Although the UK does not have hyperinflation, rather unexpectedly, there appears to be a continuing process of inflation. The latest inflation release prompted Mervyn King, the Governor of the Bank of England (BoE), to write a public letter to the Chancellor of the Exchequer explaining the current monetary situation.
The latest UK inflation figures are worryingly high. Consumer price inflation is now running at 3.1 per cent, more than one percentage point above the BoE's two per cent objective, thereby triggering the Governor's letter. However, this is "new-money" inflation. In "old-money" terms, using the traditional retail price data, inflation is higher still. Excluding mortgage interest payments, inflation is now 3.9 per cent and has been running more than a percentage point above the Bank's old 2.5 per cent objective since December. Headline RPI, which includes mortgage interest payments, is now a whopping 4.8 per cent.
Admittedly, part of the rise in inflation relates to external factors beyond the BoE's control. Food prices have been on the rise globally, reflecting poor weather conditions and last year's increases in electricity and gas prices - a lagged response to earlier increases in oil prices - will soon drop out of the year-on-year comparison, thereby automatically lowering the inflation rate. The story, though, doe not end there.
As Mr King made clear in his letter, "those factors account for only around one half of the pick-up in CPI inflation in the last year".
The BoE is increasingly concerned about the return of old-fashioned company pricing power. After a couple of years in which companies had to endure declines in profit margins as a result of higher fuel prices, it appears they are now fighting back. Margins can be rebuilt in one of three ways - cutting costs, boosting productivity or raising prices. More and more companies appear to be choosing the last of these options.
At first sight, the return of corporate pricing power is odd. Workers have seen their real, inflation-adjusted, wages continuously squeezed over the past 12 months, suggesting household spending should be on the wane. If so, companies might struggle to make price increases stick. The BoE, though, is worried that people are spending even if they are not earning. As Mr King put it in his letter, "spending in the UK economy, associated with continued rapid growth of money and credit, has recovered from the slowdown in 2005, leading to five consecutive quarters of robust growth". In other words, relatively loose monetary conditions may have paved the way for extra borrowing and, hence, extra spending
All this should be enough to persuade the Bank of England to raise interest rates again next month. There is, though, a bit of a puzzle about the latest developments. It may be that the value of the pound sterling is being debauched domestically through higher inflation but, on the foreign exchange markets, sterling is in fine fettle.
The pound is now worth more than US $2, bringing the cost of holidays in the US down to bargain basement levels. And, on the Bank of England's broad measure of sterling's performance against a basket of trading partners, the pound has been trading over the past few months at its highest value in years. So, while sterling's "internal value" is under downward pressure as a result of higher inflation, its "external" value is remarkably high. Is there a connection?
The most obvious link is interest rates. Financial investors have not yet given up on their earlier belief in the BoE's anti-inflation credibility and are regarding the recent rise in inflation as being, mostly, a temporary aberration. However, to the extent that the lift to inflation requires higher short-term interest rates, investors will choose to buy sterling at the expense of other currencies which do not offer such enticing returns. As a result, sterling's value rises.
Beyond this, though, there seems to be a threat to the BoE's ability to achieve price stability in a world of ever-increasing cross-border capital flows. The BoE is constantly having to "second-guess" what could be described as "the hidden forces of globalisation".
Shareholders of British companies sold to foreign investors often end up with more money. The shares are typically purchased at a premium to the market. London property owners who sell their houses to rich Russians end up with more money. Hedge fund managers who receive enormous inflows of cash from, say, Middle East reserve managers place bigger bets on the financial market roulette table, thereby leveraging their bonuses and ending up with more money. And, in all three cases, because the original funds come from abroad, demand for sterling goes up and the value of the pound rises on the foreign exchange markets.
These transactions can be described as external money creation. They weaken the link between UK interest rates and UK monetary conditions. Transactions along these lines suggest that old-fashioned techniques designed to determine the level of interest rates - the amount of spare capacity in the economy, the relationship between house prices and domestic incomes - are increasingly unreliable. Faced with these softening relationships, it is no great surprise that the BoE is putting more emphasis on money and credit.
These do, after all, capture both monetary creation that is a consequence of the BoE's own actions and, in addition, the external money creation. Given that money and credit growth is still so strong, it would not be surprising for the BoE to hint that May would not mark the last upward move in UK interest rates.
• This report was compiled by Peter Calleya, manager corporate strategy and research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.
The latest UK inflation figures are worryingly high. Consumer price inflation is now running at 3.1 per cent, more than one percentage point above the BoE's two per cent objective, thereby triggering the Governor's letter. However, this is "new-money" inflation. In "old-money" terms, using the traditional retail price data, inflation is higher still. Excluding mortgage interest payments, inflation is now 3.9 per cent and has been running more than a percentage point above the Bank's old 2.5 per cent objective since December. Headline RPI, which includes mortgage interest payments, is now a whopping 4.8 per cent.
Admittedly, part of the rise in inflation relates to external factors beyond the BoE's control. Food prices have been on the rise globally, reflecting poor weather conditions and last year's increases in electricity and gas prices - a lagged response to earlier increases in oil prices - will soon drop out of the year-on-year comparison, thereby automatically lowering the inflation rate. The story, though, doe not end there.
As Mr King made clear in his letter, "those factors account for only around one half of the pick-up in CPI inflation in the last year".
The BoE is increasingly concerned about the return of old-fashioned company pricing power. After a couple of years in which companies had to endure declines in profit margins as a result of higher fuel prices, it appears they are now fighting back. Margins can be rebuilt in one of three ways - cutting costs, boosting productivity or raising prices. More and more companies appear to be choosing the last of these options.
At first sight, the return of corporate pricing power is odd. Workers have seen their real, inflation-adjusted, wages continuously squeezed over the past 12 months, suggesting household spending should be on the wane. If so, companies might struggle to make price increases stick. The BoE, though, is worried that people are spending even if they are not earning. As Mr King put it in his letter, "spending in the UK economy, associated with continued rapid growth of money and credit, has recovered from the slowdown in 2005, leading to five consecutive quarters of robust growth". In other words, relatively loose monetary conditions may have paved the way for extra borrowing and, hence, extra spending
All this should be enough to persuade the Bank of England to raise interest rates again next month. There is, though, a bit of a puzzle about the latest developments. It may be that the value of the pound sterling is being debauched domestically through higher inflation but, on the foreign exchange markets, sterling is in fine fettle.
The pound is now worth more than US $2, bringing the cost of holidays in the US down to bargain basement levels. And, on the Bank of England's broad measure of sterling's performance against a basket of trading partners, the pound has been trading over the past few months at its highest value in years. So, while sterling's "internal value" is under downward pressure as a result of higher inflation, its "external" value is remarkably high. Is there a connection?
The most obvious link is interest rates. Financial investors have not yet given up on their earlier belief in the BoE's anti-inflation credibility and are regarding the recent rise in inflation as being, mostly, a temporary aberration. However, to the extent that the lift to inflation requires higher short-term interest rates, investors will choose to buy sterling at the expense of other currencies which do not offer such enticing returns. As a result, sterling's value rises.
Beyond this, though, there seems to be a threat to the BoE's ability to achieve price stability in a world of ever-increasing cross-border capital flows. The BoE is constantly having to "second-guess" what could be described as "the hidden forces of globalisation".
Shareholders of British companies sold to foreign investors often end up with more money. The shares are typically purchased at a premium to the market. London property owners who sell their houses to rich Russians end up with more money. Hedge fund managers who receive enormous inflows of cash from, say, Middle East reserve managers place bigger bets on the financial market roulette table, thereby leveraging their bonuses and ending up with more money. And, in all three cases, because the original funds come from abroad, demand for sterling goes up and the value of the pound rises on the foreign exchange markets.
These transactions can be described as external money creation. They weaken the link between UK interest rates and UK monetary conditions. Transactions along these lines suggest that old-fashioned techniques designed to determine the level of interest rates - the amount of spare capacity in the economy, the relationship between house prices and domestic incomes - are increasingly unreliable. Faced with these softening relationships, it is no great surprise that the BoE is putting more emphasis on money and credit.
These do, after all, capture both monetary creation that is a consequence of the BoE's own actions and, in addition, the external money creation. Given that money and credit growth is still so strong, it would not be surprising for the BoE to hint that May would not mark the last upward move in UK interest rates.
• This report was compiled by Peter Calleya, manager corporate strategy and research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.