More thought, less groupthink

Assessing today’s rate hike

In light of the Fed’s 75 bps hike yesterday, the BoE had little choice but to raise rates by 25 bps today with the case for action strengthened by the fact that it now predicts inflation will reach 11% before the year is out. The markets were split 50-50 between a 25 bps and a 50 bps rise - either way they will still be at record lows in real terms - but the less aggressive option has left many dissatisfied. The hawkish camp believes that rates must rise more quickly to bear down on inflation – incremental hikes of 25 bps just do not cut the mustard. Conversely, the dovish element – admittedly a minority at present – believes that aggressive rate increases are misguided at a time when the economy is clearly slowing (the BoE predicts that Q2 GDP will contract by 0.3%).

This is a genuine conundrum and there are many question marks as to whether rate hikes are the right way to deal with inflation caused by a supply shock. Higher interest rates act on inflation by curbing demand: The magnitude of the contraction required to rebalance supply and demand in such circumstances is probably much bigger than politicians, and indeed central bankers, are prepared to accept. After all, higher rates are not going to result in more oil being pumped or an increase in Asian semiconductor supply. I was thus taken by the Tweet from the journalist Ryan Avent, who noted “I feel like there's a good chance we're reading macro papers in 20 years which are like ‘the recession of 22-3 was yet another case of Fed overreaction to energy-price shocks.’”

Moreover the linkages from the real economy to prices are highly imprecise. Given that it takes up to two years for tighter monetary policy to impact on the economy, it is likely that a host of other factors will swamp price trends in the interim. Clearly, central banks are using monetary policy to try and influence inflation expectations, particularly wages. However, this is a risky strategy. Faced with rising food and energy prices, the like of which we have not seen for 40 years, workers are not going to sit idly by whilst the prices of goods and services which they consume are going up. And when central bank actions impact on their interest costs, it is no surprise that trade unions respond with industrial action.

This is not to say that central banks should necessarily refrain from hiking rates. But it is an illustration of how the textbook models used by economists to describe the workings of the economy often fall apart when circumstances change. Just as the 1970s sounded the death knell for structural macro models which did not incorporate forward-looking expectations, it will be interesting to see whether the current vogue for forward-looking DSGE models emerges unscathed from today’s events. After all, one of the criticisms levelled at central banks is that they failed to foresee the inflationary shock.

As it happens, I have sympathy with central banks’ position. Random shocks are by their nature unexpected and although central banks did highlight that inflation would rise in the course of 2022, they could not reasonably have predicted the impact of the war in Ukraine. That said, the likes of the BoE probably should have curtailed their QE programmes once it became clear that the economy was recovering. However, even by summer 2021 they had already pumped significant amounts of liquidity into the system and the effect of calling a halt earlier than planned would have had a marginal effect on inflation at best.

The groupthink criticism

At least we cannot criticise the BoE for sitting on its hands. Rates have risen at five consecutive meetings for the first time since the MPC was established in 1997. It was not always this way: After unprecedented policy easing in the wake of the Lehman’s bankruptcy, the BoE (in common with most other central banks) kept interest rates at their 2009 emergency settings for the next nine years. This contributed to excessive asset price inflation, notably for housing, and gave rise to criticisms of groupthink as the MPC ignored all the concerns surrounding a prolonged ultra-loose monetary stance and focused purely on the near-term inflation outlook.

Former MPC member Danny Blanchflower has been one of the strongest critics of groupthink, pointing to the lack of intellectual diversity on the Committee and arguing that there are fewer independent thinkers who are drawn from an increasingly narrow talent pool. As he noted in a Tweet in May, “still nobody on the MPC lives or comes from north of the Watford gap so diversity means only London  (8) & USA (1) are represented? No Birmingham Leeds Belfast Glasgow Newcastle Cardiff Liverpool Manchester representation? No representation of business?” Blanchflower may sometimes be overly critical of the BoE but he does have a point. For example, there has never, to my knowledge, been a Scottish representative on the Committee during its 25 year existence.  Given that Scotland accounts for 8% of the UK population, one would have thought they deserve some representation. Indeed, there have been more representatives born in Argentina, Belgium, India and the United States than those born north of the border.

Assessing the evidence

To assess Blanchflower’s claim that the Committee is drawn from an overly narrow pool, it is instructive to examine the universities from which MPC members graduated. Taking their highest university degree as the relevant benchmark, 12 of the 46 past and present members obtained their highest qualification from Oxford whilst another 9 were graduates of the LSE and 7 were from Cambridge. Only thirteen universities are represented in the list, which will rise to 14 when Swati Dingra replaces Michael Saunders in August. Widening the list to include those who attended British universities as an undergraduate reveals that 16 MPC members attended Oxford (almost 35% of the total) whilst 12 have Cambridge connections (26%) and 5 have an LSE-only affiliation. The response to this is that these universities attract some of the brightest and the best. The fact that they have strict entry criteria means that those with the best academic performance are more likely to study there. But by any standards this is a small sample from which to draw and does nothing to refute Blanchflower’s suspicions of selection bias.

The old joke has it that if you ask a question of nine economists, you will get nine different opinions  and another of Blanchflower’s criticisms is that there is simply not enough dissent from the majority view on the MPC. We are on more solid ground here. I have applied two ways to measure the independence of individual voting patterns: One is the proportion of times an individual votes for an option other than the committee consensus – for example, a person who votes for a 50 bps hike rather than the majority view of 25 bps is a dissenter on this measure. Another metric is the number of times an individual votes in the opposite direction to the majority, which is a stricter measure of dissent.

Based on 25 years of MPC voting, the dissent measure, which calculates the proportion of members voting for something other than the committee average, is recorded at 14.4% over the period 1997 to 2008 versus a post-2009 figure of 6.5%. Obviously times were different in the wake of the 2008 crash when there was a universal belief that an expansive monetary policy was required. But it is notable that this dissent measure recorded a figure of 16.5% during Eddie George’s term as Governor, falling to 9.3% under Mervyn King and just 6.9% under Mark Carney. Whisper it quietly, but under Andrew Bailey’s tenure the dissent measure has crept up to 7.8%. But the numbers do back up Blanchflower’s claim that there is a lot less dissent in the voting patterns.

On the stricter measure of directional dissent, a similar pattern applies. Pre-2009, on 12.9% of occasions MPC members pushed for directional rate moves which were out of line with the committee consensus versus 5.6% post-2009. The post-2009 figure is low and would appear to confirm the fact that MPC members were reluctant to stick their head above the parapet and call for rate hikes.

Last word

For all the criticism that the BoE kept rates too low for too long in the wake of the 2008 crash – a view with which I concur – and that it has been dominated by groupthink, the events of recent months appear to have shaken the MPC out of its complacency. Although there are those who believe that it should have been more aggressive today and hiked by 50 bps, my own view is that the 25 bps increase was the right move. Doing nothing was not an option but acting too aggressively would exacerbate recession concerns, which is the last thing beleaguered households need now.

The sick man of Europe suffers a relapse

Politics gets in the way …

“When a regime has been in power too long, when it has fatally exhausted the patience of the people, and when oblivion finally beckons – I am afraid that across the world you can rely on the leaders of that regime to act solely in the interests of self-preservation, and not in the interests of the electorate.” It sounds like the sort of quote that Churchill, Thatcher or Blair might have offered up. In fact it was penned by none other than Boris Johnson in 2011 in an article in the Daily Telegraph. It is worth recalling this quote in a week when Johnson survived a motion of no-confidence amongst his own MPs by a margin of 211-148. With 41% of his own MPs voting against him, the general consensus is that Johnson’s days in office are numbered. I would not be so sure.

For one thing, Johnson’s polling share amongst MPs (58.8%) is higher than the average across the previous ten contests (54.2% - see chart above). It was a big parliamentary rebellion, to be sure, and it will make life difficult but as shows of support go this was not a bad one. Public opinion polling evidence does not suggest that his popular appeal has been damaged significantly more than most Prime Ministers at this point in their term. The long-running Ipsos poll, with data back to 1977, indicates that Johnson’s latest approval rating of 26% is slightly below the long-term average of 31% whilst the disapproval rating is at 66% versus the historical average of 60% (chart below). Past experience suggests that a disapproval rating above 70% would be a cause for concern, foreshadowing a change of government in 1979, 1997 and 2010. The latest poll reported in The Observer indicates that only 26% of respondents believe Labour leader Keir Starmer would make the best Prime Minister versus 28% for Johnson. Thus the current polling readings suggest the Tories should not be in too much of a hurry to ditch Johnson. After all, who would replace him? And would the electorate forgive the Conservatives if they ditched a third leader in six years?

It is clear that Johnson believes that he has a mandate to continue. For a politician who believes a 52-48 majority in favour of Brexit represents the will of the people, a 59-41 margin represents a thumping majority. As far as Johnson is concerned, he is not going anywhere and under current Conservative Party rules he cannot be challenged as party leader for another 12 months which would confirm him in Downing Street beyond year-end. The rules can, of course, be changed and with the Prime Minister due to face the Parliamentary Privileges Committee in the autumn over whether he lied to parliament, the position could change considerably.

… but the economy is increasingly what matters for voters

The bigger problem is that the government is likely to become increasingly distracted by internal politics rather than the mounting headwinds facing the economy. Just this week, the media focused on the news that the latest OECD forecast suggests that the UK will be the slowest growing economy in the G20 after Russia in 2023 with a GDP growth rate of zero. This is driven by a number of factors including higher interest rates, higher taxes, reduced trade in the wake of Brexit and higher food and energy prices. The government has control over some of these factors; others it has not. The concern, however, is that competing factions in the Tory government will push to implement a range of potentially contradictory policies. It is an article of faith amongst many of them that taxes should be cut. Others have picked up on mounting public concern about the poor state of public service provision, most notably the NHS where workers have been rewarded for their sacrifices during the pandemic with pay rises well below the inflation rate. It is not possible to satisfy both of these competing demands. Then there is Brexit, where there are signs of unease on the backbenches that the policy is not delivering what was promised.

But the malaise goes deeper. As a recent article in The Economist noted, the “half-hearted vote to endorse Boris Johnson as prime minister, on June 6th, betrayed how deeply Britain’s ruling party fails to confront hard choices … Britain is stuck in a 15-year rut. It likes to think of itself as a dynamic, free-market place, but its economy lags behind much of the rich world. There is plenty of speechifying about growth, and no shortage of ideas about how to turn the country round. But the mettle and strategic thinking that reform requires are absent—another instance of Tories ducking hard choices.”

There is little new economic thinking coming from the government. One of the key policies announced in the March Budget was a cut in the basic rate of income tax in 2024 – a direct nod to the Thatcherite policies of the 1980s. Last week, the government announced plans to allow benefits to be put towards mortgages and permit social tenants to buy their homes, echoing the “right to buy” policy of the 1980s. Unfortunately, those with savings of more than £16,000 will not be eligible and those with savings below the threshold will struggle to fund a mortgage.

Housing policy is certainly one area where new thinking is required. The government’s approach over the years has amounted to raising demand in the face of a slowly expanding housing supply which has served to inflate prices relative to household incomes. Unlike the 1930s the government is not in the business of building houses but it is in a position to influence policy to increase housing supply which ought to alleviate some of the cost pressures on the poorest in society in the long run. The government’s stated target is for 300,000 new homes to be built per year by the mid-2020s (some estimates put the requirement at up to 340,000). Over the last five years housing completions have averaged 163,000. The Centre for Cities argues that the lack of available land in the right places is one of the key constraints on increasing supply, which could be remedied by (inter alia) making better use of Green Belt land and reforming property taxes, notably levying a tax of 20% on the selling price of new properties to develop local infrastructure and allow funding for more social housing. Whether or not these are the right policies, they are an improvement on efforts to stoke demand.

There are a host of other areas where reform is required and space considerations preclude a detailed look. However, in order to improve the economic circumstances of voters requires reform of areas such as NHS funding and the social care system. Efforts to reduce regional imbalances which could help to boost productivity, long the Achilles Heel of the UK economy, are also necessary which may require changes to regional governance. Reforms to the tax and benefits system are very clearly needed – Universal Credit is a good idea in principle but its implementation has been badly handled, as the National Audit Office pointed out in 2018 – whilst the Mirrlees Review noted more than a decade ago that “the tax and benefit system should have a coherent structure based on clearly defined economic principles.”

There are many other areas besides. But the main takeaway, as the article in The Economist made clear, is that the government has failed to take bold steps in recent years to tackle many of the underlying economic problems. It continues to rely too heavily on policies which were deemed successful in the past but which may not be appropriate today. Unfortunately since Johnson’s government will spend the next couple of years merely trying to survive and is unlikely to engage in much long-term strategic thinking, most of the UK’s economic ills will continue to fester. In the 1970s, Britain was known as “the sick man of Europe.” It appears to have relapsed.

A platinum performance

As Britain basks in a long weekend, it is a sobering thought that for those of us of a certain age the Platinum Jubilee marking the Queen’s 70 years on the throne may be the last major royal celebration in our lifetime. After all, Prince Charles will be older than the Queen is now if he ever celebrates his Silver Jubilee. It puts into perspective the fact that seven decades in the job really is a long time and the Britain over which Queen Elizabeth reigned in 1952 is in many respects barely recognisable today, especially with regard to the economy.

The economy now and then

There was a sense of expectation and excitement at the dawn of the second Elizabethan era as it was popularly known in 1952. After all, the UK was the world's third largest economy in the early-1950s, behind the US and USSR and, hard though it may be to imagine today, was Europe's industrial powerhouse. But beneath the surface, all was not well. The UK was, to all intents and purposes, bankrupt in 1945 and had been the biggest recipient of US aid under the auspices of the Marshall Plan. One of the key elements of economic policy in the early 1950s was thus to generate as much export income as possible in a bid to stay afloat.

Britain’s economy was still dominated by heavy industry in the 1950s but the rapid pace of economic reconstruction in Germany, which resulted in output exceeding UK levels by 1955, meant that the UK faced increasingly stiff competition for its manufactured goods. The next twenty years were characterised by 'stop-go' policies in a bid to relieve pressure on sterling, which was fixed to the dollar under the Bretton Woods agreement whilst the 1970s and 1980s were dominated by industrial strife as the government and unions locked horns in a bid to restructure the economy.

Such were the economic difficulties which the UK faced in 1952 that consumption of a number of goods was still rationed. The rationing of tea did not end until October 1952; sugar consumption was rationed until February 1953 and only in 1954 did cheese and meat rationing end. These were definitely not the “good old days.” Despite nostalgia for the 1950s, life is in many ways a lot sweeter today (sugar rationing notwithstanding). On average, people today are materially much better off than in 1952. Real GDP per head, for example, has quadrupled over the past 70 years (chart below) whilst the real cost of what were once luxury items has fallen. Take the example of cars, where the best-selling Morris Minor would have cost £631 in 1952 (£14,004 in 2022 prices) compared to £15,485 for the cheapest Vauxhall Corsa, the UK's best-selling car in 2022. However, an average car at the start of the Queen’s reign cost two years’ salary compared to six months in 2022. The relative fall in the price of cars has contributed to a huge surge in the number of vehicles on the road, from 2.5 million in 1952 (50 per 1000 head of population) to 37.5 million today (556 per 1000 head of population).

Perhaps one of the most notable changes since 1952 has been the technological revolution in communications, with the advent of the computer and the mobile phone changing the way in which people interact with the wider world. Less than two million households owned a TV in the black and white world of 1952, whilst households had to wait for the GPO to connect them to a system in which telephonists manually operated the exchanges. Today, anyone can walk into a shop to pick up a mobile phone from which they can immediately watch all sorts of media content and communicate with people anywhere in the world. As for computers, they were the stuff of science fiction. In 1952, IBM introduced its first fully electric system with 1Kb of RAM at a monthly leasing rate of $15,000 (£5,350 at 1952 exchange rates). A machine with 8000 times as much RAM can be bought today for around £200.

Radical social change

It is interesting to reflect on political change over the past 70 years. Winston Churchill was Prime Minister in 1952, heading a government which was very much rooted in Britain’s imperial past. In 1953, Churchill suffered a stroke which was kept secret from the public and he largely remained out of the public eye for five months. Imagine being able to get away with that in today’s world dominated by social media. The contrast between the government of Churchill and that of Boris Johnson is immense and embodies the extent to which the relationship between the rulers and the ruled has changed over the years.

Many aspects of British life in the early 1950s are very difficult to capture in terms of the data alone. For a portrayal of the hardships experienced by a large proportion of UK residents, interested readers are referred to the social history of post-war Britain by David Kynaston[1]. This paints a picture of cramped housing, dirty cities (the Great London Smog of December 1952 is believed to have contributed to the deaths of 4,000 people), lack of educational opportunity and a very steep path to the better economic times which lay ahead. Life in the UK (and indeed in many other European countries) was no picnic in 1952.

Seventy years of asset returns

Whilst the economic environment in 1952 was far from comfortable, financial markets were less volatile than they are today. An estimate of the rolling 10-year coefficient of variation for UK equity prices was at multi-year lows in 1952, although despite recent equity movements the degree of volatility on this measure is at its lowest since the mid-1950s. Over the last 70 years, UK equity prices have soared by over 10,000% (an average annual gain of 6.9%), though once we account for inflation this translates into a more modest 353% (annual average of 2.2%).

Another asset which has performed well over the course of the Queen's reign is housing. Back in 1952, the average house cost just shy of £1,900 but since the average gross annual wage in 1952 was a mere £314 (£6352 at today's prices), the price of a house was six times the annual wage. Today, an “average” house costs eight times the annual average wage. Over the Queen’s reign  house prices have risen at an average annual rate of 7.3% or 2.2% per annum in real terms which serves to support the old investment adage of "safe as houses."

Lessons for the future

Given the difficulties in forecasting trends even over the coming months, I am certainly not going to try and forecast how the UK economy will look in 70 years’ time, particularly since the problems we face today are unique in the post-1945 era. But it is interesting to reflect on past trends and assess whether there are any takeaways for the future. One feature of the UK over the period has been the relative stability of UK GDP growth (the post pandemic collapse notwithstanding). Real GDP growth has averaged 2.4% per annum since 1952 but this has slowed to an annual average of just 0.9% since 2008 (biased downwards, of course, by the 2020 collapse). But productivity growth remains one of the UK’s biggest challenges, with multifactor productivity barely growing, and with the population growing more slowly now than in the early years of the Queen’s reign (the baby boom came to an end many years ago) it is difficult to imagine the economic speed limit rising above 2% anytime soon.

One of the UK's economic success stories over the first 40 years of the Queen’s reign was the reduction in the huge debt overhang, which peaked at almost 238% of GDP in 1947. In 1952 the debt-to-GDP ratio was still at 162% and it continued falling to bottom out below 30% in the early-1990s. Economic events over the past 15 years have pushed it back to around 95%. The decline in the debt ratio was driven in part by rapid growth although as noted above, this is likely to be relatively sluggish over the coming years. Inflation also helped to erode the debt burden. Over the past 70 years, the UK has recorded an average CPI inflation rate of 4.6% which is more than double the BoE’s target rate. Stripping out the period 1971-81 results in an average of 3.3%. This may be close to the rate that the BoE will have to live with in the medium-term in order to help reduce the debt burden and may be an argument for raising the inflation target band from 1%-3% to 2%-4% (that is a debate for another time). Either way, the debt ratio is unlikely to fall rapidly in the coming years in the face of sluggish growth and big demands on government finances.

Whatever one’s views on the role of monarchy, it is nonetheless fascinating to reflect on the changes over the past 70 years. It serves as a reminder that for all the concerns about the current direction of travel, nothing is set in stone.

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[1] David Kynaston (2009) ‘Family Britain, 1951-57’, Bloomsbury Publishing

The squeeze is on

The politics …

It is hard to recall a time when a government has been so out of touch with the electorate as that led by Boris Johnson. As the squeeze on incomes posed by inflation rises up the agenda and the government doubles down on Brexit, there is a sense that a lot of things are becoming unglued. In a series of events guaranteed to cause apoplexy amongst party communications managers, Conservative MP Lee Anderson suggested that people needed to learn how to cook and budget "properly", rather than use food banks whilst his colleague Rachel Maclean recommended that people could improve their circumstances by working “more hours or moving to a better-paid job.”

Up until six months ago, despite the warnings signs of incompetence, the Conservatives were still ahead in the polls. The Owen Paterson affair provided the first sign that the electorate was fed up with being taken for fools – a trend which was reinforced by the Partygate scandal. Despite the flow of bad news, however, the Tories are not as far behind in the polls as might be expected. Indeed, Labour’s lead has remained steady at around six percentage points and were this to remain unchanged, it would unlikely be able to form an outright majority following the next election. For the record, Electoral Calculus currently predicts that Labour will win 315 seats – six short of an outright majority (for what it is worth, my own assessment is that Labour might struggle to top 300 seats).

… and the economics

Despite all the political noise surrounding Partygate which has sent the commentariat into overdrive, it is good old-fashioned economics which poses the biggest current threat to the Conservatives’ electoral chances. The cost of living squeeze, triggered by a 40-year high inflation rate in April (CPI at 9% or 11.1% using the RPI measure), is the biggest current problem. In fairness, this is largely the result of exogenous factors beyond the government’s control, particularly with regard to energy prices. However the government does have control over its response, and as the comments from the two MPs above illustrate, this has been sadly lacking.

The main criticism is that it has done little to nothing to protect low income households from the full impact of the squeeze. An uplift of 54% in the energy price cap last month is a regressive move that will hit poorest households the hardest, whilst low income families also have to contend with a food inflation rate running at 6.6%. The March Budget represented a wasted opportunity to provide some support whilst at the end of April, Chancellor Rishi Sunak suggested it would be “silly” to provide support on energy bills before knowing what is likely to happen to prices in the autumn (this from someone who, along with his wife, has just been named as the 222^nd wealthiest person in the country). In fairness, the government has granted a £150 Council Tax rebate this year but according to the OBR much of this will be clawed back over the next five years via a new tax on energy bills, which on a Ricardian equivalence basis does not represent much help at all.

In addition to blaming the public for their inability to cope with the inflation crisis, senior Conservative politicians have tried to pin the blame for the inflation spike on the Bank of England. It was accused by the Chairman of the Treasury Committee of being “asleep at the wheel” whilst the Tory peer Michael Forsyth accused it of “unleashing inflation in our country through failing to meet its proper mandate.” I will deal with the BoE’s position in a future post, but suffice to say that although it has made mistakes, this represents a blatant attempt by the government to deflect blame for its own failures.

Aside from the welcome support provided during the early stages of the pandemic, fiscal policy has generally been too tight over the past decade. George Osborne’s misguided austerity policy meant that the BoE was required to do much of the heavy lifting on policy in the wake of the GFC and the failure to provide sufficient fiscal support in recent months is one reason why the central bank has not been more aggressive in raising interest rates. There is general agreement that fiscal rather than monetary policy is the appropriate tool to provide targeted help to those most in need, and it is incumbent on the government to act rather than apportion blame. It is not as though there is a lack of options.

What can they do?

In the first instance, the government could reintroduce the uplift to Universal Credit payments used during the pandemic with NIESR calling for a rise of £25 per week which it estimates would cost £2.7bn this fiscal year. The Chancellor would doubtless argue that this will simply raise the fiscal deficit. However, it would do so by less than he thinks given that higher-than-expected inflation will boost revenues via fiscal drag following last year’s decision to freeze tax thresholds. An additional measure would be to temporarily reduce VAT on domestic fuel bills to zero and sell it as a Brexit win (EU rules do not permit this to fall below 5%). Removing the levy to fund renewables investment and energy efficiency improvements from household bills, as energy suppliers have called for, would shave another 7.8% from outlays. Adding in the Council Tax rebate, these measures would limit the latest rise in household energy bills to 23% rather than the 54% mandated by the energy price cap.

Labour has called for the imposition of a windfall tax on the profits of energy companies – a measure which the government has so far resisted. There is some merit behind the idea of such a tax. Shareholders who happen to be holding stock at the right time have simply benefited from an exogenous factor beyond their control whilst energy consumers bear the cost. With energy companies making big profits and BP’s profit having doubled in the first quarter of the year, it may be an idea whose time has come (again). Such windfall taxes have been tried before: In 1997, the Labour government imposed an additional levy on the profits of recently privatised industries, arguing that they had been sold off too cheaply. In 1981, Margaret Thatcher’s government taxed the additional profits made by banks as a result of rising loan spreads which were a result of rising short-term rates.

However, there are also many good arguments against the idea. The basis of a good tax system is that it should be fair, certain, convenient and efficient but a windfall tax would violate some of these principles. Most voters would agree that a windfall tax is fair; it is also convenient in that it would be easy to collect. However, it would introduce uncertainty about the future tax regime which would undermine the basis of the system. It would also be fiscally inefficient since it could hamper investment in cleaner energy where energy companies are in the vanguard. Finally, since a windfall tax is designed to tax supernormal profits, how do we determine what is a normal level? There is also the problem that the revenue derived from taxing energy companies would come too late to provide relief for households that are struggling right now. My own conclusion is that whilst there is a discussion to be had about levying higher taxes on energy companies, it might be more efficient to do so via the usual channels by which changes are advised well in advance. In the meantime, some of the other measures outlined above might be more appropriate.

Act now or risk an electoral drubbing

There is no doubt, however, that households are struggling to make ends meet. Consumer sentiment has fallen to its lowest level since the data were first reported in 1974 (chart above) and forecasts from both NIESR and the BoE reckon that the UK will come very close to recession by end-year (even if a technical recession is avoided). Whilst acknowledging that many of these factors are beyond the government’s control, it does control its response. Since the government sold Brexit as an idea that would make people better off whereas the opposite has occurred, there is increasingly a sense that it has a duty to step in (Brexit will undoubtedly be the subject of another post). Failure to deliver on this most basic of Brexit promises is likely to mean the electorate will not be in a forgiving mood the next time the government asks for their vote.

Not a pretty picture

This week’s decision by the BoE to raise interest rates another 25 bps to 1% takes Bank Rate to its highest since 2009 and in the process managed to please nobody. Consumers certainly do not welcome it, nor do the markets if pressure on the pound is any guide. Following on from the Fed’s 50 bps rise on Wednesday, central banks are now acting on their rhetoric to take action against the big rise in inflation which is running at 40-year highs in the US and 30-year highs in the UK. This puts the spotlight on the ECB which has yet to follow up its recent more hawkish message with action. But maybe the ECB, like many of us, has significant reservations about countering an adverse economic shock with a tightening of policy which in the short-term will squeeze the economy and make life harder for consumers and businesses which are already reeling under the strain.

The BoE’s economic forecast grabbed a lot of headlines with its prediction that CPI inflation will hit 10.2% by the fourth quarter of 2022, which would be the highest ever CPI inflation reading on data back to 1989 (the RPI series, by contrast, can be extended back to 1914). It also forecast that GDP will contract slightly in 2023, though the quarterly profile suggests that the technical definition of recession, in which there are two consecutive quarterly contractions, is not fulfilled. Looking out over the next three years, the forecast is consistent with annual average growth of just 0.3% which is a grim picture and not one in which a central bank would normally be expected to raise interest rates. So why do it? Aside from the surge in headline CPI inflation, the minutes of the MPC meeting made it clear that the Committee is concerned about the tightness of the labour market and the potential for a spillover to wages. We should thus view this week’s rate increase as a precautionary measure.

When looking ahead it is important to be aware of the interest rate assumptions underpinning the forecast. The baseline (modal) forecast is conditional on market interest rate expectations in which Bank Rate is expected to hit around 2½% by mid-2023 before falling to 2% by mid-2025. Under this assumption, GDP contracts by around 0.25% next year and the output gap widens to 1¼% on a twelve month horizon which under normal circumstances would be considered disinflationary. The central case projection also foresees rising unemployment, with the jobless rate rising by two percentage points to 5.5% on a three year view. These forces combine to produce a sharp slowdown in CPI inflation over the forecast horizon, with inflation close to target on a two year view (2.1%) and well below it by Q2  2025 (1.3%). In the alternative scenario, in which interest rates hold at 1%, the fall in output is less dramatic, with GDP growth next year averaging +0.8%. The rise in unemployment (jobless rate at 4.2% by mid-2025) and fall in inflation (still above target at 2.2% by mid-2025) are correspondingly slower. On the basis of these two forecast paths one conclusion we might draw is that in order to hit the inflation target on a three year view, rates will rise further but perhaps by less than the market is currently pricing in.

Any forecast relies on assumptions about the future, and those regarding energy prices are particularly uncertain but will have major implications for the inflation projection. As it currently stands, the BoE assumes household energy bills will rise by another 40% in October when the domestic price cap is up for its biannual review, following the 54% rise in April (5 percentage points of which were accounted for by the costs resulting from those suppliers that went bust in recent months). Yet the BoE admits that if energy prices “fall back to the levels implied by futures curves …  the level of GDP would be nearly 1% higher by the end of the forecast period and excess supply and unemployment around ¾ percentage points lower. CPI inflation would fall back towards the target more rapidly than in the central projection and would be around ½ and over 1 percentage points below the target in two and three years’ time respectively.” Bottom line: Things may not turn out quite as bad as this forecast suggests.

There are some other elements of the forecast which don’t necessarily stack up. First, if energy prices do rise by 40% in the fourth quarter, the slowdown in inflation in 2023 looks quite ambitious – the BoE estimates that energy will add only 0.25 percentage points to inflation versus 4 points in 2022. Average earnings inflation is expected to slow from 5¾% this year to 4¾% in 2023 despite the fact that if the labour market is as tight as the BoE believes, surely there will be greater upward pressure on wages rather than less as workers try to recoup some of the real wage losses suffered in 2022. This would point to upside risks to the inflation forecast and it is noteworthy that the BoE sees risks to the inflation outlook as tilted marginally to the upside.

If inflation does turn out higher, should the BoE be more aggressive in raising rates compared to current market expectations? In my view, no. Higher inflation will continue to act as a brake on real incomes and activity rates, and in an environment where the UK is struggling to come to terms with a post-Brexit world the headwinds are strong enough without an additional monetary burden (the BoE’s forecast looks for net trade to subtract 1.5 percentage points from growth next year).

Not everyone agrees. Former MPC member Adam Posen is quoted as saying that “The central bank has no choice but to cause a recession when a broad range of prices are rising at such a strong pace … It is duty bound to bring inflation down after more than a year when it has been more than 2 percentage points above its 2% target level during a period of full employment.” This is both irresponsible and wrong from an economist whose work I admire and is the kind of thinking which gets economists a bad name. It also ignores the fact that the BoE’s mandate is to maintain price stability subject to “the Government’s economic policy, including its objectives on growth and employment.” Given the Conservatives’ poor showing in this week’s local elections, I cannot imagine anyone in government believes that exacerbating the cost of living crisis is going to make them any more popular at the ballot box.

Another issue which perhaps did not get as much prominence as it deserved was that in lifting Bank Rate to 1%, the BoE has reached the threshold at which it will consider actively running down its balance sheet. We can expect more guidance as to how this might happen in the August Monetary Policy Report. Suffice to say that if the BoE is raising interest rates whilst simultaneously engaging in quantitative tightening, it is likely to make a bad situation worse.

All is vanity

Depending on your point of view, Twitter is either a moral cesspit or a source of great inspiration. I can see both sides but as a free source of insight from some outstanding academics and journalists it is hard to beat (though sometimes you do have to wade through a lot of nonsense to find it). The news this week that Elon Musk’s $44 billion bid to buy Twitter has been accepted has raised more than a few eyebrows, generating concerns that the self-styled “free speech absolutist” will turn the platform into even more of a hell-hole than many people already believe it is.

Musk has not always been such a fan. Some years ago he was quoted as saying, “I don't have a Facebook page. I don't use my Twitter account. I am familiar with both, but I don't use them.” When he did finally venture onto Twitter in 2018, his Tweets suggesting that he was contemplating taking Tesla private earned Musk a $40 million securities fraud charge from the SEC. Undeterred by his past experience, the online payments guru turned car-maker cum space explorer appears to be following in the footsteps of 1970s entrepreneur Victor Kiam whose memorable marketing catchphrase for Remington shavers was “I liked it so much, I bought the company.”

Twitter's glory days may be behind it

The motivation for Musk’s involvement remains unclear. The social media segment is increasingly competitive and depending on how it is defined, Twitter does not even rank in the global top 15 most popular social networks. Growth in the number of active Twitter accounts has slowed sharply in recent years, having grown at single digit rates since 2015. Twitter’s preferred metric these days is Monetizable Daily Active Usage (mDAU) which is a measure of users who have logged into the platform and been exposed to adverts. After global mDAU gains of 21% and 27% in 2019 and 2020 respectively, this slowed to 13% in 2021 (chart). More worrying is that growth in the critical US market slowed to 2% last year versus 15% elsewhere. Twitter has been tight-lipped as to whether the slowdown in US activity is anything to do with the January 2021 ban imposed on former President Donald Trump. Whatever the reason, Twitter recorded a second consecutive annual loss last year, with cumulated losses of $1.36 billion over 2020 and 2021.

 

Financing the deal 

The financing arrangements of the buyout are also worthy of comment. Under the terms of his proposed deal, Musk will finance the buyout with $13 billion of debt, $12.5 billion secured against Tesla stock and $21 billion of his own equity. Musk is thus financing more than 70% of the deal from his own funds which runs contrary to standard LBO wisdom in which borrowing is mainly secured against the assets of the target company. There are suggestions that the lending banks are limiting their participation due to concerns that Twitter’s revenue stream has limited growth potential. Moreover, the company’s debt ratio, calculated relative to shareholder’s equity, has been creeping up since 2019, rising from 0.46 to 1.29 by Q1 2022. Even though the debt component of the deal is relatively limited, adding $13 billion of liabilities to the existing $4.2 billion of long-term debt would raise Twitter’s debt ratio to 3.5 which is significantly above the S&P500 average of 1.5 (chart below). Conducting a buyout in a rising interest rate environment will pose additional problems.

A highly indebted company with limited revenue growth potential does not look an attractive investment proposition. Moreover, the fact that the portion secured against Tesla stock takes the form of a margin loan means that if a margin call is triggered, Musk could be forced to sell Tesla stock to meet his commitments. This risks putting downward pressure on Tesla’s price. Roughly speaking, Musk would be on the hook if Tesla stock fell by 43% from the price prevailing on the filing date of 20 April. For the record the price is down 12% in a little over a week, and the trigger point is consistent with the price prevailing in November 2020. The plan to buy Twitter thus poses unnecessary risks to Tesla, which is now a very profitable business with one of the widest profit margins in the auto industry. But if Tesla is so successful why might we expect a price fall? For one thing the rally over the last couple of years has been remarkably strong, which is always a reason to be concerned about a pullback. Second, if Musk becomes distracted by running Twitter and takes his eye off Tesla’s operations there is a risk that any problems experienced by the carmaker are initially missed or become more difficult to fix.

Can Twitter be monetised?

Aside from concerns about the financing of the deal, the episode raises a lot of interesting questions about the valuation of digital content. For a platform such as Twitter, its value is embodied in its network. In theory, Metcalfe’s Law states that a network’s value is proportional to the square of the number of nodes in the network. Thus a network like Twitter with 300 million users has an inherent "node value" of 90 quadrillion. If these were dollars, Musk would be laughing all the way to the bank But monetising Twitter's reach will prove extremely difficult. Even a small subscription fee is likely to deter many users - demand is highly price elastic. Besides, imposing a fee is inconsistent with the vision of Twitter as a “digital town square” as former CEO Dick Costolo once called it. According to media reports, Musk told banks that agreed to help fund the takeover he would crack down on executive pay to slash costs, and would develop new ways to monetize tweets. Maybe Musk does have a plan to generate money from Tweets, but it is not immediately obvious to the many analysts who follow the company.

At this stage of proceedings the financials of Musk’s Twitter deal do not look compelling. Short of a radical overhaul of the business model it is difficult to see how the company can generate the returns which would justify paying $54.20 per share. The fact that the board is prepared to sell at a price 25% below last summer’s high may tell us something about how they view the future. If the deal does go ahead – although it is far from certain that it will – it may go down in history as a vanity project demonstrating the old adage “buy in haste, repent at leisure."