My thoughts on the Policy Exchange forecast of Bank Rate at 8% in 2012

No doubt the reason Andrew Lilico, chief economist of Policy Exchange, which calls itself a think tank, chose to issue his paper forecasting Bank Rate would rise to 8% in 2012 this week is that in the August silly season when real political news is thin on the ground it is much easier to grab some headlines by publishing an outrageous forecast than when senior politicians are around to rubbish such forecasts. Policy Exchange must be desperate for some publicity.

Only last month Policy Exchange published a report questioning many of the assumptions in a book entitled Spirit Level. I have no idea whether the criticism was justified but the interesting point is that its report was entitled “Beware False Prophets,” a title which could more appropriately have been given to the report it published this week.

You will all remember that Gordon Brown abolished boom and bust (ahem!). What Policy Exchange is forecasting for the next four years is much worse than boom and bust – roller coaster would be a more appropriate term.

Lilico forecasts a double dip next year and claims we have had several double dips since the mid 1950s, but he is making up the definition of double dip to suit his purpose. The conventional definition of a recession is two consecutive quarters of negative GDP but all the double dip examples Lilico gives involve only one quarter of negative growth following the initial dip and subsequent recovery. Other economists take the view that two more quarters of negative growth are required for there to be a double dip.

He forecasts Bank Rate will rise to 2% by the end of next year and then shoot up to 8% in the following year on the back of a rapid increase in inflation caused by the Bank of England massively increasing its quantitative easing programme next year to counteract the double dip recession he forecasts next year.

If Bank rate was to increase by 6%, i.e. a 300% increase, from 2% to 8% in the space of only 12 months property prices, both residential and commercial, would collapse on the back of the inevitable massive hike in mortgage rates.

Arrears and repossessions would escalate rapidly and bank balance sheets would again come under huge pressure as a result of the massive write offs they would have to provide for on their property loans. Chances are the some of the weaker banks would again have to be rescued by the Government, assuming it had the appetite to do so and could afford to.

The Bank of England of courses realises this would be the consequence of increasing interest rates by so much so quickly and so it will not happen.

Lilico is getting his excuses in early for being wrong – the paper says:

I could well be wrong in all kinds of ways:

* We might not have a double dip, so they may raise interest rates materially in the second quarter of 2011 instead of holding them below 2% throughout the year as I expect.

* We may have a double dip and they might lose control of deflation, with prices falling dramatically through 2011 and 2012 instead of rising.

* Inflation might go much higher than the sorts of numbers I’ve suggested.

There is no reference in this paper to economic events outside the UK. Lilico appears to think that the UK operates in a vacuum, whereas more bad economic news this week from the USA has pushed gilt yields and swap rates to new all time lows, with five year swaps now down to a new all time low of 2.03%.

If Lilico is prepared to put his money where his mouth and is proved right he could make a fortune as his views are so extreme. The logical approach for someone with his expectation of how the economy will play out would be to sell any property owned, rent one’s home and invest the resulting equity in out of the money gilt put options, which are a low priced highly geared investment giving the right, but not the obligation, to sell gilts in the future at around today’s price.

Although it might be considered that the high inflation he forecasts would be good for property prices this is only true in the long term. In the short term the huge hike in interest rates to try to control the jump in inflation would be a much more important influence on property prices. Only after a few years of high inflation when borrowers had adjusted to the higher interest rates could property prices be expected to start rising again, but it would be from a significantly lower base.

Even that assumes that the banks would by then have repaired their balance sheets sufficiently from the very sizable new bad and doubtful debts they would have incurred to again become active in the mortgage lending market.