Economic review of April 2007

Inflation has finally hit 3.1%; resulting in the Governor of the Bank of England having to write his first letter to the Chancellor, after almost a decade of the current arrangement.

This was something of a surprise, since many people had been expecting a slight fall from February’s 2.8% level. But increasing oil prices have so far offset falling gas prices, which had been expected to hold consumer prices down. The fact that interest rates were held in March is irrelevant, since these do not count towards the CPI. Interestingly, had the “base” CPI figure from three months earlier been used when the arrangement was set up, it is likely that there would have been many more such letters already.

Of course, this is not a real indicator of inflation as it relates to real people. The CPI is calculated based on a basket of goods that does not relate to the way different people live. In practice, middle class families and pensioners are far worse off and students or those living at home with parents are generally better off, with lower inflation figures.

Of greater concern to some is the fact that the “broad base” money supply (M4 for those who are interested) grew by 12.8% over the year to March. This is an indicator to a number of economists that inflation is likely escalate in two years time, because there is more credit available in the economy for people to spend. Linked to concerns that the savings ratio is falling for the first time since the 1980s and borrowing is already increasing, this could be forewarning of higher inflation.

Conversely, while mortgage lending has hit its highest March level ever (the April figures are not yet available) at £5.4 billion, the seasonally adjusted figures may at last be starting to show a much needed slowdown in the property market. Time will tell. The Bank of England has already expressed concern that high street bank lending is at too high a level for safety, citing recent problems in the US sub-prime market as a warning that relaxing lending criteria too far – for consumers and businesses – is risky. Unfortunately, the banks appear to have discovered that they can lay-off much of the risk to investors via hedge funds and insurance companies through the use of credit derivatives. In this way the banks can generate even more credit at little financial risk to themselves. One wonders if the counter parties really understand what hey are doing.

Taking money by stealth Although the Bank held interest rates last month, most people believe that a further rise is now inevitable. The influential National Institute of Economic and Social Research even argues that interest rates should have been increased further last August and that current situation is partly due to the Monetary Policy Committee’s failure to do so. It does, however also agree that inflation could reach as low as 2% by the end of this year.

Claims that Chancellor Gordon Brown lost the country £2 billion by selling a substantial proportion of our gold reserves at the wrong time (leaving the Chinese to sweep up a massive profit) have been compounded by revelations that his policies have increased council taxes and business rates by £3 billion over the last ten years as local government has fought to make good the loss to pension funds following his removal of the tax reclaim on dividends from UK companies.

News that he was warned in advance what impact his now infamous raid would have may have come as no surprise to pension professionals – who were amongst those giving the warning all those years ago – but consumers (and voters) have been shocked to learn the extent of his neglect of their interests in making short term decisions that have long term impact. It has recently been estimated that pension funds of the top 200 UK companies lost a staggering £20 billion as a result of the change. That is not just a threat to the future of their employees, but also contributed significantly to the massive closure of “final salary” pension schemes – FOR ALMOST EVERYONE EXCEPT GOVERNMENT MINISTERS AND MPS.

Many are also starting to question the wisdom of increasing the proportion of Gross Domestic Product controlled by the government. Government spending now accounts for some 45.3% of GDP; more than in Germany. Worthy as individual civil servants undoubtedly are, it is questionable whether they can be expected to use public money with as much care as those who have a profit incentive to be cost effective at all times. With the budget deficit running at 3% of GDP, when it should be in surplus, we apparently have the worst “fiscal profile” in the Organisation for Economic Cooperation and Development (OECD), excluding Japan.

China is a fast growing economy that cannot be ignored There are those who say that the seemingly unrelenting growth in China’s economy – GDP grew by 11.1% to the end of March – can only end in tears, using evidence of a faster-than-expected 3.3% rise in consumer prices over the same period. While this level of inflation might be a matter for concern in a developed economy, the fact that most of China’s growth is export related means that internal inflation is of less significance than might apply in a country such as the UK, which is a net importer.

Much of China’s growth also comes from increased investment in fixed assets such as factories and so on. This makes it an attractive market for inwards investment although there is always the danger that political upheavals could cause a hiatus in ownership which could affect overseas investors. Nevertheless, a recent 4.5% fall in the A-share index, triggered by excessive reaction to the inflation figures, left an opening for further investment and the market bounced back by 7.3% over just two days in mid April. China is an increasingly important trading partner for the UK, as is India, and we cannot afford to ignore developments there.

All the “main” stock markets moved up during April with the exception of the Nikkei, with the FTSE100 rising by 2.24% and the FTSE250 by 2.05%. Over the last year, they show 7.07% and 20.76% growth respectively. Even the aim, which has fallen by 6.04% over the last year, was actually 3.04% up over the month. Star performer for April was the Dow Jones, with an impressive 5.74% growth, although the EuroStoxx50 was only slightly behind at 5.05%. Oil prices softened slightly (by 0.66%) to US$67.65 a barrel for Brent Crude 1-month. Sterling continues to strengthen, ending the month just under US$2 to the pound, a rise of 9.5% over the past twelve months. However, ground continued to be lost to the Euro.

A strong pound is not always a good thing The strength of sterling against the dollar may be good news for those wishing to fly off to the States for a holiday, but it is less helpful to the economy because it makes imports cheaper and exports more expensive at a time when we are already suffering a growing deficit in the current account (what we used to call the balance of payments). Low prices in the shops may not be inflationary, but they do encourage increased spending. What we really need is less spending and more saving, in order to bring inflation under control; unfortunately, this does not appear to be on most peoples’ agenda. If interest rates do have to rise in order to counter inflation – and there are already suggestions that 7.5% by the middle of next year is not impossible – then Sterling will become even more attractive, increasing its value against other currencies and making exports and the inwards flow of investment more difficult. This will further exacerbate the balance of payments deficit.

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