The Bank of England is still fighting the wrong dragon

The latest figures for the UK and other Western economies confirms that the main threat is falling activity rather than inflation. The ECB and the Bank of England still think they have a problem balancing their prime aim of cutting inflation with their wish to avoid a major downturn. They have kept their rates on hold. They seem to ignore the delays between tightening credit and the impact it has on prices.

Over the last three weeks there have been heavy falls in the oil price. Where last month some pundits and market participants were telling us it could only go up, and were headily forecasting even $200 a barrel oil, today there are bears on the prowl seeking to extrapolate from the most recent trends. They ask if it can fall $30 in a month, by how much more could it fall in two?

The inflation of recent months has been fuelled by the twin pressures of higher energy prices and higher food prices. In the UK this has been assisted by a government which has failed to reform the Common Agricultural Policy which has kept food prices higher anyway, and has imposed taxes on petrol and diesel which in part increase as the price of the underlying product rises. It is true that companies worldwide have so far had some success in passing the commodity price rises on, thanks to the reduction in aggressive pricing by India and China on world markets. It is also true that there is some modest upward drift in wages and salaries, reflecting links to higher Inflation statistics. Both these tendencies will be abated by the slowdown in demand. The more wages go up the more businesses will in due course shed staff as they will not be able to afford them all.

For months now I have found it bizarre that well trained and well paid people at the ECB and the Bank of England can seriously think there is an inflation problem two years hence (the typical timescale for the full effects of monetary action to be felt). In the UK have they not seen the 20% fall in commercial property prices, with more to come? Have they not noticed the sharp decline in new housebuilding, and the rapid fall in house prices in recent months? Have they seen the contraction of new mortgage credit, the main form of lending money to individuals in Britain? Just as they ignored the obvious signs of overheating and too much credit in 2005-6, so today they ignore the obvious distress of too little. They made the first mistake of failing to curb credit excess a couple of years ago because price rises then were small, thanks to Chinese and Indian pricing. They were spurred on by a UK government that was leading wonky finance with its huge commitments to PFI and PPP schemes, buying things on the never never for taxpayers who will end up paying dearly for the privilege. Now we are having to live through the second painful mistake, ignoring the collapse of credit at a time when some world prices have been rising too quickly for comfort as a result of past credit excess.

I remain of the view that inflation will subside next year as measured by the RPI, as lower commodity prices work through. I also expect more companies to reduce their workforces to combat lower demand in their sectors, and for there to be several more months of a squeeze on people’s incomes as the full effects of energy price and food price rises work through against a background of restraint on wage increases, and as more people lose their jobs.

The FSA’s prognosis that the banking sector will be in for as tough a time as 1991-2 may be right and shows the regulator understands the seriousness of what we are living through. They have been right to urge the banks in London to raise more capital. What we need is better co-ordinated action between the FSA and the Bank of England, organised by the Chancellor, if we are to continue with the three headed system Gordon Brown so foolishly designed. Identifying the problem and telling the banks to raise more capital is prudent, and all that the FSA can do. Too much prudence after the crisis will simply delay recovery – we needed more prudence before the crunch. The Bank of England needs to offset some of the contracting effects of banks raising more equity and being more cautious in their lending, through its operations in the money markets. It also needs to cut interest rates.

Without further action credit will remain too tight for comfort. Northern Rock is turning into the expensive nightmare readers of this site will be expecting. Losses of £585 million in just six months may well be followed by further losses, as the bank is writing practically no new business but still has staff numbers as if it were. I always thought they would lose us more than a billion and see nothing in these first figures to change my mind. Indeed, converting £3 billion of the outstanding taxpayer loan into new equity implies we should prepare ourselves to say good bye to a substantial sum, at least for the foreseeable future and maybe for ever. The best action the government could take is to sell what remains of Northern Rock at whatever price they could get for it as quickly as possible, with an agreed repayment programme for all the outstanding taxpayer debt and the new equity. That way we would have more chance of getting all our money back, and the newly privatised bank could start writing more mortgages again to make some money and ease the shortage of mortgage finance in the market. If the government could get £1 for it (or maybe more in an auction) and the promise of full repayment, it would be a better deal than we have now with it nationalised and destined to cut and cut again as it cannot write new business.

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7 Comments

  1. adam
    Posted August 9, 2008 at 12:36 pm | Permalink

    Put it on ebay. Someone will pay at least a fiver.

  2. harry
    Posted August 9, 2008 at 2:09 pm | Permalink

    'The latest figures for the UK and other Western economies confirms that the main threat is falling activity rather than inflation.'

    If the United Kingdom:

    (1) Dismantled the Welfare State – Housing, Health etc releasing tens of thousands of wastrel do-nothings into the labour market

    (2) Introduced a flat tax of say 15%, thus releasing tens of thousands of Uncivil Servants into the real labour market

    (3) Disassembled the system of regimentation of Capital and Business that presently exists
    (3a)Left the EU and started to be responsible again for it's own way in the world

    (4) and most importantly returned to the Gold Standard,

    then none of the present systematic fiddling around by government would be necessary. What we need is a political party which will advocate these things instead of buggerarseing with windmills, politically correct crap multi-culti trash and suchlike. Any ideas?

  3. Tony Makara
    Posted August 9, 2008 at 2:09 pm | Permalink

    I believe the MPC's decisions are being undertaken with the strength of Sterling in mind. It would be dangerous for the MPC to cut rates at a time when Trichet and the ECB are so hawkish. Once confidence in Sterling is undermined it could be open to a very severe correction sending the cost of imports through the roof. George Soros, who knows about these things, has predicted that Sterling is heading for a big fall. So the BOE is right to try and maintain the purchasing power of the pound at this time, in spite of the implications for restricted liquidity and economic downturn.

    Reply: The pound has been falling and may fall more, so the policy isn't working. The Euro is now too strong and the ECB are throttling the Euroland economy with their interest rates which are too high as well.

  4. Derek W. Buxton
    Posted August 9, 2008 at 4:47 pm | Permalink

    I wish I had your confidence that inflation will fall on it own. That will not happen while the EU mandates bi-fuel for transport and our provincial government agrees. We should certainly buy more on the world market but we are in CAP. You do say that we should get out, how? It prevents us doing what is best for our Country to help the French. On top of all that energy prices I am told are higher here than on the continent. Whilst that situation appertains we are stuck with higher prices than should apply, so inflation is built in. This is a no win situation for all those on the lower pay scales, workers, pensioners and those on fixed incomes.

    Unfortunately, there is nothing to be done while the EU rules the roost, worst of all, with a few honourable exceptions no politician even understands the problem, let alone has an answer.

    • mikestallard
      Posted August 10, 2008 at 7:38 pm | Permalink

      May I interrupt here?
      I have been asking myself for ages this question too: why do all our politicians go along with the EU?
      Is the answer that politics is all about alliances and making friends and doing deals? If you offend people, then all this goes out of the window. You are an immediate failure.
      It is absolutely obvious that the key players – France and Germany – are not going to stop supporting the EU – biofuels, windmills, Napoleonic foreign policy (without the army) and the CAP and Euro stability too. Look at how they are behaving over ireland to take just one example: fanatics! And they are not open to negotiation either.
      So the easiest thing is to go along with them. Smile and wave!
      It was, of course, the "No No No" speech of Mrs Thatcher that caused the queue of men in suits who got rid of her.
      Hence the reserve and – yes – cowardice of the current politicians.

  5. mikestallard
    Posted August 9, 2008 at 5:59 pm | Permalink

    Interesting that yesterday in the paper we read about a poor lady who, although she was a wonderful, careful person, was evicted by the ogres at Northern Rock. I suspect that the people who are evicted will not be voting Labour. So, why not just give it away, as you suggest? Is it because the Labour (still?) have faith in nationalised industry?
    Why is England so rich? I am puzzled. What do we actually produce? And why is the pound so strong? What does its power rest in? As far as I can see, we don't manufacture anything much, our agriculture doesn't really feed us and we buy in most of our stuff, like power, from abroad. We do not exploit our (rich) mineral deposits any more.
    So why should there be an upturn if we do not deserve it and have not worked for it?

    Reply: We are asset rich because many foreigners come and spend huge sums on buying London property assets, and we still generate substantial income from traded services.

  6. William B.
    Posted August 10, 2008 at 12:33 am | Permalink

    There appears to be a common theme linking this subject and the comments about Caroline Flint's public performances. Both evidence the government's lack of any apparent strategy. Lurching from crisis to crisis by announcing possible solutions and saying they are all being reviewed is hopeless. Within minutes of the current Chancellor suggesting a possible relaxation of Stamp Duty the blogosphere was awash with calls for him to make a decision because he had just frozen the housing market, and so it has proved.

    There are times when decisions must be made quickly and then changed quickly if they backfire, this requires someone to raise his head above the parapet and take the lead. I am sure the lack of strategic thinking is a direct consequence of Mr Brown simply not being one of nature's leaders. I am sure we have both seen the same at our cricket clubs, Mr Redwood, there are some who are natural captains and some who just can't do it even though they may be good players. Those, like me, who couldn't lead Bill Clinton to a pretty intern, are best advised never to put ourselves forward, if we did it would be a disaster for all.

    What a dreadful state of affairs we are witnessing.

  • About John Redwood


    John Redwood won a free place at Kent College, Canterbury, and graduated from Magdalen College Oxford. He is a Distinguished fellow of All Souls, Oxford. A businessman by background, he has set up an investment management business, was both executive and non executive chairman of a quoted industrial PLC, and chaired a manufacturing company with factories in Birmingham, Chicago, India and China. He is the MP for Wokingham, first elected in 1987.

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