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 peopleâ€™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 FSAâ€™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 â€“ 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 Â£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 Â£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 Â£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.