Category: Money Moves Markets

A previous post argued that a January speech by Bank of England Governor Mervyn King signalled a change in the Monetary Policy Committee’s interpretation of its remit. Instead of targeting a 2% annual rise in consumer prices “at all times”, policy-makers would focus on the Bank’s forecast for an unspecified “core” inflation measure, excluding “temporary price level factors”. The post suggested that this amounted to a de facto raising of the target from 2% to perhaps 3%.

Markets, it appears, agree that the Bank’s inflation-fighting commitment has softened. The yield gap between conventional and index-linked gilts of between five and 15 years’ maturity – a proxy for long-term market inflation expectations – has risen by 50 basis points (bp) since the February Inflation Report, which confirmed the dovish message of the Governor’s speech. US market-implied inflation expectations are little changed over the same period  – see first chart.

The UK yield spread is now 50 bp above the average over the last 10 years and at its highest since September 2008. It is above the levels reached before sustained increases in official interest rates starting in 2003 and 2006 – see second chart. With growth accelerating, asset prices buoyant and sterling raw material costs soaring, the Bank should already have started to withdraw emergency stimulus. Markets may yet force an earlier and larger rise in rates than most expect.

Combined industrial output in the G7 and seven large emerging economies (the “E7”) – a proxy for global activity – rose by a further 0.5% in February, to stand only 4% below its February 2008 peak. Output has rebounded by 12% since February last year, following a 14% peak-to-trough decline. Leading indicators signal a further solid gain into the summer – see chart.

The rise in consumer price inflation from an annual 1.1% in September to 1.5% in October marks the start of a trend that is likely to carry the headline rate above 3% in January, necessitating a sixth explanatory letter from Bank of England Governor Mervyn King to the Chancellor. Inflation should subside over the remainder of 2010 but is unlikely to fall below the 2% target, as forecast by the Bank of England in the November Inflation Report.

The headline rate continues to be flattered by last December’s VAT cut and lower energy prices than a year ago. The Office for National Statistics has estimated an effect on the headline rate from VAT and duty changes of 0.5 percentage points, suggesting that inflation would be 2.0% in October in the absence of the reduction. On the same basis, “core” inflation – excluding energy, food, alcohol and tobacco – might stand at 2.7% rather than the reported 1.8%.

Petrol prices accounted for much of the rise in headline inflation between September and October but there were also significant upward contributions from cars, flights, food, DVDs, computer games and landline telephones.

Inflation has overshot the Bank’s forecasts by an embarrassingly large margin this year. The central projection in the May Inflation Report showed the CPI headline rate falling to just 0.4% in the fourth quarter. Further increases in November and December are likely to result in an outturn of 2.0% or higher. The Bank’s forecasts have proved too low because it overestimated the impact of economic slack on core price trends while underestimating upward pressure from exchange rate depreciation and global commodity prices. There is little sign that it has learnt from its mistake, with the November Report continuing to place heavy emphasis on “output gapology” while playing down external price risks.

The RPI headline rate moved up from -1.4% to -0.8% between September and October and will rise much more sharply than CPI inflation over the next six months, reflecting house price and mortgage rate base effects. Even assuming house price stabilisation, RPI inflation is likely to reach about 4% by next spring, with higher figures obviously implied by any increase in official interest rates. Governor King last week stated that the Bank intended to “look through the short-term rise in inflation” but there is a risk that sharply higher headline rates will destabilise inflationary expectations in the absence of any policy response.

The charts update previously-presented profiles for CPI and RPI inflation taking into account October data and revised assumptions about energy and food prices. In particular, the 5% cut in household energy tariffs incorporated in the earlier forecast has been removed, in line with Bank’s assumption in the latest Inflation Report.

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COMMENT:
AUTHOR: Les Hambling
EMAIL: les.hambling@talktalk.net
IP: 212.183.140.35
URL:
DATE: 04/06/2010 03:19:23 PM

I am a retired Submariner with 27 years service in the Royal Navy. I am 58 and this year all pensions for servicemen and women have been frozen at last years rate. Coupled with this the tax changes by the government have now disadvantaged me by a decrease in monthly pension of £2.58 per month. I note that the rpi is showing a scale of around 4%. I wonder how many people in government service are receiving an increase this year. The armed services are defininately NOT.

MMM is taking an Easter break. Normal service will resume on or after 13 April.

Global industrial output – as proxied by production in the Group of Seven (G7) major economies and seven large emerging economies (the “E7”) – fell by 14% between February 2008 and February 2009. This was the largest peacetime decline since the 1930s, though comparable with a 12% fall in G7 output between May 1974 and May 1975, following the first oil shock. (G7 production is a reasonable measure of global output in the 1970s, when today’s emerging economies were much less influential.)
 
At the output trough early last year most economic forecasters – including the IMF and OECD – expected any revival in activity to be delayed and weak. As discussed in a post last May, however, this was at odds with the “Zarnowitz rule” that “deep recessions are almost always followed by steep recoveries”. Faster money supply growth, moreover, supported a more optimistic prognosis. A year on, a “V”-shaped recovery has been confirmed: G7 plus E7 output had risen by 11% from its February 2009 low by January 2010, to stand only 4% below the February 2008 peak. The recovery has been led by the E7, where output is 9% above its pre-recession peak and rising capacity strains signal a need for significant monetary policy tightening.
 
The 2008-09 output fall, as noted, resembled the 1974-75 contraction. The subsequent recoveries also look similar: G7 production had risen by 9% at the equivalent stage of the post-1975 upswing – see the first chart below. Both recessions were associated with a major shock – a four-fold oil price rise in 1974 and a financial crisis in 2008 – that caused firms to retrench aggressively. Final demand, however, proved more resilient than expected, resulting in an excessive decline in stock levels that, in turn, prompted a strong production rebound. Fiscal and monetary policies, moreover, were similar: the G7 structural budget deficit widened by 2-3% of GDP in both 1975 and 2009 while official interest rates were cut sharply to below inflation. (This contrasts with the aftermath of the second 1970s oil shock – governments eschewed a Keynesian fiscal response while official rates remained positive in real terms, contributing to a weaker upswing but lower subsequent inflation.) The current revival in G7 plus E7 output, therefore, could continue to track the post-1975 G7 recovery. As the first chart shows, this would imply further solid expansion during 2010, with production surpassing its February 2008 peak at the end of the year, but a significant slowdown in 2011. Indeed, the 2% gain between December 2010 and December 2011 suggested by the template might involve stagnant or contracting G7 industrial activity, allowing for much faster E7 trend growth.
 
This broad shape – strength for much of 2010 but a slowdown in 2011 – appears consistent with global monetary trends. Some monetary economists argue that an economic relapse is imminent because G7 real broad money is now contracting on a year-earlier basis – see the second chart. As discussed in several recent posts, however, negative real interest rates are reducing the demand to hold money by households and financial institutions so this weakness is unlikely to signal insufficient liquidity to finance an ongoing economic recovery. Supporting this interpretation, real narrow money, M1, and corporate broad money holdings – better leading indicators than aggregate broad money – are still growing solidly. M1 expansion, however, has declined since late 2009, consistent with slower economic momentum later this year, in line with the 1970s template.
 
While the economic outlook appears benign, monetary conditions are becoming less favourable for financial markets. The gap between annual G7 real M1 growth and industrial output expansion is a measure of “excess” liquidity available to flow into markets and push up prices. On average since 1970, global equities have outperformed cash by 11% per annum when money has outpaced output while underperforming by 5% pa at other times. The real M1 / output growth gap has been positive since late 2008 but is likely to reverse soon – second chart. Less exciting prospects for equities are also suggested by an analysis of historical recoveries after large bear markets. Prior to the 54% decline between October 2007 and March 2009, the US Dow Jones industrials index had fallen by 45-55% on six occasions since 1900. On average, the Dow recovered by 59% in the first year after these bear markets but by only 7% in the second year. The first-year gain in the current rally (i.e. from the trough on 9 March 2009) was close to the historical average, at 61%.
 
One reason that equities have tended to perform poorly when G7 real M1 growth has fallen beneath output expansion is that such cross-overs have been followed by a rise in short-term interest rates. There have been nine such signals since 1970; in all cases G7 short rates (i.e. a weighted average of national rates) were higher six to 12 months later. Reassured by central bankers’ rhetoric about output gaps and the economic drag from future fiscal tightening, markets are currently assuming that monetary policies will remain unusually loose for a sustained period. Such complacency is certainly misplaced in many emerging economies now on the verge of overheating. Even in the G7, likely confirmation that the recovery is spreading to labour markets will allay “double dip” concerns and increase debate about the wisdom of maintaining official rates far below both current and target inflation. The linkage of prolonged periods of negative real rates with the formation of financial bubbles and subsequent damaging busts must surely now be recognised even by the neo-Keynesian dogmatists who populate the major central banks.

Housing market bears recently encouraged by a fall in mortgage approvals and slower price gains may have to retreat to the woods, judging from the Bank of England’s first-quarter Credit Conditions Survey. The net percentage of banks expecting stronger demand for mortgages to finance house purchases rose to +40 – the highest in the survey’s three-year history and up from +3 in the fourth quarter of last year and a low of -40 in the second quarter of 2008. Softer indicators in early 2010 appear to have reflected bad weather and the temporary impact of the ending of the previous stamp duty holiday.

A majority of banks also expects a rise in demand for unsecured consumer loans and corporate credit – see first chart.

Credit supply, meanwhile, should improve, with the net percentages expecting greater availability of corporate, mortgage and unsecured consumer loans all positive, the latter for the first time since 2007 – second chart.

A previous post suggested that the recovery in house prices would follow the pattern of the early 1980s, a possibility also mooted by MPC member Andrew Sentance. Inflation-adjusted prices have actually moved ahead of the 1980s path recently – third chart. The bears’ assumption that restricted credit supply would offset the stimulus of low interest rates – supplemented now by an extension of the stamp duty holiday up to a higher threshold – looks increasingly questionable. Higher official rates may be needed to head off an overexuberant housing market.

The further upward revision to fourth-quarter GDP growth to 0.4% from an originally-reported 0.1% brings the official series into line with earlier expectations. The initial 0.1% estimate, released in late January, probably influenced the MPC members who considered expanding gilt-buying at the February meeting.

The revised figures also confirm that the fall in non-North Sea output in the recent recession was smaller than during the 1979-81 contraction. Gross value added (GVA) excluding oil and gas declined by 5.8% between the first quarter of 2008 and third quarter of 2009 versus a 6.4% drop between the second quarter of 1979 and first quarter of 1981 – see chart.

On top of the fourth-quarter upgrade, the fall in GVA excluding oil and gas in the third quarter was lowered from 0.2% to 0.1% (0.08% to two decimal places). Further revisions may show that the non-oil economy bottomed in the second rather than third quarter, as suggested by business surveys and labour market evidence.

The economic polling model discussed in prior posts suggested that the Conservative lead over Labour would fall into hung parliament territory in early 2010 but rewiden in the spring, mainly reflecting the negative impact on government popularity of a sharp increase in retail price inflation. Recent polls, showing a Tory fightback, are consistent with this “forecast”.

The model uses ICM polling data, which extends back to the early 1980s. (ICM is well-regarded, having scored a notable success at the 1997 election.) Based on recent economic data and a forecast further rise in inflation to 4.5% by April, the model suggested a Conservative / Labour lead of seven percentage points in March, rising to nine in April and 11-12 in May – probably sufficient to produce a Conservative majority.

The latest ICM poll, published in the News of the World on Sunday, reported an eight point gap, up from six points a fortnight earlier.

The suggestion that the economy is turning less favourable for Labour is supported by the EU Commission consumer survey for March, showing a fall in the composite confidence indicator to -5 from -2 in February – a four-year high. This may reflect the impact of higher inflation on spending power – the net percentage of consumers reporting higher prices over the last 12 months rose to 18 in March, up from a low of 7 in November and above the average of 12 since 1990.

The ECB has increased its backdoor support for Greece during the recent crisis, according to Bank of Greece statistics. Lending by the central bank to the domestic banking system rose by €12.5 billion in February to a record €59.8 billion – see first chart. Banks used the cash partly to buy an additional €2.7 billion of Greek government bonds and cover a €3.3 billion withdrawal by domestic private depositors.

A key component of the Greek rescue plan agreed yesterday was the confirmation by ECB President Trichet that the central bank will continue to accept collateral rated down to BBB- in its lending operations beyond year-end. This represents a defeat for Bundesbank-led ECB hawks who wanted to return the minimum rating to its pre-crisis level of A-, thereby cutting Greece adrift in the event of Moody’s downgrading its rating to match S&P and Fitch, both at BBB+.

The success of the plan may hinge on whether it stems the incipient run on Greek banks. Private deposits have fallen by €8.4 billion, or 3.5%, since December as EMU exit worries have mounted – second chart. The Bundesbankers may have been forced to agree to keep Greece’s life support switched on in return for IMF participation in the rescue deal but could baulk if backdoor lending continues to balloon.

The Budget was low-key and does not meet its aim of placing the UK on a “credible path of fiscal consolidation”. The projected fall in borrowing over the medium term continues to rest on optimistic economic and financial assumptions and an absence of detail about future spending cuts.

The Chancellor has been able to create the illusion of fiscal progress by revising up excessively-pessimistic revenue projections presented in the April 2009 Budget and carried over to December’s Pre-Budget Report (PBR). Net taxes and national insurance contributions are now forecast at 33.9% of GDP in 2009-10 versus 33.2% in the PBR. This explains the cut in public net borrowing from 12.6% of GDP to 11.8%.

The revenue “windfall” carries over to future years, accounting for the cut in the 2014-15 borrowing projection from 4.4% of GDP in the PBR to 4.0%.

Projections for spending, by contrast, are little changed. Total managed expenditure (TME) is forecast to fall from 47.9% of GDP in 2009-10 to 42.3% in 2014-15. The 5.6 percentage point decline over five years is ambitious but not unachievable – TME fell from 47.8% of GDP to 38.9% between 1983-84 and 1988-89. The Chancellor, however, provided no new information on the departmental distribution of cuts. Capital spending will be a major casualty, falling from 4.9% of GDP in 2009-10 to 2.6% by 2014-15, at odds with the claim that the Budget is designed to support investment.

The forecasts for debt interest continue to look optimistic. Net interest is projected to rise from 1.9% of GDP in 2009-10 to 3.3% by 2014-15. The latter figure, however, implies an average interest rate on net debt of only 4.4%, effectively assuming away any future funding difficulties. Each one percentage point rise in the average interest cost would boost the 2014-15 net interest bill by 0.7% of GDP.

The various Budget measures were designed to attract headlines but are insignificant in macroeconomic terms. A net “giveaway” of £1.4 billion in 2010-11 is offset by tax changes yielding £150 million and £705 million in 2011-12 and 2012-13.

The Debt Management Office projects that net gilt sales (i.e. gross sales minus redemptions) will fall from £211 billion in 2009-10 to £148 billion in 2010-11 – a smaller decline than expected, reflecting a cut in Treasury bill financing from £19 billion to -£2 billion. Assuming no further Bank of England buying, the supply of gilts to be absorbed by the market will rise from £28 billion this year to the full £148 billion in 2010-11 – well above the previous record of £110 billion in 2008-09.