Category: Money Moves Markets

There is an outside chance that the MPC will surprise markets with a further slug of QE tomorrow:

• The “MPC-ometer” – a statistical model designed to predict the monthly decision based on incoming economic and financial data – has a slight easing bias, reflecting recent weakness in business and consumer surveys and low average earnings growth. The latest reading is consistent with a further £25 billion of asset purchases. (The model calibrates this to be equivalent to an 8 basis point cut in Bank rate.)

• Eight of the nine members of the Sunday Times Shadow MPC favour more QE (although two of these individuals, bizarrely, also voted for a half-point rate hike this month). The Shadow Commitee has often mirrored MPC thinking.

• Adam Posen’s decision to come out for more QE last week just ahead of the start of the October deliberations suggests that he is confident of support from other MPC members and wanted to exert pressure on waverers.

The key reason for expecting the MPC to hold back is that short-term inflation prospects have deteriorated further – a combination of high VAT pass-through, rising food and gas costs and renewed upward pressure on petrol prices could push the headline CPI rate up towards 4% over coming months. This increases the risk that more QE would boost inflationary expectations, a consideration that may weigh with the majority.

Continuing the recent run of poor inflation news, the annual rates of increase of the BRC food and non-food shop price indices firmed in September – the first chart shows the relationship with the corresponding CPI components. Higher wholesale petrol costs and the October hike in fuel duty, meanwhile, suggest a rise in the average price of a litre of unleaded back towards £1.20 – second chart.

The Bank of Japan has fired the “QE2” starting gun with the announcement of a new asset purchase programme. The details, however, are unimpressive – further study will be required before buying starts and the current intention is to purchase ¥5 trillion over 12 months, or just $5 billion per month. It is unclear, moreover, whether the monetary base impact of the programme will be sterilised.

To put the initiative into perspective, the Eurozone monetary base is likely to have fallen by more than the full size of the Japanese programme last week as banks repaid 12-month borrowing from the ECB. (Figures are released tomorrow.)

Chinese monetary base figures are available only monthly with a lag but a recent rise in the one-week repo rate suggests that money market conditions have tightened.

A previous post, meanwhile, highlighted that the US monetary base had fallen to its lowest level since January.

Despite all the talk of QE2, therefore, there has been no expansion of the global supply of bank reserves. The ECB and Chinese monetary authorities probably oppose such an increase, while the Bank of Japan is a reluctant foot-dragger.

Hopes of a QE2 boost to financial markets rest full-square on the Federal Reserve and its European satellite, the Bank of England. The close ties between the two central banks were illustrated last week by MPC member Posen’s decision to break cover and call for more QE just one week after the Fed had signalled an easing bias.

Fed action is unlikely before the next scheduled meeting on 2-3 November – a long time for impatient bulls to wait. Markets buoyed by QE2 optimism may require a positive MPC “surprise” this week to sustain their recent gains.

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COMMENT:
AUTHOR: Gary_UK
EMAIL: superfurry7@gmail.com
IP: 91.111.63.125
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DATE: 10/05/2010 06:58:47 PM

Just wanted to thank you for your work. One of the most informative reads for me every day.

The Food and Agriculture Organisation food commodities price index – covering meat, dairy products, cereals, oils and fats, and sugar – rose by a further 7% in sterling terms in September, pushing annual growth up to 29% from 23% in August. This suggests upside risk to the forecast in a previous post that CPI food inflation will reach an annual 7% by late 2010 – see chart.

CPI food inflation rose from 3.0% in July to 3.9% in August. A further increase to 7% would add 0.3 percentage points to headline CPI inflation, given food’s 9.6% weight in the basket. The headline rate was 3.1% in August.

A further boost is possible via the “catering services” (i.e. restaurants and cafés) component, with a 9.8% CPI weight. A rise in annual inflation to 4% from 3.1% in August would add 0.1 percentage points to the headline CPI rate, for a total 0.4 point impact.

Petrol prices have dampened CPI inflation recently and base effects are favourable until next spring but crude oil prices are climbing again. So are wholesale gas costs – Ofgem this week suggested that domestic gas bills will rise by 13% by next spring, above the 5% increase assumed by the Bank of England in the August Inflation Report. With a 2.5% weight, this would boost the headline CPI by 0.3 percentage points.

The latest survey by the Bank’s regional agents, meanwhile, confirms earlier intelligence that most firms plan to pass on the coming VAT hike in full. The Bank estimates that this will add more than 1 percentage point to annual CPI inflation in 2011 but the effect is likely to be felt sooner as firms front-load increases.

These developments suggest significant upside risk to the Bank’s forecast that inflation will stabilise at about 3% before starting to fall next spring. A rise to 4% is possible if the various adverse effects coincide. A renewed inflation increase would make it difficult for the MPC to embark on “QE2” asset purchases; doves may wish to press their case at next week’s meeting before the window for action closes.

Chinese industrial output may be reaccelerating after a temporary slowdown. Adjusting for seasonal variation, the current and future new orders indices in the Market News International (MNI) business survey rose in September – see first chart.

The rebound has been accompanied by a pick-up in input cost and output price pressures. The MNI current and future prices received indices rose sharply this month, suggesting a reversal of the recent slowdown in producer price inflation – second chart.

The weekly food produce price index, meanwhile, continues to climb, signalling a likely further rise in CPI food inflation from an annual 7.5% in August – see previous post and third chart.

Markets have been partying in anticipation of “QE2”. Will the Chinese authorities douse the celebrations?

August monetary statistics are encouraging, suggesting a continued economic recovery and arguing against “QE2”:

• The Bank’s preferred broad money measure, M4ex (i.e. M4 excluding money holdings of “intermediate other financial corporations”), rose by a chunky 0.8% in August and has grown at a 4.5% annualised pace over the last three months.

• Within M4ex, money holdings of private non-financial corporations (PNFCs) gained 0.9%, pushing annual growth up to 5.0%. The corporate liquidity ratio – sterling and foreign currency deposits divided by borrowing – rose to its highest level since the second quarter of 2007. Excluding property companies, the liquidity ratio is close to the top of its range in recent years, supporting hopes of a further pick-up in business investment and hiring – see chart.

• M4ex lending rose by 0.3% following a 0.3% gain in July, resulting in three-month growth turning positive (0.8% annualised). This improvement mainly reflects financial-sector credit but lending to PNFCs also rose marginally in August.

• The QE2 crew will point to still-low annual growth in M4ex – 1.6% last month after 1.2% in July. They neglect that broad money velocity is rising fast – by 4.3% in the year to the second quarter, allowing nominal GDP to expand by 5.7%. When real interest rates were last negative for a sustained period in the 1970s, velocity rose by a cumulative 38.6% over six years, or 5.6% annualised. A similar trend is plausible now, suggesting that broad money expansion of 1-2% per annum is more than sufficient to finance sustainable economic growth of about 2.5% with 2% inflation.

• Monetary expansion continues to be supported by an influx of foreign funds – overseas investors bought £9.5 billion of gilts and Treasury bills in August, bringing the year-to-date total to £62.1 billion, while “monetary financial institutions’ externals” contributed £15.1 billion to the increase in M4. 

This week’s Federal Reserve policy statement raised market expectations of “QE2” asset purchases but, perversely, the Fed has allowed the monetary base – currency in circulation plus banks’ reserve balances – to contract recently. The base fell by 2.7% in the week to Wednesday to stand at its lowest level since January and 10.1% below the February peak – see chart.

The decline in the latest week reflected a rise in the Treasury’s general account balance at the Fed, which resulted in an equivalent outflow from banks’ reserves. The general account balance fluctuates as receipts from taxes and debt sales vary in relation to Treasury outlays but the Fed, in theory, can offset the impact on reserves, for example by offering banks repo loans or increasing securities purchases.

If the Fed wished to boost the monetary base ahead of any QE2 decision, it could ask the Treasury to reduce the $200 billion balance in its “supplementary financing account”. An increase in this balance was used to drain cash from banks’ reserves this spring, when the Fed was mulling an “exit strategy” – discussed in a post at the time.

The fall in the base may prove temporary but the Fed’s failure to offer resistance suggests that the internal debate has yet to be resolved in favour of further easing.

As originally discussed in a post last year and illustrated by the chart, fluctuations in the monetary base have tended to lead stock market movements since the Fed embarked on “QE1” in late 2008.

“QE2” is the wrong response to recent economic softening and, if implemented, is likely to prove counterproductive.

Some QE2 proponents claim that G7 economies are suffering from a shortage of liquidity, evidenced by slow expansion in the broad money supply. (The UK’s preferred broad money measure rose by only 1.2% in the year to July, though growth has been faster over the last six months.) An assessment of monetary adequacy, however, must take account of demand as well as supply. Money demand has been depressed by negative real interest rates, which have encouraged a large-scale portfolio shift out of deposits into other assets offering a higher yield and / or inflation protection. Record mutual fund inflows are one reflection of this adjustment.

Put differently, slow money supply expansion is being offset by a rise in the velocity of circulation. Broad money velocity rose by 4.4% in the UK in the year to the second quarter, allowing nominal GDP to expand by 5.9%. When real interest rates were last negative for a sustained period in the 1970s, velocity rose by a cumulative 38.6% over six years, or 5.6% annualised. A similar rate of increase is plausible now, suggesting that broad money expansion of 1-2% per annum is more than sufficient to finance trend economic growth of about 2.5% with 2% inflation.

Rather than inadequate monetary growth, the Federal Reserve this week cited dangerously-low inflation as a reason for considering QE2. The rise of just 0.9% in the consumer price index excluding food and energy over the last year, however, is heavily influenced by a 0.3% fall in “owners’ equivalent rent” – a theoretical sum paid by home-owners to themselves. An alternative CPI measure based on the EU’s harmonised methodology, which omits imputed rent, rose by 2.1% in the year to July, according to a comparison table produced by the Bureau of Labor Statistics.

There has been no sudden deterioration in inflation news to warrant the Fed’s heightened concern. The CPI excluding food and energy increased by an annualised 1.3% in the three months to August, above the 0.9% annual gain. The September University of Michigan consumer survey reported a mean expectation for inflation over the next five years of 3.2%, equal to the average of the last two years.

Some economists support more QE not because they think it is strictly necessary but as an “insurance policy”. This wrongly assumes that it would be costless. Additional liquidity, however, might flow into already-overheated financial markets, risking the formation of new bubbles and subsequent disruptive busts.

QE2, indeed, is probably already harming economic prospects by encouraging further speculative buying of food commodities. Recent commodity price gains suggest that G7 CPI food inflation will rise from an annual 0.9% in July to 4-5% – see chart. This would add 0.3-0.4 percentage points to headline CPI inflation, with an equivalent negative impact on consumer purchasing power. As discussed yesterday, the effects will be more serious in emerging economies.

Recoveries proceed in fits and starts and policy-makers should be cautious about attempts at “fine-tuning”, which may simply increase volatility. To the extent that policy is constraining economic expansion, proposed tax increases and their impact on confidence are of greater concern than insufficiently loose monetary conditions. In the UK, this argues for postponing or cancelling the planned VAT hike, which will pile more pressure on struggling consumers and may no longer be required given recent deficit improvement – see previous post.

Rising food prices may crimp UK consumer spending later this year but food inflation is a much bigger issue in emerging economies – the average weight of food in the CPI baskets of 120 non-OECD countries was 37% in 2006, according to a 2008 IMF study, versus 10% in the UK currently. (Food is much more important for consumers in these economies than fuel, with a 7% average weight in 2006.)

Chinese CPI food inflation rose to an annual 7.5% in August and may reach 9% by October, judging from data on edible agricultural product prices – see chart. (Product prices suggest a further increase of 1% or more in the CPI food index, which was little changed between August and October last year.) With food accounting for one-third of the CPI basket, this could push headline CPI inflation up from 3.5% currently to about 4%.

US stocks have rallied recently despite equity analysts making more downgrades to 12-month-forward company earnings estimates than upgrades. The “revisions ratio” (i.e. the difference between the numbers of upgrades and downgrades in a particular period, divided by the total number of earnings estimates) correlates with business surveys; current weakness suggests that the ISM manufacturing new orders index will fall further to around the break-even 50 level, while remaining above the 45 threshold consistent with a “double dip” – see chart.

Public sector net borrowing exceeded expectations in August but this was roughly balanced by downward revisions to earlier months in 2010-11, reflecting lower central government current expenditure and a higher yield from the bank payroll tax (now estimated at £3.5 billion versus £2.5 billion in the June Budget). Borrowing remains on course to undershoot the OBR’s full-year forecast of £149 billion by a significant margin.

Attempting to adjust for seasonal factors, borrowing excluding the temporary impact of financial interventions averaged £11.65 billion in the first five months of the fiscal year, or £140 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. Even assuming no further decline in the underlying run rate, these measures should lower full-year borrowing to £136 billion or less.

The evolving undershoot increases doubts about the wisdom of the coming VAT hike (projected to raise £12.1 billion 2011-12), especially with consumers facing a large rise in food bills this winter – food commodity prices have continued to climb recently, with the CRB spot foodstuffs index in sterling terms now 11% above its August average.