedly Mervyn King, Governor of the Bank of England. In recent speeches, he warned that the UK economy is very near the limit of what it can produce in terms of both manufacturing and services - a situation that normally pushes up prices. Unemployment is just 4.8% and consumer spending remains robust. Most menacingly, house prices are soaring at an annualised rate of 15%.

Thus UK interest rates have already risen four times in the seven months. The consensus is that they will rise another 1% in the next year.

The British economy, inflation or deflation: Deflation mutating

But hang on - how can the threat of deflation have disappeared so quickly? Stephen King, chief UK economist at HSBC, argues in a persuasive new report titled ‘Dicing with Debt’ that the threat of deflation has not gone away, it has just mutated into a different - and far more virulent - form.

The deflationary pressures of two years ago were what Mr King calls the “good deflation” of rapidly improving supply-side driven growth. Under the circumstances, there was really no need for central banks to lower rates as much as they did. The effect of cutting rates so low was to stimulate investment in risky and unproductive assets - “notably housing”. Unfortunately, because of the debts built up when rates were low, we now face “bad” debt-deflation - which is a far more worrying condition.

“De-leveraging can take place in an uncontrolled manner,” says Stephen King, “and rates of economic growth can slow swiftly.” He is not the only economist worrying about the prospects for debt deflation. Roger Bootle, managing director of Capital Economics, fears we are much closer to a crisis than the central bankers would have us believe. He notes that, once you include capital repayments to interest costs, debt-servicing costs in the UK are currently 19% of post-tax income - close to the 1990 peak of 21.8%.

If interest rates rise to 5.5% in line with market expectations, debt servicing costs will far exceed the 1990 peak. At some point, it is inevitable that households will start to repay their debts, which means they will have less to spend in the shops. Shops will be forced to drop their prices, which in turn will swell the real value of debt yet further. A similar debt-deflation was what caused the negative-equity recession of the early 1990s.

If Messrs King and Bootle are right, what does this mean for investors? Well, interest rates would fall again much sooner than anticipated - and from lower peaks. But Britain would also face a more calamitous near-term response by the economy, not least a collapse in house prices.

This chimes with MoneyWeek’s view that the residential property market is highly vulnerable to a crash. It is at odds with the view of those academic and political economists who believe inflation is the real threat.

The British economy, inflation or deflation: Other investment classes

The question of “inflation or deflation?” has a major bearing on the outlook for every other investment class, too. A period of higher inflation is traditionally bad for bonds, but can be positive for equities. If, on the other hand, we face a period of debt deflation - in which house prices fall and household savings start to rise - then you should expect economic growth to stall. The Bank of England will start cutting interest rates again, and fast.

Equity investors would be hit by falling corporate profits; bond-holders would be rewarded not only by rising bond prices, but also an increase in the real value of their assets.

Which of these two scenarios is right? At this point, the situation is far from clear. But that will change over the coming months...as the Bank of England’s baby-step rate rises really start to bite.

In the meantime, cash - with its ever-higher return and inherent flexibility - remains the asset class of choice.


Regards,

James Ferguson
for the Daily Reckoning

P.S. Britain’s current inflationary bubble has manifested itself in house prices. Yet neither house valuations nor even average mortgage costs are included in the new official measure of inflation, the more Euro-friendly CPI.

Since Gordon Brown gave the Bank of England freedom to set rates, it was inevitable that the measure he told it to target would become a political issue. But it now seems so far removed from reality, it’s impossible to tell whether Britain actually has any inflation or not. The old measure, the RPI is already growing at nearly twice the rate of the CPI - a rate of 2.8% versus just 1.5% per year.

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