Perhaps it takes a central banker, unencumbered by changes of government, to spell out what politicians on both sides of the Atlantic seem so wary of articulating, viz. that the crisis was brought about by overspending and can only be solved by lowering the standard of living in the countries concerned. Mervyn King of the BoE assumed the task this week in a major televised speech. He used the expression income squeeze, defined as wages and salaries rising more slowly than inflation, as one of the steps to the UK regaining its international competitiveness, with unavoidable cuts in public spending and a lower Pound also helping to rebalance the UK economy.
He expressed sympathy for countries in a similar position to the UK, but without the option of a weaker currency (for them only greater cuts in salaries can work), and also for savers and people living off the return on their savings. Clearly a return to normal levels of interest rates is desirable for the Monetary Policy Committee. Yet King also justified keeping rates low, even at the cost of exceeding the 2% target inflation rate, by spelling out that the BoEs remit included letting inflation exceed the target in exceptional circumstances. For him, the crisis and the rise in commodity prices are clearly exceptional.
Whether the MPC will raise rates in March remains unclear, but undoubtedly the decision will be better informed at that point in time (when we will know whether yesterdays announcement of a collapse in 4th quarter GDP numbers was indeed an aberration, largely attributable to the British weather!) . Nevertheless, a modest rise in bank rates seems likely.
Trichet of the ECB is saying much the same thing as King. The rate of inflation may have exceeded the 2% target because of external cost rises, but the key thing is to avoid secondary effects, i.e. allowing wage rises to keep up with inflation. That is the same message as Kings, albeit it expressed in a different manner.
Thus far, our expectation that the European authorities would successfully contain the sovereign debt crisis is proving justified. The need for a long-term solution, by revamping the workings of the Euro zone, remains, but is being addressed. Until recently, we could only describe investing in peripheral country debt as a punt, whereas now the entire risk/reward balance, and choosing the most attractive maturities, lend themselves to more conventional analysis.
In many ways, the situation in the US has startling parallels to that which existed before the crisis: the stock market is rising and the GDP expanding. Our own questions also remain largely unchanged, as do our concerns that this apparent recovery is not based on solid fundamentals. Where are the real investments? Has the housing crisis been solved? Is the Federal Government facing up to reducing the deficit? Is the low cost of money a reflection of its huge supply through continued quantitative easing? Why is unemployment so stubbornly high, and ultimately can a country, even a super-power, spend its way out of a crisis which it created by excess spending?
We believe the answers to these questions to be very obvious, and we have often rehearsed them here. Yet the answers to two other questions continue to elude us:
Why is the United States yet to see the inflation emerging elsewhere, and when will it?
When will QE be reversed, and what will happen at that point, when government debt begins to be sold on the open market?
When pondering these issues, we cannot help but note that the practice of a central bank buying the debt of its own government has always led to high inflation (and sometimes, to hyper-inflation). In due course, we still see the USA being forced to accept a European solution. We might then see Americas Central bankers, rather than just its movie going public, gain an appreciation of a Kings speech!
January 26th 2011
Dr. Roy Damary