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Saturday, 6 September 2008

Credit crunch continued but now with an end in sight

The credit crunch is now over a year old but to many it must feel like it is a lot longer. Those working in banking, housing or retail have felt the direct impact of failing financial markets, rising borrowing costs and higher food and energy bills. These problems are not going to sort themselves out soon.

Financial markets still have a long way before they will be back to normal. According to the Nationwide today, they do not expect an end to the current problems until 2010. It seems likely that the banking industry will have to go through a long period of painful adjustment.

Without a return to normal banking conditions we will not see an end to higher and retricted borrowing. Therefore it will remain difficult for consumers and businesses to get debt for a mortgage or to expand their business without it being exceedingly costly. As a result housing prices will continue to fall in the UK and businesses will find it very hard to expand.

As the problems continue more and more businesses will be forced to cut headcounts and unemployment will continue to rise. This will have a further negative impact upon the economy as those without work will be forced to stop spending and those still in work will reduce spending in preparation of potential unemployment.

But there are now a few signs of what should help to bring the current downturn to a halt and start the economic recovery. It seems that some parts of the economy are now beginning to work as expected. With the economy slowing demand for goods such as food and oil are declining, and therefore, following the simple rules of supply and demand, prices have fallen. Oil is now $40 below its peak and food prices across the board are down. Wheat is currently slightly cheaper than it was a year ago.

Falling prices will aid economic recovery in two ways. The most obvious is that consumers will have more money to spend on other things. Given that many of the commodities that have risen so sharply in price over the last year were imported, the rising cost has had a net negative impact on the economy, having a greater negative impact on consumers and businesses than the benefit given to domestic producers of these commodities.

The second and more significant impact of falling prices is the impact it has on inflation. Across the globe rising prices have pushed up inflation. This has limited many central banks, such as the ECB and the Bank of England, in their ability to cut interest rates. The fall in commodity prices will aid the ability of the ECB and the Bank of England to cut interest rates, helping to cut borrowing costs and aid economic growth.

One further upside of potentially lower interest rates is that it will cut the valuw of the pound and the euro. This should help to stimulate exports as they become relatively cheaper. Its not good for those of us about to travel abroad, but it should have a net positive impact upon the British and European economies. Given that some of the earlier oil prices were also stimulated by a weak dollar, a weakening euro may even help to push oil prices down further.

So there is a potential end in sight for the credit crunch and its associated economic problems. This end is over a year away, the US, UK and eurozone economies will probably see recessions but with an end in sight it is easier to prepare for the year ahead and put yourself in the best position to weather the storm and take advantage where possible.

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Tuesday, 15 January 2008

A necessary evil - Inflation in 2008

The December consumer price index data was released today showing that annual inflation remained at 2.1 per cent in the month. Annual inflation has remained at 2.1 per cent for three months now, but is likely to pick up as the year continues, particularly following Monday’s producer price index and continued high price of oil.

Nevertheless, there are signs that inflation should moderate in the second half of the year. The biggest drivers of inflation in the first half of 2008 will be food and fuel. Food prices are very hard to forecast given the variability of the weather, however, there are a few of factors that should help to increase agricultural yields.

The first is that the European Union has decided to suspend its annual subsidy to farmers that leave ten per cent of their farmland fallow.

The second factor is the fact that record highs in the price of wheat will encourage farmers across the globe to plant more and to reduce the percentage share of their crop being used for bio fuel – particularly as the price of oil is likely to fall back as the world economy slows.

Demand is unlikely to be significantly reduced by the slow down in the world economy, as food is a necessity. Therefore the supply side will be the key to reducing food prices.

Oil prices have risen significantly, almost doubling over the past twelve months. The price of oil has been supported by a number of supply issues throughout the summer and rising world consumption. Despite this, it is likely the price of oil has risen above the level suggested by simple supply and demand. The weakness of the dollar and the wider United States financial system has encouraged investors to move to safer products such as commodities such as gold and oil. Nevertheless as the US economy slows in 2008 so will their demand for oil. A significant slowdown will dampen prices. Many forecasters are now suggesting that oil prices will drop by about 25 per cent in the year. As a result by the final quarter of 2008, the year-on-year price of oil could be having a negative impact on inflation.

The rate of inflation is important because it is the key measure in determining the stance of the Bank of England’s Monetary Policy Committee (MPC). With the consumer price index currently above the target of 2.0 per cent the MPC will be keeping a close eye on this measure. Nevertheless, this is unlikely to stop the MPC from cutting interest rates at least twice (and probably more) in 2008. The MPC is willing to live with above target inflation in the short-term to maintain economic output and stave off a recession.

Tomorrow’s labour market statistics will be particularly interesting to see whether the credit crunch and the wider problems in the economy are starting to have an impact on employment. I would suggest that seasonal employment in December is likely to have hidden some of the early signs of weakness. We will see…

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