EIU: Rates to Stay on Hold Despite Inflation Fears

Tony McMahon: Hello and welcome to the Global Forecast from the Economist Intelligence Unit. I'm Tony McMahon and as ever I'm joined by Robin Bew.

Robin, the UK economy was reported to have shrunk by more than expected in December, so was it all down to the snow?

Robin Bew: Well according to the ONS, the shrinking was down to the snow, but even if we hadn't had the bad weather, they seem to be suggesting the economy would have been flat, which is a pretty poor result relative to what most commentators were expecting. Most people thought the economy was going to grow and actually grow by quite a bit.

So the snow clearly made things a lot worse, but even leaving that to one side, it was a much worse number than lots of people were expecting and of course many people are very worried about that.

McMahon: There are rumbles at the Bank of England over the current level of rates and the perceived threat of inflation. Do you think they're going to bite the bullet and up rates?

Bew: I think not. I mean inflation is high. We're running at just shy of 4 per cent and from the Bank of England's perspective, they're now talking about inflation rising towards 5 per cent over the course of the next few months. Of course, we had the VAT rise that's going to feed through, Stirling is relatively weak, commodity prices are pretty high, so you can see where more inflationary pressure is going to come from.

But equally, the economy is weak and that GDP number minus 0.5 per cent in Q4 but flat if you exclude the snow, that's before all the fiscal austerity is really starting to bite.

So I think the view of the Bank, and certainly our view as well, is that the headwinds against the economy are just going to get stronger and stronger as we go through the year and while inflation is going to be high because of these special factors, ultimately, that will drop out.

Now, of course, the Bank has been saying that for a long time and they've been wrong, but we think that the big message is that the economy is going to be soft for a long time and these inflationary pressures can't persist over the medium-term, that's right and so therefore, the Bank won't raise interest rates. They won't extend QE either, so really, the Bank of England largely on the sidelines and fiscal policy will be dragging the economy back and it's that that's going to gradually rein in inflation.

McMahon: An election is now due in Ireland and the ruling Fianna Fail Party is likely to face defeat. But for disgruntled Europeans is turfing out the incumbent government really likely to lead to any substantive change in economic policy?

Bew: Not in the short-term at least. I think when you look at what's going on at the moment, Ireland has clearly had a bailout as indeed has Greece. There is conditionality wrapped around that so of course governments are locked into a certain set of policies.

And even leaving that to one side, governments across Europe are running big budget deficits. They are having to tap financial markets for money. Financial markets look for governments to have credible fiscal policies and whoever is in power, they will have to maintain those.

So chucking out the government might change the mood music for a couple of months but it can't actually change what governments have to do.

If you look much further down the line of course and things got very, very desperate in Europe, you could imagine a lot of political turmoil if economies were in recession for three or four years or so and maybe even changing governments might go hand in hand with some more dramatic things. Even countries talking about leaving the eurozone and so on and so forth. But we're nowhere near that at the moment. The government changes that we're likely to see over the next 18 months are just going to be reactions by the public to the very difficult economic circumstances we see, but they're not going to lead to a change in policy.

McMahon: Banker bashing has been back in vogue of late, but is Basel III really likely to lead to any behavioural changes or the avoidance of similar financial crises?

Bew: Basel III ultimately is kind of ratcheting up the safety net, so you're going to have higher capital standards for banks, so that's more capital and higher quality capital so they can take bigger hits going forwards.

There is also liquidity standards because one of the problems that we saw in this crisis is that banks may potentially have been solvent but haven't been able to get hold of enough money in a hurry to meet their obligations, so those standards will also be increased.

So Basel III will do that and that will clearly help. But, clearly, it only helps to the extent that those standards are high enough and the higher you raise them, the less effective the banking system is at its other function which is of course supplying credit to the economy. So there is a balance there. Banks will be a bit more constrained, but if you got hit by a very big crisis, then the standards of course, at least for the outlying institutions which are most in difficulty, may not be high enough.

I think the other thing to keep in mind is one of the problems that we saw in this crisis is that the banking system is so interconnected now that one major failure can cause failures across the rest of the system.

Now Basel III itself isn't designed to deal with that, but the Financial Stability Board, which sits above the Basel Committee, is looking at putting in place some special regulation around institutions which are too big to fail, or what they call systemically important institutions.

We don't know what that's going to look like yet, but I think it is important to recognise that often when we hit crises like this, most banks manage to get through, but one or two are in deep trouble and perhaps can't be saved and the problem we saw in this crisis is the ones that can't be saved have a dramatic impact across the rest of the economy unless governments step in and bail them out.

I think it is actually going to be very difficult, in fact almost impossible, to come up with a regulatory regime which means that we can't go through this again. We can reduce the likelihood of this crisis happening again, but next time it will be different and I think it is going to be very hard to stop that.

McMahon: There have been some calls for the capital requirements to be doubled or more. What's your view of that kind of call?

Bew: Well I think the problem is that it is easy... you can definitely put in place a regulatory regime that means that the banking sector is very, very robust, but it also, as a side effect, means the banking sector is also very, very ineffective.

Our economy these days does involve companies and individuals being able to borrow in order to invest, and that's either to buy a home or for a business to invest in factories and increasing employment and rising output and those things and those things are of course viewed as extremely good because that's what drives economic growth. If you create a banking system that can't support that, then you've kind of been a bit self-defeating.

So doubling, trebling capital requirements may save the banks but at the expense of damaging the economy very greatly.

McMahon: A mixed picture coming out of the United States with improved consumer confidence reported but payrolls down. Add to that, we're likely to see some congressional spats over the level of government debt. So where does President Obama's recovery programme go from here?

Bew: At the moment of course things look pretty good for him. After the bashing he got in the mid-terms, actually, he managed to get through a couple of pieces of very important legislation and perhaps most important of all he managed to get through another fiscal expansion package. So extending all the tax breaks and that's very interesting. Certainly from our perspective, they're pretty much the only developed economy now which is still in that kind of fiscal push mode because if you look around Europe everyone is heading in the other direction and trying to consolidate very hard.

So in terms of his immediate growth programme, he has done pretty well. Certainly much better than most of Europe have done and our growth forecasts reflect that. We think America will grow by perhaps 2.75 per cent next year which is much, much faster than most countries in Europe perhaps with the exception of Germany. So that looks pretty good.

But I think if you look out to the longer term, of course yes America is managing to push more money through the economy. The Federal Reserve is being very supportive, but ultimately, they have the same problems that we see in Europe. The deficit is too big. They had very high debt. They have an aging population and fiscal consolidation will need to come. So they've definitely bought themselves some time and as the world's global reserve currency, they certainly aren't under the sorts of pressures that see in places like Portugal and Ireland under. They can borrow, no problem there, but at some point they're going to have to consolidate and that will rein in growth.

So while this year we think will be pretty good, we think when you get out to 2012/2013, growth will have to be slower and unfortunately these difficult decisions which they're really putting off that Europe is now making, they will have to make them too.

McMahon: You're predicting stiff price rises for food and feedstuffs in 2011. That's obviously potentially destabilising. Where might we see civil unrest and what can be realistically done to address this trend in prices?

Bew: It is pretty difficult because the trend in prices is largely around demand and supply pressures. So it's not about speculation in the markets where there are options, although it's not very easy to do something about even that, but certainly when you see a demand and supply problem, that's a significant issue. It is very hard to address that in the short-term. Where do we see the pressures coming? Well pressures always come in countries where food forms a big part of the overall basket of goods that households buy and generally that means low income countries.

So if you're spending 50, 60, 70% of your income on food and food prices double, and that's kind of what we're talking about for some foodstuffs, then that can cause significant hardship and hardship can easily spill over into other things like social unrest.

So if you look round the poorer countries in Asia, some bits of Eastern Europe and the former Soviet Union, if you look in Africa, of course, all those places are at risk.

But actually, social unrest is not only an issue driven by food prices because really it's driven by damages to living standards. Food prices drive that in places like Africa, but of course in other countries around the world there are other things like fiscal consolidation.

So in fact you can expect to see social unrest perhaps driven by slightly different causes in countries an awful lot richer than most of the ones that we were just talking about a second ago - Europe and other places around the world you could see fiscal consolidation leading to a bit of a hot summer I suspect.

McMahon: Thank you Robin and thank you for joining us this month. Now remember to join Robin Bew on Twitter to catch up with all the very latest in economic analysis and we look forward to joining you again on the Global Forecast next month.