Category: Money Moves Markets

If the consumer price index is to be believed, the volume of spending by the British public on clothing and footwear is nearly three and a half times its level in 1997.

The cash value of spending rose by two-thirds between the first quarters of 1997 and 2010. According to the CPI, however, clothing and footwear prices have fallen by 51% over this period, implying an increase in the volume of spending of 243%.

The national accounts measure of the volume of spending on clothing and footwear, based on retail price rather than CPI methodology, shows a smaller rise, of 130%. This still equates to a solid 6.6% annualised rate of increase. The CPI-based measure suggests that spending volume has grown by 9.9% per annum. Absent evidence of a boom in wardrobe sales, this looks implausible.

This example highlights the significant divergence between CPI and RPI inflation caused by the former’s use of geometric rather than arithmetic means to combine price changes of individual items. Geometric means are always lower, with the shortfall increasing with dispersion among components. Proponents of the geometric approach argue that it captures “substitution” between cheaper and more expensive goods as prices changes. The arithmetic mean, however, correctly measures the changing cost of a fixed basket of products.

Clothing and footwear prices rose by 6.3% in the year to June according to the RPI but fell by 1.4% if the CPI is to be believed. The difference subtracted 0.4 percentage points from headline CPI inflation in June. This is larger than the average 0.2 pp effect over the five years to 2009, reflecting a decision this year to use more quotes for each item, with resulting wider price change dispersion further lowering geometric mean inflation relative to the arithmetic mean.

The total “formula effect” wedge between CPI and RPI inflation, incorporating differences in other index components, was 0.8 percentage points in June – see chart.

A central bank’s key responsibility is to preserve the real value of money. Consumers on fixed incomes or with fixed savings are understandably sceptical about the “substitution” argument and believe that RPI inflation is a better guide to the erosion of their purchasing power. They have been abandoned by the Bank of England, which has failed to prevent high inflation even on the weaker CPI measure. The coalition government now plans to effect a further transfer of wealth by imposing CPI- rather than RPI-linking on pensioners, benefit recipients and wage-earners.

Failure to protect the purchasing power of money reinforces the incentive to borrow rather than save and invest, thereby preventing necessary economic “rebalancing”.

The EU / IMF rescue package for Greece has failed to stem an outflow of funds from the country’s banking system, according to Bank of Greece balance sheet data.

To bridge the funding gap, the central bank was forced to boost its lending to Greek banks from €93.8 billion at the end of June to €96.2 billion at end-July. Banks, meanwhile, reduced their deposits with the Bank of Greece from €10.0 billion to €7.5 billion, resulting in a combined transfer of €4.9 billion from the central bank.

Lending support of €96.2 billion at the end of July implies that the Bank of Greece is funding about 15% of Greek banks’ assets. The ECB has acquired additional exposure to Greece, of perhaps €25 billion, via purchases of government bonds under its securities markets programme.

Lending to Greek banks now exceeds the €94.8 billion of loans extended by the Central Bank of Ireland to the Irish banking system as of the end of June. (The Irish figure is inflated by lending to foreign banks located in Dublin’s international financial services centre.)

The ongoing loss of funds may revive concerns about the stability of the Greek banking system. Banks’ ability to obtain additional ECB funding may eventually be limited by a shortage of eligible collateral.

The useful information in each Inflation Report is summarised by a single statistic – the Bank of England’s mean forecast for inflation in two years’ time based on unchanged policies. The deviation of this forecast from the 2% inflation target is a measure of the MPC’s bias to tighten or loosen policy. (The rest of the Report contains much interesting material but has rarely proved useful, based on the Bank’s forecasting record.)

The mean two-year-ahead forecast in the May Inflation Report was 2.04%, indicating that the MPC intended to maintain current policy for some time while envisaging an eventual need for very modest tightening. The projection appears to have been lowered to just below 2.0% in the August Report, judging from the fan chart (the Bank refuses to publish numbers until a week after the Report itself). The MPC, therefore, is signalling continued near-term inaction but now views further easing – presumably in the form of additional asset purchases – as marginally more likely to be necessary than any tightening.

This change has occurred despite inflation again overshooting the Bank’s forecast three months ago by a significant margin. The new fan chart suggests that inflation will average 3.0-3.1% in the current quarter, up from 2.6% projected in May. This overshoot is strong prima facie evidence that spare capacity has failed to exert the disinflationary influence expected by the Bank but the capacity argument was again wheeled out by Governor King as a favoured deus ex machina to justify his continued assertion that inflation will eventually fall back to below the target.

As widely expected, GDP growth projections for 2011 and 2012 were lowered, with the fan chart suggesting a mean forecast on unchanged policies of about 2.4% next year versus 3.1% in May (note, though, that 2010 has been revised up from 1.4% to 1.5-1.6%). However, the reasons given for the downgrade – recent weaker surveys, tighter-than-expected credit conditions and larger-scale fiscal tightening – are unconvincing. The Governor himself argued that the fiscal effect was marginal while evidence on credit conditions has been mixed – the CBI’s July survey of smaller manufacturing companies reported that the percentage of firms citing credit or finance as a constraint on output had fallen back to its long-run average.

The suspicion is that the MPC has been spooked by double-dip talk and has taken the opportunity to lower an over-optimistic previous growth forecast, with this downgrade providing a fig-leaf for maintaining the projection of a large fall in inflation over the medium term. Policy inaction can, thereby, be justified for a while longer, to the relief of Chancellor Osborne. The Bank, however, may face a rendezvous with reality later this year as the economy defies double-dip pessimism and a continued inflation overshoot leads to a further “unanchoring” of inflationary expectations.

Inflation targeting supposedly involves the Bank of England using its huge intellectual capabilities to produce a forecast for inflation one to two years ahead and then adjusting policy to minimise deviations of the forecast from the 2% objective. This procedure has become meaningless, for two reasons.

First, the Bank’s forecasts have little information content, as documented by an article in today’s Financial Times. The chart illustrates the persistent tendency to underpredict inflation in recent years.

Secondly, the MPC appears to be more exercised by the “tail risk” of deflation than a persistent inflation overshoot, although such a bias is at odds with its remit. The Committee, in effect, is setting policy to avoid a deflationary scenario rather than taking into account the full probability distribution of future inflation outcomes.

A cynical view is that the emphasis on deflationary risks is a smokescreen to allow super-low interest rates to be maintained in order to meet objectives unrelated to the inflation target, such as providing cover for fiscal policy tightening and suppressing the exchange rate in the hope of promoting “economic rebalancing”.

Against this backdrop, it would be a surprise if tomorrow’s Inflation Report failed to follow the recent pattern of revising up near-term inflation projections significantly while forecasting a fall to below the 2% target in two years’ time, with a sufficiently wide distribution around this forecast to allow MPC doves to continue to emphasise deflationary risks.

It would be even more surprising if markets reacted to the Bank’s increasingly irrelevant musings.

UK house prices are 6% overvalued, based on a comparison of the national rental yield with its historical average.

The national rental yield is derived from national accounts data by dividing the sum of actual rental payments and imputed rents of owner-occupiers by the value of the housing stock – see first chart. The yield averaged 3.6% between 1965 and 2007. (The low value partly reflects the inclusion of subsidised social housing and vacant properties.)

The house price boom pushed the rental yield below 2.8% in the third quarter of 2007, suggesting that prices were overvalued by 30%, based on the 3.6% long-run average. Current prices are 5% lower, according to the index published by the Department of Communities and Local Government, while national accounts rents have risen by 18%. The resulting 3.4% yield implies overvaluation of 6%.

Housing market bears compare house prices with earnings rather than rents. The ratio of the value of the housing stock to household disposable income is 59% above its long-run average – second chart. This average, however, is a misleading guide to “fair value” because the ratio has trended higher over time, reflecting factors such as improving quality, the pressure of an expanding population on constrained supply and a high income elasticity of demand for housing.

The national rental yield, by contrast, has fluctuated around a stable long-run level. Rents already incorporate fundamental influences on housing demand and supply. People need to live somewhere – the choice is between buying your own home or renting, not between spending money on housing or retaining income for other purposes.

The current 6% overvaluation does not imply that house prices will fall, for two reasons. First, the deviation can be corrected by rising rents – up by 7% in the year to the first quarter. Secondly, a below-average rental yield may be sustainable as long as nominal and real interest rates remain low, limiting forced selling.

(This is a follow-up to a note in May 2009, which suggested that house prices were bottoming because the rental yield had returned to its long-run average.)

Business activity of smaller manufacturing firms is not being constrained by insufficient credit, according to the July CBI SME trends survey. The accompanying press release states that: “Just 4% of firms cite credit or finance constraints as likely to limit export orders, compared with 12% in the previous quarter. This is now in line with the long-run average. Furthermore, 5% of firms say credit or finance are factors likely to act as a brake on output, also in line with the historic mean.”

The SME survey covers firms with fewer than 500 employees. The CBI’s survey of larger manufacturers in July, released a fortnight ago, also reported a normalisation of numbers citing credit availability as a constraint on output and exports – see chart.

By contrast, the last Bank of England agents’ survey stated that, while bank credit availability had improved, “conditions remained significantly tighter than those prevailing prior to the financial crisis.” Possible reasons for the discrepancy are 1) the CBI surveys are more up-to-date, 2) the Bank’s survey includes non-manufacturers, which may be experiencing greater problems and 3) the CBI improvement may reflect stronger internal cash-flow generation that has reduced the demand for external finance – credit is probably still difficult to obtain for those firms that need it most.

A post in May last year suggested that the annual rate of change of GDP would turn positive in early 2010 while the Treasury’s forecast of 1.25% growth for the year as whole was achievable. This was based on a forecasting model that estimates the annual GDP change three quarters in advance using a range of monetary and financial inputs, including inflation-adjusted broad and narrow money supply growth, companies’ liquidity ratio, three-month LIBOR, the yield spread between corporate and government bonds, share prices and the effective exchange rate. The consensus at the time was gloomier, with many economists and journalists embracing the “creditist” view that no meaningful economic recovery was possible without a revival in bank lending to the private sector. The Bank of England was also downbeat: in its May 2009 Inflation Report, the Bank’s mean forecast for the annual GDP change in the first quarter of 2010 based on unchanged policies was -1.5%. (This was the infamous Report that also projected a fall in annual consumer price inflation to below 1% while estimating only a 7% probability that inflation would be above 3% in the second quarter of 2010 – the outturn was 3.4%.)

Recent official figures largely validate the predictions of the “monetarist” model. Excluding volatile oil and gas extraction, whole-economy output rose by an annual 0.2% in the first quarter of 2010 and by 2.0% in the second quarter. Assuming that quarterly expansion slows to 0.5% during the second half of the year (and ignoring possible upward revisions to earlier estimates), GDP will increase by 1.6% for 2010 as a whole – comfortably above the Treasury’s derided 1.25% forecast. The Office for Budget Responsibility (OBR) displayed little originality in the economic projections underlying its post Budget fiscal analysis – its forecasts of GDP growth of 1.2% and 2.3% respectively in 2010 and 2011 were suspiciously close to consensus numbers of 1.2% and 2.2% reported in the Treasury’s June survey of forecasters. Stronger 2010 expansion supports the view that the OBR was too pessimistic in projecting public sector net borrowing of £149 billion in 2010-11, a conclusion also consistent with recent monthly outturns, suggesting a full-year undershoot of at least £10 billion.

Will the recovery be sustained into 2011? While the model is not forecasting a boom, it suggests annual GDP growth of 2%-2.5% in the first half of next year, with the probability of a second recession – in the sense of an annual GDP contraction – rated at less than 10%. Prospects for later in 2011 depend on whether the recent acceleration in broad money supply growth is sustained – if so, full-year GDP expansion should exceed the current 2.1% consensus expectation reported in the Treasury’s July survey. The model’s other inputs are mostly favourable: narrow money is growing solidly, corporate liquidity is strong outside the beleaguered real estate sector, credit spreads have normalised, the trade-weighted exchange rate is at a competitive level and short-term interest rates, of course, remain at a record low. To the obvious Keynesian criticism that the model omits a direct measure of fiscal policy, the responses are that, first, fiscal effects are captured indirectly via forward-looking market variables (i.e. share prices and credit spreads) and, secondly, the model is able to explain historical growth adequately without including such a measure – see charts.

Monetary statistics for June are encouraging for economic prospects in three respects. First, the broad money supply (i.e. M4 holdings of households, private non-financial corporations and financial corporations excluding intermediaries) followed up solid gains in recent months with a further 0.2% increase. While annual growth remains low at 1.2%, broad money rose at a healthy 5.2% annualised rate during the first half of the year.

Secondly, narrow money M1 – on the ECB’s definition comprising currency in circulation and overnight deposits – increased by 1.5%, pushing annual growth up to a 26-month high of 8.3%. Hardly anybody bothers to monitor M1 these days but it has proved a better leading indicator than broad money, contracting as the economy entered a recession in spring 2008 but recovering strongly in mid 2009 ahead of a GDP rebound later last year – see first chart.

Thirdly, the corporate liquidity ratio – non-financial corporations’ sterling and foreign currency deposits divided by their bank borrowing – rose again during the second quarter, continuing a recovery from a low in the first quarter of 2009, two quarters before the trough in GDP. Excluding the struggling real estate sector, the liquidity ratio is now at the top of its historical range – second chart.

Pessimists will focus on continued weakness of bank lending to the private sector, which contracted at a 1.0% rate during the first half. Last week’s news, however, that non-oil GDP rose by 2.0% in the year to the second quarter is convincing refutation of the “creditist” view embraced by many economists and journalists last year that no economic recovery would occur without a revival in lending.

Private sector lending matters more because of its implications for money creation than its direct impact on the economy. Recent lending weakness and the decision to suspend official gilt purchases in February will not prevent a continuing economic recovery because other factors have boosted broad money expansion. Specifically, banks have stepped up purchases of public sector securities (to £23.9 billion during the first half from £10.7 billion in the second half of 2009), there has been a net influx of capital to the UK (resulting in a positive contribution to monetary growth from “external and foreign currency flows”), while banks have slowed capital-raising, relying more on deposits to fund assets (reducing the negative contribution from “net non-deposit sterling liabilities”).

Recent Eurozone economic news has been stronger than expected and somewhat at odds with trends in other countries, particularly the US. This could reflect the region’s historical tendency to lag the global cycle but is also consistent with relative monetary trends.

As previously discussed, narrow money, M1, is likely to be a better guide to monetary conditions at present than broader measures, with the demand to hold broad money depressed by negative real deposit interest rates. Eurozone real M1 rose by 2.7%, or 5.5% annualised, in the six months to June, comfortably above growth rates in the US, Japan and, probably, the UK (for which June figures are published tomorrow) – see first chart. Among major developed economies, real M1 expansion is faster only in Switzerland and Canada – both economies have been growing solidly.

A post in May suggested that relatively strong M1 expansion would contribute to a reversal of the underperformance of Eurozone equity markets earlier in 2010. The region has since rallied relative to the US and Japan – second chart – although non-EMU European markets like the UK and Sweden have also performed strongly, suggesting that monetary trends are not the sole explanation.

The Dow Industrials index has rallied back to within 4% of the “six-bear average” path, based on recoveries after previous large US stock market declines – see chart and prior post for more details. This follows a 10% undershoot in early July.

The average moves sideways into the autumn; the Dow may struggle to exceed it without an improvement in liquidity indicators. (As a follow-up to yesterday’s post, the Eurozone monetary base fell again last week – the fourth consecutive decline.)