Category Archives: Policy

Rate hike won’t sustain GBP strength

I’ll make this short because I’ve covered this ground in this blog before, but recent gains in GBP in response to the latest inflation data and the more hawkish tone from the Bank of England at the September meeting make it worthwhile to go over it once again.

First, the basics. Higher inflation, other things equal, should mean a currency goes down, not up, in order to maintain the relative price level. The fact that currencies tend to rise in the short run with upside surprises in inflation is an anomaly seemingly based on a combination of money illusion and a historic expectation that higher inflation will trigger a response from the central bank that will actually mean higher real interest rates. This seems to be a distant memory of the 1970s and 80s, because it is hard to find occasions in the more recent past where higher inflation has triggered higher real rates (as opposed to just higher nominal rates) in the major economies. Of course, real rates have been falling steadily for years as a result of structural as opposed to cyclical factors, but even the cyclical upturns have seen precious little rise in real rates (see the FX market needs to rethink inflation, November 18 2016).

All this is relevant to the recent reaction to UK news. Inflation is above target and still rising, mainly in response to the decline in GBP seen after the Brexit vote. The MPC is now considering a rate rise in response. But the rate rise will come nowhere near full compensation for the rise in inflation seen since the Brexit vote. Real rates have fallen, and even if we see a 0.25% rise in the base rate soon they will still be well below where they were not just before the Brexit vote, but immediately after the BoE cut in rates after the vote (see chart below). While inflation has also risen elsewhere, it has not moved as much, and UK real rates remain unattractive, and will remain unattractive even if they move modestly higher.

Real UK base rate

uk real rates

Source: Bank of England

On top of this, there is the question of whether higher real rates in these circumstances, if they were to come, should be seen as positive for GBP. In general, higher real rates are theoretically positive for a currency, but in the current UK situation Carney’s speech yesterday makes it clear that his case for higher rates is based primarily on the expected inflationary consequences of Brexit. This is not the usual cyclical impact of rising demand, but a structural change that will reduce both demand and supply and raise prices, at least in the short run, with Brexit effectively acting as a de-globalisation. Carney’s case for higher real rates essentially rests on the belief that the Brexit impact on supply will be greater than the impact on demand. This is debatable (as he himself admits) and it is hard to instinctively see this as positive for GBP, because real rates will be rising because of reduced potential output due to reduced efficiency and lower productivity. Any benefit from higher portfolio inflows to seek out the higher real rates seems likely to be offset by reduced inward direct investment as a result.

In summary, the case for GBP gains based on a more hawkish BoE seems very weak. Any rise in nominal rates looks unlikely to translate into a rise in real rates, and to the extent that real rates are higher than they would have been, it will likely only reflect the Bank’s concern that Brexit is going to undermine potential UK output growth by reducing productivity and undermining existing supply chains. Of course, that doesn’t mean GBP will reverse recent gains quickly (the market can remain irrational longer than you can remain solvent), but looking at the charts suggests to me that 1.38 would be a very good area to sell GBP/USD, while anything below 0.87 looks a buying area for EUR/GBP.

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Riksbank policy – dangerous, myopic and unsustainable.

I’ve seen some fairly odd decisions made by various central banks in my 30 odd years in the markets. But they normally have some sort of explanation, even if you don’t agree with it. But in the case of the Riksbank decision last week, I honestly cannot understand the rationale for not only leaving rates and asset purchases unchanged, but also leaving projections for future policy unchanged, with the first rate hike not expected until 2018. It is frankly utterly bizarre, and smacks of an ill-conceived desire to maintain a weak currency – a desire that has no justification whatsoever given Sweden’s macroeconomic circumstances.

Even at the July meeting, it was quite hard to justify the super easy stance of the Riksbank. The economy has been growing at 3% +, the employment rate was at record levels, and inflation was only modestly below target. But despite having the strongest economy in the G10 Sweden was running one of the easiest monetary policies, with the repo rate at -0.5% and asset purchases continuing. At the September meeting the Riksbank had to consider the news that GDP growth had accelerated to 4% y/y in Q2, and inflation had risen to 2.4% on their targeted CPIF measure, above the 2% target for the first time since 2010. But the Riksbank decided not only to continue with their hyper-easy policy, but didn’t change the view that they wouldn’t raise rates until the second half of 2018. Why? Well according to the Riksbank:-

” For inflation to stabilise close to 2 per cent, it is important that economic activity continues to be strong and has an impact on price development. It is also important that the krona exchange rate does not appreciate too quickly.”

In their report the Riksbank accept that growth is stronger than expected, inflation higher than expected (and above target), resource utilisation is approaching historic highs, and the employment rate and household debt at record levels, but they still want to keep rates at historic lows. The only reason they appear to have is that they don’t want the currency to rise too fast as this would endanger the inflation target. This seems to me to be an incredibly short-sighted policy, which has been shown to be unstable and dangerous in many places in the past, the UK most notably.

Sweden is a very open economy, and the currency certainly will have a significant impact on inflation in the short-term. But in the end keeping interest rates at a level that is inappropriate for the economy in an attempt to prevent currency strength is courting disaster. The result will likely be continued strong growth in the short run, further rises in household debt and above target inflation. When the brakes do have to be applied they will have the be applied that much harder, sending the currency up that much quicker. Or if the Riksbank choose not to apply the brakes, perhaps because inflation doesn’t rise too much, they result will ultimately be that the excessive debt burden causes a crash.

This isn’t just about Sweden, it’s also about the weakness of the policy of inflation targeting. The inflation process may well have changed significantly in recent years, with wage growth failing to ignite despite low and falling unemployment in Sweden and the Anglo-Saxon economies. The path from policy to the economy to inflation has not only changed, it may be almost completely blocked. Inflation is being determined elsewhere by other factors. Setting interest rates to control inflation in the short to medium term is becoming a ridiculous endeavour, and attempts to control inflation by controlling the currency are taking huge risks with the economy.

But it’s not even the case that the Swedish krona is particularly strong. The Riksbank likes to use the nominal KIX index, which shows the SEK slightly on the strong side of recent averages, and they cite the recent rally as one of the reasons for their decision in September. But measures of the real exchange rate show it to be very much on the weak side of historical norms. Attempts by the Riksbank to stop it rising are ultimately futile. Sooner or later it will return to normal levels, and it is better to allow it when the economy is strong and running a substantial trade surplus. A strong currency is a good thing – it makes consumers richer. They will be able to spend more without increasing their debt, and the trade surplus might come down. Instead, the Riksbank are following an unsustainable and dangerous policy, tying their policy to a region (the Eurozone) which is years behind Sweden in its recovery.

sek

Source: Riksbank, BIS

Germany’s trade surplus is down to Germany not the ECB

In a speech in Berlin yesterday, Merkel said the German trade surplus was propelled by two factors over which the government had no influence, namely the euro’s exchange rate and the oil price. Well, there’s some truth in that, but not much. It’s fair to say that a weak euro probably does increase the trade surplus, though the impact of the exchange rate is quite delayed and weak. And a lower oil price does reduce the oil deficit, but there is still a substantial deficit in oil so you can hardly blame this for a trade surplus.  These factors may have led to a higher trade surplus than would otherwise have been the case, but they are not the primary cause of the large and persistent German trade surplus. That much is obvious just by looking at the German trade and current account surpluses in recent years. Yes, the surplus has increased a little in the last few years in response to the lower euro and the lower oil price, and is expected to be 8.8% of GDP in 2017. But the current account surplus was already 6.8% of GDP 10 years ago in 2007 and 7.1% of GDP 5 years ago in 2012. In 2007, the euro was around 10% higher in real effective terms (for Germany) than it is now, and the oil price was around $70 a barrel. In 2012 the euro was actually not very far from current levels in real effective terms (though stronger against the USD), and the oil price averaged around $110 per barrel. The German trade and current account surpluses were nevertheless still very large. Merkel’s attempts to claim that they are a function of a weak euro and a high oil price just won’t wash.

german stuff

Source: OECD

Merkel’s comments are an attempt to evade criticism of German policy, which have come most recently from the US but have been heard before in Europe. She is arguing that the problem is out of her control because she doesn’t want to take the measures necessary to reduce Germany’s trade surplus. What could be done? It is not an easy problem to solve, but she could make some contribution with easier fiscal policy. Her fiscal stance has been very conservative and makes Britain’s attempts at austerity look spendthrift. The German budget is expected to show a 0.5% of GDP surplus in 2017, following similar surpluses in the previous 3 years. This is certainly on the austere side, and government debt has been falling fairly rapidly as a result, expected to hit just 65% of GDP this year, back to 2008 levels after seeing a peak of 81.2% in 2010. Of course, the original target for this debt level was 60% of GDP, but much higher levels are sustainable with much lower real interest rates. The Eurozone average government debt is over 90% of GDP.

german stuff1

Source: BIS

However, the big problem is really the private sector rather than the public sector. The private sector save too much (or don’t invest enough). The proper monetary policy response to this is to keep interest rates as low as possible, so on that basis the ECB are doing exactly the right thing. But more could be done with fiscal policy in Germany, either with stimulative tax cuts, or more government spending. This would both directly encourage imports and, by forcing up wages and prices, would lead to improved lower real interest rates and reduced German competitiveness. Part of the reason for the big German trade surplus is the big wage competitiveness advantage built up in the aftermath of the creation of the euro. That’s why Germany has been running big trade and current account surpluses since the mid 2000s.

But Merkel doesn’t really want to do this. She doesn’t want to undermine Germany’s competitive advantage with the rest of Europe (as well as the rest of the world). She doesn’t want to run a less austere budgetary policy and alienate the conservative wing of the CDU. So she’s blaming the ECB and the oil price. The rest of Europe need to tell her she’s wrong. I see no chance that Draghi or the ECB will take any notice of her, so logically there is little reason for the Euro to benefit directly from her comments.  But with the political and economic winds behind it, there is little reason to oppose euro strength anyway. The CHF and GBP look the most vulnerable of the major currencies in this environment, though the USD could also suffer if rate expectations drop away significantly.

german stuff2

Source: EU Commission

The UK needs a weak pound

UK Chancellor Philip Hammond welcomed the rise in the pound that accompanied the announcement of the UK election last month. He should be careful about cheerleading GBP strength, because right now the UK is more in need of a weak pound than it has been for a long time, and a significant recovery in GBP could be a big problem for the UK economy.

The UK economic situation is dangerous, not only because of Brexit, but because of the perilous position of the UK’s consumer finances. This is well illustrated by the chart below showing the financial balances of the three sectors of the UK economy, balanced by the position with the rest of the world.

sector balances

Source: ONS

The UK household deficit is at record levels, and as can be seen from the chart, the existence of a deficit is a rarity, seen only briefly in the late 80s and then for a few years in the mid 2000s. It is a danger signal. In both cases, the deficit was followed by a recession, as consumers retrenched, as can be seen from the chart below.

householdbalance and GDP

Source: ONS

The process see in the past is instructive. Most of the time, GDP grows as the household balance moves towards deficit, fuelled by deficit spending. However, when the household balance moves into deficit, it tends to reverse, and this has historically led to a recession. If this is not to happen this time around, the inevitable reversal in the household balance must be accomplished slowly while other sectors are adding to growth. With the government constrained by longer term budget issues, this really only leaves investment and net exports. This makes the danger from Brexit fairly obvious. If firms are worried about access to the single market then investment in the UK may be curtailed. Longer term, the terms of Brexit will be key for net exports, but shorter term, the export sector looks likely to be the healthiest, as UK exporters benefit from the combination of a lower pound and strengthening Eurozone domestic demand. But this is why a significant recovery in the pound is not desirable. It would both undermine export growth and discourage investment.

Is a recession inevitable when households retrench? Not necessarily – it will depend on the conditions. In 2000 when the dotcom bubble burst the UK avoided recession in spite of a very extended household sector which did retrench, because rate cuts encouraged firms to borrow. But this underlines how important business confidence is in the current UK cyclical situation. With no rate cuts available to encourage businesses or households to spend, confidence in the future is key if spending is to be maintained.

All this makes the timing of Brexit look extremely inopportune. In the mid 2000s, the household sector ran a financial deficit for a few years before the crash, but the crash was all the more severe when it came for that reason. If growth is maintained in the coming years ahead of Brexit, the situation will be similar when Brexit actually happens. If Brexit hurts exports and investment, there will be no safety net.

Policywise, this should make it clear to the government that “no deal” with the EU is not an option. The fear is that they will  believe their own publicity and see limited economic damage if they fail to get a deal. Or take the view that, politically at least, falling back on the WTO will be favourable to accepting a deal that is like EU membership only worse. Hopefully sense prevails.

But in the meantime, the UK economy needs to be managed into a position where it can deal with a potential shock. This means managing a retrenchment of household finances now – while exports are strong enough to offset the negative growth impact. Unfortunately, it is hard to think of a policy mix that will achieve the desired outcome of slower consumer spending with strong exports and investment. Higher rates would help increase saving, but would also likely undesirably boost the pound. Higher taxes wouldn’t reduce the household deficit, only consumer spending, but would give the government more scope to react to shocks in the future, so are probably desirable. Direct restrictions on consumer borrowing might also make sense. But a stronger pound would not be helpful. Hammond should not be talking it up.

Canada (and CAD longs) should be worried about the US border tax

usdcad

Trump has talked a lot about Mexico, imposing a border tax  and getting them to pay for the wall. USD/MXN has reacted aggressively, and although it is off its highs in common with the general USD dip in recent weeks, USD/MXN is still 60% higher than it was 2 years ago. But it seems to me the market ha been overly focused on Mexico when it comes to Trump’s trade policies. While he has been very vocal on the possibility of a tariff on Mexican and/or Chinese goods, the actual plan for a border tax adjustment looks much more likely to be along the lines proposed by the House Republicans. This would be part of a general tax reform involving a cut in the corporate tax rate to 20% and a “border adjustment tax” of 20%. Such a tax would likely be charged on all imports (while all exports would be tax-deductible) regardless of where the imports come from. It seems unlikely the new system would be focused on Mexico or any other single country. As such, it seems the reaction seen in USD/MXN is excessive relative to the reaction seen in other currency pairs.

This sort of tax is normally associated with consumption tax based systems like VAT. In that case, a tax is added to imports to level the playing field with domestic goods on which VAT has been charged, while exporters get VAT refunded. Although the US system isn’t a consumption tax based system, the idea is to switch the US system to a territorial system in which companies are only taxed on revenues earned domestically rather than the current worldwide system in which US companies are taxed on all revenues. The argument is then that the system (a destination based cash flow tax or DBCFT) will then be broadly equivalent to a consumption based tax system. There are several technical arguments about deduction for wages and land which mean that this is probably not correct, and the tax my consequently be against WTO rules. This may be a problem for the system in the long run, but establishing whether it breaches WTO rules and generating a response will take some time, and the short to medium term impact of such a policy, if implemented, is likely to be significant.

If such a system is implemented, it will immediately increase import prices and reduce export prices. From a trade perspective, it would effectively be equivalent to a devaluation of the USD by 20%. The academic response from trade economists to such a policy is that the market reaction would be for the USD to appreciate by 20%, leaving everything real effectively unchanged. But in practice this won’t happen. The level of the USD doesn’t only affect trade, but also asset values and capital flows, and changes in such flows in response to moves in the USD are often larger and almost always faster than changes in trade flows. It is also the case that some of the reaction has already happened, notably in the MXN. Even so some currencies are still likely to be affected if such a plan is put into practice, as it may be in time for the 2018 tax year.

While some impact can be expected on many currencies, of the liquid currencies the CAD seems much the most vulnerable. 75% of Canada’s exports go to the US, making up 4% of its GDP, so such a big move in the terms of trade would have a huge impact. Unlike USD/MXN, the CAD doesn’t start from a position of being cheap. The consumption based PPP for USD/CAD is around 1.30. Other major currencies may also be hit, but they are all less exposed to trade with the US. Many also start from a cheaper level (notably the EUR) and are more capital market determined (the EUR and the JPY). From a risk perspective, if such policies are perceived as damaging to US growth, the CAD could also be expected to suffer from the impact on risk appetite and commodity prices. Add to this the fact that the CAD has strongly outperformed rate spreads this year (see chart), so will probably weaken anyway if the market takes a positive view of Trump/Congress tax and spending plans, and the potential upside for USD/CAD looks substantial.

Policy mistakes should not always be reversed

cpimktfeb17-1

UK inflation is rising

The Bank of England cut rates by 25bp and increased asset purchases in August in anticipation of a loss of confidence after the Brexit vote on June 24. The objective was stated to be to “provide additional support to growth and to achieve a sustainable return of inflation to the target.” Subsequently, growth was substantially stronger than expected through the remainder of 2016, mainly due to strong consumer spending, funded by increased borrowing. Now, many (including myself) thought the cut was a mistake at the time. But we all make mistakes. The Bank’s assessment of the impact on confidence appears to have been incorrect. Of course, some might argue that growth was stronger because the Bank eased policy, and no-one can prove that is wrong, but I think it is far-fetched. The fact is that the majority of the population (or at least half) are in favour of Brexit, so there is no good reason why the vote should have undermined consumer confidence. Business confidence might have been damaged in the longer run, but very few investment decisions are changed in a short time frame, so if there is a negative impact, it is yet to be felt. In practice, the relative resilience of spending may convince businesses to hold their nerve until the new trade arrangements become clearer, which may well take some time, as long as growth doesn’t start to slip back.

So it certainly seems as if the Bank of England made a policy error. While there is still very likely to be a longer term supply side shock from Brexit, that may not happen for quite some time, and the demand side shock the Bank initially expected has not materialised thus far. So what should they do? Should they reverse their easing and admit their error? The latest Inflation Report certainly shows inflation is expected to move above target soon and stay above target for the whole forecast horizon, which would suggest there is a pretty good prima facie case to raise rates or at least halt the increase in asset purchases. But the best way to fix an error is not always to simply reverse policy. Unless the reversal is done very quickly, the environment faced is different from the one faced initially. Things have changed.

In this case, the most notable change has been the decline in the pound. This has been good in some ways, as it has helped sustain manufacturing an export confidence in the face of uncertain future trade relationships, but it will lead to substantially higher inflation going forward, starting quite soon, as higher import prices feed through to CPI. It has also already led to higher inflation expectations. The key question as to whether this is sufficient reason to reverse the policy easing is whether the coming rise in inflation leads to an increase in wages and other factors generating domestically generated inflation. At this stage this is not clear, and is important. If wages don’t respond, we will see a sharp decline in real income growth as inflation rises, and if we also see a rise in rates from the Bank, there is a danger this will lead to a sharp decline in consumer confidence, potentially at the same time as sterling rises in response to a rise in rates. This could make the current optimism about the UK economy evaporate quite quickly.

So at this stage it seems sensible to wait. Inflation is coming, and it would be as well to see how this impacts spending and confidence before acting to reverse the move made in August. There has been a lot of British bravado since the Brexit vote, but high levels of debt and declining real incomes, plus the uncertainty surrounding the trade relationship with the EU and elsewhere, suggest that confidence is likely to be fragile. After making a policy mistake it is important not to compound it. The Bank mustn’t act looking in the rear view mirror.

 

 

Corbyn’s cap is a bad idea

corbyn

This is not just a fashion statement, though the Mao style cap is not likely to endear Corbyn to Middle England or improve his electoral chances. It also refers to his idea of a wage cap at somewhere between his own salary (137k) and 50m. He sensibly backed away from that idea as the day went on yesterday, but unfortunately has tarnished the whole idea of dealing with excessively high pay with his ill thought out plan. Excessive  pay is an important issue, but the key point is that it is excessive, not that it is high.

He gave footballers’ high pay as an example, but footballers’ high pay is a very poor example. Footballers are talented, and are paid a lot because their talent is in demand. Their ability is broadly measurable and certainly observable, even though there may be some disagreements about the contributions that players make, and clubs compete for their services in the open market. In general they are highly trained, have committed their whole lives to honing their specific skills, and are competing in an extremely competitive market. Pay is high, but reflects both high demand for their services and the very low probability of being successful.

Compare this with the chief executive of a large public company. The skills required are more amorphous. Leadership, strategic thinking, man management, and ruthlessness may all be required, but it is very hard to quantify whether CEOs are making a difference. If their companies are outperforming in their sector it may be a partial guide, but that may be because of their workers or company specific factors unrelated to them. Nevertheless, it’s necessary to measure performance in some way, and the company’s performance is a better guide to CEO performance than most, because the CEO’s objective should presumably be to maximise shareholder value (subject to some constraints of acceptable behaviour). Other employees can no doubt have more specific objectives, but for CEOs the bottom line should be the…er….bottom line.

But the argument many give for paying CEOs of large companies big salaries is that the larger the company, the greater the potential for the CEO to add value. If a CEO makes a decision that raises revenue by 1% it makes a difference of 100m for a company with 1obn in annual revenue, but only 10m for a company with 1bn in annual revenue. But this cuts both ways. If the company underperforms by 1% the CEO will be losing the company more money the larger the company is. This suggests that larger companies’ CEO salaries should be more volatile. Potentially larger but more dependent on performance. But you don’t see too many pay deals where the CEO has to pay the company money, so any deal has to accept that the CEO gets a basic salary that can only be increased by the bonus. On this logic, surely the larger the company the lower the CEO’s basic salary should be and the higher the gearing to performance.

Anyway, this is the sort of detail that Mr Corbyn didn’t seem to consider before jumping into the debate with both feet. A salary cap is precisely the wrong way of going about things, as it would just mean a lot of underperforming CEOs earning a lot of money regardless of performance. Admittedly this is not very different from the current situation, but with lower salaries, given the general lack of sensitivity of CEO salaries to performance. In that sense Corbyn is right in recognising there is a problem, but his solution was initially ill thought out, and subsequent attempts at a more sensible presentation of ideas have been tarnished by his initial floundering.