After An October To Remember What Next, Inflation or Deflation?

October has been another month of great change, starting with the US Congress finally passing the $700 Billion bail-out of US banks and now with a week to go, we have the Governor of the Bank of England (pre-empting the publishing of data) announcing in a dinner speech that the UK economy is now officially in recession.

During October we’ve witnessed the collapse of the Icelandic banking system and the bankruptcy of their government, the £37 Billion investment by the UK government into shares of RBS, Lloyd’s TSB and HBOS as part of a wider £500 Billion UK bail-out package; and similar actions by the rest of Europe to recapitalise the western baking system with taxpayers money.

To fund the UK governments spending spree we’ve seen UK borrowing for the first 9 months of the year reach £37.5 Billion and we now look well set to break £60 Billion national debt for the year. We’ve also seen the CPI measure of inflation reach 5.2%, well above the Bank of England’s target of 2%, and we have also seen the BoE lower interest rates down to 4.5%.

The results from these events on the UK are as follows, in Iceland UK councils, police forces, universities and private individuals have seen nearly £1 Billion pound of investments disappear into the black hole of bankruptcy, with only the first £50,000 worth of investment looking likely to comeback out. This means huge losses for UK investors and institutions, and the rather humbling acceptance by the Icelandic government that they are unable to financially rescue their banks or wider economy, and will probably default on payments themselves.

The bail-out of the UK banks by Gordon Brown’s Labour government was carried out through crisis talks at 10 Downing street, held with the CEO’s of the UK high-street banks, and put together a deal which would see an immediate £37 Billion investment in shares, a £250 Billion lending guarantee to kick start interbank lending which has dried up and been replaced by the BoE. The final £213 Billion would be used to purchase the ‘Toxic’ debts that are still on the balance sheets of UK banks, and are preventing this crisis from ending.

For the banks part of this package they are to end the ridiculous bonuses to employees that have seen this collapse occur in the first place, a moratorium is to be placed on the payment of dividends while using tax payers money, and the senior executives of the banks involved are to leave without taking their golden parachute payouts (severance pay).

Moving beyond the distractions of leading UK banks, I would like to deal with the real problem that is at hand, the now apparent UK recession. I have heard many commentators such as DeAnne Julius (former MPC member) or Anatole Kaletsky (Writing for the Times) suggest that we need to lower interest rates, and more aggressively that the 0.5% cut that the BoE did this week.

Both commentators suggest that a rate cut would help fix the lack of credit availability and lower the current borrowing costs between banks, known as LIBOR. This would then help stimulate the UK economy and help prevent a prolonged recession. The difference between the commentators is the acceptance by DeAnne Julius that this policy will cause long term damage, where as Anatole finishes his article by suggesting that a drop in interest rates would help lower the trading value of the pound and help stimulate export sales, further boosting the economy.

I however take a very different view on the current situation and the results of interest rate changes. I think inflation will not fall but instead will increase. This is because although prices of commodities have started to fall now that a global recession is taking hold, I don’t see these price drops being passed onto UK consumers.

After a difficult 12 months in which most companies have see their gross profits squeezed to almost nothing, the chance to buy in at a lower price while holding a higher sales price will help off-set some of the missing revenue of the last 12 months. The banks have already started to make this a reality with the latest round of interest rate cuts by the BoE not being passed onto consumers, but quickly being passed onto savers. This will maximise the banks revenues out of both savers and borrowers, but at the same time demonstrates how the current assumption, that we will experience a period of deflation, is not going to happen.

Further evidence of the UK’s inability to price downwards can be seen in the latest data coming out from the Farming industry, as despite a global fall in the price of dairy goods has already begun, the UK market has actually seen price rises.

Secondly, As Alice Cook from UKBubble fame is regularly pointing out, there is still a massive disconnect between interest rate movements and the resulting movement in the LIBOR rate. The lowering of rates is in fact making the gap more pronounced and as LIBOR refuses to budge, the gap shows how the mechanisms that make interest rate moves so effective, have now gone, and demonstrate the weakness of the Bank of England in effecting the key market area of lending rates.

This now means that the area most affected by interest rates is not lending or borrowing, but is in fact savings. As returns for savers are cut by the banks, two negative responses will occur. Firstly cash will leave UK banks for foreign banks, as they offer better returns, further damaging the capital base of struggling UK banks. Secondly, and Most importantly however will be the collapse in our currency, the Pound, on the international markets.

Unlike Anatole Kaletsky I see this as damaging the UK economy because we don’t export manufactured goods any more, and since the credit crunch started we don’t export that many financial products either. We currently have a balance of payment problem where we import £7.5 Billion per year more in goods than we export. This means that although the gap may narrow due to changes in purchasing behaviour, unlike the rest of the world where prices of food are falling, our collapsing currency will actually see our prices rise, as our imports become more expensive.

The third reason why we will see inflation not deflation is that for the last 12 months we have seen inflation increase well beyond the 2% target set by the UK Government and Bank of England. This prolonged period of high inflation has now translated into higher wage demands. My primary evidence for this (apart from it being obvious) is that my own employer agreed 18 months ago to provide a pay increase at the rate of either 2.5% (near the CPI target) or at the current level of the Retail Price Index. When this agreement was originally struck RPI was below 2.5%, so not a problem. Now however RPI stands at 5.0%, and it has been confirmed that I will very soon be getting a backdated pay increase of 5.0%. As I doubt that my company are alone, and as I’m aware that most Financial city jobs also track the RPI for pay increases, this is a clear demonstration that the wage price spiral has now begun.

Taken together, price reductions not reaching customers, a falling currency and the start of wage related inflation indicates that prices will be increasing, not decreasing. Further more, a higher national debt level and plans to massively increase government spending in the economy with that borrowed money, sound like the old inflation generating Keynesian policies that failed during the 1970’s, of ’spend your way out of trouble’. The added problem of reduced interest rates, and a disregard for inflation mean that any benefit that is derived from reducing interest rates today, will not only fail to arrive in time to help, it will undoubtedly be at the expense of double digit inflation tomorrow.

DeAnne Julius knows this, when asked in her interview about the impact of current government moves to spend £37 Billion with borrowed money, she didn’t deny it would have a serious negative (upward) impact on inflation further down the line. Gordon Brown knows this, which is why he had 2 big rules – only spend to invest & his golden 40% borrowing rule. This was because spending to stimulate demand caused hyper inflation in the 1970’s leading to the ‘Winter of discontent’ in 1979, where we had double digit inflation and interest rates.

In my estimation this is where we are headed again, double digit inflation & interest rates. As inflation isn’t dealt with because the government and ‘Leading Economists’ (who didn’t see the credit crunch coming) now claim we will experience deflation; what we’ll end up with is rampant inflation and then the inevitable move by the Bank of England, an increase in interest rates to deal with this problem. At that point we’ll have the 1979 problem of high inflation and high interest rates, huge government borrowing and crippling interest payments on the new bonds (gilts), issued to pay for the increased government spending. All we then need is increased public taxation to replace the declining revenues of businesses, and we’ll have the full set (Although this at least has not yet been announced).

The affects of 8% (or higher) interest rates on anyone who has fallen into negative equity (estimated to be 2-3 million homes) will be horrendous as the majority will be repossessed and bankrupted, and we’ll be back to 1990 again, with keys being posted back through estate agents letter boxes. As both the government and Bank of England know that a failure to control inflation will cause this, I would disagree with DeAnne Julius, Alistair Darling (Chancellor), Merv King (BoE), Anatole Kaletsky and the whole dam world by the look of it, that lowering interest rates is the right thing to do, or that inflation will be lowered by falling commodity prices.