The return of global inflation in goods and services
The experimental monetary policies that central banks have deployed in recent years – notably quantitative easing (QE) and now negative interest rates – are killing off companies’ desire to invest, other than in rapid payback items such as information technology and vehicles. In their enthusiasm to encourage private-sector spending, central banks are distorting capital expenditure (capex) incentives and undermining the motivation for long-term decision-making. There are three strong reasons to believe that, far from promoting greater investment, their policies are doing more to discourage firms from spending.
First, corporate cash hoarding is a wholly rational response to an economic environment in which the prospective real returns to business investment are highly uncertain. QE and “lower for longer” interest rate policies betray a lack of confidence on the part of the policymaker towards the economic outlook. Rather than giving the economy an extra push, they introduce yet another layer of doubt – and risk.
Second, policies designed to crush the term premium (the spread between the interest rate on longer-term bonds and those on shorter-term ones) have also promoted the idea that the terminal real interest rate has fallen to around 1%, or even to zero. It is impossible to avoid the implication from this that the long-run pace of real economic growth has been similarly reduced. Hence firms’ planned expansions in capacity must be scaled back accordingly in response to expectations for lower growth and weaker demand.
Third – and perhaps most compelling and damning – large-scale asset purchases by central banks have brought down government bond yields across the maturity spectrum and driven investors to search for higher yields elsewhere. When investors reach for yield in fixed interest, they invariably bear more capital risk. When investors reach for yield in equities, they concentrate in safe companies with dependable cash generation. This sends a powerful signal to quoted companies to distribute profits to shareholders, rather than reinvest in physical assets.
As a result, the implied hurdle rate of return – the return needed for a company to justify an investment rather than pay the cash out as dividends – has been rising even as bond yields have fallen. Jason Thomas, director of research at the Carlyle Group, a private equity firm, shows empirically in a recent paper that “by increasing the market value of current income relative to future returns, unconventional policy may lead corporate managers to boost shareholder distributions at the expense of capital accumulation.” When the same managers are personally incentivised by the share price performance of their companies, the effect is compounded.
Wishful thinking on UK inflation
The New Normal crowd has had it their own way for much too long: the notion that grindingly slow economic growth will be accompanied by the long-term sterility of consumer prices has a powerful grip on Bondworld. Throw in the demographic and the technology arguments and they reckon that a future of low or no inflation is a slam dunk.
Then came Brexit and an abrupt 13% depreciation of Sterling. How would the New Normal crowd react? It is no surprise that their instincts are to downplay the inflationary impact of Brexit. They expect headline CPI inflation to rise only moderately over the coming year, as compared to their pre-Brexit baseline, touching 2% at worst and averaging only 1.5% for 2017. They anticipate that the weakness of domestic demand will open up a large output gap and exert disinflationary pressure. They posit weakness in core goods and services prices which will counteract the effects of the stabilisation and partial recovery of the US Dollar oil price, and of the impact of the pronounced drop in Sterling on import prices. Another suggested route to a similar outcome focuses on a very weak pass-through of Sterling depreciation into domestic prices.
Those of us with long memories tend to take a very different view. The UK has been one of the most inflation-prone countries in western Europe over the past 25 years. Our 20th century peak inflation rate of 25% a year was in 1975. We managed double-digit CPI inflation as recently as 1990. The UK is heavily dependent on imports across a wide swathe of manufacturing sectors, susceptible to bouts of money madness and protective of oligopolies in consumer-facing sectors such as megastores and car dealerships. Ripping off the punter is a national sport.
Our latest decomposition of the RPI shows private sector inflation (excluding fuel and light) rebounding over 3%. We prefer the old retail price index for this analysis because it includes housing. UK inflation remains elevated in comparison to the 1992-2007 period, which Mervyn King termed the NICE (non-inflationary constant expansion) years. The global financial crisis marked the beginning of a new era of erratic and generally higher UK inflation. The crisis weakened the forces of domestic competition and allowed the profitability of the service industries to soar to new heights.
The New Normal crowd are dismissive of normalisation and Brexit-related pressures. They expect them to be muted and temporary. Others take the view that Sterling import prices will increase materially and that headline CPI inflation will reach over 2.5% next year, maybe even 3%. The remarkable aspect of this divergence is that we can observe already a substantial impact on imported inflation in the July and August producer price inflation data.
Based upon the historical relationship between import inflation and CPI inflation for non-energy industrial goods, headline CPI inflation should move up by 1.5 to 2.0 percentage points from its current 0.6% by mid-2017. For RPI, the implied shift is from 1.9% currently to around 3.5% by mid-2017. Without the assumption of an initial post-referendum output and spending slump, there is no justification for a sharp downward price adjustment.
Could the UK become a corporate tax haven?
The outcome of the UK’s recent referendum on membership of the EU has sparked a wide spectrum of responses from terror to euphoria. The UK political establishment, a staunch advocate of ‘Remain’, was dealt a stern rebuke by the British people, who voted to leave the EU by a majority of 52% to 48%. A month later, while there are many who fear that the UK has walked into an economic minefield, there is a growing sense of liberation from the straitjacket of EU rules, regulations and timetables.
The corporate sector, in particular, senses that Brexit has delivered a golden opportunity for the UK to become a global tax haven. George Osborne, the former Chancellor of the Exchequer, spent his last days of office in New York spreading the word that the UK was still a great place to do business. One of his pitches was that the UK could drop its corporate tax rate from the current 20% to 15% “and preferably lower”. The Internal Revenue Service would not have been amused by his overtures to US businesses to invert to the UK for tax purposes. There is no question that Osborne’s remarks would meet the strongest resistance in the other EU member states. We have not heard anything from Philip Hammond, successor to George Osborne as Chancellor of the Exchequer, about corporate tax policy, but it is unlikely that Hammond will take a markedly different line to Osborne: the opportunity for the UK to press ahead with a radical agenda on corporate tax will not have escaped his attention.
Assuming that the UK government does indeed invoke Article 50 and formally start the process of withdrawing from the EU, then there will be a protracted negotiation of terms between the UK and the remaining members of the EU. It is increasingly likely that the EU will take a tough and punitive line so as to dissuade other countries following the UK out of the door. Osborne’s corporate tax message could be seen as saying ‘give us a good deal in the negotiations or we will put a large tax haven 20 miles off your shores.’ There is added significance to the timing of the UK’s impending exit from the EU. The EU has long been aware of the complex issues surrounding tax competition between member states. There has been an international trend towards lower marginal corporate tax rates over the past 20 years, with the notable exception of the US, but some countries have objectively pursued low rates. The Irish Republic established its totemic 12.5% rate in 2003. Multinational corporations have used internal transfer pricing to minimise their European tax bills and, specifically, North American companies, including Apple, have used Ireland for ‘tax inversion’.
In an attempt to put an end to corporate tax competition within the EU, in 2011 the European Commission proposed a common system for calculating the tax base of all businesses operating in the EU. The idea was that a company would have to comply with only one EU system for computing its taxable income, rather than different rules in each member state. In which they operate. Member states would still be able to set their own tax rates, but the EU would have an overview of the tax affairs of all companies operating in their jurisdiction. This would strengthen the hand of the EU in combatting tax avoidance by removing the current mis-matches between national systems. The UK and Ireland raised loud objections to the original proposals for EU tax harmonisation and the plans were dropped.
Recently, however, the Common Consolidated Corporate Tax Base (CCCTB) has been revived, but in a more threatening form. Under the new proposals, it would become mandatory, rather than voluntary, for corporations to apply the CCCTB regime. Corporations headquartered in UK and Ireland would appear to be most at risk of bearing a higher overall tax bill. There is no longer any prospect of the UK harmonising its tax code with other EU countries. Currently the UK corporate tax rate is nearly 10 percentage points lower than Germany’s and more than 13 below that in France. These substantial differentials would be even larger if the UK were to adopt a radical tax agenda. How better to confound the pessimists over the UK economic outlook than to create a unique corporate tax environment. At the same time, it would act as a deterrent for businesses already located in the UK to move their operations abroad as a consequence of Brexit.
The UK has already made big cuts to its corporate tax rate, it was 30% in 2008 and has fallen steadily to 20%. The transition to 15% or lower would be a natural extension of existing policy. The additional attractions of UK location are well known: English, the international language of business and education; a large and skilled workforce, a centuries-old justice system, parliamentary democracy and reasonable infrastructure. The UK also has flexible labour laws, a favourable time zone and a rich cultural landscape. Not to mention the inertia that comes with already being host to so many companies.