Author: admin

The November Inflation Report published today is very dovish and will boost expectations of a fall in Bank rate to below 2% by early 2009. In his press conference comments, Mr. King also appeared to welcome substantial fiscal loosening while playing down concerns about the plunge in the exchange rate. However, the commitment to maximum policy stimulus sits oddly with the Report’s forecast of a relatively shallow and short recession. Markets may begin to worry about a loss of financial discipline.

Key points:

• The mean CPI inflation forecast in two years’ time based on an unchanged 3% Bank rate is just 0.9%, by far the largest deviation from target in the MPC’s history – see chart. This compares with an above-target forecast of 2.2% in August.

• The associated fan chart implies a 20% plus chance of CPI inflation being below zero in two years’ time.

• While it is difficult to infer precise figures from the chart, the growth forecast based on unchanged rates is consistent with GDP declining by about 0.5% per quarter between Q4 2008 and Q2 2009, stabilising in Q3 and then recovering by 0.5% per quarter over the following year. This would imply a peak-to-trough decline in GDP of about 2%, with annual average changes of -1.3% in 2009 and +1.7% in 2010.

• As discussed in a previous note, an average path derived from the last three recessions would entail a peak-to-trough fall in GDP of 2.3% with a recovery delayed until Q2 2010. This path would imply an annual fall of 1.7% in 2009 with growth of just 0.4% in 2010.

• Mr. King also stated that an updated growth projection would be less gloomy because of prospective fiscal loosening and recent sterling weakness.

• The large and sustained inflation undershoot is questionable against the background of a moderate recession and a substantial fall in the exchange rate. Either the MPC’s GDP forecasts are insufficiently downbeat or inflation is likely to revive sooner than the Report projects.

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COMMENT:
AUTHOR: Gaurav
EMAIL: panchalgaurav@gmail.com
IP: 90.192.151.16
URL:
DATE: 11/13/2008 01:44:26 PM

Hello Simon,
It seems all along the way the severity of the crisis has been underestimated, the BoE included. Proof of which was the 150bps ‘panic rate cut’. There is way too much volatility in the markets (and datawise). The fear is that after a fall in inflation, deflation could become a reality in 2009. History has shown that bad news goes out with a bang and this is surely the worst. I feel that it is not as simple as it looks. Even the US TARP plan is being questioned and it has been proven that Europe/UK are one step behind the US in this financial crisis. Deflation could be real bad news.
Best Regards,
Gaurav
Journalist
London, England

The October Royal Institution of Chartered Surveyors (RICS) housing market survey suggests a recovery in turnover from current rock-bottom levels together with a slowdown in the rate of decline of prices. Smaller price falls would be consistent with the equivalent stage of past housing downturns – see previous post.

The survey confirms a recent slump in activity and prices. However, the new buyer enquiries index tends to lead turnover and price momentum and rose for the sixth consecutive month in October, though remains in negative territory – see charts below.

The earlier fall in the index was exacerbated by uncertainty about changes in stamp duty. The recent revival probably also reflects lower prices and expectations of interest rate cuts (the survey was conducted before last week’s MPC move).

The slowdown in negative momentum should not be mistaken for the approach of the end of the downturn. While turnover may be bottoming, the next stage of the price decline is likely to be driven by rising supply as unemployment climbs. As the earlier post showed, experience in the mid 1970s and early 1990s suggests a sustainable recovery in prices will be delayed until 2011 or beyond.

Three-month sterling LIBOR fixed today at 4.42%, down from 5.56% before the Bank rate cut and 6.28% as recently as 10 October.

LIBOR can be decomposed into the expected level of Bank rate – measured by the overnight indexed swap (OIS) rate – and the credit risk / liquidity premium banks need to pay to attract term funding.

Of the 186 bp decline in three-month LIBOR since 10 October, 163 bp reflects lower expectations of Bank rate with just 23 bp due to a narrowing of the bank premium, measured by the LIBOR / OIS spread – see chart. The spread is 190 bp today, down from a recent peak of over 230 bp but well above the 75-85 bp level prevailing before Lehman’s failure in September.

With banks’ lending rates mostly linked to either LIBOR or Bank rate, recent falls will bring significant relief to existing borrowers.

However, the high LIBOR / OIS spread suggests banks still face major difficulty raising funds to finance new lending. To the extent that banks are financing loans linked to Bank rate with borrowing linked to LIBOR, it also frustrates their efforts to widen net interest margins – necessary to rebuild capital in order to support additional lending.

The large fall in LIBOR is welcome but the LIBOR / OIS spread also needs to decline significantly to justify hopes that financial and economic risks are diminishing.

A comparison of the current housing market downturn with the slumps in the mid 1970s and early 1990s suggests prices could fall by a further 15% from October levels, with a recovery delayed until 2011 at the earliest.

On a quarterly average basis, the Halifax and Nationwide house price measures both peaked in the third quarter of 2007. By October, the Halifax index had fallen 16% versus 14% for the Nationwide.

The first chart below compares the inflation-adjusted decline in the Nationwide index with falls in the last three housing downturns – 1973-77, 1979-82 and 1989-95. The comparison is made in real terms because high inflation bore the burden of reducing housing valuations in the 1970s and early 1980s. The Nationwide index is used because the Halifax measure began only in 1983. The inflation adjustment is based on the retail prices index.

The decline in real prices since the third quarter of 2007 has closely matched the initial stages of the 1989-95 downturn. This was the most severe of the three, with a peak-to-trough fall in real prices of 37% over 26 quarters.

For comparison, real prices fell by 32% over 15 quarters in 1973-77 and 17% over 10 quarters in 1979-82.

The second chart reverts to nominal prices and shows illustrative scenarios assuming 1) inflation-adjusted house prices follow the same path as in 1989-95 or 1973-77 and 2) retail prices rise at a 2% annualised rate.

Interestingly, both scenarios suggest a bottom in nominal prices in the first half of 2011, at 15% and 13% respectively below the most recent – October – level. However, a repeat of 1989-95 would imply a further three years of stagnation, with a sustained recovery beginning only in 2014.

Could prices fall by even more than in the early 1990s? Based on the rental yield – a better measure than the house price to earnings ratio – housing overvaluation was less extreme in 2007 than 1989. Also, the early 1990s slump was exacerbated by sterling’s membership of the ERM, which constrained cuts in official interest rates.

However, these factors could be outweighed by the current mortgage famine, caused by banks’ efforts to shrink their balance sheets, high funding costs and the rapid rundown of Northern Rock’s loan book. Cuts in official interest rates alone will have limited impact on mortgage credit supply.

Drastic action was warranted but there is a risk of exhausting interest rate ammunition too soon. The cut will have limited impact unless the financial system starts to function normally. The MPC is hoping to shock money and credit markets back to life but the Fed’s rate-slashing failed to avert a US credit crunch. UK policy-makers may need to consider additional steps to ensure the flow of credit to firms and households, such as TARP-style purchases of private sector debt and an expansion of the small firms loan guarantee scheme.

Headline money supply M4 numbers have been artificially boosted by a rerouting of interbank business through non-bank financial intermediaries, partly reflecting the operation of the special liquidity scheme. Unlike interbank lending, the deposits of these intermediaries are included in the M4 definition.

The Bank of England’s industrial analysis of bank deposits, published yesterday, permits a more accurate estimate of this effect. Specifically, an adjusted M4 measure was calculated excluding deposits held by five industrial categories within the financial sector – bank holding companies, mortgage and housing credit corporations, non-bank credit grantors, “other financial intermediaries” and “other activities auxiliary to financial intermediation”.

While headline M4 climbed 12.4% in the 12 months to September, the adjusted measure rose by just 2.9% – the lowest annual growth rate since 1999. In the latest three months adjusted M4 contracted at a 2.7% annualised rate.

While the headline M4 numbers are hugely inflated, the adjusted measure could in theory understate underlying broad money trends, to the extent that the non-bank intermediaries have created money-like liabilities. However, the bulk of their borrowing will have been from banks so any such effect should be small.

The collapse in money growth, when correctly measured, adds to arguments for a large cut in Bank rate tomorrow. Incorporating today’s services PMI results, my MPC-ometer now suggests a 55% chance of a full-point move and 45% of 75 basis points.

As previously reported, the liquidity ratio of private non-financial corporations – their M4 money holdings divided by bank borrowing – is at its lowest since 1991.

Bank of England data published today permit an analysis of liquidity ratios by industry. The low level of the aggregate ratio mainly reflects weakness in the real estate and construction industries.

“Normal” levels of the liquidity ratio vary by industry so it is more informative to monitor developments relative to a long-term average. The first two charts below show industry ratios relative to averages since 1998, when the Bank of England data began. In addition to construction and real estate, liquidity has deteriorated significantly in “legal, accountancy, consultancy and other business activities” – closely linked to property and financial markets.

By contrast, the liquidity ratio in manufacturing is above its post-1998 average and much higher than before the industrial recession in 2001.

The third chart shows the aggregate ratio for private non-financial corporations split between real estate and construction and other industries. The other industries ratio has declined sharply recently but has yet to fall beneath its level before the 2001 economic downturn.

The less dramatic liquidity deterioration outside real estate and construction may temper coming declines in business investment and employment. However, the industry skew is bad news for banks – real estate and construction loans account for 54% of their sterling lending to private non-financial corporations, having grown at an 18% annualised rate over the last five years.

One of my themes this year has been that the US economy would outperform Europe.

Between the fourth and second quarters, US GDP rose by an annualised 1.8% versus 1.0% in the Eurozone and 0.6% in the UK.

Preliminary third-quarter US figures released yesterday show a 0.3% annualised decline but the UK fall was much larger, at 2.1%. Coming Eurozone numbers look set to show a performance closer to the UK than US.

The US figures were depressed by Hurricanes Gustav and Ike and a strike at Boeing. The Federal Reserve estimated these factors depressed industrial production by 2.75% in September, implying a 0.9% impact on the third-quarter average, or 3.6% annualised. Industrial production accounts for 16% of GDP so this will have cut annualised GDP growth by 0.6%. This ignores effects on other sectors. In other words, the preliminary third-quarter growth estimate would have been slightly positive without the disruptions.

US GDP will decline in the fourth quarter but I still think prospects are worse in Europe.

David Blanchflower joined the MPC in June 2006, when money and credit growth were booming. The last move in official rates had been a cut (in August 2005). Blanchflower opposed the quarter-point rises in August 2006, November 2006 and January 2007. In March 2007, he voted for a cut. Had his view prevailed, the credit bubble would have been larger and its subsequent bursting even more destructive.

Bizarrely, in May 2007 Blanchflower joined the MPC majority in voting for a fourth quarter-point rise, implicitly accepting that his opposition to the previous 75 bp increase had been misguided.

Blanchflower resumed his calls for lower rates from October 2007, voting for a reduction at every meeting since then. The MPC did cut in quarter-point moves in December 2007, February 2008 and April 2008. These declines arguably had little effect because the monetary transmission mechanism was broken.

Blanchflower apparently wishes the MPC had emulated the Fed’s rate-slashing, although it is debatable whether this has helped either the economy or financial markets. The main impact was to push the dollar lower, contributing to soaring commodity prices and higher inflation. The inflation spike squeezed real incomes and was partly responsible for the 3.1% annualised decline in US consumer spending in the third quarter.

Rising inflation has also been a major economic drag in the UK. Earlier large rate cuts would probably have caused an even greater plunge in the sterling exchange rate and a higher inflation peak.

A large cut is now warranted because 1) inflationary pressures have eased, 2) rates are being reduced in other economies, limiting the risk of a further plunge in sterling and 3) the recent support package for the banks increases the chances that policy easing will be transmitted to borrowers.

Blanchflower’s opposition to higher rates in 2006-07 was harmful. He was prescient in forecasting that the financial crisis would lead to major economic weakness but this does not imply that earlier large rate cuts were the correct policy prescription.

The dramatic negative shift in the economic outlook resulting from the post-Lehman freezing of money and credit markets is confirmed by detailed monetary statistics for September released today.

Forget the headline annual increases of 12.4% and 14.2% in broad money M4 and bank lending (excluding securitisations) – these have been hopelessly distorted by a rerouting of interbank business through non-bank financial intermediaries. For a truer read, look at M4 and lending excluding “other financial corporations” (OFCs). Annual increases in these measures dropped to 5.0% and 6.8% respectively in September – the lowest since 1999/2000.

It gets worse. In the last three months, M4 and lending ex OFCs grew at annualised rates of just 2.8% and 2.3% – see charts.

The non-OFC private sector comprises households and non-financial corporations. Companies are under severe financial pressure. Their M4 holdings dropped again in September and are down 3.8% over the last year – the largest annual fall since 1980. Meanwhile, their access to credit has been curtailed at a time when working capital needs are likely to have been boosted by the economic downturn. Outstanding bank credit contracted in the three months to September.

Narrow money developments are equally concerning. M1, comprising currency in circulation and instant-access deposits, rose by just 0.1% in the year to September – the lowest annual increase since 1969. Real M1 contracted by 4.7%, the largest fall since 1980.

With the September figures unlikely to capture the full impact of the freeze, monetary trends clearly warrant a large cut in Bank rate next week. My MPC-ometer continues to project a reduction of 75-100 basis points, with a full-point move likely if three-month LIBOR is above 5.75% at the time of the meeting.