Price Inflation and Social Welfare Rates

Today’s inflation numbers show further falls in July for both the CPI and HICP. The falls sa are not as big as the raw nsa figs. The CPI is now (sa) 6.4% below the October 2008 peak. The HICP, which excludes mortgage interest and some other small items and which I prefer, is 2.6% off its November 2008 peak (sa).

There has been, understandably, considerable reaction to the Bord Snip proposals for cuts in Social Welfare rates. These were increased in last October’s budget by 3.1 to 3.3%, the increases effective from January. In the budget speech, the Minister predicted a positive inflation rate in 2009 of 2.5%. If he had instead predicted a zero rate, it is a fair guess that there would have been no change. It now looks as if the 2009 price level will work out perhaps 5% below what was assumed in the budget. 

If the proposal to cut rates by 5% were to be implemented from January next, the resultant rates in real terms, using the HICP rather than the CPI, would still be ahead of the October 2008 level, even if there are no further falls in the HICP. If the alternative 3% cut were implemented, the resultant rates would leave recipients better off in real terms than they were prior to the October 2008 increase. Of course, the big losers from the recession to date have been those laid off and newly reliant on Social Welfare (apart from ex-billionaires), and not the (far larger) group of long-term recipients.  

Richard Tol and David Madden have posted notes here drawing attention to the distributional impact of relative price changes which deserve a more extended response when time permits. For now, I would just like to make two comments:

(i) David notes that the lowest income deciles smoke cigarettes, and it has long intrigued me that the regressive impact of sharp recent increases in cigarette taxes attracted no negative comment from the political left. They should’nt smoke, you see.

(ii) Even the 5% reduction would still keep real HICP values at about pre-budget levels, if I understand Tol et al correctly. 

Finally, if all the €21 billion gross spend on social transfers were directed at the very lowest income groups, some of the more hysterical reactions would be reasonable (‘destruction of the welfare state’, no less). As a glance at the Household Budget Survey will confirm, significant entitlements reach well up the income distribution, reflecting the presence of substantial universal, as distinct from means-tested, expenditures.

Exchequer Cost of NAMA and the Social Dividend

There has been understandable focus on what NAMA will pay for distressed assets, and the risk of over-payment. This is the biggest component in considering the broader problem of re-constructing the banking system at minimum cost to the Exchequer, but it is not the only one.

Excess Exchequer cost could also be incurred if NAMA comes under pressure to dispose of assets on anything other than best commercial terms, and this pressure has already commenced. A ‘social dividend’ from NAMA has been suggested, notably by ICTU president Jack O’Connor. Mr. O’Connor called on RTE radio on Friday for the State’s newly-acquired property portfolio to be deployed in the provision of schools, sports facilities and health centres. There seems to be some support for this approach from Green Party spokespersons, and it is all too easy to see the notion growing legs.

Disposal of assets at less than best commercial value is a direct cost to the Exchequer, € for € as costly as excess payment for those assets on acquisition. There may well be a case for improved provision of schools, sports facilities, health centres, and indeed lots of other things, but it is an illusion to pretend that the State’s imminent acquisition of an enormous property portfolio at enormous cost somehow relaxes the overall Exchequer constraint.

NAMA will of course need to avoid over-payment. It will also need to avoid becoming an adjunct to the National Lottery Fund, dispensing property assets to worthy causes.

The June Inflation Figures

Price index numbers for June were published last Thursday. There are consistent seasonals in the Irish numbers, although CSO does not adjust, presumably because the seasonals are small, ranging only from 98.9 to 100.6 for the HICP. But the seasonals are big enough to affect month-to-month comparisons when inflation is around zero, and it is better to adjust. This note uses the 2008 seasonals computed on the data run up to Dec 08 by John Lawlor of DKM mentioned here in an earlier posting.

Seasonal effects are small through most of the year but bigger over year’s end. No statistically significant nit should be left unpicked.

Both HICP and CPI sa fell again in June. HICP has fallen for seven straight months, CPI for eight. The last twelve sa HICP and CPI numbers are, in mom % changes,

sa % Chg   HICP     CPI

Jul 08       +0.1     +0.1    

Aug 08     -0.2     +0.2   

Sep 08     +0.2     +0.2

Oct 08       0.0     +0.1

Nov 08       0.0     -0.8

Dec 08     -0.5      -1.1

Jan 09       0.0      -0.9

Feb 09     -0.6      -1.1

Mar 09     -0.4      -0.3

Apr 09     -0.1       -1.0 

May 09    -0.6       -0.7

Jun 09    -0.1        -0.3 

The HICP peaked in July 08, since which point it is down 2.2% sa. The CPI peaked in October last, and has fallen 6% sa from that point. The HICP is a subset of CPI – about 9.5% of CPI by weight is excluded from HICP, and 6.7% of this is mortgage interest. So the difference between the two is almost entirely mortgage interest.

I have argued elsewhere that mortgage interest (the price of credit, not of a good or service) does not belong in a general index of consumer prices, and I prefer HICP, which has recently been falling more slowly. It was the other way round a couple of years back, when interest rates were rising. There will be another switchback when the ECB gets round to raising rates again. (Don’t ask!).

The June Euro-area figs will be out in the next few days. I expect that they will show that Irish HICP inflation over the last twelve months has run about 2% below the Eurozone average. This is not much of a real-exchange-rate adjustment and it is fair to ask whether it has further to run.

The Govt increased Social Welfare rates of payment by a little over 3% in the October budget, with the increases effective from January 09. Jobseekers’ Allowance, for example, rose 3.3%.

In the October budget documentation, Finance stated that they expected HICP inflation, year 09 versus year 08, to be about +2.2%. At this stage, it looks as if the actual fig could be more like -2.2%, and the real value of the main payment rates (using HICP) is about 5% ahead of where it was last Summer.  

CSO have set up a committee to review price index numbers and it is to advise the DG of CSO before year’s end. I prefer HICP to CPI, and the UK, whose RPI has the same mortgage interest problem as our CPI, has begun to place more stress on the HICP. There are of course other options. If you have any views on the best way to measure consumer prices, this is a good time to let CSO know.

Employment Gains and Losses by Sector

The National Accounts suggest that the activity peak was about Q2 2007, so the last reading on pre-recession employment was about Q1 2007. The QNHS published yesterday gives Q1 data for 2007, 2008 and 2009 on the new basis. Figs in 000 are from the sa Table 3.

Sector                    Q1 07      Q1 08     Q1 09     % Chg 09/07

Agriculture              108.9       116.9     102.7           -5.7

Industry                 305.3       288.1     268.6          -12.0

Construction           270.7      256.6      184.0           -32.0

‘Public Sector’         453.2      463.7      480.7            +6.1

All Other                963.1     1013.6      945.3            -1.8

Tot Employment     2101.2    2138.9     1981.3            -5.3  

Unemployed             98.5       109.9     223.4          +126.8

Labour Force         2199.7     2247.6    2203.0            +0.2

‘Public Sector’ is the sum of NACE categories O, P, Q, Public Administration, Education and Health, and includes over 100K not formally public servants. Some commercial Semi State employees are in Industry. The most dramatic collapse is in Construction, down 32%, with Industry down 12%. The OPQ ‘Public Sector’ has grown 6%,  and is the only sector exempted from the downturn thus far. The quarterly peak was actually in Q4 08 and there are now recruitment curbs and budget cuts, so this sector may turn negative through 2009. But to date, the OPQ sector has added 27,500 since the downturn started (+6.1%) while the rest of the economy has shed 147,400 (-8.9%).

The propagation of the employment contraction out of construction in 07 into the rest of the private economy in 08 is clear. The QNHS unemployment rate grew from 4.5% to just 4.9% through 07, but soared to 10.2% in the four quarters to Q1 09. Since the most sharply-contracting sector has a mainly male workforce, an interesting effect is that 45.1% of the employed workforce is now female, an all-time record. Labour force growth has ceased and the participation rate has been dropping steadily for a year. In total employment terms, the fastest decline was in the most recent quarter, and with probably not a single sector now expanding, the Q2 figures will hardly bring much joy.

Goodbye to All That

I’m not a fan of the Ireland Inc line of chat. But the concept has more immediacy and policy relevance since the balance sheet of the main banks has been more or less socialised. Recent discussions about the BOP turn-around, fiscal stabilisation, the rising savings ratio, NAMA, (State purchase of bank assets, risks of over-payment), and about off-balance sheet financing wheezes to sustain construction activity can all usefully be thought about in the context of the national balance sheet.

In addition to fiscal stabilisation, bank re-construction and the restoration of competitiveness, the national balance sheet needs to be shrunken and de-leveraged. By 2007, we had created an economy with an emerging public finance crisis, iffy banks, weakened competitiveness and a balance sheet with too much debt supporting over-valued assets. The balance sheet was in any event too big for comfort, even had the assets (property, equities) turned out OK.

They did’nt, net worth declined sharply in line with asset prices, and credit markets turned nasty. The declining net worth supports a smaller balance sheet anyway, and the nasty credit markets suggest contraction even if net worth was unimpared. So the decline in private sector credit demand, rising savings rate and improving BOP are to be welcomed, and substitution of private with public borrowing to be mourned, in this view. The macroeconomic strategy is to avoid  anything that looks even remotely like a return to 2007. This was not a good place to be. 

The Canadians had a phrase, in the 1980s, for the national inferiority complex occasioned by the decline in the Can $ versus the real thing. They called it ‘parity nostalgia’. There is a mood beginning to emerge, in policy proposals from opposition parties, social partnership talks, lobby group suggestions and from some economists, that I am going to call ’07 Nostalgia’. Things were better back then – we had higher employment, (incuding jobs for graduates!), higher investment, easier credit. So lets have some job creation, off balance sheet spending on infrastructure, banks that can lend again etc etc. This is 07-Nostalgia.

In three or four years time, if we are lucky, we will have an economy which needs to look very different from 2007, the final year of the first credit-fuelled bubble in the State’s history. It should look like this: (i) Government debt ratios stabilised and sovereign credit spreads back to low levels; (ii) competing banks strong enough to lend (a little); (iii) a competitive economy producing more exports, less houses, and (iv) a smaller and less leveraged balance sheet. This economy will inevitably be smaller than 07 for a while, have lower employment, a smaller construction sector, smaller aggregate bank balance sheet, bigger Exchequer debt, lower public spending, higher tax rates and possibly BOP surplusses for a few years.

All policy wheezes emanating from the commentariat over the next few months should be smell-tested for 07 Nostalgia, and rejected at the merest whiff.  We have been there and it did’nt work.

Why Should Geithner’s Auctions Work?

According to the New York Times, pools of distressed mortgage-related assets of US banks have been 30 cents bid, 60 cents offered, in recent weeks. The bidders are hedge funds, the potential sellers under-capitalised, but State-guaranteed, US banks.

The Geithner plan appears to include a new type of investment vehicle with capital structure 3% private equity, 12% taxpayer equity, and 85% debt, also provided by the taxpayers. The holders of the 3% private equity would provide management and would bid for the distressed assets at auction. The expectation is that they would bid more than 30 cents on the dollar, thus improving banks’ balance sheets.

If the State equity is fully participating, it changes nothing from the standpoint of the fund manager. Only if the 85% debt is available at terms better than debt currently available to the hedgies (who will bid no more than 30 cents) can the plan work. The NY Times says that the 85% debt will be non-recourse, which certainly helps, and that it will be ‘cheap’, details to follow!. If it is provided at anything close to T-bill rates or short Treasury note rates, it’s a steal, and the Geithner hedge funds will of course bid more than 30 cents. I suspect that 85% non-recourse lending to distressed-asset hedge funds is not available at non-stratospheric prices right now. This is not a certainty-equivalent game since nobody knows the true value of the distressed assets, but cheap, non-recourse leverage will improve the bid price for any plausible distribution of returns.

The government could achieve the same objective by lending cheap non-recourse money to existing hedgies, unless I am missing something. But this would lack opacity. The critical economic component in all of these plans (including bad banks and insurance schemes) is the distribution of gains and losses. The critical political components appear to be fig-leaf involvement of private equity, the avoidance of overt nationalisation, and non-transparency.

Deflation Once Again

The CPI has fallen 1.0% sa in February and 3.9% in the four months since the turn in October (versus 4.4% unadjusted). HICP is down 1.1% sa in the three months since its later turn in November. The HICP fall of 0.6% sa in February is its largest to date. The difference between the two is mainly mortgage interest – owner-occupied housing costs are excluded from the HICP.

Year-on-year carryover in the CPI (what the year’s avg for 09 would be versus 08 if there is no further change from Feb) is now -2.7%. At Budget time in October, the expectation was for about +2.5%, so a prospective gap has already opened up of over 5% against Budget-time expectations, even if there are no further CPI falls. The recent ECB cut would have been too late for the March CPI (taken on second Tuesday) but will impact April, as will electricity and gas price reductions. If there are excise duty increases on April 7th., they would be just in time to impact April figs also. It is difficult to know if the currency appreciation against sterling has passed through yet, and there could be some increased outlet substitution bias problems for the CSO to grapple with. Overall there could be some further monthly falls, but the 1%-per-month drop in the CPI can hardly continue for long.

For 5 marks: What would the Budget in October have contained had the Minister known what was going to happen to CPI inflation?

De Larosiere on Bank Regulation

On a first reading, there is an elephant in Jacques de Larosiere’s kitchen. The report recommends a new architecture for pan-European supervision, falling short of a single pan-European regulator as Kevin O’Rourke notes. It also recommends revisions to Basel II, without much in the way of specifics. The report has been welcomed by the Commission and is to be considered by EU Finance ministers next month.

The elephant is moral hazard. European governments have instituted wide-ranging guarantees of bank liabilities, amounting to de facto (and potentially free in some cases) unfunded deposit insurance for commercial banks. The report rattles on about the possibility of a limited and pre-funded deposit insurance scheme, with the option of national variations on a European template. But it seems to me that the genie is out of the bottle, and that, if and when business-as-usual returns, the public will not believe that there are deposit insurance limits. If there is a systemic crisis, Governments will be expected to step in. Even if there is just one distressed commercial bank, it is difficult to see how the clamour for retrospective liability guarantees can be resisted. These expectations could be with us for generations.

Clearly there are categories of near-banks (hedgies, prop-trading units) which could credibly (in the eyes of the public) be placed outside the pale, and denied guarantee. But how to prevent banks, believed to be guaranteed, from lending to these entities at inadequate rates, endowed with too-cheap funds from the public deposited on the basis of an assumed guarantee?

The net question is this. What are the implications for regulation and supervision of a European banking system in which liabilities of all the main commercial banks are perceived to be guaranteed?  Can it be less than Glass/Steagel, plus high capital and liquidity ratios, plus intensive supervision and risk monitoring beyond anything thus far contemplated?

Margaret Thatcher lamented, at the end of the Cold War, that nuclear weapons could not be de-invented. Can the perception of perpetual availability of retrospective and ‘costless’ bank liability guarantees be de-invented?

December Retail Sales imply Rising Household Savings?

The sa volume of retail sales peaked in Q4 2008. This morning’s release for December completes the 2008 picture. There were qoq falls from Q1 to Q4 of 1.8%, 3.3%, 1% and 2.2%. The Dec figure was 8% below Dec 2008.

The quarterly national accounts, available only to Q3 2008 anyway, do not give the income table, and we can only guess at the intra-year patterns. If consumption has followed retail sales volume, there must have been a sharp increase in the savings rate through 08. Household income cannot have fallen anything like 8%, and even in Q4 it is doubtful if the income decline was as much as the 2.2% quarterly fall in retail sales volume. The direct tax increases had not kicked in, and many enjoyed nominal pay rises from September as consumer prices began to fall, offsetting the income loss from employment contraction. Household income will possibly fall more rapidly in Q1 2009, since unemployment seems to be rising faster; direct tax hikes are kicking in; and there seems to be a pay-reduction round going on in the private sector. If the savings rate continues to rise, the implication could be dire retail volumes for a while yet.

Here’s a question: the figures coming out since year-end have been pretty poor overall, suggesting that activity is declining even faster than feared. Does this mean that the downturn could be shorter? Is it the case that there is a given (given by world trade volumes, real exchange rate and competitiveness) macro-correction of x% to be endured, but x does not get bigger just because the economy gets through it faster?

January HICP and CPI

There are seasonals in the price indices, and they happen to matter when comparing January with December. Both HICP and CPI ‘should’ fall by about 0.7% in Jan. HICP sa changed little from Oct to Nov, but dipped about 0.5% in Dec. It has dipped about 0.1% further sa in Jan. CPI, mainly due to declining mortgage costs, fell almost 1% sa in both Nov and Dec, and has fallen a further 1% in Jan. The main difference between the two is owner-occupied housing costs, excluded from the HICP. It would be nuts to annualise the sa CPI fall of the last three months, would imply minus 12% or more for the year. Interest rates can decline only a little further.

The annual % change in CPI is now about zero. But the last three months sa has shown an average CPI drop of 1% per month. The (preferable, in my view) HICP seems to be dropping about 0.3% per month for the last two months, would give an annual fall about 4%. The twelve-month HICP figure (meaningless) is still showing +1.1%. I reckon, for what it is worth, that HICP could begin to drop (sa) a bit quicker than CPI over the next few months. There is more sterling pass-through on the way, but maybe not much more from ECB.

These January figures are consistent with recent forecasts of significant price declines for 2009 over 2008. Numbers like minus 3 or 4% for 2009 over 2008 are plausible, even though it is early days. There are obvious implications for indirect tax revenue, and for informally index-linked income variables.

Household Savings Rate Rising Sharply?

The CSO Index of Retail Sales had been rising to mid-Summer 2007, flattened for a few months and has been falling since October 2007, which was (just marginally) the sa peak. November 2008 was 8.1% off the peak, and October plus November combined down just under 8% on the same two months of 07. Today’s Sunday Business Post reports a survey by Retail Excellence Ireland and CBRE for the full fourth quarter. They believe that value of sales was down 10.7% over Q4 2007, and that the figure would have been even worse (14%) if the DIY and electrical sectors had been included in their survey, which seems to have a somewhat narrower coverage than the CSO’s inquiry. Nonetheless, the survey confirms anecdotal evidence that December was dire, and that Q4 volumes could be down anything up to 10% on Q4 2007. Some sales were brought forward into December, and the January figures could well be pretty poor too.

Notwithstanding the diversion of trade into NI retailers, consumer spending must be falling faster than household disposable income. There will have been a hit to income in Q4 from job losses, but not yet from tax increases. Pay rates (outside the construction sector) were still rising in Q4 so far as I can see, although they may fall in the private economy overall in Q1 2009. The implication is that the household savings rate rose sharply in Q4 08, and that the marginal propensity to save must be high. This is also consistent with the historic lows in the consumer confidence indices.

If the consumer has decided that it’s time to repair the balance sheet, the case for fiscal stimulus is even weaker than normal, which in Ireland is pretty weak to begin with. The corrolary is that fiscal tightening has even less output cost than the macro models indicate.

(Cliff, an SBP headline today contains the coinage ‘oversaturated’. Is this overexaggerated? When will the slaughter cease?).

How fast is Irish inflation falling?

The twelve-month CPI and HICP rose 1.1% and 1.3% to December, and these numbers were duly headlined. But both indices have been falling in recent months, and it beats me why people use 12-month numbers in the middle of a big macroeconomic correction. Karl Whelan made a similar point here recently in the context of the quarterly national accounts.

There are small but significant seasonals in the CPI and HICP. The CSO does not adjust, but the following is based on up-to-date factors (an Excel file with the data and factors is available from john.lawlor@dkm.ie). Unadjusted, HICP showed small monthly changes in Sept, Oct, Nov, then fell 0.73% in Dec. The adjusted pattern was similar, but the fall in December lower, at 0.46%.

For unadjusted CPI, Sept and Oct showed only small changes, but then big falls of 0.93 and 1.21 in Nov and Dec. The adjusted falls were again smaller at 0.84 and 1.09 (but these are still very large month-on-month numbers).

Thus for the last two months, and seasonally adjusted, the CPI has dropped almost 1% per month. The HICP has been falling only for a month, and more slowly. The difference between the two is mostly about mortgage interest (see my paper in ESRI QEC for September 2007), and I think the HICP is a better index. When I expressed this view in 2007, the CPI was rising faster than the HICP, and my argument was described as academic (ie wrong) by ‘certain parties’ keen on compensation for inflation. A change of horse by these parties is confidently predicted (difficult manoeuvre at speed unless you are a Cossack).

Recent forecasts of FY 2009 CPI inflation are minus 2% (ESRI) and minus 2.5% (Pat McArdle of Ulster Bank). These numbers look well within range, but HICP could show a smaller fall than CPI if mortgage interest rates continue to drop. Either way, we are a long way away from mid-September, when the pay deal was negotiated. At that time, inflation looked set in a band around plus 4%. 

There is a big shift in the price index seasonals from December to January – if the adjusted trend is zero, the unadjusted shows a significant drop. If anyone quotes the unadjusted drop next month, they incur four faults.

Monday’s Conference ‘Responding to the Crisis’.

There has been a big response and Stefanie Feicke will be emailing all those who sought places today. There is almost no capacity left.

Authors are preparing papers late, and we will not be able to photocopy and distribute at the conference. However, the presentations will be posted on this website as they become available.

Should Ireland Try a Fiscal Stimulus?

Responding to Labour leader Eamon Gilmore’s suggestion of a fiscal stimulus at his party’s recent conference in Kilkenny, Jim O’Leary argued in yesterday’s Irish Times that the option is unattractive. I would like to expand on some of Jim’s points and offer a few more.

The first is that the Government’s fiscal targets for 2008-2011 will in all likelihood be over-shot significantly in 2008 and 2009, and will be hard to hit in the terminal year of 2011. The targets are (as per the Budget Stability Update), GGB deficits for the years 2008 to 2011 at 5.5%, 6.5%, 4.7% and 2.9%. The gross debt grows from 36% through 43.4%, 47.5% to 47.8%, while net debt starts at 25% and grows through 31% to stabilise at 34% for both 2010 and 2011. 

To begin with, the out-turn for 2008 will be a GGB deficit of maybe 6.5%: the NPRF vauation was 10% of GDP at end-June, but can only be 9% at best now; and GDP for 2008 will probably come in under the figure assumed in this table. At end 2008, gross and net debt ratios will likely be 2 to 3 points higher for these reasons. But borrowing in 2009 could be in the 8 to 9% zone, rather than the 6.5% target, and the assumed growth in NPRF value in 2009 may not happen. There could be bank bail-out costs not included in the budgetary arithmetic. At end 2009, gross debt will likely breach 50% (of nominal GDP below the 2008 outcome), and the net debt ratio could approach 40%. These would be the numbers before the fiscal consolidation begins!

There is a casual assumption being made by some commentators, and possibly some Governments, that the sovereign debt markets will pony up whatever is required, at least for developed countries and certainly for Eurozone members. But Germany struggled with a bond issue during the week, secondary markets are illiquid, spreads have widened and the weakest Eurozone member (Greece) trades 1.65% above bunds at ten years. The second-weakest is Ireland at 1.35%, and some Eurozone countries with worse debt ratios are trading on narrower spreads than us.

Martin Wolf argued in the FT during the week that a weaker Eurozone member could, in principle, default. There cannot be a currency crisis, but there can be a credit crisis instead. Greece is the current bookie’s favourite, but Wolf described Ireland as ‘…a dramatic case’, noting the speed of the fiscal deterioration and the over-leveraged private sector. The system as a whole needs to de-leverage, and there is no point offsetting a necessary balance-sheet improvement in the private sector with a public borrowing explosion. Indeed, de-leveraging the public sector through liquidation of the NPRF at some stage, and crystalising the painful losses, will need to be addressed. If you can’t easily sell debt, you may have to sell equities, as many hedge fund managers have discovered.

Any attempt by Government to stimulate will run up against Ricardian Equivalence anyway, even more so in the UK version, where the tax reductions are accompanied by specific commitments to increase taxes later. If the private sector is determined to improve its balance sheet through cutting consumption and investment spending, fiscal easing will either fail, in which case it is pointless, or ‘succeed’ at the cost of frustrating the unavoidable private sector adjustment.

Finally, Mr. Gilmore proposed specific capital spending initiatives, such as school building. These may be better projects than some other components of the capital programme, but it is notoriously difficult to fine-tune with capital spending.