Cheap currency, inflation, economy - UK's case

The UK is diving into stagflation - Is that so?

The UK's GDP unexpectedly shrank 0.5% in the last quarter, the first-time decline in five quarters since the Lehman crisis in the third quarter of 2009. The hardest hit was the construction sector which decreased 3.3% from the previous quarter, followed by the service sector which lost 0.5%. What caused it? According to the ONS,

The change in GDP in Q4 was clearly affected by the extremely bad weather in December last year. The disruption caused by the bad weather in December is likely to have contributed to most of the 0.5 per cent decline.

So, it's the bad weather to be blamed. Along with it, they also admit that

if there had been no disruption, GDP would be showing a flattish picture rather than declining by 0.5 per cent.

GDP wouldn't grow at all in the fourth quarter last year even without the bad weather.

Meanwhile, a cheap currency has contributed to the rise of the UK's inflation. In real terms, sterling fell more than 20% in four years, now one of the cheapest among major currencies. It's no doubt that weak sterling has pushed up the inflation rate through imports, and helped survive manufacturing industry in the midst of crisis which hit the UK's once-touted financial sector the hardest.

The problem is: Is a cheap currency enough to help float the UK economy?

Given the current trend of declining manufacturing and surging services in the UK economy, it's an open question whether a weak currency keeps on underpinning the economy through exports, ignoring rising inflation.

From deflation to inflation?

The world has recently seen rising prices which are not only a concern for economic stability but also causing deadly riots in North Africa, where Tunisia's Ben Ali was forced into exile after 23 years in dictatorship.

Inflation has been creeping into advanced nations, too. The UK's consumer price index in December increased 3.7% from the previous year, the highest since April 2010. The largest contributor to December's rise was transport which claimed nearly 30% of total increase. Food was the second largest contributor, and restaurants the third.

Likewise, Germany's Harmonised Index of Consumer Prices (HICP) rose 1.9% in December, the biggest since October 2008. About 40% of rise came from energy, which was the largest contributor to nearly two-year high. Traffic and food followed.

Meanwhile, the US is also feeling the rise of inflation, albeit very slowly, even though deflation was perceived as the biggest risk for a little while back. A 1.5% growth of CPI in December is lower than the UK and Germany, but it's the highest in 8 months, nonetheless. Transportation was the largest driver of the increase, beating medical care and food and beverages.

The common factor behind the latest inflation in those three countries is the rise of energy and food price. Transportation is the prime sector that passes through soaring energy costs on fares. Restaurants are also vulnerable to the swing of food prices, and have little choice but to raise retail prices in face of escalating food prices.

The fear of inflation is gradually appearing on a radar screen of European authorities' mind. In the recent interview, ECB President Jean-Claude Trichet brought inflation fighting back to the agenda.

European Central Bank President Jean-Claude Trichet said policy makers are monitoring price developments "very closely" after euro-area inflation breached the ECB's limit in December, Germany's Bild newspaper reported.

"We are always concerned if inflation rises and are following developments very closely," Trichet told the newspaper in an interview. "But the figures for December can be accounted for, above all, by rising energy prices."

Reuters poll indicates that some analysts are anticipating the Bank of England's rate hike in as early as the third quarter of this year, though a majority forecasts a rise in the fourth quarter.

This is all happening when economic activity around the world is still and will be fragile for a while, at least this year. It should be dubious that inflation persists with considerable resources still in slack mode, but the world might have to recall how to tackle and tame stagflation in the 1970's.

Who bears cost?

The US has every reason to fear disinflation which could spiral into deflation. As the last post shows, core CPI, CPI excluding volatile goods like food and energy, has increased only 0.61% in October over the year, the smallest on record.

Why is low inflation a problem? It appears to be a bonanza for consumers, because they can afford to buy low-priced goods and services, be it from Chinese or domestic markets. But things aren't so easy as is life itself.

One of the reasons why the inflation rate is so low in the US is that given a considerable gap between supply and demand, US companies have failed to pass through costs coming from soaring commodity prices onto consumers. In other words, companies have very weak pricing power over their products.

Businesses have to struggle in a quagmire of low margins, and as a consequence are unwilling to turn to labor markets, which could cap personal income, and hence reduce the purchase of even such low-priced goods. If so, cash-strapped companies would be compelled to cut more costs, and on and on... In the meantime, inflation could die down even into a negative territory, that is, deflation. This "vicious cycle" would continue until a wide gap between supply and demand goes away so that corporations regain control over prices, which would end up as a resumption of, more or less, price increase.

Low inflation environment brings a classical case of prisoner's dilemma for companies. Every company wants to reflect higher costs on selling price, but is afraid to lose when does it because there is no assurance that others follow suit. They might leave prices at the same low level to gain market share and push competitors out of business. Hence, there is a huge incentive to cut cartel agreements on price adjustment.

The comparison with other countries, especially the UK, clarifies how US corporations have lost pricing power in the midst of growing costs.

First, let's look at the CPI, the index of prices that consumers pay. October's CPI in three countries, the US, the UK, and Germany, increased 1.2%, 3.1%, and 1.3%, respectively, over the year. Among them, UK's inflation rate is quite notable compared with the other two.

On the other hand, the PPI, the index of prices that producers sell, rose 4.3%, 4.0%, and 4.3%, respectively, in October from the previous year. Output price increased almost the same across all three countries.

What do these numbers tell us? UK consumer prices grew higher relative to the others while factory prices rose similarly in all three. In other words, UK companies have succeeded in a cost pass-through while the other two have to internalize cost pressure.

Britons may look like paying more than Americans, but the reason is not that British prices are too high, but its domestic demand is just brisker than the counterparts. A storm of cost cut would overwhelm American and German corporations.

In favor of manufacturing

It looks like the age of manufacturing has come back at last after its long losing battle against service industry, especially finance. Recent results in Purchasing Manager's Index or PMI, which captures current business condition, showed more bright pictures for manufacturers in the US, the UK, and China, indicating that unexpected recovery led by manufacturing now under way is strong enough to maintain the economy for some time.

However, one has to understand that the reason of a sharp recovery is not the same across the three countries. Meanwhile, major central banks are in no mood to rush to an exit strategy, taking on disinflation or deflation with another round of quantitative easing at hand. Let's look at one by one. The keyword is "Global rebalance".

According to a Bloomberg report, manufacturing picked up a sudden momentum in October in the UK, a country known for its finance-centered economy.

U.K. manufacturing growth unexpectedly accelerated in October and hiring improved as export orders increased.

A gauge based on a survey of companies by Markit Economics and the Chartered Institute of Purchasing and Supply rose to 54.9 from 53.5 in September, according to an e-mailed statement today in London. The median forecast of 25 economists in a Bloomberg News survey was for a decline to 53. A measure above 50 indicates expansion.

Manufacturing is gaining traction after a drop in the pound since the start of 2007 boosted demand for British exports, and economic growth in the second and third quarters was the strongest for two consecutive quarters since 2000. Still, the Bank of England will probably keep its asset-purchase program at 200 billion pounds ($322 billion) this week as the government prepares the biggest public-spending cuts since World War II.

"Exports are very much the engine of growth within manufacturing at the moment," David Noble, chief executive officer at CIPS, said in the statement. "It's difficult to predict the impact of fluctuations in export markets so the recovery may continue to be bumpy. What is clear is that manufacturing looks set to drive further gross-domestic-product growth in the fourth quarter."

The pound rose as much as 0.3 percent against the dollar after the report was published, and traded at $1.6086 as of 9:32 a.m. in London.

Employment Boost

Glasgow, Scotland-based Weir Group Plc, the world's biggest maker of pumps for the mining industry, said today it expects profit for the fiscal year 2010 will be slightly ahead of previous forecasts.

New export orders rose at the fastest pace in five months in October, CIPS said, with companies reporting sales increases to Europe, Latin America, the Middle East and Africa. Employment rose at the fastest pace since June, while average input costs rose for a 14th month.

The U.K. economy grew 0.8 percent in the third quarter, double the forecast of economists in a Bloomberg survey. Growth was 1.2 percent in the second quarter, the fastest in nine years.

"This report confirms that the improving picture painted by last week's good GDP data has continued into the final quarter," James Knightley, an economist at ING Financial Markets in London, said in an e-mailed statement. "With the pain yet to bite from government spending cuts, we remain cautious and see growth slowing through 2011."

The government's spending reductions will eliminate 490,000 jobs in a bid to wipe out a record budget deficit by 2015. The cuts will peak at 81 billion pounds in 2015.

Thirty-eight economists in a Bloomberg News survey forecast the Bank of England will maintain the size of its bond-purchase plan, while two predict increases. All 60 economists in a separate poll say the bank will keep the benchmark interest rate at a record low of 0.5 percent. The bank announces the decision at noon in London on Nov. 4.

One might find it difficult to locate where 'Made in UK' products are sold outside the country. Aside from it, this result has two important implications, which would be a harbinger of transformation in the economy.

First, manufacturing is finally gaining its ground in the country, which has lost factories to overseas and deferred to finance over the years. According to ONS, manufacturing GDP lost its value in the last 20 years, while business service GDP has kept expanding by 3.8% per annum.

Second, exports could contribute to the economy more profoundly than before, reflecting weaker domestic demands. The share of exports in GDP, though not yet restored the pre-Lehman shock level, is gradually soaring since the mid-2009, in part due to weak pounds.

The UK is far away from rebalancing its economy, but those two features can be a sign for the country tilting toward a more manufacturing- and export-driven nature.

Rebalance needs a partner to offset a country's surplus or deficit. The world's biggest surplus country, in turn, showed the acceleration in manufacturing driven by internal demand amid subdued exports.

The official purchasing managers' index (PMI) rose to 54.7, from 53.9 in September and 51.7 in August. Readings above 50 indicate expansion.

The result was driven by rising transport and general equipment orders, thanks to strong state-sponsored investment in infrastructure.

The trends were confirmed by a separate report from HSBC bank.

Like the official PMI from the China Federation of Logistics Purchasing (CFLP), the HSBC report on China produced by data services company Markit "suggests strong growth momentum in domestic demand," said HSBC chief economist for China, Qu Hongbin.

He predicts a 9% growth rate in the fourth quarter - moderately slower than the 9.6% already announced for the third quarter - despite the "still soft increase in new export orders".

Price pressures

The official CFLP report has remained above 50 - indicating expansion of the manufacturing sector - for all of the last 20 months, as the government pushed an investment splurge to offset the effect of the global recession.

Spending on new projects in the first nine months of this year was up 25% on a year ago.

The data was particularly strong as it coincided with an annual week-long national holiday, which normally causes a small drop in the index during the month of October.

Stock markets reacted well, with the Shanghai Composite index ending the day up 2.5%, while Hong Kong's Hang Seng rose 2%.

But it will add to concerns about rising inflation at China's central bank.

The People's Bank of China raised interest rates by 0.25% last week, in the hope that - along with moderate strengthening of the yuan - this may stabilise rising prices.

However, the CFLP report showed that manufacturers continue to report a high and rising cost of raw materials, particularly for cotton and rubber.

Contrasting fortunes

Data from other big Asian economies gave a more mixed picture.

Like China, India saw further growth in manufacturing in October, according to HSBC.

The bank's PMI for India rose to 57.2 from 55.1 the month before.

As with China, the expansion was fuelled by growing domestic demand, while exports remained relatively subdued.

South Korea and Japan in contrast showed further signs of a possible contraction.

In Japan - where the government warned last month of an economic standstill due to the strong yen - car sales fell 27% compared with a year ago, to their lowest October level on record.

The drop was in part due to the expiry at the end of September of a government subsidy for environmentally friendly cars.

Meanwhile, South Korea's manufacturing PMI, also commissioned by HSBC, fell to 46.7 in October from 48.8 in September, indicating that the sector's contraction steepened in the month.

While current exports have risen some 30% over the last year, the survey indicated that new export orders for Korean firms contracted in October for the first time since February last year.

Note, again, that China's expansion "was fuelled by growing domestic demand, while exports remained relatively subdued." The country is notorious for its export-driven economy powered by the cheap currency, condemned by some as one of the main culprits of global imbalance which is widely believed to give birth to the current recession. Unfolded in the recent PMI reports is, however, an economy transforming itself to extend domestic demand instead of searching for foreign markets.

Manufacturing activity also expanded in the world's largest deficit country, the US, in October. It's no doubt that the cheap dollar is playing a major part to enhance manufacturing through exports.

Manufacturing activity expanded last month at the fastest pace since May, driven by demand in the United States and abroad for cars, computers and other goods. 

The report signals that U.S. factory output, which slowed over the summer, remains a strong player in an otherwise weak economy. A separate report on Monday showed that manufacturing in China, the world's second-largest economy, also grew.

The Institute for Supply Management said Monday that its manufacturing index read 56.9 in October, up from 54.4 in September. It was the 15th straight month of growth. A reading above 50 indicates growth.

"This was a very positive report, and it suggests that the U.S. manufacturing sector is beginning to reap the benefits of the weak dollar," Eric Green, an economist at TD Securities, wrote in a note to clients. A weak dollar makes U.S. goods cheaper overseas.

Manufacturing helped drive the U.S. economy out of recession last year, but growth had slowed in recent months. The ISM's manufacturing index rose to 60.4 in April, the highest level since June 2004. The index had bottomed out at 32.5 in December 2008, the lowest since June 1980.

The jump in October could ease concerns that companies are almost through rebuilding their stockpiles — a trend that appeared to be slowing factory output growth in recent months.

"The U.S. manufacturing sector is getting a second tail wind," Green said.

Manufacturing activity in China also improved last month. A survey affiliated with the government said its measure rose to 54.7 in October from 53.8 in September.

Brian Bethune, an economist at IHS Global Insight, said China's growth is important for the U.S. economy. China's manufacturing sector is key to the rest of Asia's economy, and the region as a whole is a leading destination for U.S. exports.

Still, much of the U.S. economy's health depends on consumer spending and the gains in manufacturing can't be sustained unless that picks up.

The dollar has been weakened by the Fed's ultra loose monetary policy, sending the yen to nearly a 15-year high. A cheap currency surely helps boost exports,

which leads manufacturing activity to compensate for declining imports due to soft domestic demand. The US, along with the UK,  is on the way to rebalance the economy with benefit of weak dollars.

All results above indicate that rebalancing is under way among major economies, but questions remain on how to stop competition for cheaper currencies to keep afloat.

Britain's surprising GDP

The release of Britain's third quarter GDP surprised the markets, which estimated the economy to grow by mere 0.4% compared to the actual 0.8%. Stock markets reaction seemed muted at best, but the currency markets welcomed the news with a sharp rise in the British pounds.

The result would be a boon for the country which has just launched a bold plan for substantial cut in budget deficit estimated to be above 10% of GDP. The Chancellor of the Exchequer George Osborne was delighted to declare,

What you see today, in an uncertain global economic environment, is Britain growing, growing strongly, the strongest growth we have seen in this part of the year for a decade, and also our country's credit rating being secured. That is a big vote of confidence in the UK, and a vote of confidence in the coalition government's economic policies.

In spite of the government's relief, pundits may raise some questions over the content of growth.

Several analysts are concerned about the durability of construction-led growth, which accounts for half of overall growth in the second and third quarter. Moreover, the government sector contributed one fourth of growth to the economy in the third quarter, which is in turn likely to wane along with public construction if budget cut program begins. Business services and finance contributed the most in the third quarter, but given tightening regulation over finance industry, this sector also could not be counted much in the coming years.

Standard & Poor's lifted its outlook for Britain's triple-A sovereign debt to 'stable' from 'negative' in the same day as GDP release on the notion that

The decisions reached by the United Kingdom coalition government ... reduce risks to the government's implementation of its June 2010 fiscal consolidation programme.

But at least the question over the state of Britain's economy remains unanswered, and the markets would not be fully convinced of how the massive cuts in public spending rock the economy.

Britain's gamble might pay off

Britain's gamble has just started with 81 billion pounds of public spending cuts which cost half a million jobs in public sector. The Chancellor of the Exchequer George Osborne revealed the plan yesterday.

Britain will cut half a million jobs, lift the retirement age and slash welfare as part of an unprecedented cost-cutting drive announced on Wednesday which will test the strength of the economy and the government.

The long-awaited spending review confirmed 80 billion pounds of cuts, sent unions into a fury and turned up the heat on the Liberal Democrats, the junior coalition partners who campaigned against such sharp fiscal tightening before the May election.

The jury remains out on whether the economy -- just recovering from the worst recession since World War Two -- can survive the squeeze which will cut growth by around half a percent each year. Analysts expect the Bank of England to keep monetary policy super-loose for the foreseeable future.

Nor is it clear whether the cuts -- aimed at bringing down a record budget deficit of 11 percent of GDP -- can actually be achieved. More of the burden has been shifted to the notoriously hard-to-cut welfare bill -- an extra 7 billion pounds on top of the 11 billion pounds cuts already announced.

Conservative finance minister George Osborne said that was the best way and would mean that government departments outside protected areas like health and international aid would only see their budgets shrink by, on average, 19 percent, not the 25 percent announced in his budget.

Britain's budget deficit in 2009 is, according to IMF, 10.3% of GDP, one of the highest among developed nations. George Osborne is right to say, "Today is the day when Britain steps back from the brink, when we confront the bills of a decade of debt", given the huge budget deficit which is less than Ireland, Greece, and Spain but more than Portuguese and Italy. But the question may arise: Can Britain survive a massive fiscal cut?

The analogy can be found with Japan's experience in the late 1990's, when the country slashed public spending and raised consumption tax rates toward fiscal consolidation, ignoring simmering concern that fiscal contraction might sap vigor out of the economy.

Fiscal contraction starting in the late 1997 in Japan gave rise to huge deflationary pressure, which dragged the country into severe recession. It took more than 10 years for inflation rates to turn to positive in terms of the yoy growth rate of GDP deflator. The biggest difference between Japan and Britain is that Japan's GDP deflator grew only by 1.2% yoy when fiscal reform began, while Britain's has just grown by 4% yoy in the second quarter of this year. That's only the third time for Britain's GDP deflator to increase by 4% yoy in 18 years. Given a large buffer against deflation, Britain could keep away from deflation. Britain's gamble might pay off.