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No respite soon for high inflation Britain

With consumer price inflation 3% or above for all but nine months of the past three years, after a while it can be no surprise if inflation expectations rise and remain at a higher level. According to the latest survey from Citigroup, inflation expectations for the coming year rose to 3.4% in the current month, up from 2.9% previously. A concern is that consumers continually expect inflation to remain well above the central bank’s 2% target, no surprise really when one considers that inflation has averaged 3% in the country over the past five years! An additional observation is that companies appear to be able to pass on price increases with relative ease.

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How is this possible, it could be asked? With private sector demand having collapsed by 7% over the past three years, the conclusion is inevitable – Britain is now basically a price-taker for most items, and for those goods/services produced domestically where there is little foreign competition, clearly the recession has shrunk the number of local competitors to just a few. How else could inflation in excess of 3% evolve so consistently from a situation of zero growth? This whole scenario remains a huge dilemma for the MPC. If the Bank had raised rates over the past three years in an attempt to contain inflation, it is just possible that the economy may have been tipped into an even deeper morass, without necessarily having any beneficial impact on inflation. Also, it cannot be argued that a very loose monetary policy is somehow contributing to demand-pull inflation, because the private sector is in hibernation. No, high inflation in the UK is for the most part a product of both foreign demand strength and a lack of local supply. Realistically, where the Bank sets the base rate cannot affect either. The MPC may have a 2% inflation target, but unfortunately at times like these it has very little prospect of achieving it, because it cannot affect either strong foreign demand or low local supply. Painful as this may sound, we may have to get used to high inflation here in the UK for a while longer.

The dollar takes a hit after softer US data. The dollar and treasury yields declined yesterday in response to softer-than-expected Q1 GDP and claims figures. Q1 GDP was unrevised at 1.8%, with the expected upward revision to consumer spending failing to materialise. That said, at least the US consumer is going forward, which is more than can be said for the UK consumer. Slightly more worrying is what seems to be happening to initial jobless claims, which have been drifting higher over recent weeks. This recent run of less convincing US growth data is one of the major reasons for what has been a fairly striking rally in US treasuries – the 10yr yield has fallen more than 50bp over the past couple of months, in part on the assumption that more tepid growth means that the Fed will stay on hold for longer. Overnight the dollar has continued to slide, especially against both the Swiss franc and the euro. The EUR’s price action was especially interesting – it briefly fell below 1.41 yesterday afternoon after some cantankerous comments from Juncker (see below), but has since recovered in fairly remarkable fashion and is now up to 1.4250. The star of the show however was again the Swiss franc, which recorded a new record high against both the dollar and the euro.

More harsh words for Greece. As the Greek tension builds, the true feelings and thoughts of those parties involved starts to emerge. We had Luxembourg PM Juncker suggesting yesterday that the IMF may not be able to release the next tranche of bailout money to Greece at the end of June because their rules stipulate that it can only be advanced if they believe that there is a 12m refinancing guarantee. This contention was subsequently confirmed by an IMF spokesperson. Juncker also suggested that EU governments were not in a position to make up for any IMF shortfall. Separately, ECB Council member Bini Smaghi stated that ongoing liquidity support by the ECB to national banking systems required compliance with EU/IMF programs. Both of these comments from Juncker and Bini Smaghi suggest that Europe is rapidly ratcheting up the pressure on Greece to get with the program, or else. Lastly, ex ECB Chief Economist Otmar Issing spoke from the hip when he claimed that Greece was not just illiquid but also insolvent. He was joined by Paul Krugman, who opined that ‘it’s basically inconceivable that there won’t be some significant losses on present value for bondholders’ of Greek, Portuguese and Irish debt. Krugman also put the odds of Greece leaving the euro at 50%. It is difficult to disagree with any of Krugman or Issing’s statements.

China’s continuing commitment to the antipodean currencies. Over the past couple of years, one of the reasons why the antipodean currencies have generated such decent performance is because of the ongoing support of sovereign wealth funds in both Asia and the Middle East. This heightened demand reflects two principal considerations – firstly, a desire to diversify out of the dollar which many managers of fx exposure recognise is being deliberately debased, and secondly an appreciation for the favourable fundamentals of currencies like the Aussie. Over the past couple of days both the AUD and the Kiwi have benefitted from a story put out by a New Zealand-based financial advice website claiming that the CIC (China Investment Corporation) may put as much as 1.5% of their fx reserves (close to $5bn) into New Zealand companies, bonds and other assets. The same article suggested CIC had allocated 2% to Australian assets. China in particular has been a big buyer of NZ government bonds this year. In response, the Kiwi has popped 2% against the dollar in the last two days. Overnight, it fell just short of a new 3yr high. The Aussie has also recovered after falling below 1.05 earlier this week, now just shy of 1.07.

UK services sector offers some cheer. At a time when the consumer is on its knees, the UK economy needs a positive contribution from production sectors like manufacturing and services to prevent a lurch back into recession. For the latter, the recent prognosis is reasonably encouraging, although not without worry. The CBI services index measure fell to -23 in the three months ended May, the lowest reading since late 2009, which on the surface might have triggered some concern. Interestingly, however, respondents to the survey reported a significant acceleration in employee costs, a worry expressed yesterday by departing MPC hawk Andrew Sentance. More positively, the hiring component of the CBI survey surged to +12, the highest reading since mid 2008, with expected employment for the next quarter up at a very perky +30. The results of the CBI survey follow yesterday’s index of services report from the ONS, which showed a rise of 0.6% in the month of March and a 0.9% increase in the first quarter as a whole. With consumers hibernating, investment spending declining and the public sector in retreat, the UK needs the services sector to deliver.


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