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The MPC-ometer is designed to predict the outcome of each month’s MPC meeting based on incoming economic news and financial market developments. The model, like the consensus, forecasts no change in either Bank rate or quantitative easing plans today. The balance of news over the last month, however, is judged to be slightly dovish, suggesting the MPC may announce an expansion of QE in June when the current £75 billion asset purchase programme reaches completion.

The MPC-ometer includes both growth and inflation indicators. Growth news has been mixed: GDP plunged 1.9% in the first quarter but business and consumer surveys showed a surprisingly large improvement in April, while financial market conditions have eased. Inflation indicators have weakened since last month: the headline CPI increase remains above target but average earnings growth fell to an annual 0.1% in the three months to February and a large majority of manufacturers plan price cuts, according to the April CBI industrial trends survery.

The MPC could, in theory, lower Bank rate further from its current 0.5% level – the Federal Reserve has set a target of 0%-0.25% for US official rates. The Committee, however, judges that a further reduction would deliver little if any economic stimulus, reflecting a likely negative impact on banks’ profits and willingness to extend credit. Any further easing of monetary policy should therefore take the form of stepped-up QE; the Chancellor has already granted the MPC authority to expand the programme to £150 billion.

The Bank of England is on track with plans to buy £75 billion of securities, mostly gilts, by early June. March monetary figures, however, showed a disappointing initial impact from QE: the broad money supply M4 rose by just 0.2% from February, with cash held by non-financial corporations falling. This reflects two factors. First, the Bank appears to have bought more gilts from banks and overseas investors than domestic non-banks in March – only UK non-banks’ money holdings are included in M4. Secondly, the positive monetary impact of QE was offset by a fall in bank lending to the private sector (a small rise in sterling loans being offset by a contraction of foreign currency credit).

The Bank had bought only £17 billion of securities by the end of March so it is too early to conclude that QE is failing to achieve the MPC’s monetary goals. Unless April money numbers show a pick-up, however, the Committee should extend the buying programme at its June meeting, probably for a further three months. Super-low interest rates are providing support to the economy but stronger money supply growth is needed to lay the foundations for a sustainable recovery.

Broad money figures for March show a disappointing initial impact from QE. It is too early to make a firm judgement but the numbers suggest that Bank of England asset purchases will need to be expanded beyond the planned £75 billion by early June to boost monetary growth sufficiently to support a sustained economic recovery. (The Bank has Treasury authority to buy up to £150 billion.)

Monetary trends are best monitored using the Bank of England’s adjusted M4 measure excluding “intermediate other financial corporations” – this removes distortions due to the financial crisis but includes investing institutions’ money holdings, which should be inflated by a successful QE operation. The Bank of England does not release its monthly adjusted M4 estimates but the aggregate is likely to have been little changed in March, since overall M4 rose by only 0.2% on the month, while M4 excluding all financial corporations declined by 0.1%. (The Bank will publish March quarterly data for its adjusted M4 and M4 lending measures on 8 May.)

The Bank of England bought £15 billion of gilts in March, equivalent to 0.9% of adjusted M4. There are two possible reasons why the money numbers have shown little response. First, the Bank may have bought securities mainly from banks and overseas investors rather than domestic non-bank investors – only money holdings of the latter are included in M4. Secondly, a positive impact from QE may have been offset by other influences on M4, such as weak bank lending to the private sector.

Both factors were in play in March. Statistics on gilt transactions by sector show that Bank purchases of £15 billion were balanced by net sales of £7 billion by overseas investors, £6 billion by domestic non-banks and £2 billion by banks – see table. So the direct impact of purchases on M4 was only 40% (i.e. £6 billion out of £15 billion). (The outstanding stock of gilts was little changed in March, with DMO issuance offset by a large redemption. This may have affected the sectoral pattern of transactions.)

Meanwhile, credit weakness was a significant drag on M4: sterling bank lending to households and non-financial corporations, adjusted for securitisations, rose by only 0.2% in March and there was a large repayment of net foreign currency borrowing by UK residents. In addition, while domestic non-bank investors reduced their gilt holdings by £6 billion, they bought £21 billion of other forms of public sector debt, including £10 billion of Treasury bills. The overall public sector contribution to monetary growth – including the impact of the public sector net cash requirement, the Bank’s purchases and other debt transactions – was therefore only £6 billion, or 0.4% of adjusted M4.

While this month’s numbers are disappointing, money trends have improved significantly since last autumn: M4 excluding financial corporations rose at a 4.0% annualised pace in the three months to March after just 0.8% during the the fourth quarter. Annual growth slipped to 2.5% in March but in real terms – relative to retail price inflation – has recovered from a low of -0.6% in October to 2.9% now. This is consistent with improving economic prospects but a further pick-up is needed to lay the monetary foundations for a recovery.

The MPC is likely to wait until its June meeting before deciding to expand its QE operation, partly because it would be unwise to make a judgement about its impact on the basis of just one month’s data, and partly because an expansion of the programme would probably take the form of an extension of buying for a further three months, rather than a step-up in the weekly pace of purchases.

Eurozone monetary statistics for March and the latest survey of bank loan officers suggest an urgent need for the ECB to embrace US / UK-style quantitative easing at its meeting next week.

Broad money M3 has contracted over the last three months, pulling annual growth down to a five-year low of 5.1% – see first chart. The liquidity squeeze remains focused on the corporate sector, with M3 deposits of non-financial companies 1.2% lower than a year ago.

In terms of the credit counterparts, M3 weakness reflects a recent fall in bank lending to the private sector – second chart. A similar decline in the US has been offset by the expansionary impact of the Fed’s securities purchases, so US M2 has continued to grow, albeit at a slower pace than in late 2008 – see last post.

The latest bank loan officer survey shows a fall in the net percentage tightening credit standards on corporate loans but the decline was much less than in the Bank of England survey released in early April – third chart. The equivalent US survey is due next week; the Fed’s statement yesterday referring to “some easing of financial conditions” hints at favourable results.

US money measures accelerated sharply when the Federal Reserve embarked on quantitative easing in late 2008, buying commercial paper and mortgage-backed securities. Three-month growth in the broader M2 aggregate reached an annualised 24% in December – see first chart. The monetary injection laid the foundations for the March / April rally in equities and recent improved economic news.

M2, however, began slowing in early 2009 and has actually fallen over the last four weeks, bringing the three-month rate of change down to 3%. Annual growth remains solid at 8% but has retreated from 10% in January.

Recent M2 weakness has not reflected any slowdown in Fed securities purchases. At its March meeting, the Fed announced a big expansion of its buying plans to a potential $2 trillion by the end of 2009 – second chart. This would imply $1.25 trillion of purchases over the remaining eight months of the year, or about $35 billion per week. Recent buying has been on roughly this scale.

Unlike the ECB and Bank of England, the Fed does not publish a “counterparts analysis” of the drivers of M2 growth but it appears that the expansionary impact of official securities purchases has been offset by a recent contraction in bank lending to the private sector. Commercial bank loans and leases outstanding have fallen at an annualised 5% rate over the last three months – third chart.

On further analysis, this contraction mainly reflects declines in commercial and industrial loans and advances under sale-and-repurchase agreements. Corporate lending has been depressed by recent heavy destocking while the fall in repo advances is consistent with other evidence of investor deleveraging. With the stocks cycle turning, and investor risk appetite beginning to revive, lending trends could improve going forward.

M2 trends are not yet ringing alarm bells but a further slowdown would question the sustainability of recent equity market gains and tentative economic improvement.

The Treasury’s medium-term fiscal forecasts appear to rest on optimistic assumptions about future borrowing costs. On reasonable alternative assumptions, public sector net interest payments could rise to 3.9% of GDP by 2013-14 versus an official projection of 3.0%.

The Treasury’s forecasts for debt interest have received limited scrutiny partly because they are buried within the detail of the Budget documents. Medium-term projections for public sector net interest as a percentage of GDP can be derived from Table C2 of the Financial Statement and Budget Report (FSBR) as the difference between public sector net borrowing and the “primary balance”. These forecasts can be converted into nominal terms using money GDP assumptions from Table C1.

To derive the Treasury’s unpublished assumptions about future borrowing costs, it is necessary to put these public sector net interest numbers onto a general government gross basis by adding back estimated interest receipts and adjusting for public corporations. The gross interest projections can then be compared with published numbers on gross government debt to derive an average interest yield.

According to the FSBR, public sector net interest will rise from 1.6% of GDP in 2009-10 to 2.6% in 2010-11 and 3.0% in 2011-12 – see first chart. A further small increase to 3.1% in 2012-13 is then reversed in 2013-14, when the proportion returns to 3.0%. This stabilisation raises suspicion, since general government gross debt is projected to rise by 17% in the two years to the end of 2013-14.

To generate this profile, the Treasury must be assuming a fall in the interest yield on government debt in 2012-13 and 2013-14. The FSBR projections are consistent with the yield averaging less than 4% in the three years to 2013-14, far below projected money GDP growth of more than 6% per annum over this period – second chart.

The bulk of outstanding debt consists of fixed-coupon gilts. The interest yield in a particular year is a weighted average of the rates on existing debt and new borrowing – not just to cover the budget deficit but also to finance gilt redemptions and roll over the stock of Treasury bills. For the average yield to fall after 2011-12, as implied by the FSBR forecasts, the interest rate on new borrowing in 2012-13 and 2013-14 would have to be well below 4% – a rough calculation suggests an average of about 3% over the two years.

The charts present an alternative scenario for the average yield and net interest as a percentage of GDP based on the assumption that the interest rate paid on new borrowing in 2011-12, 2012-13 and 2013-14 is equal to the projected rate of money GDP growth in each year (i.e. 6.0%, 6.2% and 6.1% respectively). This generates a gradual rise in the interest yield to 4.9% by 2013-14. While significantly higher than the 3.8% implied by the Treasury’s forecast, this is below the 5.2% average between 2004-05 and 2007-08 (when money GDP grew more slowly than projected for the three years to 2013-14).

On this alternative scenario for the average yield, net interest as percentage of GDP rises to 3.9% of GDP by 2013-14 against the Treasury’s projection of 3.0%. More pessimistic scenarios are clearly feasible, based on investor concerns about inflation and / or solvency pushing new borrowing costs above the rate of money GDP growth.

A higher interest bill would imply either a greater squeeze on non-interest spending or, more likely, further fiscal slippage. According to the Treasury’s forecasts, real current spending will rise by 0.7% per annum in the three years to 2013-14. Stripping out interest costs, however, the rate of growth is just 0.2% pa. On the alternative scenario presented here, real non-interest spending would need to fall by 0.7% pa over this period to make room for higher debt-servicing costs, assuming no further upward revision to plans.

The 1.9% fall in GDP in the first quarter represents the largest quarterly drop since a strike-related 2.4% plunge in the third quarter of 1979. GDP has now declined 4.1% from its peak in the first quarter of 2008, which compares with peak-to-trough falls of 2.5% in the 1990-91 recession, 3.3% over 1973-75 and 5.9% in the 1979-81 slump.

The chart shows the current fall in GDP together with Treasury and Bank of England forecasts and the 1979-81 decline, rebased to the peak in the first quarter of last year. The first-quarter result was 0.8% lower than implied by the central projection in the Bank’s February Inflation Report. The MPC judged that the latest indicators were broadly consistent with this forecast at its April meeting so today’s number could boost the chances of an expansion of QE.

The Treasury’s Budget forecast implied that GDP would fall by 2.2% between the fourth quarter of 2008 and the second half of 2009. This looked hopeful even before today’s news of a 1.9% first-quarter loss. A monthly GDP estimate derived from data on industrial and services output was 0.4% below its first-quarter average in March, suggesting a further fall of at least this amount in the second quarter.

The Treasury projects a recovery in GDP of 2.9% per annum between the second halves of 2009 and 2011. While widely derided, this is lower than the 3.3% pa increase over the same period forecast in the Bank of England’s February Inflation Report. A key issue is whether the Bank will retain this steep recovery profile, albeit from a lower base, in its next Report, released on 13 May.

The 1.9% first-quarter decline is difficult to reconcile with available expenditure data. With retail sales rising by 1.0% in the first quarter, overall consumer spending seems unlikely to show a decline larger than the 1.0% recorded in the fourth quarter. Trade figures for January and February signal little impact from net exports. Meanwhile, output of “government and other services” rose in the first quarter, suggesting higher general government consumption. The implication is that GDP weakness was driven by investment and stocks.

Destocking already amounted to 1.3% of GDP in the fourth quarter, based on current data. This offers a glimmer of hope – a faster cut-back in the first quarter would imply a correspondingly larger future boost to GDP when stock levels stabilise.

The Budget “Red Book” paints a dire picture of the state of the public finances. It is tempting to suggest the Chancellor has exaggerated the gloom to create room for favourable “surprises” ahead of the election but the assumptions underlying the projections look, if anything, too optimistic.

• In the five months since the Pre-Budget Report, forecast net borrowing in 2010-11 has ballooned from £105 billion to £173 billion. Collapsing receipts account for £48 billion of this increase, with the remaining £20 billion due to higher expenditure.

• Receipts could yet undershoot even this revised forecast. The ratio of taxes to GDP is projected to bottom at 33.0% in 2009-10 before recovering but reached a low of 31.8% after the less-severe recession of the early 1990s.

• The Augustinian approach to spending discipline is maintained. Longer-term projections benefit from cuts to previous plans but the expenditure-GDP ratio surges to 48.1% in 2010-11 – the highest since 1982-83 and up from 41.0% as recently as 2007-08.

• After a 3.5% drop this year, GDP is forecast to grow by 1.25% in 2010, 3.5% in 2011 and 3.25% per annum in later years. While not unreasonable, this is clearly at the optimistic end of the range of possible scenarios.

• The Budget changes were modest in terms of sums dispensed. A net “injection” of £5.2 billion in 2009-10 is reversed in 2010-11 as the tax hike on higher-earners kicks in. The key measures this year are a temporary boost to capital allowances (costing £1.6 billion), phasing-in of the uprating of business rates (£700 million), employment initiatives (£890 million) and winter payments to pensioners (£600 million).

• The planned hike in the income tax rate on high-earners to 50% will tie the UK with Japan at the top of the G7 league table. This will create significant negative economic incentive effects and is unlikely to raise the amounts projected, especially if capital gains tax is kept at the current 18%.

• With the rise in net borrowing fully reflected in the “central government net cash requirement”, the Debt Management Office projects net gilt sales of £220 billion in 2009-10, up from £146.5 billion in 2008-09. The Bank of England, however, will absorb at least £55 billion – the gilt market’s day of reckoning may be delayed until 2010-11, when a similar level of funding will need to be raised without Bank support

The macroeconomic judgement underlying the Chancellor’s strategy is that higher borrowing will deliver an economic stimulus even though households and companies anticipate a significantly higher tax burden in years to come. This would be questionable in normal times but is even less likely given the unprecedented scale of necessary future fiscal adjustment bequeathed by Mr. Darling to his successor.

The plunge in sterling has pushed the gap between UK and Eurozone consumer price inflation to its highest level since 1992 – despite the UK number being artificially depressed by December’s VAT cut.

Slower food and energy price gains caused UK annual CPI inflation to ease from 3.2% in February to 2.9% in March but the equivalent Eurozone measure slumped from 1.2% to just 0.6%. The difference of 2.3 percentage points between the UK and Eurozone increases is the largest since a 2.8 point divergence in March 1992 – see chart.

The gap would be significantly larger but for the VAT cut. The CPI at constant tax rates (CPI-CT), which assumes that the reduction was passed on in full, rose by an annual 3.9% in March – one percentage point more than the headline measure. Some retailers have used the cut to boost margins: a conservative assumption that only half of the reduction has been transmitted to consumers would imply “true” CPI inflation of 3.4%, 2.8 percentage points above the Eurozone level.

The gap can be attributed roughly equally to differences in food and energy price trends and “core” inflation – both have been affected by the fall in sterling. The UK CPI excluding unprocessed food and energy – a measure of core prices – rose by an annual 2.3% in March, or 2.9% assuming 50% pass-through of the VAT cut, versus an increase of just 1.5% in the equivalent Eurozone index.

The IMF’s latest World Economic Outlook is downbeat on recovery prospects, based partly on an analysis of business cycles in 21 economies since 1960, showing that recessions associated with financial crises or with a strong global element tend to be longer and followed by weaker upswings.

The IMF’s findings, however, are at odds with longer-term historical evidence that “deep recessions are almost always followed by steep recoveries” – a regularity known as the “Zarnowitz rule” after the distinguished US business cycle analyst Victor Zarnowitz (quoted by former IMF Chief Economist Michael Mussa in a recent paper).

The table below, documenting the six largest declines in US industrial output between 1880 and 1960, illustrates Zarnowitz’s observation. The 1929-32 slump clearly stands out in terms of severity and duration. The other five recessions / recoveries show considerable similarity – contractions were deep but lasted no more than 14 months, while subsequent recoveries were strong, with peak output regained within 19 months.

These five recessions include downturns associated with a severe financial crisis (e.g. 1907-08) and / or globally-synchronised weakness (e.g. 1920-21).

The 18% fall in Group of Seven (G7) industrial output since its peak in February 2008 is in the middle of the range of these five severe US recessions (excluding the 1929-32 slump). The US historical experience suggests that the output fall – 12 months in duration as of February, the latest data point – should be approaching an end. If the recovery were also to follow the US historical pattern, output would regain its February 2008 level by late 2010 at the latest. This would imply a growth rate of output during the recovery phase of about 11% per annum – far higher than suggested by the IMF’s gloomy forecasts.

Indicators supporting a V-shaped recovery include surging G7 real money growth and a widening gap between retail sales and production, suggesting a potential big boost from the stocks cycle. Credit conditions, however, remain restrictive, though have started to ease, a process that could gather pace if investor risk appetite returns.

How is the Bank of England’s “quantitative easing” initiative progressing?

The Bank is on course to achieve its target of buying £75 billion of assets by early June. As of yesterday (16 April), cumulative purchases had reached £34.3 billion, comprising £31.5 billion of gilts, £0.5 billion of corporate bonds and £2.4 billion of commercial paper – see first chart.

The dominance of gilt-buying has led to criticisms that the Bank is failing to achieve its objective of improving the flow of finance to companies. This is simplistic, ignoring the indirect benefit of institutions that have received cash from the Bank in return for gilts reinvesting the proceeds in corporate securities.

Another criticism is that corporate yields are little changed from their level when the asset purchase facility was first announced in late January. However, stability in the investment-grade index conceals a material fall in yields on securities issued by non-financial companies offset by a rise in financial yields – second chart.

In any case, the impact of the scheme on credit conditions cannot be measured simply by yields – improving companies’ ability to raise funds is a more important goal. Encouragingly, underwritten sterling bond issues have totalled £54 billion so far in 2009 versus £94 billion in all of 2008, according to Bloomberg.

The success of QE will ultimately hinge on its impact on monetary growth – particularly broad money. As expected, unsterilised asset purchases have boosted banks’ reserves at the Bank of England, which – together with currency in circulation – comprise the monetary base. Annual growth in monetary base has soared to 66%, well above levels in the Eurozone and Japan though lower than in the US – third chart.

March broad money figures will be published next Wednesday but – as previously discussed – headline M4 has been distorted by the activities of “intermediate other financial corporations”. The Bank of England is unwilling to publish monthly estimates of its adjusted M4 measure, excluding money holdings of these entities. The last quarterly number, for December, showed annual growth of just 3.8%; the next Inflation Report, due on 13 May, should include a chart incorporating a March figure.

Annual growth in adjusted M4 probably needs to rise to 10% to lay the foundations for an economic recovery. The Bank’s asset-buying plans appear to be on the right scale – £75 billion is equivalent to 4.5% of adjusted M4 so a one-for-one impact, assuming a stable underlying trend, would imply a rise in annual growth to 8-9%.

There are two risks. First, to the extent that the Bank buys securities from banks and overseas investors, rather than domestic non-banks, there is no direct positive impact on M4. The Bank will publish March data on gilt transactions by non-banks, banks and overseas investors on 1 May. These are, however, net figures, including purchases of new issues from the Debt Management Office.

Secondly, the boost to M4 from QE could be offset by a further slowdown in private sector lending growth, reflecting weak credit demand and / or continuing efforts by banks – particularly foreign-owned institutions – to shrink balance sheets. Continued sluggish M4 growth would indicate not that QE has failed but rather that plans need to be expanded to utilise more of the £150 billion authority granted by the Treasury.