91Èȱ¬

Setting prices

• Evan Davis
• 8 Jan 08, 03:41 PM

What determines a price in a market?

Competition? Regulation? The whims of politicians? Illegal collusion between suppliers?

Looking through history, you'll find examples of all four playing a part in setting the price that consumers pay.

But these days we tend to think competition is the best of the lot.

And as a result, for gas and electricity, we introduced it. We got the regulator out of price-setting, we left politicians to do other things. And we have strict laws against cartels and collusion.

For several years it gave us low energy prices and we never complained. But now we are apparently unhappy.

My instinct is to assume that we consumers are an inconsistent bunch. We like competition if it delivers low prices, but grumble if it delivers the bad news that prices need to go up.

But in fact, it isn't that simple… there are issues in energy markets.

If you eye-ball the graph of the wholesale price of gas and the retail price over the last three years, you wouldn't think another retail price hike is now due. In fact, if anything, it looks as though we might have expected bigger cuts in prices early last year.

Wholesale gas accounts for about half the cost of domestic gas, and you'd think that retail prices are not massively out of line with where they were three years ago, but they will be if prices rise again.

Which raises the question: is competition failing? Are we being ripped off?

Well, a good rule of thumb is that competition doesn't usually fail, it just operates a little clumsily. And its imperfections have long exercised economists.

In this case, it all comes down to the word "oligopoly". It's a lovely word, and applies to many many parts of the economy - including energy. Oligopoly is defined as a market dominated by a smallish number of suppliers. And it has spawned a myriad of different theories as to how prices are set in practice...

One theory that goes back to the 1930s - one that A-level students might recognise as the curve theory - observes that in oligopoly, prices are often sticky.

In essence, suppliers don't like to upset things by pricing aggressively. It's not that they are crooked or anything... it's just market logic. If you cut prices to gain new customers, you'll fail as other suppliers will soon cut prices too, and so no new customers will come. Ergo - don't cut prices unless someone else does.

In energy markets, this could be the case, reinforced by the fact that most of us can't be bothered to switch supplier anyway. If one company cuts prices, the others will have plenty of time to follow them before their customers get off their backsides and make an effort to switch supplier.

In this world, companies will also be reluctant to raise prices because their competitors might not follow. Or competitors might delay rising for a few weeks to follow with their own price rise, hoping to gain some switchers in the meantime.

Being a price-hiking first-mover is an uncomfortable position.

It's the possible asymmetry of competitors' reactions to an initial price cut or price hike that might account for price-stickiness. Companies will only raise prices when they have to as their costs are too high. All one can say is that given the frictions in the energy market, it would be odd if prices weren't a bit sticky, especially sticky downwards.

Of course, the real issue facing us is not whether competition is perfect; it isn't.

It's whether you want to improve it with occasional divine intervention from regulators or MPs. Unfortunately, over the long term, in a complex market, that's a very tall order. You can get the price wrong if you try to influence it, and in the long term if there is free entry into a market, oligopoly can work more competitively.

Best advice - if you're paying too much, don't write to your MP - shop around.

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Unsustainable deficit

• Evan Davis
• 20 Dec 07, 03:43 PM

We got , giving us a full picture of the third quarter of this year. And guess what - it didn't contain much Christmas cheer.

The data shows that the UK balance of payments deficit (the broadest measure of our international trading position) is as bad as it has ever been. We earned less from the rest of the world, than we spent in the rest of the world, to the tune of 5.7% of our national income.

To put it another way, our spending in the summer was maintained only because foreigners lent us almost 6% of our national income.

Most shockingly, that means our balance of payments deficit is now bigger in proportional terms than that of the United States. (It's been a very long time since we could say that.) The US deficit has shrunk from 5.6 per cent of national income in the first quarter of this year, to 4.9 per cent in the third.

The only occasion that our deficit was this high was in the third quarter of 1989. The good news then was that the deficit soon came down. The bad news was that it was corrected with the aid of a very serious recession.

Now, I don't want to be alarmist about this. The balance of payments deficit is a funny old measure and it is quite volatile. It might well fall back next year on its own. Quite a large part of the deterioration reflects the fact that our banks have been paying more interest to foreigners and that might adjust automatically.

And we certainly don't have to worry about it as we once did. Back in the 1960s and sometimes the 70s and 90s, we worried about these things because the exchange rate was fixed and deficits literally meant the country could run out of money.

But mostly when the balance of payments deficit is large it is telling us that the British are borrowing and spending heavily, thus relying on imported goods. And that is a good deal of the story at the moment (other data released today showed the household savings ratio falling).

In that sense, the deficit is reminding us of a problem we have already known about.

But even if we are not going to run out of money to buy things, and even if we know that we have had rather low savings recently, the deficit can offer a forewarning of a pretty serious adjustment to come.

This is because our balance of payments deficit is manifestly unsustainable, and as there is a hackneyed saying in economics that if something is unsustainable, it won't be sustained.

The question is how the eventual adjustment will shift to a smaller deficit will come about.

The most obvious two ways are through a slowdown in our own spending (which reduces imports) or through a fall in the value of the pound which promotes exports.

One or both of these look likely over the next couple of years.

How does this play into the already fragile state of our economic nerves at the moment?

Well, the data is already old news. It barely reflects any impact of the credit crunch on the real economy. Indeed, it is probably best viewed as the last guide to what was going on before the storm broke.

And my own interpretation would be that it indicates we are entering 2008 with more serious imbalances than perhaps previously understood.

If the economy is turning away from rising house prices, low savings, high borrowing and easy lending, the balance of payments will improve. But it seems we have a bigger turn to make than we realised.

The US has been in a similar position. It has already started improving its current account, with the dollar falling very significantly.

The UK looks it has had more in common with the US than we thought.

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The first quarter...

• Evan Davis
• 29 Jun 07, 05:15 PM

might have averted our gaze, but some rather interesting statstics were relased this morning that more or less complete the picture we have of the economy in the first quarter of the year.

The two main headlines for me: real household disposable incomes (i.e. incomes after tax and inflation) fell for the second consecutive quarter. And (probably as a resuilt of that) savings collapsed to their lowest proportion of income since 1960.

Putting these in numbers, households were 0.3 per cent poorer in the first quarter of the year than they were three months before. And they saved a mere 2.1 per cent of their incomes. (It's not much if they aspire to retire on a reasonable income for a quarter of their adult life).

Consumer spending was robust, growing 0.5 per cent in real terms. The economy grew strongly, by 0.7 per cent in the quarter. It's three per cent bigger than a year ago.

How should we interepret the data?

It seems that the economy is still being to some extent sustained by consumers who are struggling to adjust to the fact that their spending power is not rising as fast as it was. They are still spending more even though their income has not been rising.

One wouldn't want to be too alarmist about this, but it slightly smacks of the cartoon character chased off a cliff - with the legs still running before the character finds the ground is no longer there and a fall is imminent.

The fundamental problem is that unless household incomes start rising quite fast again, some adjustment will surely have to be made to spending. Historically, we have saved about seven or eight per cent of our disposable income. A big economic question is how the economy will fare in the short to medium term, when we return to that normal level. (Alternatively, one might ask how on earth we would fare in the long term, if we didn't save at that normal level!)

The best hope for us is that real incomes improve, either through a large increase in our own producitvity and earnings, or through a fall in the prices we pay for things. Perhaps if the kind Chinese workers could supply us with yet cheaper goods, the adjustments that seem necessary would be more comfortable!

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The Bank's worst decision

• Evan Davis
• 5 Jun 07, 11:19 AM

Mervyn King, the Bank of England governor never comments on the past decisions of the .

He's often invited to admit to a mistake, or a regret, or even allow a moment of self-congratulation. But he generally declines to comment, explaining that the Bank has to focus on the next decision, not the last one.

He's right to remain silent. If he comments on one decision, he'll be invited to comment on another, and he'll soon be forced to comment on everything, which would be fine except his extensive commentary would then inevitably be over-interpreted.

But just because he doesn't comment, doesn't mean we can't.

And there is one decision taken by the MPC that deserves to be named and if not shamed, at least named and regretted.

It was taken in August 2005, and it was one Mervyn King himself did not agree with. Indeed, it was noteworthy as the first decision in the history of the independent Bank of England in which the governor had been overruled, and it was in retrospect probably also the worst decision the Bank has taken.

It was 4 August 2005, not long after the 7 and 21 July attacks on London. The Bank cut rates by a quarter point, from 4.75 to 4.5%, after a year of having held them constant, and prior to that having raised them from a low of 3.5%.

The upward swing in rates of the previous two years had actually taken the steam out of the economy and the housing market, and it had done so rather gently and rather successfully. I had personally described it as a "perfect slowdown".

So why cut rates in August 2005?

Well, the city expected a cut, and indeed another one to follow. Inflation was bang on target, the economy had slowed down to a 0.4% quarterly growth rate in the latest data, and there was a little concern that consumer spending would slow a bit too much.

Interestingly, the people on the committee who voted to cut were the professional economists. Charlie Bean, the late David Walton, Kate Barker and Stephen Nickell, plus Richard Lambert. They are all competent and sensible people, worthy members of the MPC; they acted on their interpretation of the data, and were clearly fulfilling the expectations of other economists too (the Reuters poll of analysts showed a large majority expecting a cut).

But in hindsight, they got it wrong.

The signal provided by that cut in August 2005 sent people back out into the shops and estate agents, and made them far too relaxed about the natural limits of the economic cycle.

It made them think 4.75 was the highest rates needed to go. And in unwittingly sending that message, the lower rate enticed people to borrow amounts that now seem incautious. In stirring up the economy. it sewed the seeds of what we now face -- impending rates of 5.75%.

Cutting the base rate was an easy mistake to make. Hindsight was not available to those supporting the move, and it was nine months before there was a single vote to reverse it (it was David Walton who led the way in May 2006, a month before he died).

But it seems to me there are four lessons from the episode that any new member of the MPC might choose to draw.

1. The committee should not attempt to fine tune the economy. Trying to be too precise in steering a course for the economy in response to quarterly growth rates is a mistake. And it is even more of one if the goal is to get rates as low as possible as quickly as possible consistent with the inflation target.

2. The committee should not be a hostage to city expectations of rates. Unless there is a danger of serious financial turmoil, the fact the City thinks rates will be cut is of no relevance to the decision whether to cut them.

3. For good or ill, interest rate moves have some signalling value. But it is the public who are the important signalees - not the city.

4. It is worth looking more closely at the evidence that does not fit the theory you have of the economy, than at the evidence which does fit the theory. In the August 2005 case, money supply was providing the oddball data. (One monetarist hawk, Gordon Pepper, who sits on the Shadow MPC of the Institute of Economic Affairs actually supported a quarter point rise in rates at the time). Money's importance was too lightly dismissed by the MPC. For me, this is not an argument for monetarism, as an argument for looking at all the data more open-mindedly. We are all subject to the strong tendency to frame a view of the economy, and then to select the evidence we define as important, and unsurprisingly to then find it supportive of the view we first thought of.

The minutes of the discussion at that fateful meeting suggest several members of the committee had reservations about the decision, and thought the City was far too inclined to think rates were about to enter a new downward cycle, and thought it was worth waiting more than usual, to obtain more information.

Looking at the consequence of the decision, one can say that it had a benefit - in probably mildly contributing to the 2.8% growth rate we enjoyed in 2006.

But the cost has been a degree of overheating that we are now dealing with, and a degree of over-borrowing. Much of that borrowing was on two-year fixed interest rates, and so the consequences of August 2005 will only come home to roost later this year.

PS Given I'm arguing with hindsight, I think it is only right to re-publish my words on the subject at the time, which were a bit equivocal (as they would be from a 91Èȱ¬ journalist). But among my comments on the Ten O'Clock News were these:

"Looking back over the last few years, you could say consumers had a bit of a party and the Bank of England tried to damp it down. They brought out the strong black coffees to sober us up a bit. Cutting the rate again, it's like discovering a couple of unopened bottles of wine in the fridge and saying we can carry on. "

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Inflation predictions

• Evan Davis
• 16 May 07, 04:47 PM

The Bank got it wrong last year. It thought inflation was under more control than it was. It's now having to catch up -- and it seems that for that purpose, interest rates .

The Bank's projection for inflation sees inflation coming in on target, on the assumption that rates go up another quarter point or so.

That would be the fifth rise in the latest sequence, and would push base rates to five and ¾%.

As the risks still seem to be "on the upside", we can't rule out the idea that rates may have further to go after that.

For borrowers, it might feel as though the pain is never-ending -- but in recent history, when interest rates have moved up or down, they have done so in cycles that amount to about 1 and ½ percentage points. On that basis, you might expect two further rises if this is an average cycle -- let alone a painful one.

Here is the data of peaks and troughs in recent history -- the average move up or down between the extremes of the cycle is 1.40.

Feb 94      5.25
Dec 95      6.50
June 96     5.75
June 98     7.50
June 99     5.0
Feb 00     6.0
July 03     3.5
August 04     4.75
August 05     4.50

Now this is not particularly helpful in providing exact guidance as to the magnitude of interest rate cycles, as it is hard to decide whether the current interest rate is part of a short cycle that started from the 4.5% trough of August 2005 to 2006. Or whether it is part of a long cycle that started back when rates were 3.5% in 2003. It depends whether you think the 4.50 in 2005 was itself a cycle, or a (probably misguided) digression from an upward swing in rates.

But the point of this data and the argument over the magnitude of cycles is not to predict how far rates will go, but to remind us that rates do move about in a range, and we should not let the recent relatively narrow history of rates limit our horizons as to how broad the range typically is.

People seem shocked by the idea that rates may reach 6%. I think we can say it would be surprising if they went that high, but not shocking. It is quite within the range of possibilities suggested by recent experience.

The real problem though, is that we don't actually know. As the last year has proved, inflation is unpredictable.

Some people think they can (and did) predict it -- but the problem for the rest of us is that we can never be sure their prediction is the right one for us to be following.

The key thing is not to fixate on a particular prediction of rates, but to prepare for realistic scenarios, to which history can be a useful pointer.

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Happy talk

• Evan Davis
• 20 Feb 07, 03:08 PM

The latest Consensus Forecasts have landed on my desk.

You might remember from a previous entry that Consensus Forecasts is a simple document that compiles all the reputable forecasts that are out there – and ingeniously takes the average of them! I think of it as a very useful compendium of the general economic view of where the economy is going.

(As it happens, I also think that economic forecasts are of limited value as the periods that are worth forecasting - when the economy turns up or down - tend to be the periods that are most unpredictable.)

But that all being said, short-term forecasts have a value and Consensus Forecasts is the best way of seeing where we are. The interesting feature this month is that the forecasters seem to have been upping their dose of happy pills since last month.

The UK is now expected to grow 2.6% this year, not the 2.5% a month ago. The Eurozone is expected to grow 2.1%, not 2.0. But most striking, the US is now expected to grow at 2.7% this year, not the 2.4 previously reported.

In all three economies, the forecast growth of personal consumption has been raised. The odd thing about the change is that this was the year that the US and the rest of us began to converge, as the Eurozone grew faster, and the US slowed down.

Now, it seems, economists are postponing that convergence. It seems they think the golden scenario prevalent over the last few years has another year to run, and the US can continue to outpace everybody else.

Given the momentum in the world economy at the moment, economists are probably right. But at some stage, doesn’t it seem like the US has to slow down?

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Good news on inflation

• Evan Davis
• 13 Feb 07, 04:02 PM

Today's from the Office for National Statistics suggests that last month's surge in inflation was a blip. We are now back to where we were two months ago.

If you want to read my short missive on where this leaves us, it's over on the business website .

But this month's fall in inflation after last month's rise, raises an interesting question. Do we tend to overreact to monthly data?

There is necessarily always a lot of "noise" in these monthly statistics from the ONS. They go up, they go down. And they go up again.

Indeed, in my early years as an economics journalist, after reporting the inflation figures for the 28th time, I asked myself how I would keep my interest up when I got to 228th time. The answer is that one doesn't need to be too interested in monthly movements at all. There's little point in slavishly following every twist and turn in the figures. Reading meaning into every data release is a distraction from the real goal, which is about identifying the underlying story of the economy.

The monthly data may come in thick and fast, and we might react to it rapidly. But if we react sensibly, the monthly data should only affect our view of the underlying story of the economy fairly slowly.

That being said, we did cover the jump in inflation , and led most of our news bulletins with it. I like to think that was not because we overreacted to the data; it was because until then, we had not given enough prominence to the real underlying story that inflationary pressure had picked up. The figures that day made us realise we had a bit of catching up to do.

Finally, a good question for today: should we give much prominence to the fall in the inflation rate this month? If we give you the bad news with lurid headlines in January, shouldn't we give equal space to the good news in February?

Again, I think not. The underlying story last month stands, even if it is not quite as urgent or extreme is it seemed. The inflationary pressure has not entirely evaporated.

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Gulp!

• Evan Davis
• 1 Feb 07, 11:32 AM

There's more evidence that pay settlements are edging up in response to higher inflation. The pay research group, Incomes Data Services, says the median settlement for pay rises in the last three months has been 3.5%, which is half a point higher than the previous published figure.

It was a month ago that the first trickle of data suggested an upward trend in pay rises. But with 64 pay deals now effective this month, the evidence is more than anecdotal.

If the Bank of England was hoping that higher inflation would be dismissed by pay-negotiators as nothing more than a blip, the news is discouraging. Especially, as many of the rises included in this latest survey were settled before the headline inflation rate hit 4.4%.

If pay rises too fast, it obviously threatens to push inflation yet higher.

The good news is that the Bank can always cure the problem.

The bad news is they only have one remedy, and that's to use ever higher interest rates to reduce borrowing and spending, to slow the economy down and to make jobs more insecure. That'll make us worry less about how much extra we're getting this year!

This is a real test of the Bank's credibility. If we all believe the Bank really will crack the whip to hold inflation down, then the Bank may not need to hit us at all, as we'll "behave" in the knowledge that inflation is going to be low again soon.

But if the Bank lacks credibility, and we don't really believe their threats, then we're probably in for a good whipping to knock us into line.

The Bank has always thought it has credibility as polls have long suggested that people believe inflation will be about on target.

But the Bank has not faced a test of its credibility as severe as this one, since gaining independence ten years ago.

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House prices

• Evan Davis
• 30 Jan 07, 11:23 AM

The Nationwide house price index is published today.

I don't encourage people to look too closely at it.

We get far too many monthly measures of house price inflation and we're already too pre-occupied by house price movements. I've had frequent arguments with colleagues who want the 91Èȱ¬ to cover every set of house price figures we get and who tell me the audience like reading about house prices. I'm not convinced - in my view, we would be doing more of a public service to cover celebrity news, for which there is also a big audience demand.

The most interesting fact in the Nationwide press release is not the one that tells us this month's change in house prices, but the one that reiterates the long term trend over the last three decades. Guess what, the trend rise in house prices is 2.6% per year over inflation.

My guess is that most people would assume house prices grow more quickly than that. But with the economy growing at about 2.5% a year on average, it makes sense for house prices to more or less tag along at about the same rate.

You can see the .

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Consensus forecasts

• Evan Davis
• 29 Jan 07, 11:21 AM

The latest Consensus Forecasts has arrived on my desk today.

For those of you who are not familiar with it, it is a monthly private, subscription publication (£370 a year I'm afraid), which simply collates all the reputable economic forecasts for all the main developed economies. You get the forecasts for this year, and for next.

It's an excellent idea. And even better, the team there calculate the average of the forecasts too. If you're a big company, why bother to hire an economist to make forecasts, when you can simply buy the output of existing forecasters for a fraction of the cost?

Anyway, being a January edition of Consensus Forecasts, we get a first glimpse of the forecasts being made for 2008, as well as 2007.

And the news is, for the UK, economists think (on average) we'll get 2.5% growth this year, and 2.4% next.

In other words, the forecasters have nothing better to assume, than that the UK grows at its average rate for the next couple of years. It's not a bad guess in the absence of any better information.

As for the US and Eurozone, the forecasters think they both have a slowdown this year (2007 growth of 2.4% for the US, and 2.0 for the EZ). But the US bounces back next year, and the Eurozone does not. (3.0 for the US and 2.1 for the EZ).

My advice: forecasts for the current year are quite useful. They are often wrong, but given where the economy is at the start of year, you can normally determine something useful about where it'll finish.

The same does not apply to next year's forecasts though. They offer a spurious precision that economists can't realistically deliver.

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