Economics and the markets

The disinflation phenomenon

Nov 1st 2013, 14:32 by Buttonwood

THERE was striking news from the euro zone yesterday, the inflation rate fell to 0.7%
in October, the lowest for almost four years. There is much speculation now that the
ECB will have to ease monetary policy further. And the EU is not alone. Figures from
the Conference Board show that the growth rate of the harmonised index of consumer
prices (HICP), an internationally comparable measure, was 0.8% in the US in
September this year, compared with 2.1% a year earlier. Japan and Switerland are
exceptions to the rule; they have edged out of outright deflation but only into very mild
inflationary territory.
Lower commodity prices have helped; energy prices in the euro zone are down 1.7%
year-on-year while food prices are rising only 1.9%, compared with 2.6% a year ago.
But core inflation is also lower; it is only 0.8% in the euro zone.
Alan Ruskin of Deutsche Bank writes that
There is a clear global element to the disinflationary story related to a lagged response
to large output gaps; reduced China-led commodity price pressure; and improved
energy supply buffers, most notably in the US
So why haven't we had the inflation that some predicted in the wake of quantitative
easing? The reason is that central banks are not the only, nor indeed the main, money
creators. Money is usually created by the private banking system and that has been
trying to shrink. If the money supply is a bath, then the central banks may have turned
on the taps but the commercial banks have pulled out the plug. Eurozone money
supply growth slowed to 2.1% in September from 2.3% in August; bank lending fell
1.4% year-on-year.
What does all this mean? It seems likely that central banks will maintain their very
loose monetary policy; they can justifiably claim that, with inflation under control, they
can focus on unemployment. For investors, this may mean more support for equities.
But it is worth noting that falling inflation rates are now making real bond yields
positive again; food for the many bond bears to ponder.
For workers, they may not be getting much of a pay rise but at least the squeeze on real
wages may be easing. For governments, lower inflation seems like good news but it
also means, that despite the rebound in eurozone economies, nominal GDP is still not
growing very fast. Marchel Alexandrovich at Jefferies estimates that Spanish and
Italian nominal GDP may be settling into a 2.5% annual growth rate, compared with 5-
7% growth in the 1990-2008 period. In both countries, their bond yields are higher
than that level, making the debt dynamics very difficult; without sizable primary
budget surpluses (i.e. before interest payments), debt will tend to rise as a proportion
of GDP.
To go back to my oft-stated dilemma, if you can't grow your way out of a debt crisis,
you must inflate the debt away or default. Well, the euro zone is not growing very fast
and it is not inflating; that leaves default as the most likely option.
Royal Bank of Scotland
Is a "bad bank" any good?
Nov 1st 2013, 16:50 by J.R.

INVESTMENT bankings trading businesses are a bit like the nuclear power plants of finance.
When all is running smoothly, they hum along and throw out fantastic amounts of money. Yet
if things go wrong, they go spectacularly wrong. And winding them down is a long and
dangerous process. It requires skilled hands in the control room and a lot of patience, for it is
only once the last of their radioactive assets have been moved on that they can safely be
switched off.
Royal Bank of Scotland (RBS), which once aspired to be among the worlds largest traders of
bonds and manufacturers of debt securities before going bust in 2008, is the latest European
investment bank to start withdrawing the radioactive fuel rods from its reactors. On
November 1st the largely state-owned bank announced plans to create an internal bad-bank
in which it would park 38 billion ($60 billion) of its riskiest assets.
The internal bad-bank is essentially window dressing, since it does not remove these assets
from the RBS balance sheet nor does it immediately free up any capital that the bank could
then use to back new lending. In fact, setting it up will trigger impairment losses of around
4.5 billion and push it into a substantial loss for the year.
But it does get the bank and the government off the hook after George Osborne, Britain's
chancellor of the exchequer, promised earlier this year to examine the case for splitting RBS
into a good bank and bad bank. Splitting RBS up, however, would have led to taxpayers
putting yet more money into the bank for negligible benefit. The main value of this internal
bad bank is that it sends a clear signal of intent. RBS plans to sell most of the assets within it
by the end of 2015 and will review the future of the rest of its investment bank by February
2014.
It also announced plans to speed up the sale of its American retail-banking business, Citizens.
This unit, which has been built up by a series of acquisitions, is the ninth-largest bank in
America when measured by the number of branches it has. Yet it has performed poorly over
the years and RBS now plans to list its shares on the stockmarket next year and to sell its
entire stake by the end of 2016.
These big structural reforms should help RBS to focus and reduce some of the risks on its
balance sheet. But it still faces a long road back to reasonable profitability. The core retail
and commercial banking business it plans to focus on is not performing well at all. Its costs
are high, its IT systems are rickety and its returns are weaker than those of its rivals. Fixing
the retail bank in good times would be a challenge. Yet its new chief executive, Ross McEwan,
will have to do so in an environment of great volatility and risk. One of these risks is that RBS
may face ever-higher claims for compensation and fines, particularly with another possible
scandal brewing. On November 1st Barclays said it has suspended six traders as part of an
internal investigation into possible manipulation of prices in foreign-exchange markets.
RBS too has suspended some traders and said it is co-operating with regulators. With the
smoke barely clearing from the scandal over manipulation of key interest rates including
LIBOR, the worlds biggest banks are already stumbling into the next.