Monday, 29 June 2009

Inflationists vs deflationists

The UK base rate is currently 0.5%. The question is: how long will it stay this low?

The markets are pricing in 2.5% by the end of the year. And yet various commentators are pointing out that there are deflationary pressures in the economy (job loses, commodity gluts) and so no reason why the BoE couldn't keep the base rate at 0.5% for years to come. In the past, eg the 1930s-1940s, the base rate has been kept very low for decades - although never as low as 0.5% it must be said - and there was a world war on for part of that time.

But on the other side of the equation the UK is having to offer higher interest rates to sell its debt. Gilt yields are now on 3% (approx). The Americans are also finding they need to increase the "insult" to place their debt.

The economic world is now divided between the "inflationists" who think printing money will cause price inflation, and "deflationists" who think the global recession will make prices fall.

Ironically this low base rate is not actually doing any good to the economy. It has not filtered through to the consumer. Mortgage rates for new borrowers tend to start at around 5% - and can be has high as 7%-8% for those with little equity. These numbers are consistent with a base rate of four or five percent. The margins are nice for the banks but useless to the rest of us. On the flip side savings rates are abysmally low.

Most likely the "real" reason for the low base rate (and let's not forget CPI is STILL above target!) is that the government is simply trying to keep its debt costs down so the binge spending can continue.

This blog takes the view that current monetary policy is storing up inflation for the future. And guess who agrees? The Bank of England's own pension fund has moved 70% of its assets into RPI-linked gilts. They seem to be expecting inflation.

Link: Report

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