Category: Money Moves Markets

National accounts revisions released today confirm the earlier estimate that constant-price GDP rose by 0.3% in the first quarter to stand 0.2% lower than a year before. The new figures, however, contain important changes in other aspects of the accounts:

• Current-price GDP is now estimated to have grown by 2.7% in the year to the first quarter versus 3.3% before, reflecting a downward revision to the rise in the deflator. This appears to weaken the argument made by the MPC’s Andrew Sentance, among others, that current high consumer price inflation partly reflects a solid rebound in money GDP. On closer inspection, however, the revision is concentrated in the second quarter of 2009 and the new figures still show a significant acceleration in nominal expansion more recently, with current-price GDP rising at an annualised rate of 5.5% in the three quarters to this year’s first quarter.

• Domestic demand was stronger than previously thought in the latest quarter and over the last year, with net exports correspondingly weaker. The demand upgrade was focused on fixed investment, which is now estimated to have risen by 5.7% from a trough in the second quarter of 2009 versus 1.6% previously. Worse trade performance partly reflected changes to the export and import deflators, resulting in a smaller portion of the observed rise in export values being attributed to increased volumes, and a larger portion for imports.

• The gross operating surplus of corporations was 4.7% lower than previously estimated in the first quarter, with income reallocated to employee compensation. Partly as a result, the household saving ratio remained at a respectable 6.9% in the first quarter, little different from the long-term average and far above the norm for the last decade – see chart. This may reduce concerns about a further rise in the ratio acting as a drag on consumer spending growth.

• Constant-price GDP is now estimated to have fallen by 6.4% during the recession versus 6.2% previously. Further major revisions, however, will occur in future years, with a significant cut in the output decline possible, based on the evolution of official data after the last three recessions and the “conundrum” of recent labour market resilience.

• Even on the current vintage of data, the recession was slightly less severe than the 1979-81 contraction once adjustment is made for North Sea oil and gas output – declining recently but rising then. Constant-price gross value added excluding oil and gas fell by 6.1% between the first quarter of 2008 and the third quarter of 2009 compared with a 6.4% drop between the second quarter of 1979 and the first quarter of 1981.

There is growing acceptance that high UK inflation cannot be explained simply as the result of a series of adverse one-off factors, as claimed by Bank of England Governor Mervyn King in recent explanatory letters. External Monetary Policy Committee (MPC) member Andrew Sentance has linked the overshoot to a surprisingly strong recovery in nominal spending, while his colleague Adam Posen argues that inflationary expectations have become dislodged from the target. Is there a fundamental driver linking these views?

Previous posts have argued that the root cause of disappointing inflation performance has been an excess of the supply of money over the demand to hold it. An attempt by consumers and firms to eliminate this surplus has contributed to the pick-up in nominal spending; an environment of excess liquidity may also have made it easier for companies to pass on higher costs while increasing unease about inflation prospects.

Most economists with monetarist leanings have dismissed the possibility of such an imbalance because of the slow pace of broad money supply expansion in 2008-09. The surplus, however, is the result not of an excessive rise in supply but rather a fall in demand, as negative real deposit rates have encouraged investors to rebalance portfolios away from money into assets offering a higher yield and / or inflation protection.

To the extent that the possibility of a decline in money demand is acknowledged, the consensus is that this represents a one-off shift, implying no lasting economic implications. Such a view, however, is at odds with experience in the 1970s, when a fall in the ratio of money to national income was sustained for several years as the monetary authorities, as now, maintained official interest rates well below the rate of price increases.

A pick-up in money supply expansion, moreover, could now be taking over from declining demand as the key driver of surplus liquidity. The Bank’s favoured broad money measure, M4 excluding holdings of non-bank financial intermediaries, rose at an annualised rate of the 9.2% in the three months to May, the fastest since the third quarter of 2007 – see chart.

The consensus is that this pick-up will, again, prove temporary because bank lending to the private sector remains weak. Money and lending, however, can, on occasions, diverge significantly. One possibility is that the combination of Eurozone stability worries, an undervalued exchange rate and the coalition’s early action to tackle the fiscal deficit will result in a sustained inflow of foreign capital into the UK. A combined surplus on the current and non-bank capital accounts of the balance of payments will, other things being equal, expand the money supply relative to private sector lending. Recent strong foreign buying of gilts and Treasury bills could be an early indication of such an inflow.

The risk, therefore, is that the supply of money will continue to run ahead of monetary demand, with the excess sustaining faster nominal spending growth and higher inflationary expectations. The neo-Keynesian MPC is relying on fiscal tightening to slow nominal income expansion but it may simply result in a less favourable real growth / inflation split, particularly in view of the VAT rise and other tax increases planned for next year.

On this analysis, there is little prospect, on current policies, of inflation returning sustainably to target. An early rise in official interest rates is warranted, not to choke off faster money supply expansion but rather to boost demand to eliminate surplus liquidity. Higher rates would further increase the UK’s attractions to foreign investors, with an increased capital inflow likely to put upward pressure on the exchange rate and partially offset the impact of a rise in the demand to hold money on the monetary imbalance. An appreciation of sterling, however, may be needed to reverse the recent upward drift in inflationary expectations and allow a more favourable real growth / inflation division of nominal income expansion.

You don’t have to be a Keynesian to worry about the recent Budget.

There is no dispute that immediate fiscal tightening is required but the previous government’s plans already implied a fall in the “structural” current deficit from 5.3% of GDP in 2009-10 to 1.6% by 2014-15, with an additional 2.3 percentage point cut in net investment. Chancellor Osborne could have concentrated on filling in the detail of proposed spending restraint while signalling that further action would be taken to achieve his new fiscal “mandate” of current balance by the end of the parliament, i.e. in 2015-16.
 
The Budget, instead, targets a much faster adjustment and a structural current surplus of 0.8% of GDP in 2015-16, implying overachievement relative to the mandate, probably to create scope for largesse in the run-up to the next election. There is a direct link between this target and the decision to raise the standard VAT rate from 17.5% to 20% from January 2011 – 0.8% of GDP implies a cash surplus of £15 billion in 2015-16 while the VAT hike is projected to raise £14 billion in that year.
 
The impact of fiscal tightening on growth is uncertain but there is credible evidence that tax increases inflict significantly more damage than cuts in current spending. It may be wrong, moreover, to assume that indirect tax hikes harm incentives less than rises in direct taxation: higher VAT boosts the marginal tax rate on consumed income and consumption, presumably, is the ultimate aim of most work and investment. (The 2011 VAT increase, representing a permanent change, should have a much larger economic impact than the recent rise, which reversed a temporary cut.)
 
The Chancellor estimates that expenditure reductions will account for 77% of total consolidation by 2015-16 but the proportion is smaller in earlier years – only 57% by 2011-12. The VAT hike and tax rises announced by the previous government are projected to raise £14 billion, equivalent to 0.9% of GDP, next year. Early spending cuts, moreover, are focused not on current outlays but rather investment – projected to fall by 16% and 20% in real terms in 2010-11 and 2011-12 respectively.
 
Fiscal risks to growth, however, do not imply that the Monetary Policy Committee (MPC) should refrain from normalising interest rates, if it is serious about meeting the inflation target. MPC member Adam Posen recently argued that the current overshoot partly reflects an “unanchoring of inflation expectations”; these may be further destabilised by the coming VAT hike. Until the Bank acts to reverse this drift, high inflation may continue to coexist with a sluggish economy.

The relationship between the US monetary base (i.e. currency plus bank reserves) and equities identified by Andy Kessler and discussed in previous posts remains intact. The fall in the US market from a temporary rally peak in mid June followed a renewed decline in the monetary base starting about a month earlier, continuing last week – see chart.

The Eurozone monetary base, meanwhile, will have contracted significantly last week as banks repaid ECB loans – figures are released on Wednesday.

Recent US dollar weakness may partly reflect expectations that the Federal Reserve will respond to rising financial / economic risks by reinjecting reserves. One possibility is a suspension of the “supplementary financing program” (SFP) under which the Treasury has issued an additional $200 billion of Treasury bills and onlent the proceeds to the Fed. The SFP was the main reason for the contraction in the monetary base between late February and early May. A reversal would involve the central bank creating new bank reserves to repay the Treasury and, in turn, bill investors.

Caution, however, remains warranted until such a policy change is confirmed.

Recent stock market weakness was signalled by a rise in G7 annual industrial output growth above real narrow money, M1, expansion in February. Since 1969, world equities have underperformed US dollar cash by 5% per annum on average when output has grown more strongly than real M1, while outperforming by 11% pa when there has been “excess” money – see charts and earlier post for more discussion.

Between the end of March, when the February output / real money growth cross-over was known, and the end of June, equities underperformed cash by 13% (not annualised).

Based on partial data, G7 industrial output growth was an annual 10% in May versus a 5% increase in real M1. Equities may struggle to mount a sustained rally until this gap closes.

G7 output momentum has been expected to slow during the second half, based on monetary trends and history. This prospect has been confirmed by recent softer business surveys. A “soft landing” scenario might involve annual industrial growth moving down to below 5% by year-end.

If annual real M1 expansion were to stabilise at 5%, therefore, the money / output relationship could generate another “buy” signal in late 2010.

A “double dip”, of course, would hasten a new cross-over of industrial growth beneath real money expansion. In this scenario, however, “excess” money would probably flow into high-grade bonds and other “safe havens” rather than equities, which would suffer from earnings weakness. (A temporary slowdown rather than a double dip will remain the central case here unless real M1 contracts.)

Markets were relieved that banks bid for “only” €132 billion at the ECB’s latest three-month refinancing operation today, suggesting that funding pressures are less acute than feared (although that conclusion is provisional pending the results of tomorrow’s special six-day operation).

A corollary, however, of the low take-up is that the monetary base (i.e. currency plus banks’ current account and deposit facility reserves) is likely to fall significantly when the ECB’s €442 billion 12-month facility matures tomorrow. The magnitude of the decline will depend on the six-day operation, among other factors, but could be as much as €250 billion – equivalent to 19% of the monetary base as of the end of last week.

Such a decline would probably put upward pressure on market interest rates – see chart – and would be a further reason for caution about near-term equity market prospects, given the recent strong correlation between the monetary base and stocks in the US discussed in several prior posts.

The Bank of England’s favoured broad money measure – M4 excluding deposits held by non-bank financial intermediaries – continued to strengthen in May, arguing against an extension of official gilt-buying. Broad money has surged at a 9.2% annualised rate over the last three months.

Sectoral detail shows that recent growth has been focused on financial institutions – M4 held by households and non-financial corporations rose by 1.5% annualised in the three months to May. Financial money, however, is likely to be transferred to other sectors (e.g. to non-financial firms via purchases of new issues of equities and bonds).

The broad money pick-up is encouraging but narrow money, M1, has recently been a better guide to economic prospects. M1 contracted as the economy entered recession in mid 2008 but recovered strongly in mid 2009, presaging GDP expansion late last year – see first chart. Annual growth has stabilised, consistent with a continuing economic upswing.

The corporate liquidity ratio (i.e. non-financial firms’ sterling and foreign currency deposits divided by their bank borrowing) is little changed since March but remains well above its early 2009 low, supporting hopes of a revival in business investment and hiring – second chart.

In terms of the “credit counterparts” arithmetic, the pick-up in the Bank’s M4 measure since gilt-buying ended in January mainly reflects a larger offsetting swing in “sterling net non-deposit liabilities”. Banks, in other words, had been funding assets through capital issues and longer-term borrowing but have switched to deposit financing more recently.

Reflecting capital flight from the Eurozone, foreign purchases of gilts and Treasury bills were again strong in May at a combined £7.1 billion, though down from £14.9 billion and £18.7 billion respectively in April and March.

Respected fund manager / economist John Hussman argues that the US is entering a “double dip” on the basis of four criteria that, in combination, have identified the last seven recessions (at least). Hussman used the approach in late 2007 to anticipate the 2008-09 contraction.

The criteria are:

1. Wider credit spreads than six months ago.
2. A moderate or flat yield curve, defined as a yield gap of no more than 3.1 percentage points between 10-year Treasury bonds and three-month Treasury bills (currently 2.9).
3. A lower stock market than six months ago, as measured by the S&P 500 index.
4. A manufacturing purchasing managers’ index (PMI) at or below 54 coupled with non-farm employment growth of less than an annual 1.3%.

The PMI condition in the fourth criterion has yet to be fulfilled but Hussman argues that this is likely based on recent weakness in the weekly leading index (WLI) compiled by the Economic Cycle Research Institute (ECRI). Indeed, the WLI can be used instead of the PMI and yields nearly identical historical results, with the criterion already met.

Are there any reasons for thinking that “this time could be different”?

One doubt concerns the employment condition in the fourth criterion. In the last seven recessions, the annual growth rate fell beneath 1.3% from above. Employment is currently still lower than a year ago. Is a recovery in growth to above the critical level necessary before a new recession signal can be generated?

In earlier work, moreover, Hussman used a slightly different formulation, with a simpler fourth criterion – a manufacturing PMI of below 50 – and a lower critical value of 2.5 percentage points for the 10-year / three-month Treasury yield gap in the second criterion. Both formulations signalled the recent recession but only the modified version is currently giving a warning. Hussman, presumably, would argue that the new model is superior and provides more of a lead; the old version is likely to follow in due course.

The view here has been that narrow money trends are not yet weak enough to suggest a second recession. The chart shows a US real money measure that has weakened ahead of 10 of the 11 recessions since the second world war, the exception being the 1953-54 downturn, which was triggered by a large fall in government spending following the end of the Korean war. The measure has continued to rise recently, albeit at a slowing pace.

US fiscal policy is scheduled to tighten significantly in 2011 but it is doubtful that the economic impact will be as great as the post-Korean-war cuts – government spending on goods and services fell by a real 6.8% in calendar 1954, cutting 1.64 percentage points directly from GDP.

The UK’s inflation performance appears to compare unfavourably with the US – “official” consumer price indices rose by 3.7% and 2.2% respectively in the year to April. The gap, however, largely disappears if US inflation is recalculated using the European Union’s “harmonized index of consumer prices” (HICP) methodology. US HICP inflation was an annual 3.5% in April.

The US figure comes from a table of international HICP inflation rates published each month by the US Bureau of Labor Statistics. The UK and US April annual rates of 3.7% and 3.5% compare with 1.5% in the Eurozone and -1.4% in Japan. Similar UK and US inflation experience could reflect identical monetary policy strategies, involving large-scale “quantitative easing” and currency depreciation.

A key difference between the official US consumer price index (CPI) and the HICP is that the latter excludes owner-occupied housing costs, of which the most important component is “owners’ equivalent rent” (OER) – a notional payment by homeowners to themselves for accommodation. OER has a 25% weight in the CPI basket and is estimated – based on market rents – to have fallen over the last year, exerting a major drag on official inflation measures.

It is debatable whether OER, involving no cash transaction, should be a component of the CPI basket. An implication of its inclusion is that homeowners’ financial position has improved as a result of the recent decline in rents, even though this fall is a lagged consequence of a housing market slump that has slashed the value of their properties – by 32% from peak to trough according to the Case-Shiller house price index.

US “core” inflation (i.e. excluding food and energy) would also be significantly higher using the HICP methodology. A back-of-the-envelope calculation based on the CPI / HICP inflation gap adjusting for the larger weight of OER (32%) in the core basket suggests an April annual rate of about 2% versus an official 0.9%.

The lower official measure, heavily reliant on OER weakness, is helping the Federal Reserve to justify sustaining its super-loose monetary stance and encouraging claims that the US stands on the brink of deflation. The Fed would face a tougher task if required, like the Bank of England, to evaluate inflation performance using the HICP.

It would be understandable if some Monetary Policy Committee (MPC) members felt wary about the Osborne-King deal, under which the Chancellor believes he has bought off interest rate rises by acceding to the Governor’s demands for accelerated fiscal tightening while transferring supervisory powers to the Bank, including new “macro-prudential” tools to be wielded by a rival Financial Policy Committee. They might, in addition, be uncomfortable with Mr. King’s unilateral reinterpretation of the MPC’s target as “2% inflation at some point in the future excluding the impact of temporary factors and ignoring any price-level overshoot in the interim”.

Such frustrations, perhaps, contributed to external MPC member Andrew Sentance’s surprise decision to vote for an immediate quarter-point rate hike this month, despite financial fragility in the Eurozone and the imminent emergency Budget. His view – that accelerating real and nominal growth, persistently high inflation outcomes and doubts about the dampening impact of spare capacity warrant some withdrawal of current exceptional stimulus – is shared, however, by a significant minority of economists, including the four members of the Sunday Times Shadow MPC who also favour immediate tightening (see David Smith’s blog for the minutes).

The “MPC-ometer” model – which attempts to forecast the monthly vote based on the latest economic and financial indicators, with indicator weights derived from regression analysis of historical decisions – similarly predicted a three-member minority to hike this month. Yet the minutes suggest little support for Dr. Sentance’s argument, with an opposing minority even claiming that downside inflation risks have increased. The Governor, it seems, exerts an iron grip. A decision by the Chancellor to fill the external MPC vacancy with another neo-Keynesian sympathizer will seal the Osborne-King deal and confirm that the inflation-targeting regime has changed.