Category: Money Moves Markets

Consumer price inflation fell from an annual 3.5% in January to 3.0% in February but this is unlikely to mark the beginning of a sustained decline to about 1% by early 2011, as forecast by the Bank of England in the February Inflation Report.

A return to 3% was predicted in a post last month and reflected a fall in food and energy inflation together with a large monthly rise in “core” prices in February 2009 dropping out of the annual comparison. A further decline, however, is unlikely near term: monthly core price increases were low over March-June 2009 while energy inflation should rebound as a result of higher petrol prices and cuts in household bills last spring falling out of the calculation.

Assuming no significant impact from Budget decisions, CPI inflation is projected to fluctuate in a 3.0-3.25% range until mid-year before declining modestly during the second half, remaining well above the 2% target.

Services inflation has exerted downward pressure on the headline rate over the past year, falling from an annual 4.6% in December 2008 to 3.0% in February. The decline, however, may be coming to an end as the economy recovers: the balance of consumer services companies planning to raise prices has increased sharply, according to the first-quarter CBI / Grant Thornton survey released earlier this month – see first chart.

Goods inflation excluding food and energy, meanwhile, eased from an annual 3.3% to 2.6% in February but will be underpinned by recent exchange rate weakness and pass-through of surging raw material costs – sterling commodity prices, as measured by the Journal of Commerce industrials index, are two-thirds higher than a year ago. The balance of CBI manufacturing firms planning to hike prices rose to an 18-month high in March and is above its long-run average – second chart.

The February headline rate of 3.0% compares with the Bank of England’s forecast a year ago that inflation would average 1.3% in the first quarter of 2010. The Bank has failed to provide a coherent explanation for its forecasting miss and markets appear to be increasingly sceptical of its inflation-fighting commitment, judging from a widening yield gap between conventional and index-linked gilts – third chart.

The Federal Reserve this week reiterated its assessment that “economic conditions … are likely to warrant exceptionally low levels of the federal funds rate for an extended period”. While official rates will stay low, however, the Fed has already begun to withdraw liquidity from the banking system.

The monetary base – currency plus bank reserves at the Fed – has fallen for three consecutive weeks, by a cumulative 4.7%. This mainly reflects the impact of the “supplementary financing programme” (SFP) under which the Treasury issues bills and deposits the proceeds at the Fed – this has more than offset a further liquidity injection from central bank purchases of mortgage-backed securities (MBS).

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

The Fed will complete its $1.25 trillion of MBS purchases by the end of the month but carried $1.066 trillion on its balance sheet as of Wednesday, suggesting a further substantial liquidity injection. The SFP, however, is scheduled to rise from $75 billion to $200 billion. The net impact of these and other changes on the monetary base is uncertain; a further decline would be another warning signal for markets.

The Dow Jones industrial average fell by 54% from peak to trough in the bear market between October 2007 and March 2009. The Dow has declined by 45% or more on seven prior occasions since 1900 – see table. Six of these declines were in the 45-55% range, the exception being the depression bear market of 1929-32, when prices dropped by 89%.

The Dow reached its low on 9 March 2009 and had risen by 61% by 9 March 2010. This is in the middle of the 42-85% range of first-year recoveries after the six prior big bear markets, excluding the 1929-32 decline. The mean rise across these recoveries was 59%.

The Dow’s performance was mixed in the second year after the troughs of these prior cycles. The change in prices ranged from a fall of 8% to a rise of 22%, with a mean increase of 7%. In one case – the recovery after the 1973-74 bear – a strong second-year gain followed a below-average rise in the first year.

Historical evidence, therefore, suggests that equity markets are entering a less dynamic period, although any downside risk should be modest against the background of a continuing economic recovery. This conclusion is consistent with evidence of less favourable global liquidity conditions discussed in yesterday’s post.

The liquidity “jaws” are closing. Annual growth in Group of Seven (G7) real narrow money, M1, was only marginally higher than industrial output expansion in January – see first chart. The series are likely to have crossed in February, with the annual output gain boosted by a large monthly decline in February 2009 falling out of the calculation.

Since 1970, global equities on average have underperfomed cash by 5% per annum when annual real M1 growth has fallen short of output expansion while outperforming by 11% pa at other times – see previous post. These averages, of course, conceal significant variation but the ex ante return / risk profile of holding equities has deteriorated.

Slower real money growth than output expansion implies that the economy is draining liquidity from markets. Historically, cross-overs have also signalled higher short-term interest rates. On average, G7 short rates have risen by 0.7 percentage points per annum during real money / output growth shortfalls while falling by 0.9 points pa at other times – second chart.

G7 plus E7 industrial output continues to rise solidly and is now only 4% below its pre-recession peak – see prior post – while the recovery is broadening to labour markets. Central bank policies adopted during the financial emergency – suppressing official interest rates below inflation and flooding banking systems with reserves – are increasingly misaligned with economic developments.

The Federal Reserve last night repeated its commitment to low interest rates for an “extended” period but this does not preclude an early withdrawal of liquidity. A rise in Chinese official rates is overdue while the UK “MPC-ometer” is close to signalling a need for policy restriction. Earlier-than-expected monetary tightening could be the trigger for a set-back in equity markets.

Prior posts have argued that weak broad money trends in the US and Europe are not an obstacle to a continuing economic recovery because corporate liquidity is rising solidly, supporting prospects for business investment and hiring. Firms have been able to raise cash levels because of a fall in the demand to hold money by households and financial institutions, mainly reflecting negative real interest rates.

This hypothesis received further support from US fourth-quarter flow of funds accounts data released last week. A broad money measure comprising currency, banking system deposits, money market mutual funds, repurchase agreements and foreign deposits was unchanged in the year to end-December but this stability concealed a rise of 8.5% in business holdings offset by falls of 1.9% and 3.0% respectively in household and financial money – see first chart. Business liquidity grew at a 15.0% annualised rate during the second half.

The decline in household and financial money implies that there is less “sideline cash” available to flow into markets and push up prices. Expressed as a proportion of financial assets, however, money holdings are still at a “normal” level by recent historical standards – second chart. Investors may wish to rebalance their portfolios further away from cash in response to the negative real interest rate “tax” imposed by central banks.

Combined industrial output in the Group of Seven (G7) major economies and seven large emerging economies (the “E7”, defined here to include Brazil, China, India, Russia, Korea, Taiwan and Mexico) rose by a further 0.8% in January to stand 10.9% above its trough reached in February 2009. Following a 13.6% drop during the recession, output is now only 4.2% below the peak reached in February 2008.

The recovery has been led by the E7 – output has risen by 19.1% from a low in January last year and is 8.8% above its pre-recession peak. G7 production, by contrast, has recovered by 8.3% from a March 2009 trough and is still 12.9% below peak. Relative performance improved in January, however, with a 1.4% gain versus flat E7 output, reflecting a sharp fall in Russia.

The recession and recovery in G7 plus E7 output continues to track closely G7 performance during and after the mid 1970s first oil shock downturn. This template suggests a sustained economic upswing but with momentum slowing during the second half of 2010 and into 2011 – see first chart.

The interpretation here is that recent monetary developments are consistent with this template. G7 real broad money is contracting on an annual basis but this is unlikely to signal insufficient liquidity to support an ongoing economic recovery because of a fall in household and institutional money demand due to negative real interest rates. Corporate liquidity – a key driver of the business cycle – continues to improve while narrow money M1 is rising solidly. Real M1 expansion, however, has moderated, suggesting slower economic growth later in 2010 – second chart.

The surprisingly dovish February Inflation Report suggested a shift in the Bank of England’s priorities towards supporting growth in the face of coming fiscal tightening rather than achieving its formal remit target of a 2% annual CPI increase “at all times”. The Bank, of course, justified its stance by projecting a future fall in inflation but its forecasts have little credibility, having been overshot persistently in recent years.

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 steadily from a short-term low the day after the Inflation Report, yesterday reaching its highest level since October 2008. US market-implied inflation expectations are little changed over the same period  – see first chart.

Sterling, meanwhile, has fallen by 4% both against the US dollar and in trade-weighted terms since the Report. Coupled with renewed strength in dollar commodity prices, this has resulted in an 11% surge in industrial raw material costs, as measured by the Journal of Commerce index in sterling terms – second chart. Input costs are 60% higher than a year ago.

The Bank is now in a bind. Markets are rebelling against its dovish shift and their reaction further increases the risk of a sustained inflation overshoot, warranting consideration of an early Bank rate hike. This would be highly contentious given the imminent election and weather-depressed economic reports but policy inaction could result in an extension of recent market moves, ultimately forcing the Bank’s hand.

The view expressed in prior posts that the global economic recovery will be sustained through 2010 rests on improvements in corporate liquidity feeding through to a pick-up in business investment and hiring, with rising employment supporting consumer incomes and spending. Recent US and UK evidence is consistent with firming labour demand.

In the US, non-farm payrolls fell by 171,000 in the three months to February but last month’s number was depressed by snow storms that prevented some existing employees and new hires from turning up for work. An alternative payrolls measure based on households’ assessment of their employment status is likely to have been less distorted by weather effects and rose by 292,000 over the last three months – see first chart. A catch-up gain in headline payrolls is possible this month.

Leading indicators have improved further: a measure based on the ISM manufacturing employment index, the NFIB small firm hiring plans index and the Challenger-Gray-Christmas lay-offs tally has risen to a level historically consistent with three-month payrolls growth of between 250,000 and 500,000 – second chart.

In the UK, job vacancies rose by a surprisingly-strong 11% in the three months to January from the prior three months, a pick-up confirmed by the Market jobs survey – third chart. Vacancies correlate with GDP so this suggests that underlying economic momentum, abstracting from weather effects, strengthened around year-end – final chart.

Current low monetary growth will not prevent inflation overshooting the 2% target because the velocity of circulation of money is rising fast in response to negative real interest rates. The Bank of England should raise interest rates to stem the fall in the demand to hold money and slow the pick-up in velocity.

Nominal GDP rose at an annualised rate of 3.9% during the second half of 2009 while the broad money supply – as measured by M4 excluding money holdings of non-bank financial intermediaries – fell by an annualised 1.2%. The velocity of circulation of money, therefore, increased by an annualised 5.1% – the largest two-quarter gain since 1999.

The velocity rise is the counterpart of a reduction in the demand to hold money by households and financial institutions, driven partly by a recovery in confidence but more importantly by the negative post-tax real return on bank deposits, which is encouraging a rebalancing of portfolios. Record mutual fund inflows are evidence of this portfolio shift: retail investors bought a net £1.8 billion of unit trusts and OEICs in January, bringing the 12-month running total to £26.4 billion, equivalent to 2.7% of household money holdings, according to Investment Management Association figures released yesterday – see chart.

Post-tax real interest rates were last negative for a sustained period in the 1970s. M4 velocity rose at an average annualised rate of 4.7% over 1974-79.

The 2% inflation target is consistent with nominal GDP growth of 4-5% per annum over the medium term, assuming trend real economic expansion of about 2.5% pa. If velocity were to continue to rise by about 5% pa, this would imply no room for any increase in the money supply. A policy of expanding asset purchases to achieve a positive rate of monetary growth would be misguided, leading to an inflation overshoot.

M4 excluding intermediaries’ money holdings rose by an annualised 1.9% in the three months to January. On current velocity trends, therefore, money growth may already be too strong to achieve the 2% inflation target. Rather than expanding asset purchases, the Bank of England should be considering raising interest rates to stem the flow of funds out of bank deposits and restrain the pick-up in velocity.

UK government debt has a longer average maturity than the international norm. Official figures, however, overstate the advantage because they fail to account for the “maturity transformation” implied by the Bank of England’s gilt-buying.

According to the Debt Management Office (DMO), the average maturity of gilts and Treasury bills outstanding was 13.5 years at the end of 2009. This figure, however, includes £190 billion of gilts bought by the Bank of England, representing 23% of the stock of debt held outside the DMO.

The market has, in effect, exchanged these gilts, with an average maturity of about 10 years, for central bank reserves, which are repayable on demand. The relevant metric for assessing refinancing risk is the average maturity of the market’s combined holdings of debt and reserves, not that of the stock of debt including the Bank’s gilts. This is significantly lower, at about 11 years, down from 14 years in mid 2008 – see chart.

The Bank of England pays Bank rate on reserves. This results in an interest saving when Bank rate is below the initial yield on purchased gilts, as at present. The Bank, however, might be forced to tighten monetary policy aggressively in the event of a funding or exchange rate crisis. This would be instantly reflected in the combined government / Bank interest bill.

The UK’s “true” debt maturity is still significantly longer than for other major countries – the US is at the low end of the range, with an average maturity of publicly-held marketable debt, including bills, of about four years. The gap, however, is much smaller than a year ago and would erode further if the Bank were to extend its gilt-buying programme.