Good News In the Month

• The total amount of personal debt in the United Kingdom has continued to fall. The rate of fall did slow due to seasonal borrowing but the trend is in the right direction.
• The total number of people in work has risen but unfortunately so has the number of unemployed.
• National opinion poll (GfKNOP) market researchers report that consumer confidence rose 4 points in January. Optimism for the next 12 months also improved.
• USA have started to report minor improvements in economic sentiment. This week it was an improvement in the amount of savings as more money was tucked away.

Less Good News of the Month

• Politicians are getting more involved in the management of British banks via the ‘Bonus Shambles’. We were then taught a lesson by the markets who decimated the share price of the banks and reduced the value of the countries investment dramatically.
• Europe and the Euro continue to vacillate about the politics of the solutions and our government seems to be uncertain bit players.
• The barometer for unemployment looks set for more turbulent times.
• Too many major issues and initiatives are still in the political melting pot eg Welfare reform, NHS organisational framework, delivery of the economic reform and debt reduction
• The population is still concerned about MP’s moral compass and sleaze, nepotism, hypocrisy, probity etc are set to remain on the agenda.

Wish List for David Cameron

• Stand firm on Europe and keep looking to BIRC and the rest of the world.
• Complete at least one reform with vision, energy and panache. No dithering or turning.
• Make sure the pain of the present ‘delivers the goods.’

Basic Economics Behind Predictions for Value of Pound.

The Pound will tend to appreciate (increase in value) under the following circumstances:

1. If UK interest rates rise relative to our competitors. If UK interest rates increase it is more attractive to save money in UK banks
2. Economic recovery in the UK relative to elsewhere. If the UK economy recovers, the Bank of England will be more likely to increase interest rates back to normal levels
3. Low Inflation / Improved productivity. Low inflation makes UK exports relatively more competitive. The best combination is low inflation, plus economic growth
4. Confidence in government finances. If markets fear the government could default on its debt. Foreign investors would sell UK bonds causing a fall in the value of the Pound.
5. General market sentiment.
6. Reduction in current account deficit – i.e. improve in our trade relative to the rest of the world.

Predictions of Pound Against the Dollar

Against the dollar, the Pound could fall. The US economy is predicted to recover the quickest and therefore the US is likely to exit the liquidity trap quicker than the UK. Therefore, US interest rates are likely to rise before the UK. This increase in US interest rates would cause hot money flows to US and appreciate the dollar.

During the 2008-09 recession, the UK economy suffered the most because of its reliance on the financial markets and an asset (housing) boom. The UK recession was very deep, and this was one reason for the 25% devaluation in the Pound in 2007-09. Since then the Pound has maintained a fairly constant value – despite high inflation and a policy of quantitative easing.

Strength of the Pound Relative to Euro

One strength of the Pound relative to the Euro, is that markets are fairly confident about UK government bonds. Bond yields in the UK have fallen. Markets have more confidence in UK debt because the Central Bank can print money to buy bonds and being outside the Euro, the UK retains more flexibility in monetary policy and exchange rate. The UK recovery should be stronger than the Eurozone because

• UK has benefited from past devaluation restoring competitiveness.
• UK has benefited from quantitative easing
• Whilst ECB raised interest rates in 2011, this looked overly optimistic. The IMF have downgraded forecasts for EU growth considerably.

Forecast for UK Inflation

After experiencing cost-push inflation in 2011. Inflation is set to fall dramatically as we no long have cost push factors of

• higher taxes
• imported inflation from devaluation
• rising commodity prices

This sharp fall in inflation, will relatively strengthen the Pound. However, it does make an interest rate increase less likely.

 Potential Weakness of Pound

However,, despite a 20% depreciation in sterling, the UK retains a persistent trade deficit suggesting an underlying imbalance in the economy. Since the credit crunch there are less capital flows to finance a current account deficit. Therefore there we may need to have to be a further depreciation to boost exports relative to imports.

Another factor in the equation is the scale of government debt and the purchase of government gilts. This has potential to worry markets and raise future inflationary pressures. Although bond yields have stayed low. Markets will be worried about prospects of a double dip recession in the UK.

Given these factors the prospects for Pound Sterling would usually look pretty grim. Low interest rates and quantitative easing usually would weaken sterling and the government’s fiscal position will not help.

The saving grace for Sterling may be the relative weakness of our competitors. The Euro is starting to look prohibitively expensive, at least for south European economies like Spain and Ireland. Though the Eurozone is emerging from recession, it still looks pretty weak and it could experience a severe double dip recession because of austerity and spending cuts which weaken growth. The ECB takes a fundamentalist approach to keeping inflation low, but, even the ECB will be hard pressed to justify rate increases with the Euro economy so weak.

The good news for sterling is that the worst may (hopefully) be over. If we don’t get dragged down by Eurozone recession, we could emerge from recession, towards the end of 2012.

It is hard to make predictions because the current situation is exceptional with no real precedent. A lot will depend on the nature of recovery. If the UK’s growth continues to be weaker than our competitors sterling will continue its downward slide. But, if the UK grows quicker than expected and confidence is restored in the UK people may switch back to Pounds. But, overall, I think the most likely scenario is that the Pound will remain weak. A lot of us could be spending our summer holidays in old Blighty rather than paying to go to Euroland.

Related

• Forecasts for UK Economy
• Interest rate predictions
• interest rates and exchange rates

Generally, an increase in interest rates in the UK would increase the value of Sterling.

Why Higher Interest Rates Increase Value of Exchange Rate

• If UK increase interest rates relative to other countries, it becomes more attractive to save money in the UK. Therefore, if the UK give a better rate of return on savings, people will save money in the UK. Therefore, they will have to buy pounds to save in British banks.
• For ordinary investors it wouldn’t be worth the hassle of saving in another country, but for investment banks and pension funds with millions of pounds, 1% difference in interest rates can make a big difference, and they have much lower transaction costs.
• This increase demand for pounds to save money in the UK causes a rise in the value of the pound.
• This is termed ‘hot-money’ flows. – Relating to how money is moved to countries with the highest interest rates.
• Another factor is that higher interest rates tend to reduce inflation, therefore over time, UK exports will become more competitive. This is another factor which increases value of Pound.

Link Between Interest Rates and Exchange Rate

Value of Sterling (Exchange Rate Index)

The Pound fell in 2008, this reflected the deterioration in the UK economy. Interest rates fell to 0.5% by March 2009

Other Factors To Consider

There are many other factors which influence exchange rates, therefore, the link is not always clear.

• Inflation. Suppose a country, such as India, increased interest rates to 10%, but had an inflation rate of 15%. The inflation rate of 15% would lead to a depreciation in the value of the Indian currency. The depreciation due to inflation would be greater than the interest payment you received.
• Relative Interest Rates. In some circumstances, interest rates are very low all around the globe. Therefore, demand for a currency considered safe would be high – even if they had low interest rates. For example, in 2011, there was great uncertainty, therefore many investors wanted to buy Swiss Francs despite low interest rates in Switzerland. In the end the Swiss Central bank had to intervene to sell Swiss Francs to prevent an appreciation in the currency.
• Prospects for future Interest Rate changes. If a country reports faster economic growth than anticipated, this often causes a rise in the value of the exchange rate. The logic is that if a countries growth is higher, it is more likely interest rates will rise sooner. Therefore, investors buy now anticipating the future increase in interest rates. – Investors don’t wait until interest rates actually rise, they try and anticipate changes.
• Confidence in Economy. In 1992, the UK was in the Exchange Rate Mechanism (ERM). The government were trying to protect the value of the Pound. To prevent the Pound falling, they increased interest rates to 15%. In theory, this should increase demand for sterling as people move currency to UK. However, markets didn’t believe the government was credible. They felt interest rates of 15% were far too high for the state of the economy, and that they couldn’t be maintained. Therefore, despite high interest rates, markets kept selling pounds. The government were forced to leave the ERM, interest rates fell and the pound devalued 20%.
• Long-Term competitiveness. In the long-term, competitiveness of exports is a major factor in determining the value of the exchange rate. For example, the German D-Mark appreciated in value against the pound in the post-war period because the German economy was becoming relatively more competitive and German exports were more attractive.
• Government Debt. If markets fear government default, this will tend to reduce the value of the exchange rate.

Does the Exchange Rate Affect Interest Rates?

• If the government is targeting the exchange rate,  a fall in the exchange rate may cause them to increase interest rates. however, interest rates are now set by the Bank of England. They only target inflation, not the exchange rate.
• The Bank of England may feel a rapid devaluation could be inflationary, and therefore, they increase interest rates to reduce inflation.

Related

• UK Interest rate predictions
• Interest Rates and the economy

Economic Pluses

• The UK can pay it’s way and borrow at cheaper interest rates than many other countries.
• Pensions and public sector wages are paid in full and on time unlike Greece and Ireland. Recent Irish savings of 1.76bn euros came from the public sector pay bill and social welfare.
• The number in work and the economy continues to grow although the number unemployed is also growing
• The UK can contemplate easing money into the economy. This includes starting construction projects and being on of Europes early tax cutters as the world recession eases.

Moans About the UK Economy

• I was recently asked what has happened to UK manufacturing will it ever return? Well many sectors are still vibrant and world leading. Don’t knock the manufacturing that we have.
• Energy and power costs are too high and growing too quickly. Taxation and environmental pressure do not look set to change in the near future. We may have to live with the problem.
• Imports from the Far East are too cheap and costing jobs. Well our view is that a far east worker is probably paid 5p for every £1 we retail a product at. The shipping, duties & taxes, wholesale margins and retail margins earn more for the UK than the far eastern economy. There are long term risks but we can enjoy the short term gains.
• Bad news is news and feeds our voracious and rapacious media industry- good news is not in abundant supply! Why run ourselves down all the time.
• Many sectors are hiding incompetent management by using the economy as an excuse. ‘The economic climate is blamed for an increased number of complaints to Yorkshire Water’ more ‘Customers are complaining about being harassed and mistreated by banks and financial institutions over mortgage arrears and loan repayment disputes.’
• Pensions are not adequately funded. Too many snouts have been in the trough including the tax man, the banks and the mercenary pensioners.

Economy on the Right Track

• Hotels seem quite full and room rates are quite high without too much discounting. Just wait until the Olympics!
• Eating out has not diminished although there may be a move towards good value cooking rather than branded boil in a bag eateries.
• Christmas shopping has started early and the warm weather is helping. It is too early to predict the total effect but some high street brands look set to make major in-roads into the market share of weaker competitors.
• Survival of the strong and capable whilst accepting the sacrifice of the weak is part of a natural economic cycle.
• Equality between public and private sector workers need to continue to be tweaked to remove some glaring anomalies.
• Will the European Union face up to its eco-political problems or will unilateral action become a necessity?

This is a simple guide to how the EU debt crisis came about.

Problems of European Debt Crisis

Recession. Markets are worried about size of debt in Eurozone economies, pushing up interest rates. This forces economies to pursue austerity measures, such as spending cuts. However, the size of these spending cuts are pushing countries back into recession. Falling GDP, actually makes it harder to reduce debt to GDP ratios. Thus austerity measures can often be self-defeating, leading to calls for more austerity and spending cuts. Therefore, as widely expected, the EU has downgraded growth prospects for 2012 to 0.5%. However, if the crisis continues to bite, this could be much worse and we could see a fall in GDP, and much higher unemployment.

Bank Exposure to Sovereign Government Debt. Greece was relatively small. But, Italy has debts of $2.2tn, or 120% of gross domestic product. If Italy defaults, the knock on effects will be much greater. It will cause many commercial banks and investment trusts to lose money. Banks can ill afford to write down more losses. Most banks are still recovering from the credit crunch. If there is another debt default, bank lending will once again be squeezed.

No Credible Rescue Plan. Markets fear there is no solution to the debt crisis. The EFSF (bailout fund) doesn’t have unlimited funds. It is backed by money from countries like Italy. The ECB is not willing to act as lender of last resort.

How Crisis Will Affect UK

Slower Growth. UK growth is already anaemic, given spending cuts and low consumer confidence. A recession in Europe would definitely lead to lower exports and lower confidence; this combination would lead to lower growth in the UK – it could be the trigger which pushes UK into a second recession in the space of a couple of years.

Bank Lending. Bank lending is slowly starting to recover from the depths of the credit crunch. Although it is much lower than pre-crisis levels, there has been some recovery in mortgage lending which has helped to stabilise the UK housing market. But, a significant debt default in Europe, would lead to a second credit crunch with banks short of finance and unwilling to lend scarce funds.

UK Housing Market. The UK housing market is driven by several factors, however, a second recession and lower lending could push UK house prices 10% lower as demand dries up.  There will still be fundamental shortage of supply, but in the short term, the fall in demand could push down prices. It would probably have most impact in the London housing market. The London housing market has been the strongest to recover since fall in house prices. But,  a Euro debt crisis could impact on high income earners (wealthy foreigners and bankers the most)

To some extent the UK is more insulated from the debt crisis than Eurozone members. The UK

1. Has access to independent monetary policy. The Bank of England is willing to pursue quantitative easing to provide monetary stimulus during fiscal contraction

2. The UK has independent exchange rate. The devaluation of pound helped restore competitiveness providing boost to exports.

3. The UK has a lender of last resort (Bank of England willing to buy bonds if a liquidity shortage). This is one reason why UK bond yields have stayed low – despite UK having one of largest budget deficits in Europe.

Forecast for interest rates.

This new debt crisis does increase the likelihood of UK interest rates staying at low for considerably longer

Related

• Credit crunch explained
• Euro debt crisis explained

Be scared if you have to pay taxes! National debt per tax payer $130,520

Be scared if you have your own debt! Personal debt per citizen $51,452

Be scared if you don’t understand economics and be very scared of anyone who claims to understand economics.

See the

  USA Debt Clock

ticking away your future!

Run your mouse over the clock and you will get definitions for each of the clock counters.
In the one hour I have been watching the clock the US National debt increased by $0.221 billion to $14,609,193,027,540.

UK Situation

It may be me but the clock seems to be ticking faster in the UK version. It isn’t as complex as the US clock but have a look anyway.

This clock covers government debt excluding bank bailouts.

Debt is equal to £15,298 per person or £33,250 per tax payer!

You may think this is a timebomb, I couldn’t comment but this clock is a variation on a theme.

Bond yields on UK government securities have continued to fall in 2011 – despite having one of the largest budget deficits in the UK.

This is in sharp contrast to peripheral members in the Eurozone. Greece, Ireland, Spain, Portugal and Italy have all seen a rapid rise in government bond yields as markets become worried about the fiscal situation.

Why Have UK Bonds Fallen

By being outside the Euro, the UK has more flexibility in managing its debt. e.g. if the UK expereinced liquidity problems, the Bank of England could buy bonds as a lender of last resort. Therefore, markets don’t fear liquidity problems in the UK. HOwever, in the Euro, liquidity problems could be a real problem as governments need to rely on markets buying bonds. The ECB is much more reluctant to buy bonds in sufficient quantities. Therefore, being outside the Euro, is an advantage and one reason the UK has one of the lowest bond yields.

Sluggish Growth.

Low growth tends to reduce bond yields. Rather than investing in private capital projects, investors tend to prefer the security of government bonds. The fall in UK bond yields is primarily a reflection of the markets pessimism over UK growth prospects. This is why Japanese bonds have reached virtually zero, despite a national debt of over 220% of GDP.

Spending Cuts.

Spending cuts have made a dint in the UK budget deficit. Unlike, the US, the UK has greater political will to enforce unpopular tax rises and spending cuts. Though the concern is that spending cuts will aggravate the primary problem of weak recovery and slow growth.

Forecast for Bond Yields

Recent evidence in the Euro, suggests that market expectations of bond yields can quickly change. Several European bond markets saw a sharp reversal in bond yields which contradicted previous market expectations.

However, outside of the Euro, with its own monetary policy, I don’t foresee the UK experiencing the liquidity fears which have engulfed Euro members. The primary driver of UK bond yields will be the state of the economic recovery. As long as growth remains below forecast, the Bank of England will be unwilling to increase interest rates from their current low. This will mean as long as we have economic stagnation, bond yields will remain low. However, when the recovery occurs (and a real recovery of above trend growth, which actually reduces spare capacity) then the Bank could quickly raise base rates, this would have a knock on effect for bonds.

However, the big question is when will the UK experience strong recovery. At the moment, it is hard to foresee where this boom in economic growth will come from.

Related

Causes of Double dip recession

In this economic post, (difficult choices on interest rates) I’ve written in more detail on the dilemma. In particular, it is important to bear in mind the different measures of inflation we have.

It may not be much comfort for those facing higher living costs, but the high CPI inflation is primarily due to taxes, food prices and energy prices. These factors usually tend to be short term and temporary. Underlying inflation is currently on target. There is no sign of an overheating economy and wage inflation. This is the justification for keeping rates low, despite high inflation.

Source: Focus on Consumer Price Index ONS

CPIY = CPI – effective of taxes like airport tax and VAT.

From: Which measure of inflation should we use?

The problem is the Bank of England keeps saying (with justification) that inflation is due to temporary factors. But, these temporary factors have been around for quite a while now.

However, the persistence of inflation does raise the likelyhood of interest rate increases, sooner than later – despite the sluggish recovery, the austerity measures and high unemployment.

For first time buyers in this situation, many are increasingly using housing schemes, which enable them to part buy and part rent. For teachers, nurses and other key public sector workers, there are quite a few opportunities to part buy using schemes such as this.

Inflation and Interest Rates

A paradox of the UK economy is the fact inflation is remaining stubbornly high, despite high unemployment and spare capacity in the economy. Usually, high inflation would occur during an economic boom. However, inflation is currently above target because of a mixture of tax increases, and cost push factors like rising commodity and energy prices.

The paradox is shown by an inflation rate (3.3%) of much higher than the Bank of England base rate. It is certainly not a good time to be a saver.

This places the Bank of England in a difficult situation. On the one hand there is an instinct to raise rates to reduce inflation below target. On the other hand, they want to promote economic growth, important given the spending cuts and tax rises which will reduce aggregate demand.

Given the spending cuts, job losses and wage freezes in the public sector, it hard to see this cost push inflation translate into wage inflation. You may ask your boss for higher wages to pay for rising energy prices, but given unemployment of 10%, it is hard to see a wage price inflation spiral.

A look back at the past decade – The Economics of the Naughties

- A decade which brought us everything from NINJA mortgages to Quantitative easing and a new meaning of the phrase ‘economic stability’