Aug 29 2007
The markets fall again
After some respite markets lurched downwards again in the first half of this week. One of the problems was the report from the Fed’s last meeting, where there was no discussion of early Fed interest rate cuts to deal with the crisis. The continuing uncertainty over how much each bank and fund has lost, and what impact this will have on future lending is always with us as a reason to be nervous.
I still think the crucial actors in this drama are the main Central Banks.
Since the worst of the crisis it appears that the Fed has changed its stance. The fact that the last meeting did not report a future move to lower interest rates is no longer proof that interest rates are going to held at present levels. It is quite likely that the September meeting will take a different view. The Fed cutting rates would boost confidence.
The European Central Bank has now changed its official position. Following the massive assistance it offered a vulnerable banking sector it has now acknowledged that further interest rate rises are not a good idea. The ECB cutting rates would help the troubled Euroland economy and banking system.
Only the Bank of England remains officially thinking of a further interest rate increase.
Some of my readers seem to hold the view that teaching the institutions who have lent and borrowed too much would be a good idea. My response is I think they have been taught a lesson, by central banks who have lurched from encouraging them by keeping rates too low, to warning them off by hiking them too high. The problem is you cannot insulate the impact of high interest rates just to a few rich companies and people who went over the top. Everyone feels the impact, because interest rates are the means by which the authorities either speed up or rein back the economies. If they keep rates too high for too long it will mean fewer jobs, and less propserity.
John Redwood has been the Member of Parliament for Wokingham since 1987. First attending Kent College, Canterbury, he graduated from Magdalen College...
John, do you think there is a real danger that the US economy could overheat if interest-rates are cut, particularly as the dollar is relatively weak these days? The last thing the US economy needs now is the return of inflation.
Reply: No I don’t think there is much of a danger of strong inflationary pressures. The banks are going to be very cautious in how much they lend for bit.
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The problem is that if the central banks cut rates, then won’t we all pay for the risky lenders’ mistakes in higher inflation? And when inflation rises (it’s already high) rates will have to rise further? I think the BoE should keep rates on hold for the moment to see what happens. I don’t want a credit crunch but surely solving a bubble situation by pumping more cash into the system is just delaying the inevitable?
Reply: There are no easy answers. The Central banks have made a large collective mistake by keeping rates too low for too long, inviting the debt mountains we now face. They now have to ensure enough liqudity and low enough interest rates in the system to prevent the protracted and damaging kind of squeeze Japan experienced for more than ten years from 1990. They also need to make sure they do not cut rates so much that they increase the propensity to borrow in an inflationary way. The problem at the moment is the reluctance to lend, not any great pressure to inflate, in both the US and Euroland.
The Uk is a bit different, because the government has been boosting demand artificially by borrowing so much. Inflation has risen higher here (on the RPI) and we still have to deal with the impact on food prices of the poor summer. Even so, I think we have seen the peak of the inflation in the UK. If the government wanted to help, it would start to increase productivity in the public sector, which would make an important contribution to curbing inflation. It has been increases in student fees, postal charges, rail fares and some other public sector costs that have boosted inflation.
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John, considering the exceptional strength of sterling, which must now have peaked, do you see a danger of inflation once the pound starts to take a sustained tumble?
Should such inflation occur, and the BOE ups interest-rates, is there not a danger that the extra interest will increase debt thereby creating a demand for money that doesn’t already exist, creating a wave of inflationary pressure?
The way Labour have tried to create growth through debt and spending has produced a dangerous ‘interest-impetus’ which will not be easy to iron out.
Reply: A fall in sterling will push import prices up, but it will mean a further squeeze on our spending power. Watch wages - they are under reasonable control, and Brown is now for the first time this century putting a real squeeze on public sector pay. Whilst inflation is worse here than in the US or Euroland, it is not going to run out of control in my view.
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“I think they have been taught a lesson, by central banks who have lurched from encouraging them by keeping rates too low, to warning them off by hiking them too high. ” (JR)
What lesson have we learned then? From a personal perspective I’d say I’ve learned the world revolves around money and that human financial behavior can be controlled to some extent by shifting interest rates down and up. Recent events have been most enlightening.
I do often wonder about the gap in perception of, for example, ‘inflation’ between yourself and a non-economist such as I. You probably hear the word and understand the concept in advanced economic terms, whereas all I know is that it is fundamentally in increase in the money supply and measured by RPI and CPI.
Therefore when you say inflation has peaked, I cannot help but think that more rises in oil prices, now that deflationary pressures from the developing world are decreasing, and that the pound is not rising against the dollar, could push up the CPI and RPI. This might not be ‘inflation’ as in people printing lots of money but if the BofE are targeted on 2% CPI surely it can affect interest rates as well as prices?
Reply: I see and experience inflation as you do. The CPI has been well below the typical experience of Uk consumers in recent months. The RPI has been closer to the average experience, and running at a much higher rate than CPI. Of course some prices will continue to go up, but I think we will find that the overall rate of price increases is less fast in the year ahead than it was in the year just gone. Wages are being kept under strong control. Inflation was brought on in the UK by the government borrowing too much and pushing too many bank notes out into the banking system with the help of the Bank of England. Now they are trying to rein this excess back in with higher interest rates and fewer notes being printed. The US sub prime collapse will help bring credit under control.
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This is interesting from the telegraph 30/08/07 I’m facinated to see what will happen when sterling takes a dive. In my opinon the strong pound has been Gordon Brown’s main defence against underlying inflation.
Sterling falls after BoE makes emergency loan
By Richard Blackden
Sterling declined against the dollar as news that the Bank of England had lent
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