***Will interest rates be cut soon?
***Central bankers are cowards
***RECOMMENDED ARTICLES: Why the dollar is set to slide... The two simple numbers behind successful stock-picking...
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Has the inflation monster been defeated?
We certainly seem to have it licked here in the UK. In December, consumer price inflation fell back to an annual rate of 2%, bang on the Bank of England's target.
You'd think Governor Mervyn King would be breaking out the champagne and toasting the Monetary Policy Committee's success in navigating the UK economy.
But instead he's been busy warning businessmen in Kent about asset bubbles and the "conundrum" of low long-term interest rates.
And, needless to say, we think he's right to be worried...
Annual consumer price inflation fell to 2% in December, the first time it's been at the Bank of England's target rate since June 2005.
Commentators immediately fell over themselves to predict continued falls in inflation, and interest rate cuts later this year possibly as early as February.
But before anyone gets too excited, it should be remembered that one of the main reasons for the decline in the inflation rate was a significant fall in petrol prices last month. The AA's fuel price report for December points out that the average price of unleaded petrol fell below £4 a gallon for the first time since early July.
Needless to say, with crude oil spiking up to more than $65 a barrel, it seems unlikely that petrol prices will continue to fall this month. As the AA points out, most of the decline took place at the start of December, with prices changing little towards the end of the month. The motoring organisation predicts that "pump prices are set to remain around these levels" in January.
So we wouldn't be banking on an interest rate cut just yet.
And another reason we wouldn't be banking on a cut anytime soon is because the good Governor is clearly still worried about high property prices and runaway prices in equities, bonds, gold and just about any other asset you care to mention.
Mr King, like his US counterpart Alan Greenspan, can't work out why long-term interest rates are so low. The interest rate on long-term UK government bonds is at its lowest level for over 50 years. The real interest rate on a 20-year inflation-linked UK gilt is now 1%, compared to a range of 2% to 4% over the past 25 years.
So what's going on? Mr King points to two explanations.
On the one hand, there's the argument, famously put forward by Federal Reserve governor-to-be Ben Bernanke, that there is a "global savings glut". This proposes that Asian economies in particular, have been saving more than they normally would, partly because of the currency crises that hit the region in the 1990s.
Much of that surplus cash has gone overseas, into dollar-denominated assets like US government bonds - so 'rather surprisingly', as Mr King puts it, 'capital is flowing from some of the poorest countries of the world to some of the richest.'
Meanwhile, business investment in the developed economies "has been weak in recent years for reasons we do not fully understand".
So basically, this argument says that Asians have a lot of spare money, which they are putting into nice 'safe' investments in the West. In fact, Asians have so much spare money that they are saving more than Western businesses want to borrow to invest in factories and new equipment, among other things. If you've got lots of money, but not enough people to spend it, the cost of borrowing the money becomes cheaper hence low interest rates.
But there's another less palatable explanation for low long-term interest rates. In this version, rapid growth in the amount of money available, fuelled as Mr King says, by central banks keeping 'official interest rates very low', has pushed up asset prices as investors look for a decent return on their cash.
IMF statistics show that in 2003 and 2004, the world's supply of money grew at its fastest rate since the late 1980s. And in tandem, asset prices have surged property, bonds, shares, gold you name it, and cheap money has pushed it higher.
Under this argument, cheap credit and little incentive to save has tempted investors into putting money into ever-riskier investments, such as emerging markets, without expecting a correspondingly higher return on their money.
This has to come to an end eventually. At some point asset prices will revert to the mean which means that either asset prices fall, or the prices of goods and services rise to match them. And the more overstretched people are when that happens, the more painful the consequences will be.
"In neither case," Mr King says, "would it be easy to keep inflation close to the 2% target."
So which explanation seems most likely? If you accept the "savings" glut explanation, you have to accept a fundamental shift in the way the world works. It argues that at a global level, human beings have become more prudent and more interested in saving for our future, and that's where all the extra money is coming from.
But to accept the second explanation, you just have to believe that central banks have made the very human mistake of trying to delay a painful adjustment for as long as they can by making people feel richer than they really are.
We know which explanation we find more convincing.
If you'd like to read more on this topic, one of our recent recommended articles conducted an in-depth dissection of central banking and inflation you can read it on our website here: Has the inflation monster really been captured?
Turning to wider markets...
The FTSE 100 ended 41 points lower at 5,699. Supermarket giant Tesco slipped 2% to 312.25p as its Christmas sales figures met hopes, but failed to excite investors amid a generally downbeat outlook for the retail sector. Mining sector stocks were among the top risers, on ongoing strength in metal prices. For a full market report, see: London market close.
Over in continental Europe, the Paris Cac 40 closed down 48 points at 4,807, while the German Dax fell 54 to close at 5,460.
Across the Atlantic, US markets were on the slide after Monday's holiday, as nervous investors eyed surging oil prices. Declines on Wall Street could be extended later today - earnings from both Yahoo and Intel, posted after trading closed on Tuesday, missed analysts' forecasts. The Dow Jones fell 63 points to 10,896, while the tech-heavy Nasdaq lost 14 to 2,302. The S&P 500 shed 4 points to 1,282.
In Asian trading hours, oil was still rising, trading at around $66.70 a barrel in New York, while Brent crude also headed higher, to around $64.90.
Meanwhile, spot gold prices fell as the metal ran into profit-taking, slipping back to about $545 an ounce. Silver also eased back to about $8.95 an ounce.
In Asian stock markets, the Nikkei 225 plunged 464 points to 15,341 - and may have fallen further, save that trading was halted prematurely as a surge in orders overloaded the Tokyo Stock Exchange's computer systems. The overload is the latest in a series of events that have exposed embarrassing vulnerabilities in the system running the world's second-largest stock market.
The continuing investigation into online media group Livedoor drove the mass exodus, with other internet-related shares such as Softbank and Yahoo Japan also hit by selling. Disappointing results in the US from Intel and Yahoo also damaged sentiment.
And in the UK this morning, DSG International, owner of the Dixons electrical chain, saw sales at stores open at least a year rise 2% in the eight weeks to January 7th. Demand for flat-screen TVs and satellite navigation systems drove the gains.
And our two recommended articles for today...
Why the dollar is set to slide
- Gold's strength shows a lack of confidence in all currencies, say John Robson and Andrew Selsby at RH Asset Management. But needless to say, the most important is the US dollar - and recent developments in China spell bad news for the greenback. To find out why they think the dollar will slide by as much as 30%, click here: Why the dollar is set to slide
The two simple numbers behind successful stock-picking
- Stock market investors are right to be wary of magic formulas - the market has more than its fair share of fallen gurus, says Chris Mayer of The Daily Reckoning. But with annualised returns of 40% since 1985, Joel Greenblatt deserves more attention than most. The secret to finding good quality companies at bargain prices boils down to two key ratios. To find out what they are, click here: The two simple numbers behind successful stock-picking
