This blip will not bring a policy change at the Bank

Anthony Hilton
24 Mar 2009

For all the talk of deflation in Parliament and the media, the great British public sees precious little of it. Economists may say that an unchecked spiral of falling prices is the major threat to the economy but the rest of us say, if only. Higher fares, higher council taxes and higher food bills seem much more common than the lower fuel and utility bills which are supposed to come through in response to the much-reduced price of oil.

Many of the professional economists of the City had gone out on a limb to predict that the retail price index would go negative this month — for the first time since Lonnie Donegan topped the pop charts in 1960 with My Old Man's A Dustman. But not for the first time the economists were wrong. When the figures were released today they showed — against all expectations — that the Retail Prices Index slipped less than expected to zero and the Consumer Prices Index had edged higher in February.

But just as one swallow does not make a summer, one month's figures can usually be ignored. Though prices appear to have blipped up, the trend remains firmly down. In a few months' time, this is likely to be seen clearly for the aberration it is — a one-month check on the downward slide.

That certainly appears to be Mervyn King's view. Because CPI inflation is high enough to be outside its target band, the Governor of the Bank of England has been obliged to write a letter of explanation to Chancellor Alastair Darling. And his explanation strikes an echo with the view from the High Street.

The plunge in the exchange rate of sterling has been passed on in higher prices, not just for food and clothing but for components and parts used in manufacture. Because oil and most commodities are prices in dollars, sterling's plunge meant we have not enjoyed the full benefit as they have come down in price. They went up a lot further than they have fallen back. And meanwhile the promised fall in utility bills remains just a promise, though they are supposed to be with us shortly.

Basically, therefore, we can all ignore these figures. The key aspects of policy are not going to change. Interest rates will remain at their rock-bottom 0.5%. The effort to boost the money supply through purchase of vast amounts of government bonds — or quantitative easing, as it is known — will continue unchecked. Deflation remains the number one concern.

In other words we are certainly not out of the woods yet. And just to complicate things totally, Crispin Odey, a leading hedge-fund manager, today expressed the view that a major leap in inflation is almost certain.

Haunting legacy of the zombie firms

There is a lot of talk about zombie banks so burdened with debt that, while still just about alive, they are too weak to fulfil their normal functions — such as extending credit. There is less talk about zombie companies, but arguably as measures to unfreeze the banks begin to have an effect, the companies may turn out to be the bigger problem.

The afflicted firms are those that succumbed to fashion in the days of easy credit, and took on a mountain of debt. This may have been for acquisitions, or because gearing up was encouraged to enable boards to return cash to shareholders. Or it may have been that the business was subject to a leveraged buyout by one of the ­private-equity houses.

The actual reason matters less than the problem, which is similar in most cases. The value of the business has ­collapsed so the equity is virtually worthless, but the business is trading well enough to service its debts and not to be in any imminent danger of breaching its covenants. There are dozens, perhaps even hundreds, of businesses like this.

They are stable but not going anywhere. There is no incentive either for the banks to pull the plug or for the bondholders to take a haircut — accept a loss — so that the business can be recapitalised. Meanwhile the business has no money, all its cashflow goes on debt servicing and the equity is almost worthless, so it cannot be used for acquisitions.

Managements of such firms have no incentive to drive them forward because their share-option schemes will never pay out. For shareholders, the returns are too poor to encourage an injection of further funds to pay off the debt.

A lot of these businesses languish in the buyout funds that invested so heavily until three years ago. They are not necessarily bad ­businesses but, saddled with the wrong financial structure, fail to fulfil their potential. They make for an uncomfortable legacy of the time when financial engineering ruled the roost.