Author: admin

The August Inflation Report is much less dovish than the market expected and signals that the Monetary Policy Committee now has a neutral policy bias, following the £50 billion expansion of QE announced last week.

The mean inflation forecast based on an unchanged level of Bank rate is an estimated 2.1% and rising at the two-year horizon. This is up from 1.7% in May and a record low 0.4% in February, and the first above-target projection since August last year. The deviation from 2% is an indicator of policy bias and has often signalled rate moves – see chart.

This inflation view rests on a respectable economic recovery but the MPC’s GDP forecasts are not particularly aggressive. Output rises by about 2% in the year to the second quarter of 2010 in the central case based on unchanged rates. Risks, however, are weighted to the downside, so the mean projection is only about 1.5%.

In addition to the two-year-ahead projection, the MPC has raised its shorter-term inflation forecasts, partly reflecting a less optimistic assumption about domestic energy prices (expected to fall by 5% during the second half versus 15% in the May Report). After an undershoot in the second half, inflation returns to about 2% in early 2010.

Bank of England Governor Mervyn King referred to the likelihood of having to write a letter to the Chancellor explaining a fall in inflation to below 1% later this year. However, the central-case and mean projections for the third and fourth quarters are above 1%, suggesting that any move below will last a single month (and would not have occurred without the VAT cut).

Echoing earlier remarks in a speech, Deputy Governor Bean referred to the option of achieving a future tightening of policy initially by raising Bank rate, with gilt sales staggered over a longer period and conditioned on market developments. The difficulties of reversing QE imply that rate rises, when they begin, could be rapid.

Unemployment is still rising rapidly but job vacancies – a coincident rather than lagging indicator – suggest economic stabilisation. Vacancies bottomed in May and have edged higher in June and July. The rate of change over three months is still negative but has recovered to a level historically consistent with marginal GDP expansion – see chart.

The May trough in vacancies, like the peak in February 2008, was signalled in advance by the Market job placements index – see earlier post. The Markit index fell back in July but remains well above the low reached in December 2008.

US labour market statistics for July suggest that the recession has ended, for two reasons. First, the (smaller) fall in payroll employment last month was offset by a rise in the length of the average working week. Aggregate hours worked in the private sector were therefore unchanged – the first month not to register a fall since last August. Since labour productivity has continued to rise during the recession, stability in hours worked implies an increase in output.

Secondly, the unemployment rate – derived from a survey of households rather than employer payrolls – fell slightly in July. Historically, a monthly decline following a sustained steep increase has marked the end of a recession – see chart. This is true even when the rate subsequently rises to a new peak, as it did in the aftermath of the 1990-91 and 2001 recessions.

Some commentators have dismissed the significance of the fall in the unemployment rate on the basis that it reflected a contraction of the labour force rather than a rise in the number of households in employment. This may be unwise. Historically, the first monthly decline after a significant peak has often been associated with a fall in the labour force, e.g. in 1975, 1980, 1982 and 2003. Moreover, a measure of payroll jobs derived from the household survey increased, by 70,000, last month.

The improvements in both the employer and household surveys are consistent with other labour market evidence, including a recent large decline in corporate layoffs (see here), falling initial unemployment claims, a stabilisation of help-wanted advertising and less negative employment readings in business surveys.

OECD trade – the combined volume of exports and imports – contracted by 18% between the second quarter of 2008 and the first quarter of this year. However, two pieces of information released this week suggest that trade is now recovering.

First, German export orders rose by a further 8% in June, to stand 19% above the low reached in February. Orders are correlated with OECD trade volumes, with a historical “beta” or elasticity of about two – see first chart.

Secondly, the sum of the US ISM manufacturing imports and export orders indices broke above 100 in July, i.e. more firms now report rising volumes than falls. This indicator is also a good proxy for changes in OECD trade – second chart. The rise in the imports index probably mainly reflects slower destocking by US firms.

A comparison with the last three recessions suggests that National Statistics’ current estimate of a fall in GDP of 5.7% between the first quarter of 2008 and the second quarter of 2009 will be revised to show a significantly smaller decline over coming years. This claim is supported by labour market indicators, which, though weak, have deteriorated by less than would have been expected given the estimated GDP drop.

The Bank of England has helpfully compiled a “real-time” database of national accounts statistics that, for some series, including GDP, extends back to 1976. Following the end of the recessions in 1974-75, 1979-81 and 1990-91, GDP was estimated to have declined from peak to trough by 4.6%, 6.5% and 4.3% respectively. In the latest vintage of statistics, the falls are 2.7%, 6.0% and 2.5%. So revisions have cut the GDP drop by 1.9 percentage points for 1974-75, 0.5 pp for 1979-81 and 1.7 pp (after rounding) for 1990-91.

The smaller adjustment in 1979-81 may be misleading because revisions have also resulted in a major change to the profile of the recession. The originally-estimated 6.5% GDP decline referred to the change between the second quarter of 1979 and the third quarter of 1981 but the recession trough was subsequently shifted to the first quarter of the latter year. The latest statistics show a 4.6% GDP decline over the original recession period.

These comparisons indicate that the current estimate of a 5.7% GDP decline by the second quarter of 2009 could eventually be revised down by as much as 1.9 percentage points. A simple model for GDP growth based on changes in vacancies and claimant-count unemployment confirms that a substantial adjustment is possible. The model tracks the GDP falls in the last three recessions reasonably closely and suggests an annual decline of 3.7% in the first quarter of 2009 versus a current official estimate of 4.9% – see chart.

By announcing a further £50 billion slug of QE, bringing the total to £175 billion, the MPC has signalled that it places more weight on weak GDP numbers and still-modest broad money expansion than recent stronger business surveys, which suggest an early return to economic growth.

The additional £50 billion of purchases will occur over three months, implying a monthly rate of £16-17 billion, down from about £25 billion in the first phase of QE between March and July.

The decisions to stop QE and restart it a month later have resulted in unnecessary market volatility. The MPC could, instead, have announced a slowdown in buying last month (as some commentators suggested at the time), confirming this reduced pace at today’s meeting.

Banks’ cash reserves at the Bank of England should rise further from their current level of £164 billion as a result of today’s decision but by much less than £50 billion because of an offsetting decline in repo open market operations. Reserves are currently about three times the value of notes and coin circulating in the economy (£54 billion at the end of June), versus a pre-crisis ratio of less than a half.

With cash piling up at the Bank of England, banks have less need to boost their holdings of gilts and Treasury bills to ensure sufficient liquidity in the event of another market seizure. If banks lower their buying or even sell gilts to the Bank, this will offset the positive impact of QE on the broad money supply. (Banks’ holdings of gilts and Treasury bills have fallen slightly since QE began, having risen strongly in late 2008 and early 2009 – see chart.)

The Bank of England’s favoured broad money measure – M4 excluding money holdings of “intermediate other financial corporations” – grew at an annualised rate of only 3.7% during the second quarter despite a large positive impact from official gilt purchases. Coupled with a significant downward revision to the first-quarter rate of increase, from 6.2% annualised to 3.3%, the latest figures imply that monetary trends are less favourable for economic prospects than seemed the case a month ago, on the basis of data up to May.

While today’s report is disappointing, the 3.5% annualised growth rate of the M4 measure during the first half is slightly higher than a 2.7% increase in the second half of 2008. Moreover, a broader liquidity measure including Treasury bills and repo borrowing by the Debt Management Office (a close substitute for bank repos included in M4) has risen by 5.2% annualised so far this year. The large first-quarter revision, coupled with the high volatility of its monthly estimates, suggest that the Bank is still refining its approach to measuring the new aggregate, implying the possibility of further adjustments.

M4 growth remained sluggish during the second quarter because the positive impact of QE was offset by a rise in banks’ “net non-deposit sterling liabilities” and, to a lesser extent, a reduction in their net external and foreign currency lending. The increase in non-deposit liabilities partly reflects banks’ efforts to rebuild capital by retaining profits and issuing long-term debt and equity. However, both of these monetary counterparts show considerable volatility and the negative second-quarter effect may well reverse during the second half.

In assessing the economic implications, it is important to focus on real rather than nominal money supply trends. The annual rate of change of real M4 – relative to the retail prices index – has recovered from a low of -0.7% in the third quarter of 2008 to 4.7% by the second quarter, supporting expectations of economic improvement during the second half. With RPI inflation on course to rebound sharply in 2010, however, nominal money expansion will need to accelerate significantly over the remainder of 2009 to sustain real growth at its current rate.

The Bank’s gilt-buying will have further lagged positive effects on monetary trends during the second half but today’s figures suggest that the MPC should extend asset purchases by at least the further £25 billion currently mandated at its meeting on Thursday. Until broad money growth revives convincingly, there remains a risk that a near-term economic recovery will give way to renewed weakness in 2010-11.

A post in March argued that – contrary to the claims of the FT‘s Martin Wolf and many other commentators – sterling had fallen to a level implying significant and unsustainable undervaluation. This judgement was based partly on evidence from the quarterly CBI industrial trends survey – the percentage of manufacturers citing price competitiveness as a constraint on exports was the lowest since 1974.

Sterling’s effective index has rallied by 14% from its low in late December and by 9% since March. Yet the July CBI survey, released during MoneyMovesMarkets’ absence, shows that exporters remain bullish about their ability to compete: at 41%, the proportion citing price constraints remains far below its 1972-2006 average of 61% – see first chart. Worries about sterling’s rebound aborting an economic recovery are therefore misplaced.

In any case, the July manufacturing purchasing managers’ survey released today shows that domestic demand rather than exports is driving economic improvement. While the overall new orders index jumped to 55.9 last month, its highest level since November 2007, the export orders index was little changed at 48.5. Orders strength suggests an imminent resumption of manufacturing growth – second chart.

Global economic news has been generally encouraging during MoneyMovesMarkets’ absence, with Asian industrial activity, in particular, rebounding impressively, partly on the back of resurgent Chinese domestic demand.

Today’s US second-quarter GDP report continues the hopeful pattern, showing the economy’s contraction slowing to 0.3%, or 1.0% at an annualised rate, from 1.6%, or 6.4% annualised, in the first quarter. Stronger net exports and government outlays partly offset further, though smaller, declines in personal consumption and capital spending.

Destocking rose further to 1.1% of GDP in the second quarter, which appears to be a post-war record (based on earlier data – figures released today extend back only to 1995). With final demand stabilising, firms should resist further declines in inventories, implying a significant boost to production during the second half.

Annual revisions show that the recession has been deeper than previously thought, with the fall in GDP by the first quarter of 2009 now put at 3.7% versus 3.1%. However, GDP is still estimated to have peaked in the second quarter of 2008 – at odds with the National Bureau of Economic Research’s claim that the economy has been contracting since December 2007.

Recent corporate earnings news is consistent with improving global economic momentum. Equity analysts’ revisions ratio, defined as the number of upgrades to 12-month-ahead forecasts minus downgrades expressed as a proportion of the total number of estimates, rose to its highest level since late 2007 last week and suggests further gains in purchasing managers’ new orders indices – see chart.

The 0.3% fall in US GDP last quarter compares favourably with a 0.8% decline in the UK, reported last week. The UK figure, however, is difficult to reconcile with business survey results – better in the UK than the US recently – and labour market indicators (see previous post on vacancies). A comparison with initial GDP estimates in prior recessions suggests that the UK numbers will eventually be revised higher – more on this next week.

Global monetary conditions remain supportive for markets but a further rally in equities could be delayed by rising issuance. Gains also depend importantly on central banks continuing to support money supply growth until private credit expansion revives.

Monetary conditions tightened last year because moderate growth in the G7 broad money supply was insufficient to accommodate higher inflation and a rise in the precautionary demand for money due to the financial crisis. This tightening was evidenced by a contraction in real narrow money M1 – a better measure of cash held for transactions purposes and often more closely related to economic activity and flows into markets.

Conditions began to improve in late 2008 as Federal Reserve asset purchases boosted US broad money, a sharp drop in commodity prices pulled inflation lower and falling economic activity reduced money demand. The emergence of “excess” liquidity was reflected in a strong acceleration in G7 M1 and laid the foundations for both the spring rally in equities and the current incipient economic recovery.

Broad money has slowed again since early 2009, with the impact of “quantitative easing” offset by weak private credit trends. Improving market and economic conditions, however, are likely to have reduced the precautionary demand for money (i.e. the fall in velocity during 2008 may now be reversing). Consistent with liquidity remaining favourable for markets and economies, M1 is continuing to expand faster than broad money.

This positive assessment is subject to two qualifications. First, cash inflows to equity markets could be absorbed by issuance rather than reflected in higher prices. A proxy for the global volume of shares outstanding rose by 1.1% during the second quarter – the biggest gain since the second quarter of 2002. This was influenced by post-stress-test capital-raising by US banks but non-financial companies and banks elsewhere are likely to step up issuance if market conditions allow.

Secondly, monetary conditions could deteriorate if central banks step back from QE efforts before private credit expansion recovers. The Fed’s asset purchase plans imply a further significant boost during the second half of 2009 but prospects for the equivalent UK scheme are uncertain, while the ECB’s alternative approach of supplying liquidity to banks has yet to yield results. With inflation risks viewed as minimal, however, policy-makers are likely to be open to further “unconventional” actions should credit weakness persist.