Category: Money Moves Markets

Budget forecasts imply that public spending (“total managed expenditure”) will fall from 48.1% of GDP in 2010-11 to 42.3% in 2014-15. The consensus view is that a cut-back on this scale will cripple economic growth and entail huge public-sector job cuts. Evidence from the 1990s suggests otherwise.

TME fell from 42.5% of GDP in 1994-95 to 37.2% in 1998-99 – a 5.3 percentage point reduction over four years versus the 5.8 pp cut envisaged by current plans. GDP growth averaged 3.3% per annum over 1995-99. This resilience, moreover, did not reflect offsetting monetary policy loosening – Bank rate was little changed between the start and end of the period.

Pessimists claim that public-sector jobs were slashed. They cite Labour Force Survey statistics showing that public-sector employment fell from a peak of 6.01 million in 1991 to a trough of 5.16 million in 1997, a reduction of 840,000. These numbers, however, are misleading because they fail to adjust for privatisations and outsourcing. An alternative measure unaffected by public-to-private-sector transfers is the Workforce jobs series covering public administration, education and health. This fell by only 130,000 – see first chart.

Rather than slashing jobs, the pay bill was contained by limiting wage rises. Public-sector earnings growth lagged inflation and was much lower than in the private sector – second chart.

Minimising the pain of fiscal adjustment requires policies to promote offsetting private-sector expansion. Rather than spending cut-backs, the key risks currently are tax rises that damage incentives to work and invest and excessive financial regulation that restricts credit supply needed for a sustained economic recovery.

Avoidance of a Greek default requires not only a large expansion of the proposed official aid package but also a commitment by the ECB that it will continue to lend to banks against Greek government debt in unlimited size even if other credit agencies follow S&P in downgrading its rating to junk. A run on the Greek banking system is already under way and will accelerate without this commitment.

In an article in Monday’s Wall Street Journal, Daniel Gros of the Centre for European Policy Studies suggested that Greece could default without abandoning the euro. Greek banks would lose access to ECB support and the country’s status “would resemble that of Montenegro, which adopted the euro as legal tender without officially being a member of the single currency zone”. According to Mr. Gros, “the spanner in the works would … be contagion”, with default likely to “trigger speculative attacks on government debt and financial institutions in systematic countries like Spain and Italy”.

In reality, any government attempting to default without simultaneously exiting EMU would be unlikely to survive. Greek banks would become insolvent, as Mr. Gros acknowledges, and could not be bailed out by a bankrupt government. Bank depositors would suffer large losses, while credit would freeze. A resulting economic collapse would undermine any post-default fiscal reconstruction plan.

The only viable escape-route would be EMU exit and recreation of a national currency, which the central bank could then print and use to recapitalise the banking system – the policy approach of the UK authorities during the financial crisis. The new currency, of course, would trade at a large discount to the euro but the aim of its creation would be to provide the means to rescue the monetary system rather than boost the economy via an improvement in Greek competitiveness – the initial devaluation benefit would probably dissipate rapidly in rising prices.

The Bank of Canada last week became the first G7 central bank to signal policy tightening by abandoning its “conditional commitment” to maintain the overnight interest rate target at 0.25% until mid-year. This surprised economists but had been foreshadowed by a recent rise in short-term bond yields – see first chart.

The consensus view is that Canada represents a special case because of its healthier banks and budget finances. Policy-makers in other G7 economies, it is argued, will be slower to tighten because growth will be constrained by restricted credit supply and fiscal tightening.

The differences, in fact, are not so great. Loan officer surveys suggest a similar improvement in credit conditions in Canada and the rest of the G7 – second chart. Canada’s fiscal position is better but it is still running a structural deficit of more than 3% of GDP, according to the OECD. Other G7 countries, moreover, are hoping to delay wielding the axe until 2011 or beyond. The Bank of Canada, like other G7 central banks, believes that domestic economic slack is substantial. With core inflation below target and the exchange rate strengthening, policy tightening is arguably less urgent than in the UK, where the Bank of England is losing control of inflationary expectations.
 
This suggests that either other G7 central banks will soon follow the Canadian lead or else the Bank of Canada will be forced to backtrack, perhaps because of a surging currency. A rise last week in US and UK short-term bond yields is consistent with the former scenario – first chart – but a policy shift could be delayed if the Eurozone debt crisis continues to escalate.

The US monetary base, comprising currency in circulation and banks’ reserve balances at the Fed, contracted by a further 1.4% in the week to Wednesday and is now 7.3% below its February peak – see chart.

As previously discussed, the fall reflects a build-up of cash in the Treasury’s accounts at the Fed, mainly due the “supplementary financing programme” (SFP), involving the Treasury issuing additional bills and depositing the proceeds at the central bank. The resulting reduction in bank reserves has contributed to a recent firming of short-term market rates.

The liquidity withdrawal suggests that the Fed is in the early stages of a tightening process that could result in a rise in official rates this summer. If so, the statement issued after next week’s policy-setting meeting should be less dovish, qualifying the commitment to “exceptionally low levels of the federal funds rate for an extended period”.

The SFP is now up to the targeted $200 billion, implying no further negative impact on the monetary base. If the Fed wishes to continue to drain liquidity, it must either request an expansion of the programme or begin to conduct reverse repo operations or auctions of term deposits, as described in a February speech about exit strategy by Chairman Bernanke.

GDP is provisionally estimated to have risen by only 0.2% in the first quarter but this is likely to be revised up, as were the prior three quarters – fourth-quarter growth was raised from an original 0.1% to 0.4%.

The current estimate is overly reliant on data for January and February, when the economy was hit by bad weather. National Statistics has assumed that GDP rose by 0.3% between February and March – see chart – but this may underestimate the catch-up effect. An upward revision is also suggested by labour market data and business surveys, showing a further rise in capacity utilisation last quarter.

GDP is currently estimated to have been 0.3% lower than in the first quarter of 2009 but this decline is explained by lower North Sea production – gross value added excluding oil and gas extraction was up by 0.1%, the first annual gain since the third quarter of 2008.

Previous posts have suggested that the Bank of England has adopted a looser interpretation of its remit in order to justify maintaining its current policy stance despite a significant inflation overshoot (“inflation targeting lite”). This is based partly on statistical analysis of the Bank’s historical “reaction function” – the “MPC-ometer” model indicates that several Committee members should already have voted to tighten, if the “old” rules still applied. (The model, however, has yet to forecast a majority vote for restriction.)

The suggested shift is also consistent with a speech by the Bank’s Governor Mervyn King in January, in which he appeared to downplay the “official” inflation measure in favour of a loosely-defined core concept excluding “temporary price level factors”. Core inflation, he argued, would be determined by the “output gap” and broad money growth, both of which were giving a reassuring message. (The view here is that slow M4 expansion is not disinflationary because negative real interest rates have cut the demand to hold money.)

This raises the possibility that the Bank will seek to formalise its policy shift by requesting that the new government change its remit to specify a core inflation measure as the operational target, similar to the Canadian approach. The obvious candidate measure would be the consumer price index excluding energy, food, alcohol and tobacco – this omits most of the impact of commodity price and excise duty changes (not air passenger duty) and could be further adjusted for future VAT shifts. (It does not, however, fully exclude the effect of exchange rate fluctuations, which – bizarrely – Governor King suggested should also be discounted in policy-setting.)

Against a background of likely continuing upward pressure on commodity prices and indirect taxes due to strong trend emerging-world growth and necessary fiscal retrenchment respectively, such a change would represent a de facto raising of the inflation target. Over the last five years, core consumer prices on the above definition have risen by 0.9% per annum less than the headline CPI.

A remit change is hardly likely to be resisted by politicians keen to preserve low interest rates in order to ease the perceived pain of fiscal tightening and minimise debt service costs. The possibility of such a development may partly explain the sharp rise in market inflation expectations discussed in prior posts – see the chart in Tuesday’s inflation comment – and belatedly acknowledged in the April MPC minutes.

The recent “stealth tightening” by the Federal Reserve – removing reserves from the banking system in order to push the Fed funds rate towards the top of the 0-0.25% target band – is probably a response to stronger-than-expected economic news and associated evidence of rising capacity strains.

A measure of supply bottlenecks that has correlated with Fed policy shifts historically is the Institute for Supply Management (ISM) manufacturing “vendor deliveries index”, based on the net percentage of firms reporting lengthening delivery times (a reading of 50 indicates balanced responses). This surged to 65 in March – the highest since June 2004.

The index has reached the current level on 12 prior occasions since 1950 (instances separated by less than year are counted as a single occurrence). Every case was associated with a significant rise in official interest rates – see chart. In the last cycle, the index rose above 65 in March 2004; the Fed embarked on a long series of rate hikes in June.

The Bank of England’s fantasy forecast of a decline in annual CPI inflation to about 1% in early 2011 looks even less credible in the wake of March numbers showing an unexpectedly large rise from 3.0% to 3.4%. The increase partly reflected strength in energy and food prices but “core” inflation also firmed – the CPI excluding energy, food, alcohol and tobacco rose an annual 3.0%, up from 2.9% in February.

The significant overshoot of the 2% target cannot be attributed simply to January’s VAT hike. Assuming 50% pass-through of tax changes, CPI inflation would stand at about 2.5% if VAT and duty rates had been held constant over the last year. (This estimate is derived by averaging the annual increases in the headline CPI and the CPI at constant tax rates, which is calculated assuming 100% pass-through.)

The headline rate may rise again in April, possibly exceeding January’s 3.5% high. Budget-announced duty increases are officially estimated to add 0.18% to the CPI versus 0.08% in April 2009, while the monthly rise in core prices was unusually low in April last year, implying an unfavourable base effect. The Bank will be forced yet again to raise its near-term forecast in the May Inflation Report – the February Report projected a second-quarter average of 2.8-2.9%.

Continued core inflation stickiness reflects residual exchange rate effects and a revival in pricing power as the recovery has gained momentum. Consistent with business surveys – see last month’s inflation comment – services inflation firmed from an annual 3.0% to 3.3% in March. Core goods inflation has slowed slightly, reflecting recent sterling stability, but will be underpinned by pass-through of surging input costs – already evident in producer output price numbers.

The persistent overshoot coupled with the Bank’s relaxed response have contributed to a significant rise in market inflation expectations, as implied by the yield gap between conventional and index-linked gilts. The Bank’s own estimate of 10-year-ahead implied inflation has risen by half a percentage point since the dovish February Inflation Report to its highest level since August 2008 – see chart. Early policy tightening is likely to be required to stabilise market expectations and reestablish inflation-fighting credibility.

The recent surge in the Liberal Democrats’ popularity appears to have pre-dated last Thursday’s leaders’ debate. An ICM poll conducted on Wednesday and Thursday (i.e. presumably mostly before the debate) showed support up to 27% from 20% in the previous survey over 9-11 April.

This pick-up probably reflects a favourable response to Wednesday’s manifesto launch and in particular the pledge to raise the personal income tax allowance to £10,000. Tax policies are having a significant influence on voting intentions – the Conservatives had benefited from their opposition to Labour’s planned national insurance rise but their lower-tax mantle has been stolen by the Lib Dems.

A Tory fight-back strategy, therefore, must aim to undermine the Lib Dems’ claim that most voters will benefit from their tax plans, with the £16.8 billion estimated cost of the higher personal allowance “paid for in full by closing loopholes that unfairly benefit the wealthy and polluters”. The largest offset (£5.5 billion) is from extending Labour’s restriction of pension tax relief to all higher-rate earners, not just those with gross income including pension contributions of more than £150,000. The swingeing rise in air transport taxes (£3.3 billion) will also be widely felt, as will the new levy on bank profits (£2.2 billion), which will be passed on in borrowing / saving rates. Small business owners and buy-to-let investors, meanwhile, will be hit by the equalisation of capital gains and income tax rates.

Earlier posts suggested that less optimistic voter perceptions of the economy would undermine Labour support as the election approached. There is evidence of this effect – both the EU Commission and Nationwide consumer confidence indicators fell in March – but the polls have been dominated by the swing to the Lib Dems. This, however, looks vulnerable to greater scrutiny of the party’s tax plans, as well as a less impressive performance by Mr. Clegg in the remaining debates.

Federal Reserve Chairman Ben Bernanke this week delivered a more upbeat assessment of US economic prospects while – in response to questioning – repeating the mantra that very low official rates will be needed for an “extended” period. Markets, however, may be wrong to assume that this implies no policy tightening until late 2010 at the earliest.

The Fed’s management of its balance sheet, indeed, suggests that a policy reversal has already started. The monetary base – currency plus banks’ reserve balances at the Fed – has fallen by 6.0% over the last seven weeks. This reflects the impact of the “supplementary financing programme” (SFP) under which the Treasury issues additional bills and deposits the proceeds in its account at the Fed, resulting in a reduction in bank reserves.

Monetary base movements have recently led equity market fluctuations – see Andy Kessler’s Wall Street Journal article and the first chart below.

The SFP is now up to $175 billion of a targeted $200 billion, suggesting that its negative impact on the monetary base will abate. The Fed, however, could request a further expansion of the programme or use other methods to continue to drain reserves, such as reverse repurchase agreements or auctions of term deposits.

In an earlier speech on the Fed’s exit strategy, Chairman Bernanke suggested that the first stage of a tightening process would be a liquidity-draining operation designed to align market interest rates with the officially-set rate paid on reserve balances, currently 0.25%. The second stage would be a hike in the reserves rate. Consistent with this plan, the effective Fed funds rate has risen from a range of 0.10-0.14% in January and February to 0.20% as the monetary base has contracted – second chart.

The cautionary message for equities and other risk assets from the Fed’s apparent policy shift is reinforced by a recent cross-over of G7 annual industrial output growth above real narrow money expansion – third chart. As previously discussed, global equities have underperformed cash by 5% per annum on average since 1970 when production has outpaced real M1, outperforming by 11% pa at other times.