Inflation and deflation

James Ferguson - Wed 02 Jun, 2004

...Only a year or so ago the main worry was deflation. Today, it’s inflation...

Inflation and deflation

The fickleness of market commentators is famous. But the last year has seen swings in opinion that are impressive even by their usual standards.

Only a year or so ago the main worry was deflation. Today, it’s inflation. Just two months ago, the Monetary Policy Committee (MPC) of the Bank of England voted eight to one to keep rates unchanged. But the minutes from their last meeting show them discussing raising rates in half point stages, something I’m sure isn’t far off.

Inflation and deflation: Why the big shift?

But why the big shift? On the surface, nothing seems to have changed. The consumer price index (CPI) seems almost comatose at 1.2%. And while house prices are still rising rampantly, it’s hardly a new worry. They rose 15% last year.

However, it’s not the CPI that has really got the MPC’s goat - although there are clear signs that general inflation is on the up. Instead, it’s debt. The Bank has diligently lifted rates by a quarter point three times. But to no avail. The April data show that, rather than slowing down as it was supposed to, the growth of personal debt - both unsecured and mortgage related - is out of control.

Consider mortgage equity withdrawal (MEW). Rising house prices mean that UK home owners have been withdrawing equity at record rates. Total MEW not only far exceeds mortgage borrowing for new house purchases, but is now back at levels last seen in 1989.

Inflation and deflation: The Bank of England's fault

This worrying state of affairs is all the Bank of England’s fault, as the MPC well knows...

** Back in 1998, when Russia defaulted on its debt, they decided to do their bit to prevent a global meltdown. So they cut rates from 7.5% to 5%. On the plus side, this did stop meltdown.

** Unfortunately, the easy availability of cheap money it caused also led to the dotcom bubble of 1999 and then to the bust of 2000, an equity market disaster that made it impossible to inch rates up again. Instead, we got another round of cuts, this time from 6% down to 3.5% last year.

** Again, this tactic came with an upside and a downside. The upside was that the cuts bailed out corporate profits. The downside? Another liquidity driven bubble...this time in the housing market.

It is this bubble that has led to the surge in Mortgage Equity Withdrawal and hence of debt-fuelled consumption. And the reason the MPC is spooked? This kind of situation often ends in recession.

Inflation and deflation: Recession

To understand why debt-led consumption is so often a route to recession, think of the whole economy as just one company. Let’s say the firm has sales of £100 and total costs - mainly wages - of £88, and hence a profit margin of £12 or 12%. Then let’s say that, with house prices booming, the excited labour force withdraw equity from their homes to give themselves total spending power of £95 (and the total economy spending power of £107) - much more than their income. Then sales go to £107 and profit margins to 19%. This isn’t like real growth - wages haven’t gone up and there is no further income-tax increase on the additional spending. But corporate profits will still reach record levels.

Note that in the UK today profits are at historically high levels, but Gordon Brown is seeing significant tax-revenue shortfalls...

Inflation and deflation: "Imbalance"

For now, this situation may be - as the Bank says - “an acceptable imbalance”. But “imbalance” is Bank-speak for something that can’t go on forever. If house prices stop rising, mortgage equity withdrawal will fall off. But the workers won’t want to see their spending fall, so they will demand higher wages...even as the national company’s sales are falling. Our firm now has margins falling back to 12% and really doesn’t want to raise costs, but what can it say when unions point to big gains in profits last year?

So what happens next? Sales and profits stagnate amid rising wage demands. The final result: stagflation and recession.

This scenario isn’t inevitable - debt could slow down. But for now debt is still growing. And now Britain’s firemen and railwaymen are already threatening to strike...

Inflation and deflation: Debt service costs

What bothers the MPC is that over the last decade people were less concerned with their absolute levels of debt and more with how much it costs them to service it. Debt service costs have stayed at about 9% of post-tax income for some time: as rates have fallen, households have been able to take on more and more debt, but keep the costs of that debt steady. So far so good, but the fact is that taking on debt is much easier to do than getting rid of it when interest rates start to rise.

You might start trying to pay back your principal debt faster, but higher rates are already taking a bigger slice of your income in interest. That’s why recessions often last longer than the bubbles that set them off.

But that’s not the end of the MPC’s worries. The next nightmare is an increase in “precautionary saving”. Usually, as soon as whatever external shock it is that initiates the end of a debt-fuelled boom has hit - an oil crisis, house-price collapse, or some such event - the response is a sharp increase in the savings rate as the population panics. The savings rate went from 4% in 1971 to more than 10% by 1975 as the 1973-4 housing collapse hit, for example. That hit consumption and made recession even more likely. Today, the savings rate is 2% below its long-term average. If consumers get nervous, it will rise fast.

Inflation and deflation: Raise rates fast

So what can the Bank do to mitigate the pain of this scenario? Raise rates fast, I’d say. If it doesn’t take serious action now and accept some kind of controlled crash, there’ll be a bigger one later.

The Bank’s Sir Andrew Large, for one, is aware of this. In March, Large pointed out that the debt-service burden, then around 10%, would hit its 1990 peak of 15% within two years if we don’t start paying down our debt sharpish. The MPC won’t now just sit around and wait for this to happen, particularly as the Bank has already admitted that they have been “surprised somewhat” by the strength in house prices since they started raising rates, and by the continued rise of consumption over the last few years.

The fact is that rates have been too low for too long, and the Bank of England knows it.

Inflation and deflation: Baby steps versus shock tactics

Yet so far, the MPC tactic for dealing with their crisis has been to take baby steps - raise rates bit by bit until the rate of debt increase slows down. But it isn’t working. Debt growth in April was at record levels and mortgage acceptances are still rising fast. The upshot? It’s time for shock tactics.

The next move is likely to be a full 0.5% hike in rates. The bond market knows this. That’s why yields on ten-year gilts are their highest for two years. High yields suggest an expectation of high rates.

The Council of Mortgage Lenders knows it too. This is why they have aggressively raised their year-end interest rate forecast from 4.5% to 5.25%.

But when will home owners and buyers recognise this, and stop ratcheting up their debt levels? Rates are going to rise far faster and further than most of us think, starting next month.

Smart investors will be ready.


Regards,
James Ferguson
for the Daily Reckoning


P.S. Even the pundits in the press have finally woken up to the need for a sharp rise in UK interest rates. “Rates are going up, however uncomfortable for homebuyers - and the Government - it will prove,” said an editorial in The Scotsman last week. “The jumping point for the boiling frog must be close,” said Bill Jamieson in Scotland on Sunday, “but it may be in for a bigger shock when the cold air hits.”

Yet still British consumers borrow and spend like the E-Z credit cycle is only just beginning...instead of reaching its end. As the Telegraph put it a few days ago, “The Bank of England needs to rediscover the virtue of surprise and raise rates by a half a point next month.”

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