Bank of England Rate Cut. The Pound Falls - Inflation Rises
Even before the Bank of England started to cut interest rates the smart money was on the pound / dollar reaching $1.80 at some point in 2008. Both the Bank of England and the Government must have been aware of such sentiments and the 6% fall in Sterling that followed the cut of last December gave a pretty clear signal that they are probably correct. So the question arises - Why did they choose to cut again in February?
Sterling fell on the back of the cut in December; from a high the previous month of $2.10 to $1.96. This amounted to a 6% devaluation tariff on everything we import from fuel and food to manufactured goods and equipment. The fact that the international benchmark prices for fuel and food have in any case been soaring is well enough understood, but the manufactured element is equally important.
Inflation in the UK is the sum of many parts and the China factor has been a big player here, causing the cost of consumer, household and electronic goods to be effectively falling in price for years. As a result these have acted as deflationary factors when it came to calculating core inflation. However the growth of Chinese domestic inflation to 9% in 2007, with their currency fixed to the US$ causing their raw material and energy costs to rise sharply, means that the China factor has now come to an end. Quite apart from the headlines dominating the news on food and fuel prices, a large proportion of all kinds of consumer goods; which have effectively masked other problems for years, are now set to become part of the problem itself.
The Government might argue that exports will be in a position to take the strain thanks to a lower pound; this however is a fiction. Manufacturing industry in this country has been shredded as a component of the economy as a whole to the extent that it is no longer in any position to make that much of a difference. In any event a lower pound means higher material and energy costs, while component parts usually have to be sourced from overseas, simply because the small factories that used to be in business here to make such things no longer exist. The news in February that factory gate inflation rose to 5.7% after two months of a $1.96 pound says it all in this respect.
One view of the effect of inflation is that it can solve itself eventually by acting as a brake on demand. However if the benchmark prices of the things we need to buy such as fuel and food are constantly rising while being magnified by a falling pound, this cannot happen. Another problem in this respect is that as a seven year boom in the economy was underway on the back of a flood of easy credit, the Government itself decided to join in.
We are therefore now left with huge financial deficits everywhere we look, including public sector borrowing, the national current account, balance of trade and now a jumpof £95 billion in the national debt courtesy of Northern Rock. Servicing such debt becomes even more expensive when you factor in devaluation. Worse still our inward currency flows are supported in significant part by the notoriously fickle carry trade, which is not going to hang around if the pound keeps falling.
It is also worth mentioning that UK personal debt as in mortgages, credit cards and bank loans stood at £1.35 trillion at the end of 2007. The GDP (gross domestic product) was £1.33 trillion that year. This is a debt to national income ratio of 101%. If the UK were a business with a ratio like that, it would already be in the hands of the receivers.
So back to the question: Why did the bank of England cut rates at all? Well the answer may lie in the history books. We last faced a series of problems like the ones we do now in 1973 / 1974; growing inflation, a weak pound, a banking liquidity crisis, a house price crash getting underway and key national deficits. What followed was a torrid few years in which inflation soared, taxes followed suit and the standard of living actually fell. Inflation in 1974 was 16% and in 1975 it rose to 24% before falling back in 1976 to 16%. What this did was to cut the true value of personal debt by more than half.
The government appears to lack both the will and the capacity to address the problems we are facing now: Or does it? - Are the lessons of the 1970s the new economic policy that dare not speak its name?
Click here for ONS report on UK balance of trade and current account deficits (Qtr 3 2007)
Click here for Bloomberg view on UK economy and the Pound (December 2007)
Click here for FT-Alphaville chart on inflation in China
Click here for Guardian article warning of higher food prices (November 2007)
Click here for Washington Post article on Maize prices in Mexico (January 2008)
Click here for Telegraph article on stagflation (February 2008)
Click here for Bank of England table of base rates 1853 to 2008 (PDF)
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