Category: Money Moves Markets

In a recent speech, Mervyn King, Governor of the Bank of England, claimed there was a shortage of money in the British economy. This shortage, he argued, was a drag on economic growth and threatened to push inflation below the 2% target over the medium term, a prospect warranting consideration of a further round of “quantitative easing” (QE).
 
Mr King’s diagnosis is faulty. Far from a shortage, there may be surplus money circulating in the economy at present. This means a further injection of liquidity by the Bank’s Monetary Policy Committee (MPC) could boost prices rather than economic activity, sustaining the current inflation overshoot.
 
The Governor’s claim stems from recent slow growth in the broad money supply – the stock of savings held by consumers and companies in the form of notes and coin and bank and building society deposits. Broad money has risen by only 2% over the last 12 months, compared with an average annual growth rate of 7% over the previous decade.
 
Any judgement about money supply adequacy, however, must also take into account the velocity of circulation – the rate at which the existing money stock turns over. A rise in velocity has exactly the same economic impact as an expansion of the money supply itself. Velocity has surged over the last year and there are grounds for believing this pick-up will continue. This means monetary conditions are much looser than Mr King and his fellow MPC doves claim.
 
Velocity is calculated by dividing gross domestic product (GDP), measured at current prices, by the money supply. The recent increase is unusual: over the last 50 years, broad money velocity has fallen by 0.5% a year on average.
 
To support real economic growth of 2.5% a year along with inflation in line with the 2% target, money supply expansion and the change in velocity must add up to 4.5%. If velocity were to decline at its historical 0.5% rate, broad money would need to expand by 5% a year rather than the current 2%. This explains why many economists are calling for a further infusion of liquidity.
 
The trend in velocity, however, is not fixed but depends on the relative attraction of money as a store of savings. When deposit-account interest rates fall below inflation, as at present, families and firms have a strong incentive to economise on money holdings, resulting in an increase in the rate at which the existing stock turns over.
 
One way of getting rid of excess liquidity is to spend it – this provides a direct boost to the economy and prices. Savers will also attempt to move money into other assets offering either higher yields or greater perceived protection from inflation. Resulting increases in asset prices lift wealth and confidence, thereby supplying an additional indirect stimulus to economic activity.
 
Recent news fits this story. Economic growth and, especially, inflation are running well ahead of Bank of England and consensus forecasts. Current-price GDP has risen by a bumper 6% over the last year. With broad money up by only 2%, velocity has climbed 4% – the largest annual gain since 1980.
 
Further evidence of a “dash from cash” includes record retail buying of mutual funds and a decline in institutional investors’ “liquidity ratio” – the proportion of their portfolios held in money and short-term securities.
 
Meanwhile, equities, bonds, housing, commercial property, commodities, art, antiques and fine wine have all appreciated, in some cases substantially, over the last year – strongly suggestive of surplus money rather than the Governor’s mooted shortage.
 
The recent pick-up in velocity contrasts with a slump during the financial crisis as investors scrambled to reduce exposure to markets. This decline, coupled with a slowdown in money supply growth, imposed a vicious monetary squeeze on the economy, explaining the recession’s severity and justifying the first round of QE launched in March 2009.
 
Those arguing favour of further monetary stimulus now implicitly assume that the velocity rise will slow sharply or reverse. The shift in financial behaviour, however, may be at an early stage, with many families and companies yet to take on board the MPC’s message – reinforced by the Bank’s Deputy Governor, Charles Bean, in a recent interview – that monetary savers should expect to suffer a sustained erosion of their real wealth.
 
In the 1970s, when interest rates were last held beneath inflation for a sustained period, broad money velocity rose by 39% over six years, or almost 6% a year. If such an increase were repeated now, the current 2% rate of broad money expansion would deliver a large inflation overshoot.
 
More QE, therefore, would be dangerous. Money supply trends may be starting to improve, with annual growth up from 1% in the summer. A further QE injection could have more powerful effects than last year, when additional liquidity was partly absorbed by capital-raising by banks. It could increase surplus money in the economy, resulting in higher inflation and new asset price bubbles.
 
Rather than further stimulus, the Governor and his colleagues should be discussing restoring positive real interest rates to reflect the normalisation of economic and monetary conditions. An increase would help rebuild the MPC’s tattered inflation-fighting credibility as well as promoting necessary economic balancing. The Governor should take away the punch bowl instead of threatening to spike the cocktail and turn up the party music.

An edited version of this article appeared in today’s Daily Telegraph.

The latest monetary statistics are consistent with a continuing business-led recovery but economic growth is likely to moderate from its recent strong pace:

• Broad money (i.e. M4 excluding intermediate other financial corporations) rose by 2.0% in the year to September and by 2.6% annualised during the third quarter. Growth remains slow by recent standards but must be assessed against a rising trend in velocity – up by about 4% over the last year versus an average decline of 0.5% per annum over the last half-century. (Note: monthly broad money figures show a rise of only 0.3% annualised in the three months to September but the Bank is reviewing its seasonal adjustments and recommends focusing on quarterly data.)

• Within broad money, holdings of private non-financial corporations rose by an annual 5.2% in September, up from 3.4% in June. With companies continuing to repay debt, the corporate liquidity ratio – sterling and foreign currency deposits divided by bank borrowing – reached its highest level since the second quarter of 2007. Excluding the property sector, the liquidity ratio is at a new record in data extending back to 1998 – see chart.

• Money holdings of households rose by an annual 2.8%, down from 3.0% in June. Growth continues to be restrained by a portfolio shift into mutual funds: net retail buying of unit trusts and OEICs totalled £25.3 billion in the 12 months to August, equivalent to 2.5% of household broad money (September figures are released next week). The recent slowdown may partly reflect a fall in the saving ratio.

• While nominal broad money trends remain satisfactory, faster price increases – due to the coming VAT hike and rising food and energy costs – may act as a drag on real expansion, implying less monetary stimulus for economic growth. Narrow money trends may be signalling a peak in economic momentum: annual M1 expansion slowed from 8.3% in June to 2.6% in September, although this partly reflects an unfavourable base effect and may prove temporary.

• Overseas investors bought a further £8.5 billion of gilts in September, bringing the year-to-date total to £62.7 billion – 48% of net issuance. Banks, by contrast, reduced their holdings slightly in August and September, possibly in anticipation of a “QE2” boost to their reserve positions at the Bank of England – higher reserves imply less need for gilt purchases to meet liquidity targets.

The net percentage of UK consumers expecting prices to rise at a faster pace over the next year is at a 25-month high, according to the October EU Commission consumer survey.

The net percentage reporting an increase in prices over the last 12 months also jumped and is well above its long-run average.

The forward-looking indicator usually leads swings in inflation so the latest rise is consistent with the forecast here of a pick-up in the headline CPI rate – see chart.



GDP growth of 0.8% in the third quarter should scotch any discussion of “QE2” at next week’s MPC meeting. GDP has now recovered 40% of its loss between the first quarter of 2008 and the third quarter of 2009. Even assuming that growth slows to 0.4% in the fourth quarter, GDP will increase by 1.8% in 2010 versus a consensus forecast of 1.3% at the start of the year. Relative to the previous peak, GDP is higher than at the equivalent stage of the early 1980s recession / recovery.

Other points:

• A monthly GDP estimate derived from data on services and industrial output was 0.4% above its third-quarter average in September, implying positive “carry-over” into the current quarter – see first chart.

• Sceptics will point to the significant, and unsustainable, contribution to recent growth from construction and government services. Excluding these sectors, however, output still grew by 2.6% in the year to the third quarter.

• It is wrong to assume that coming public spending cuts imply a decline in government services output. To the extent that cuts fall on transfer payments and public sector wages, there is no impact. Government services output rose by 8.8% over 1992-97 despite a 5.5 percentage point fall in the public spending share of GDP between 1992-93 and 1997-98.

• Third-quarter GDP was 3.9% below its peak level in the first quarter of 2008, compared with a maximum decline of 6.5% in the third quarter of last year. At the equivalent stage in the early 1980s (i.e. in the fourth quarter of 1981, 10 quarters after the peak in the second quarter of 1979), GDP was 4.4% lower – second chart.



Are markets too focused on prospective monetary easing in the US and, possibly, the UK, neglecting policy restriction elsewhere?

China delivered a “surprise” interest rate hike last week but, in addition, the ECB has been “tightening by stealth”. The expiry of long-term refinancing operations has resulted in a 19% contraction in the monetary base since late June, contributing to three-month Euribor moving above 1.0% versus a first-half average of below 0.7% – see first chart.

The Eurozone reduction has been the main driver of a 7% fall in the G7 monetary base over the same period. World equities have tracked the G7 base since the Fed launched “QE1” in late 2008 but a large gap has opened up recently, suggesting that markets have already priced in an additional injection of about $400 billion – second chart.

An important issue is whether the Fed chooses to sterilise the monetary base impact of the additional asset purchases it will, presumably, announce next week. “QE1” was accompanied by the introduction of the “supplementary financing programme” (SFP), under which the Treasury issues additional bills to soak up liquidity created by the Fed. The SFP has been static at $200 billion in recent months.

In a recent speech, Fed Chairman Bernanke referred to asset purchases providing stimulus by lowering longer-term interest rates rather than boosting the monetary base, suggesting that he would be comfortable with a fully- or partially-sterilised operation. A “QE2” initiative accompanied by an increase in the SFP would probably deliver less “bang for the buck” in terms of wider market impact. 

Several MPC members not previously known for their devotion to monetary analysis have cited weak broad money supply growth as a reason for expecting inflation to fall below target over the medium term, a prospect warranting consideration of “QE2” asset purchases. The implications, however, of a given rate of monetary expansion for the real economy and inflation depend on the velocity of circulation. The claim that money growth is “too weak” assumes that velocity will be stable or decline but it has risen strongly over the last year and there are grounds for believing that this pick-up will continue.
 
Velocity is defined as current-price GDP divided by the stock of money; it represents the flow of income supported by each unit of cash. Since the start of quarterly data in 1963, broad money* velocity has fallen by 0.5% per annum (pa) on average – see chart. To support sustainable real economic growth of about 2.5% pa with 2% inflation, monetary expansion and the change in velocity must sum to about 4.5% pa. If velocity were to decline at its historical rate of 0.5% pa, this would require an increase in broad money of 5% pa. Put differently, sustained growth at the recent slow pace – 1.6% in the year to August – would support a rise in current-price GDP of only about 1% pa, suggesting renewed economic contraction or a big inflation undershoot.
 
Velocity movements, however, are not fixed or “exogenous” but vary depending on the relative attraction of money as a store of savings. When interest rates on bank deposits fall beneath inflation, as at present, consumers and companies have a strong incentive to economise on cash holdings. This boosts current-price GDP both directly as part of the monetary “excess” is spent on goods and services and indirectly as purchases of other assets push up prices, leading to expansionary wealth and confidence effects. The combination of higher GDP and lower money holdings, of course, is reflected in a rise in velocity.
 
Recent economic and financial trends are consistent with such a process being under way. Current-price GDP rose by a stronger-than-expected 5.7% in the year to the second quarter; with broad money up by only 1.4% in the year to June, velocity surged by 4.3% – the largest annual gain since 1980. Other evidence of a “dash from cash” includes record retail sales of mutual funds, a decline in the “liquidity ratio” of insurance companies and pension funds (i.e. the proportion of portfolios held in money and short-term securities) and generalised strength in asset prices, with equities, bonds, commodities, houses and commercial property all appreciating over the last year.
 
The view that current monetary growth is “too weak” implicitly assumes that the rise in velocity will slow sharply or reverse but it is more likely that the financial shift is still at an early stage, with many consumers and institutions yet to take on board the MPC’s message – delivered most recently by Deputy Governor Bean – that monetary savers should expect to suffer a sustained depreciation of their real wealth. When real interest rates were last significantly negative in the 1970s, broad money velocity rose by 39% over six years, or 5.6% pa – see chart. If such an increase were repeated now, money growth of 1-2% pa would deliver a large inflation overshoot.
 
The MPC’s born-again “monetarists” talking up QE2 are playing a dangerous game. Broad money has been rising faster recently – by 4.5% annualised in the three months to August. With banks in better shape, asset purchases could have a much larger monetary impact than in 2009, when cash injections were partly absorbed by capital issues. Combined with the rising trend in velocity, this suggests that QE2 on any significant scale would lead to a further acceleration of current-price GDP expansion, entrenching and possibly extending the recent inflation overshoot.

* “Broad money” here refers to the Bank of England’s preferred aggregate M4ex (i.e. excluding money holdings of “intermediate other financial corporations”) from its inception in 1998 and M4 for earlier years; quarterly growth rates were chain-linked to derive a break-adjusted level series.

A post in July drew attention to a reacceleration of G7 real narrow money, M1, suggesting that this would be followed by a rebound in global industrial momentum at the end of 2010 after an extended “soft patch”. This revival, it was argued, would be foreshadowed by an improvement in leading indicators in the autumn.

An update last week noted that the pick-up in real M1 had been sustained while the decline in the OECD’s G7 leading index was losing momentum, consistent with an imminent bottom.

Business surveys this week provide further evidence that industrial weakness may be abating. In the US, the future new orders balance in the Philadelphia manufacturing survey jumped to a five-month high in October; this usually leads the national Institute for Supply Management new orders index – see first chart. The Eurozone “flash” purchasing managers survey for October also reported a rise in manufacturing new orders while, in the UK, CBI industrial output expectations strengthened significantly.

The improvement in surveys tallies with a rise in the net proportion of equity analysts upgrading forecasts for company earnings (i.e. the earnings revisions ratio) – second chart.

Against this encouraging backdrop, the Federal Reserve and its local incarnation, the Bank of England, are threatening to lob a monkey-wrench into the economic machinery by embarking on substantial “QE2” asset purchases.  Since growth is not currently constrained by a shortage of money, such an initiative would probably feed directly into prices – either of assets or goods and services.

A key risk is that additional liquidity fuels further commodity price gains, squeezing real incomes in consuming countries and forcing monetary policy tightening in overheating emerging economies; China’s “surprise” interest rate rise this week may be a harbinger. Such adverse effects could, in the worst case, abort the incipient global industrial pick-up.

Similarities may be drawn with late 2007, when “pre-emptive” Fed interest rate cuts sent oil prices through the roof, thereby nailing down the coffin lid of the US consumer and removing any remaining possibility of the economy avoiding a recession.

There was little macroeconomic “news” in the Spending Review.

The Chancellor confirmed the current expenditure totals set out in the June Budget. By cutting a further £7.0 billion from the welfare budget and finding other savings of £3.5 billion, however, he was able to moderate the squeeze on departmental current spending, which will be £10.3 billion higher than previously announced by 2014-15.

There is also a small rise in capital spending relative to previous plans, of £2.3 billion by 2014-15. The investment outlook, however, is still grim, with a real-terms fall of 39% between 2009-10 and 2014-15.

“Total managed expenditure” (TME) – current plus capital spending – is projected to peak this year and fall by 3.3% in real terms by 2014-15. Contrary to popular assertion, such a decline is not unprecedented – following the IMF rescue in 1976, real TME was cut by 3.9% in a single year in 1977-78.

As a proportion of GDP, TME will fall from a peak of 47.5% in 2009-10 to 41.0% by 2014-15 – a cut of 6.5 percentage points over five years. This also has historical precedent: the TME share declined by 6.5 percentage points in five years from a peak in 1982-83 and by 5.5 percentage points in five years from 1992-93 – see chart.

A projected 1.2% real-terms reduction in TME in 2011-12, equivalent to about £8 billion, is unlikely to derail the economic recovery. A much greater threat is posed by previously-announced tax measures designed to raise nearly £20 billion next year – see previous post.

Public sector net borrowing excluding the temporary impact of financial interventions (PSNB ex) rose to £16.2 billion in September from £15.5 billion a year earlier. Incorporating a £0.7 billion downward revision to earlier months in 2010-11, however, borrowing still looks on course to undershoot the Office for Budget Responsibility’s (OBR) full-year forecast of £149 billion.

The chart shows a crude attempt to adjust the monthly numbers for seasonal variation: adjusted borrowing averaged £11.75 billion in the first six months of the fiscal year, or £141 billion annualised – see chart. The OBR forecast, therefore, implies renewed deterioration over the remainder of 2010-11. This is unlikely because the benefits of economic recovery should grow as the year progresses while much of the £8.1 billion of spending cuts and tax rises announced since the election has yet to take effect.

Central government current expenditure rose by 6.8% in the six months to September from a year earlier, above the OBR’s projection of full-year growth of 5.6%. This was more than offset, however, by a 9.2% increase in current receipts, versus a 6.5% full-year forecast.

The figures also indicate that capital spending has yet to be reined back. Public sector net investment was little changed in the six months to September from a year earlier, implying a drastic cut over the remainder of 2010-11 to achieve the OBR projection of a 21% full-year reduction.

The expenditure cuts to be spelt out in tomorrow’s Spending Review will be criticised for endangering the economic recovery. In reality, coming tax increases pose a much greater threat to growth next year.

The Treasury claims that 77% of planned fiscal consolidation between 2009-10 and 2015-16 will occur via expenditure restraint rather than higher taxes. The proportion, however, is lower in the early years – only 57% by 2011-12. This is because spending cuts are being phased in while tax rises are front-loaded.

The Treasury’s estimate of the split, moreover, may be questioned. Expressed at constant (i.e. 2011-12) prices, total managed expenditure is projected to fall by just £2 billion between 2009-10 and 2011-12 versus a £45 billion increase in current receipts  – see chart. This suggests that taxes will bear 96% of the burden of adjustment by 2011-12 rather than the 43% claimed by the Treasury.

Tax increases announced by either the coalition or the previous Labour government (since the 2008 Pre-Budget Report), with estimates of the 2011-12 yield in brackets, include:

• Rise in national insurance rates offset by higher thresholds / new business relief from April 2011 (£2.6 billion)

• Restrictions on pensions tax relief from April 2011 (£0.6 billion based on previous government’s proposals, rising to £4.0 billion in 2012-13)

• Rise in main VAT rate to 20% from January 2011 (£12.1 billion)

• Rise in insurance premium tax from January 2011 (£0.5 billion)

• Bank levy from January 2011 (£1.2 billion)

• Rise in higher-rate capital gains tax to 28% from June 2010 (£0.7 billion)

• Additional 50% higher income tax rate from April 2010 (£3.1 billion, up from £1.3 billion in 2010-11)

• Withdrawal of personal allowance from £100,000 from April 2010 (£1.5 billion, up from £0.9 billion in 2010-11)

These increases dwarf the planned £1,000 rise in the personal allowance (costing £3.5 billion in 2011-12) and a phased reduction in corporation tax (£0.4 billion, rising to £1.2 billion in 2012-13).