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The economic surprise of the last six months has been the strength of the rebound in global industrial activity. The surprise of the next six months could be the speed of the turnaround in labour markets.

A fundamental reason for optimism is the impressive recovery in company finances, which should encourage more expansionary behaviour. In the US, the corporate financial balance – the difference between retained earnings and capital spending – has moved from a deficit of 2.1% of GDP in the first quarter of last year to a surplus of 1.1% by this year’s second quarter. Excluding the third and fourth quarters of 2005, which were distorted by a one-off repatriation of foreign profits to take advantage of temporary tax incentives, this is the highest since the fourth quarter of 1960. The financial balance is a leading indicator of employment – see first chart. The equivalent UK balance has also moved into surplus.

Trends in temporary employment often provide early warning of changes in labour demand. US “temporary help” jobs fell by just 2,000 in September versus a prior six-month average of 26,000. The American Staffing Association’s staffing index, moreover, has recovered strongly in recent weeks, suggesting that Friday’s payrolls report for October will show a rise in temporary jobs – second chart. (The index is a survey-based measure of demand for short-term and contract workers; the series in the chart has been adjusted for seasonal variations.)

In the UK, the Markit / Recruitment and Employment Confederation Report on Jobs survey for October released today showed a further recovery in demand for both temporary and permanent staff. The permanent placements index is well above the break-even 50 level, suggesting a stabilisation and recovery in private-sector employment over coming quarters – third chart. Purchasing managers’ employment indices – coincident rather than leading indicators – remained below 50 in October but improved from September.

The strong consensus in favour of central bank policies staying “loose for long” rests on a forecast of continuing labour market weakness. An earlier-than-expected return of jobs expansion would boost confidence in the sustainability of the economic recovery but could signal the end of the liquidity-driven rally in markets.

The percentage balance of consumers expecting higher inflation over the next year has risen from -5% in July to +4% in October, according to the EU Commission survey. The current balance, while still depressed by historical standards, is the highest since November last year – see chart.

It is tempting to discount the recent increase as a reflection of the coming VAT hike. The latest Citigroup / YouGov survey, however, shows that longer-term inflation expectations have also firmed, with the average forecast rising from 2.8% in January to 3.2% in October.

There is a danger that expectations are moving higher partly because of doubts about the Bank of England’s ability or willingness to achieve the 2% inflation target over the medium term. The Bank’s inflation forecasts have been consistently too low in recent years while its gilt-buying may have raised concerns about policy independence.

The survey measures are influenced by current inflationary trends and have historically correlated more closely with retail than consumer prices. Headline RPI inflation is likely to rise from -1.4% in September to 3% or more by next spring as a result of the VAT hike and unfavourable energy, house price and mortgage rate effects – see previous post.

Inflation expectations are an important influence on the Bank’s policy decisions – the EU Commission measure is a component of the “MPC-ometer” model for forecasting interest rate changes described in earlier posts. The recent increase is a further argument against an expansion of gilt purchases at this week’s meeting.

Recent posts have argued that the Bank of England should not and probably will not expand asset purchases at its meeting this week. A range of evidence suggests that monetary conditions are sufficiently and possibly excessively loose. The Bank, meanwhile, faces difficulty in justifying a further extension given medium-term inflation prospects.

By contrast, 43 out of 62 economists polled by Reuters last week expect more asset-buying, with the majority split between a £25 billion and £50 billion increase. The Sunday Times Shadow MPC, which is often a good guide to the Bank’s thinking, is also strongly in favour of an extension – see David Smith’s blog for details.

This week’s purchasing managers surveys for October are likely to be an important influence on the decision. As mentioned last week, earnings revisions pointed to strong results; the manufacturing survey this morning duly surprised positively, with the leading new orders component rising to its highest level since January 2004.

The companion survey covering the larger services sector will be released on Wednesday. Suppose, however, that the new business component is unchanged from its September reading. A weighted average of manufacturing new orders and services new business would then reach its highest level since September 2007 – two months after the final interest rate increase in the last tightening cycle. 

The chart shows Bank rate together with this new business indicator, with the last data point incorporating the services assumption. The MPC has eased policy only once with the indicator at or above its implied October level – in February 2001. Consumer price inflation, however, was then below 1% (and undistorted by VAT effects) while the US economy was entering, not exiting, a recession.

Proponents of keeping Bank rate at its current 0.5% level for a sustained period argue that substantial economic slack will bear down on inflationary pressures, risking an undershoot of the 2% target over the medium term. There is no dispute that output is currently below potential; the issues are the size of the gap, its “coefficient” in an inflation model and possible offsets from other factors.
 
Most methods for estimating potential output assign a large weight to recent actual data. This is problematic during recessions, when some business activities contract on a permanent basis as capacity is scrapped. Unusually severe credit restriction in the current downturn may have magnified this capacity effect.

Some recent business surveys cast doubt on claims that companies have scope to boost output significantly, at least without a rise in marginal costs. In the latest CBI industrial trends survey, for example, the percentage of firms citing plant capacity as a factor limiting output was close to its long-run average. The implied disagreement with output gap estimates, such as those produced by the OECD, is unusually large – see chart. (There is a similar divergence between US gap estimates and ISM survey evidence of lengthening delivery times, indicating supply bottlenecks.)
 
A generalised “Phillips curve” inflation model should include not only the output gap but also its rate of change, inflation expectations, the exchange rate, global commodity prices and the real level of indirect taxes. The last three factors have been the key drivers of inflation movements in recent years. If sterling continues to weaken, commodity prices remain underpinned by rapid emerging-world growth and indirect tax increases bear a significant burden of necessary fiscal adjustment, these factors may continue to outweigh the disinflationary impact of economic slack.

UK monetary statistics for September are much better than they look on first inspection. The Bank of England’s preferred broad money measure – M4 excluding “intermediate other financial corporations” – fell sharply on the month, resulting in a third-quarter contraction of 1.7% at an annualised rate. This would seem to argue strongly in favour of a further expansion of asset purchases at next week’s MPC meeting.

On closer analysis, however, the quarterly decline was entirely due to “non-intermediate” financial corporations running down their money balances. Insurance companies, pension funds, trusts and other fund managers reduced their M4 holdings by £10 billion last quarter, presumably reflecting increased confidence in financial market prospects.

M4 excluding all financial corporations, i.e. money holdings of households and non-financial companies, rose by 0.3% in September and 3.8% annualised in the third quarter – the fastest since the second quarter of 2008. This should encourage Bank policy-makers, indicating that liquidity created by official gilt-buying is filtering down to “end-users” responsible for spending decisions.

As well as increasing their sterling deposits, non-financial firms continued to add to foreign currency holdings while repaying sterling and foreign currency bank loans. Accordingly, the corporate liquidity ratio, i.e. money holdings divided by bank borrowing, rose further to a two-year high – see first chart. This ratio is a leading indicator of business investment and hiring.

Further encouraging features of the data include a pick-up in narrow money M1 and a continuing recovery in mortgage approvals for house purchase, suggesting that net mortgage lending will rise to £2 billion a month or higher by late 2009.

Meanwhile, EU Commission consumer survey results for October also released today showed a further strong improvement in confidence, which has now returned to its long-run average. Confidence has recovered much faster than in other major economies – second chart.

The official estimate of a 0.4% GDP decline in the third quarter implies a further widening of the “output gap” – the difference between actual and “potential” GDP. Business surveys, however, suggest that capacity utilisation has stabilised or increased recently.

For example, the Bank of England’s agents’ survey scores on capacity constraints in services and manufacturing have risen since the spring. The numbers remain very low by historical standards but any increase should, in theory, reflect higher output and – strictly speaking – above-trend expansion.

The chart shows quarterly changes in GDP and a weighted average of the agents’ scores. The capacity indicator gave timely warning of the onset of the recession and suggests that output in the sectors covered should have increased last quarter and possibly even in the spring quarter also.

The MPC’s judgement about how much weight to give to stronger survey evidence may be influenced by tomorrow’s US third-quarter GDP numbers. Purchasing managers’ survey results have been similar in the US and UK recently; if US GDP posts a solid increase, as markets expect, this would cast further doubt on the reliability of the initial UK estimate.

October PMI results released next week, and the Bank’s latest agents’ scores, will also be important. A significant set-back would lend credence to the GDP number; the PMI surveys, however, correlate with equity analysts’ earnings revisions, which strengthened further this month.

Eurozone broad money M3 slowed further in September – annual growth fell to 1.8% from 2.6% in August while M3 rose by just 0.8% annualised over the last three months. As in other major countries, however, headline broad money numbers probably understate monetary support for an economic recovery.

A key reason for a more hopeful view is the continued strength of narrow money M1 – up by 12.8% in the year to September and by 16.9% annualised over the last three months.

Secondly, the M3 slowdown has been exaggerated by weakness in financial companies’ money holdings – less likely to be reflected in spending decisions. M3 held by households and non-financial corporations rose by an annual 5.0% in September, well above the 1.8% headline rate.

Thirdly, the non-financial corporate liquidity ratio – M3 deposits divided by bank loans of less than five years’ maturity – continues to recover rapidly, suggesting improving prospects for business spending. This echoes trends in other major economies – see chart. (The UK publishes September monetary data on Thursday.)

The shock 0.4% further drop in GDP in the third quarter reflects falls of 0.7% and 0.2% in industrial and services output respectively. Industrial weakness had already been signalled by August production numbers but the services decline is a big surprise and at odds with recent stronger purchasing managers’ survey results (although the coverage of this survey is narrower than that of the GDP figures).

August monthly figures for services output were also released today. The July / August average of this series, which feeds directly into the GDP numbers, was 0.05% below the second-quarter level. To generate a 0.2% quarterly decline, the Office for National Statistics must be assuming a significant output fall in September. This seems odd given the limited information available at this stage.

The chart plots quarterly GDP together with a monthly proxy based on industrial and services output. After recovering by 0.4% in June and July, monthly GDP is estimated to have slumped by 0.6% in August with a further 0.3% decline in September implied by the quarterly estimate.

Today’s figures conflict with the MPC’s assessment at its last meeting that “output in the third quarter was likely to be close to the central projection in the August Inflation Report” – this projection implied a 0.1% rise last quarter (taking account of a 0.2% upward revision to second quarter numbers). The Committee, however, is likely to be puzzled by the apparent inconsistency with survey evidence and the assumption of a further output fall in September.

November’s meeting is shaping up to be a cliff-hanger, with GDP weakness offsetting other factors arguing for an increase in the MPC’s inflation forecast, including recent higher-than-expected outturns, better global economic news, stronger asset and commodity prices and a fall in the exchange rate. The two-year-ahead projection based on unchanged policies was above the target at 2.17% in August so the MPC needs to conclude that inflation prospects have improved to justify extending asset-buying. This still looks a stretch, even after today’s number.

More equity analysts upgraded their forecasts for company earnings in October, suggesting a further rise in economic momentum. The world earnings revisions ratio – i.e. upgrades minus downgrades divided by the total number of estimates – reached its highest level since May 2004. The ratio is closely correlated with business surveys, which may show further improvement this month – see chart.

The Bank of England’s gilt-buying has cut the effective maturity of the UK’s public debt, implying greater vulnerability of interest costs to changes in market rates. The maturity of liabilities remains longer than in other major countries but the gap has narrowed significantly over the last year.
 
According to the Debt Management Office (DMO) Quarterly Review, the average maturity of conventional gilts outstanding fell to 13.4 years in September 2009 from 14.3 years 12 months earlier. The latest figure, however, is misleading because it includes the £164 billion of gilts now held by the Bank of England’s asset purchase facility (APF) – 27% of the total stock.
 
The market has, in effect, exchanged these gilts, with an average maturity of about 10 years, for reserves at the Bank of England, which are repayable on demand. The relevant metric for assessing refinancing risk is the average maturity of the market’s combined holdings of gilts and reserves, not that of the entire stock of gilts, including the APF. This is significantly lower, at about 10.7 years (based on a 10-year average life of APF gilts).
 
The Bank of England pays Bank rate on reserves. This results in an interest saving when Bank rate is below the average yield on gilts, as at present. The differential, however, has been positive for about half of the time since the MPC’s inception in 1997 and could rise sharply in the event of a loss of market confidence in UK economic policies. This would be instantly reflected in the combined government / Bank interest bill.
 
The DMO figure also does not take into account expansion in the stock of Treasury bills, from £18 billion at the end of 2007 to £52 billion currently. If these are included in the calculation, in addition to adjusting for the APF gilts / reserves swap, the average maturity of liabilities falls further to an estimated 9.8 years. (All these figures exclude index-linked gilts.)
 
This is still significantly longer than for other major countries – the US is at the low end of the range, with an average maturity of publicly-held marketable debt, including bills, of less than four years. The gap, however, is much smaller than a year ago and will continue to erode if the Bank of England extends its gilt-buying programme.