"Terms of Endearment"

There was something endearing about listening to Mervyn King the Governor of the Bank of England (BoE) and Chairman of the UK Monetary Policy Committee telling MPs at a recent House of Commons grilling about the worsening "terms of trade" that the UK was experiencing. There was the look on his face of a naughty school boy who, as long as he could give a reasonable explanation as to exactly why he was going to smash the window, he was going to be allowed to do so by his parents.

For those of you who are unfamiliar with the concept "terms of trade", it is simply the ratio of export prices (what a nation sells things for) to import prices (the price of things it buys). A rising terms of trade is therefore a good thing and vice versa. This seems a strange idea to hang an economic policy on, but a quick look at how the BoE sees the circuit diagram of the UK economy gives you an insight into why they think its important (see first chart). Towards the right you can see import prices in very close proximity to the evil and terrible "inflation".

Personally, I'm not a very good economist - I'd even go as far as to say that I'm pretty terrible at it so don't take my word for how bad an idea terms of trade is to judge economic policy; take it from someone who knows what they are talking about;

"In the real world of over 200 nations trading hundreds of thousands of products, terms of trade calculations can get very complex. Thus, the possibility of errors is significant. 2 "

If that is what the BoE is looking at then you have to keep an eye on it and have a regard for the idea. With this in mind, we looked at the terms of trade for the UK and globally. We found some very odd things (see second illustration).

Taking the last point first, it's easy to understand why the Bank of Japan (BoJ) has an itchy trigger finger with respect to interest rate policy, especially when it can see some inflation measures consistently in positive territory. But the politics of the situation is somewhat against the BoJ in the near term. Even so it would be best to be mindful of their mindset going forwards if terms of trade means anything to them.

The next curiosity is why the Bank of England is so keen to increase interest rates. Any central bank has a monetarist sensibility within it and would be worried about double-digit year-on-year broad money supply growth rates like we have in the UK (and quite rightly so). But, as we have pointed out in the past, the UK economy is very delicately poised because of the amount of personal borrowing. Using simple assumptions it is possible to show that moving interest rates between about 4.75% and 5.25% can reduce disposable income by between 5 and 10% which is enough to have real economic effects (see third illustration).

Terms of trade clearly isn't a great indicator with which to run the UK economy, which leads us to expect this current tightening phase to be regretted and reversed in coming months especially if weakness in the U.S. economy spreads across the Atlantic. In that case all sterling cash should be invested in UK bond markets (especially short-dated bonds) and we should be concerned that sterling could come under pressure as the interest rate prop is pulled from underneath it.