Category: Money Moves Markets

An ICM poll published over the weekend reported a rise in the Conservative lead over Labour to nine percentage points from seven points in mid February, against the recent trend. This has not been confirmed by other pollsters – BPIX reported a further narrowing to just two points – but is consistent with the prediction of the economic polling model discussed in prior posts, beginning in December.

In this model, the governing party’s poll position relative to the main opposition depends positively on wage and house price growth and negatively on inflation, unemployment and interest rate changes. The model predicted a big narrowing of the poll gap in late 2009 and early 2010 but has been suggesting that the Conservatives would pull ahead again into the spring, mainly reflecting the negative impact of higher inflation on Labour’s popularity. A caveat, however, was that voters might blame the Bank of England rather than the government for faster price rises.

The approach, of course, can be criticised as reductionist and the model’s historical fit is far from perfect. It will, however, be interesting to monitor poll developments against its forecast of a widening of the Conservative / Labour lead to 11-12 percentage points in May (based on a rise in retail price inflation to 4.5% by March and stability of the other inputs).

If the model is to be believed, a Conservative majority is likely and Labour will rue not calling an early March election.

Irish 10-year gilts are currently trading on a yield spread of 150 basis points (bp) over Bunds, down from a peak of 270 bp a year ago and compared with 300 bp for Greek bonds. This seems modest compensation for the financial risks. Irish and Greek spreads were similar as recently as November.

Ireland gained plaudits for a tough December Budget that cut the projected 2010 general government deficit from 13.5% of GDP to 11.6%. Following the further measures announced this week, however, Greek plans are more ambitious, targeting a budget shortfall of 8.7% of GDP this year.

Ireland’s stability programme envisages a decline in the deficit to 2.9% of GDP by 2014, a reduction of 8.7 percentage points over four years. This looks impressive but assumes €5.5 billion of unspecified future fiscal retrenchment. On current policies, the 2014 deficit would be 5.6% of GDP.  This compares with UK general government borrowing of 4.6% of GDP in 2014-15 projected in December’s Pre-Budget Report.

Within general government, the Exchequer or central government deficit is projected to decline by 26% in 2010. The shortfall in January and February, however, was 15% higher than a year before. Current spending fell by 5% but current receipts were down by 18%. Ireland is lagging the global recovery – the OECD’s leading index is up by 3% over the last 12 months compared with gains of 10% and 9% for its Eurozone and UK indices. With the UK accounting for more than a fifth of trade, recent sterling weakness against the euro is unwelcome.

Ireland’s banking system is critically dependent on ECB life support. Central Bank of Ireland lending to banks was €98 billion at the end of January, the equivalent of 60% of annual GDP. This represents 13% of total Eurosystem lending to banks compared with Ireland’s 2% share of Eurozone GDP. The Bank of Greece’s lending to banks amounts to 20% of Greek GDP while numbers for Spain and Portugal are much lower – see previous post.

A renewal of market worries about Ireland would be expected to be reflected in a withdrawal of funds from its banking system, necessitating increased ECB support. Irish central bank lending is down from a peak of €130 billion in June 2009 but rose in December and January. This bears monitoring: an increase in lending in mid 2008 preceded a sharp rise in the Irish / German yield spread – see chart.

The “MPC-ometer”, discussed in numerous posts between 2007 and early 2009, is designed to predict monthly Monetary Policy Committee decisions based on incoming economic and financial data. The model suggests that policy tightening will soon be necessary, barring new “shocks”. This contrasts with the message of the February Inflation Report but news may force the MPC to execute a swift U-turn. An attempt to maintain inappropriately loose policy settings could accelerate sterling’s slide, further undermining the credibility of the Report‘s forecast of lower inflation.

The MPC-ometer is designed to predict the weighted-average interest rate vote of the Committee’s members. For example, if five want to raise official rates by 25 basis points (bp) while four prefer no change, the weighted-average vote is +14 bp (five-ninths of 25). If it is assumed that votes are either for no change or a move of 25 bp – reasonable under “normal” economic and financial conditions – then the model forecasts an actual rate change when the weighted-average prediction is greater than +12.5 or less than -12.5 bp. Introduced in September 2006, the MPC-ometer performed well over the subsequent two and a half years, correctly signalling the month and direction of 12 out of 13 rate movements – two more than the mean economists’ forecast from the monthly Reuters poll.

The MPC-ometer’s 12 inputs were selected on the basis of statistical analysis and can be grouped into indicators of economic activity, inflation and financial market conditions. The inflation sub-set is largest, comprising the latest headline annual increases in consumer prices and average earnings as well as several measures of expectations. Activity indicators include GDP growth and business / consumer confidence while credit spreads and movements in share prices and the exchange rate are used to gauge financial conditions.

A review of its forecasts during the period of unchanged rates since last March indicates that the MPC-ometer has continued to provide guidance about policy decisions. Specifically, it predicted further easing moves in May and August, months in which the MPC announced a £50 billion expansion of asset-buying plans. The model suggests that the MPC regards £50 billion of additional purchases as equivalent to a reduction in Bank rate of about 17 bp. On this basis, the £200 billion programme has substituted for a further rate cut of about 70 bp.

The weighted-average interest rate vote forecast by the model was negative between April and November last year, consistent with a residual easing bias. It rose, however, to +3 bp in December and +10 bp in January before falling back to +2 bp in February in response to preliminary figures showing GDP growth of only 0.1% in the fourth quarter. The forecast has rebounded to +12 bp in March, reflecting higher inflation, further gains in business and consumer confidence – both now well above long-run average levels – and upwardly-revised GDP expansion of 0.3% last quarter.

The MPC-ometer suggests, therefore, that as many as four members will vote to tighten policy this week. The February Inflation Report and more recent MPC communications indicate that such an outcome is highly unlikely. The current divergence between the model’s forecast and MPC behaviour raises three possibilities.

First, the model may be signalling an imminent shift in the Committee’s thinking. It has sometimes been “early” historically. Economic news and market developments since the Report was prepared have weakened the case for retaining an easing bias and may have emboldened members concerned about excessive policy laxity.

Secondly, the model may simply have broken down. Estimated on data since the MPC’s inception in 1997, it may be failing to capture the full range of influences on monetary policy in the wake of a deep recession. This argument, however, is weakened by the similarity of the model’s prediction and the latest vote of the Sunday Times Shadow MPC, which also has a good forecasting record. Three Shadow MPC members voted to raise Bank rate by half a percentage point this month – see David Smith’s blog for the minutes.

This leads on to the third possibility, which is that the MPC’s historical reaction function, rather than the MPC-ometer, has broken down. The Committee has, in effect, shifted to “inflation targeting lite”, downplaying the requirement of its remit to achieve the 2% inflation target, defined by the consumer price index without exclusions, “at all times” in favour of supporting an economic recovery and promoting fiscal tightening by promising a monetary-policy “pay-off”. Market suspicions of such a shift may be contributing to current sterling weakness.

GDP fell by 6.2% between the first quarter of 2008 and the third quarter of 2009 before recovering in the fourth quarter. The drop exceeds the peak-to-trough decline of 6.0% during the 1979-81 recession.

The recent GDP reduction, however, was magnified by a large fall in oil and gas production, reflecting reserves depletion. Oil output rose during the 1979-81 recession, when the North Sea was coming on stream.

With North Sea production driven by supply capacity rather than domestic or global demand, it may be more appropriate to focus on non-oil output when comparing economic weakness across cycles.

On this basis, the recent recession was less severe than 1979-81: the peak-to-trough fall in non-oil “gross value added” is currently estimated at 5.8% versus 6.4% – see chart.

This note examines the outlook for consumer and retail price inflation in 2010-11 from a “monetarist” perspective. The approach is to build up a forecast by considering in turn “core” inflation, VAT effects, food and energy prices and owner-occupied housing costs (relevant for the RPI).

The conventional “Keynesian” approach is to model core inflation as a function of the “output gap” with some allowance for the effect of exchange rate movements on import prices. The trouble with this is that the output gap is difficult to measure, particularly in real time, while currency movements are largely unpredictable. The consensus view, embodied in the MPC’s Inflation Report forecast, is that a large negative gap has opened up and will persist in 2010-11, exerting sustained downward pressure on core inflation. Yet the financial crisis may have damaged supply capacity by more than the consensus assumes, by raising the cost of capital, disrupting its efficient allocation and reducing the sustainable size of the financial sector – the Treasury has cited estimates of a negative effect on potential GDP of up to 6%. History suggests that caution is warranted: an overestimate by policy-makers of the degree of economic slack contributed to the inflationary upsurge in the 1970s.

An alternative approach is to base a forecast for core inflation on the simplistic monetarist rule-of-thumb that the money supply leads prices with a variable lag averaging about two years. The monetarist rule has arguably performed much better than output gapology in recent years: a large fall in core inflation in the late 1990s was preceded by a major monetary slowdown, while faster money growth forewarned of the inflationary overshoot of 2007-08. The late 1990s disinflationary episode can be used to calibrate the possible impact of recent monetary weakness on core inflation. Annual growth in broad money M4 fell from 11.9% to 2.8% between Q4 1997 and Q3 1999 – a 9.1 percentage point drop. Annual core inflation – as measured by the CPI excluding unprocessed food and energy – subsequently declined by 1.9 percentage points to a low of just 0.1% in July 2000. So the “elasticity” of inflation to monetary growth was 0.21 (i.e. 1.9 divided by 9.1). Recent monetary trends are best measured by the Bank of England’s adjusted M4 measure, excluding money holdings of financial intermediaries. Its annual growth rate fell from 11.6% in Q3 2006 to 3.6% in Q4 2008, rebounding to 4.2% in Q1 2009. Assuming that Q4 2008 was the low – reasonable given the positive impact of Bank of England gilt purchases in Q2 and Q3 2009 – the monetary slowdown suggests an eventual fall in annual core inflation of 1.7 percentage points (i.e. multiplying the money growth decline of 8.0 percentage points by the inflation elasticity of 0.21).

A major difference, however, between the late 1990s and now is a higher starting level of core inflation. The CPI excluding unprocessed food and energy rose by an annual 2.1% in May compared with 2.0% in February 1998, when the prior big slowdown began. However, recent numbers have been flattered by the temporary cut in the main rate of VAT from 17.5% to 15% last December. Assuming average pass-through of 60%, the core CPI measure would have risen by an annual 2.9% in May in the absence of the VAT change, down from a peak of 3.0% in February. (The 60% assumption may be conservative – the Office for National Statistics has estimated that 70% of prices collected from shops had been reduced to reflect the lower VAT rate in January.) Applying the predicted 1.7 percentage point fall in annual core inflation to the 3.0% February peak, the monetarist approach suggests an eventual trough of 1.3% – well above the 0.1% low reached in 2000. Assuming a two-year lead of money on prices, this trough could be reached around the end of 2010, with the recent recovery in monetary growth reflected in higher core inflation in 2011.

The outlook for headline CPI and RPI inflation will also depend on future VAT effects, food and energy prices and housing costs. The forecasts below assume that the planned return in the main VAT rate to 17.5% from January 2010 goes ahead, again with average pass-through of 60%. A further 1 percentage point increase is pencilled in for January 2011, on the basis that higher VAT will bear some of the burden of future fiscal consolidation. Unprocessed food inflation – still running at an annual 9.3% in May – is assumed to fall significantly by the end of 2009 but to remain positive, reflecting a judgement that the large increase in prices over 2007-09 reflected a “structural” shift. Following a modest further cut in retail tariffs later this year, energy prices are similarly projected to trend gradually higher. For the RPI forecast, the components linked to house prices are assumed to stabilise from late 2009 after a 20% drop from the peak. Finally, the average mortgage interest rate – currently 3.6% – is projected to fall slightly further over the remainder of 2009 before recovering by about 1 percentage point during 2010, reflecting an assumed rise in Bank rate from 0.5% to 2.5% next year.

The results of this exercise are shown in the chart. Annual CPI inflation falls from its current 2.2% towards 1% by autumn 2009, reflecting favourable food and energy price effects, but rebounds to about 3% in early 2010 as VAT is hiked. Slower core trends gradually reverse this increase and inflation moves temporarily below 2% again in early 2011 as a result of VAT effects (i.e. a smaller rise in 2011 than 2010), before drifting higher later in the year in lagged response to the current pick-up in monetary growth. Mirroring the CPI profile, the annual RPI change moves deeper into negative territory into the autumn but increases much more sharply in 2010, with the VAT increase compounded by a big turnaround in the housing costs component, reflecting both unfavourable base effects and higher mortgage rates. Annual RPI inflation peaks at about 3.5% in late 2010, slowing temporarily during the first half of 2011 as housing effects wane.

Two features of this forecast are worth emphasising. First, the CPI profile is significantly higher than the central projection in the May Inflation Report, which shows average inflation of 1.5% this year, 0.9% in 2010 and 1.3% in 2011. The difference mainly reflects the sustained disinflationary influence of a negative output gap in the Bank of England’s forecasting model, although assumptions about VAT and commodity prices may also contribute. The MPC’s recent forecasting record warrants some scepticism about its current prognosis: the central projection for annual CPI inflation one year ahead has been too low in 15 out of 17 Inflation Reports between February 2004 (after the inflation target was switched to the CPI from RPIX) and February 2008, with a mean forecast error of 0.7 percentage points.

Secondly, the swing in RPI inflation between 2009 and 2010 is unusually large and may have negative economic implications. Wage growth has slowed sharply since the onset of the recession in spring 2008 but it is unclear whether this reflects labour market flexibility or is simply a response to annual RPI falls. A pick-up in wage settlements as RPI inflation rebounds in 2010 would cast doubt on the MPC’s view that economic slack will drive core price trends significantly lower. On the other hand, continued weak wage growth would imply a squeeze on real disposable incomes, potentially undermining prospects for consumer spending and an economic recovery.

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COMMENT:
AUTHOR: Chris Spencer
EMAIL: newstudents@christopherspencer.co.uk
IP: 84.92.150.76
URL:
DATE: 08/13/2009 12:04:21 PM

I found the article interesting and readable and the arguments make sense.As a complete amateur in economics I can only use intuition but the conclusions of the report happily are consistent with my decision to hold on to my large holding in NS&I index linked savings certifates.

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COMMENT:
AUTHOR: Mary Dunn
EMAIL:
IP: 88.108.119.9
URL:
DATE: 11/06/2009 08:45:41 AM

I am a Chartered Financial Planner and often use Cash Flow modelling for a number of my clients, I found the article very interesting and exactly what I was looking for. Readable, understandable and justified. Thank you very much.

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COMMENT:
AUTHOR: Brian
EMAIL:
IP: 89.243.20.135
URL:
DATE: 11/19/2009 08:37:11 PM

As increases in my Civil Service pension are based on the previous September’s RPI figure, I welcome the prospect of a possible 3% rise in 2011 compared to the 0% in 2010……..’Every little helps’, goes the saying.

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COMMENT:
AUTHOR: Glauco H. Ayres
EMAIL:
IP: 86.170.111.249
URL:
DATE: 12/15/2009 08:53:48 AM

This is an interesting read. I indeed like the monetarist approach to understanding the causes of inflationary/deflationary pressures in our economy. As one of the chief negotiators for my Union I need to keep up with the economic outlook for years to come and I am certainly looking for further advice to enlighten my options. Thank you.

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COMMENT:
AUTHOR: C Worthy
EMAIL:
IP: 86.150.24.126
URL:
DATE: 02/03/2010 11:16:26 PM

I see little chance of inflation peaking at 3.5% later in 2010. With China wizzing away and using its power to buy raw materials, RPI inflation is more likely to peak at between 6 to 9% in June. I am not sure after that.

Cuthbert

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COMMENT:
AUTHOR: lee mcvey
EMAIL: l.mac54@yahoo.com
IP: 92.40.53.94
URL:
DATE: 03/01/2010 08:51:08 PM

The fiscal stimulas package used by the government to boost consumer spending has caused the RPI to rise erratically and falsely, which is a short term way for the government to demonstrate a recovery in the economy but long term will devalue the strenghth of the pound. But Labour are only interested in short term gains so they can win the election in May. The UK is heading for a massive fall, if the Tories gain power Labour will blame it all on them and return to power in 4 years, when recovery will be more likely after the Tories have weathered and rode the storm!

Broad money trends remain weak: M4 excluding money holdings of non-bank financial intermediaries was unchanged in January and has contracted at a 1.9% annualised rate over the last six months. This weakness, however, is compatible with both a solid economic recovery and inflation overshooting the 2% target.

The key monetary driver of the business cycle is the corporate liquidity ratio – companies’ money holdings divided by their bank borrowings. This ratio is a major influence on firms’ decisions about capital spending and employment, with the latter driving household income and, in turn, demand. In contrast to aggregate broad money, corporate M4 rose by an annualised 4.6% in the six months to January.

The corporate liquidity ratio forewarned of the recession in 2007 at a time when aggregate money and credit were still rising strongly. It reached a low in early 2009 and has recovered significantly, suggesting an imminent pick-up in business spending and hiring. Excluding the struggling real estate sector, the ratio is above its average level since the late 1990s – see chart.

Firms have been able to rebuild their liquidity despite weak aggregate M4 growth because of a fall in the demand to hold money by households and institutional investors. This partly reflects a revival in confidence in markets; in addition, the negative real post-tax return on bank deposits may be triggering a major rebalancing of portfolios.

The current monetary environment resembles the aftermath of the 1974-75 recession. GDP rose by 6% in the first two years of the subsequent recovery despite a 6% contraction in the real broad money stock. The corporate liquidity ratio increased strongly before this upswing as household and institutional money demand fell in response to negative real interest rates. Inflation accelerated as the recovery developed.

The 1976 sterling crisis was caused partly by fiscal laxity – public sector net borrowing reached 7.0% of GDP in 1975-76 – but monetary policy was also too loose, with interest rates held below inflation and the deficit financed largely through the banking system. Current Bank of England policy is identical to that pursued by the monetary authorities in 1975-76 and carries a significant risk of similarly inflationary consequences.

Consumer confidence continued to strengthen in February, reaching a seasonally-adjusted -2 – well above the average of -9 since 1990 and the highest since February 2006. The rise was driven by improved expectations about the labour market and wider economy. A solid consumption recovery may already be under way – see first chart.

The confidence rise supports the view that the recent narrowing of the Conservative / Labour poll lead reflects economic factors, as discussed in the last post.

Interestingly, consumers’ inflation expectations, having risen in prior months, stabilised in February, despite retail price inflation accelerating to an annual 3.7% in January – second chart. Households may have been influenced by the dovish forecasts in the latest Inflation Report, even though the Bank of England failed to predict the current spike. With RPI inflation likely to rise significantly further, this stabilisation may prove temporary. Retailers’ price expectations are notably stronger than consumers’ – second chart.

The confidence revival contrasts with weak news on business investment, which fell by a further 5.8% in the fourth quarter. Provisional investment estimates, however, are often revised substantially and the large decline is difficult to reconcile with rises in capital goods production and imports last quarter.

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COMMENT:
AUTHOR: Jan Luthman
EMAIL: jan.luthman@wcgplc.co.uk
IP: 193.227.201.118
URL:
DATE: 02/26/2010 12:00:02 PM

"Households may have been influenced by the dovish forecasts in the latest Inflation Report"

Errrmmm – no. A few fund managers may have been influenced, but, in the real world of whitevanman and OK magazine, households do NOT study BoE Inflation Reports. Sorry.

Revised fourth-quarter GDP figures confirm that a recovery is under way while nominal income is growing at a rate consistent with the inflation target, arguing against any further expansion of asset purchases.

Key points:

• GDP rose by 0.3% last quarter versus an originally-estimated 0.1%, with market-sector output up by 0.4%.

• Consumer spending rose for the second consecutive quarter, by 0.4%. A further increase in consumer confidence in early 2010, to above its long-run average, suggests a continuing recovery.

• A 5.8% fall in business investment was offset by a slower rate of destocking so total spending by companies was down by 0.9%. Improving corporate liquidity should support outlays and hiring in early 2010 – vacancies rose by 11% over November-January from the prior three months.

• GDP at current market prices rose by 1.1%, or 4.5% at an annualised rate, last quarter. Gross value added at current factor cost – a measure of aggregate wages and profits – grew by 6.0% annualised. The 2% inflation target is consistent with nominal income expansion of about 4.5% per annum over the medium term.

• GDP finished the quarter strongly: a monthly proxy based on services and industrial output was 0.4% above its quarter average in December – see chart. This reduces the risk of a first-quarter relapse although January is likely to have been depressed by bad weather.

Today’s news, however, may not result in a further improvement in Labour’s poll ratings. Historical analysis indicates that the popularity of the governing party is sensitive to changes in retail price inflation – a further rise to about 4.5% this spring may outweigh the poll impact of better GDP.

The US monetary base rose to another new high in the week to Wednesday – see chart – but the forecast in a previous post of a further large increase into the spring is no longer valid because of a Treasury / Federal Reserve decision this week to expand the supplementary financing programme (SFP) from its current $5 billion to $200 billion.

Under the SFP, the Treasury issues additional Treasury bills and deposits the proceeds with the Fed. The expansion of the programme means that the Fed will be able to finance remaining purchases of mortgage-backed securities (MBS) without creating new bank reserves, included in the monetary base.

While the monetary base is unlikely to rise much further, the recent expansion may have a positive impact on markets near term. Financing MBS buying by issuing Treasury bills rather than creating reserves, moreover, arguably makes little difference – the transaction still results in an increase in market liquidity while bills may be bought by banks and regarded as a close substitute for reserves.

It would have been more straightforward for the Fed to have sterilised the monetary base impact of MBS purchases by other means, e.g. selling Treasury securities from its portfolio, conducting reverse repos or raising reserve requirements. Officials were presumably concerned that such actions would suggest a tightening of monetary policy so chose the more circuitous route of SFP expansion instead.

Recent commodity price gains and sterling weakness are putting strong upward pressure on manufacturers’ input costs.

The Journal of Commerce industrial commodity price index – covering 18 materials used in manufacturing production including crude oil and natural gas – rose to a new recovery high last week. In sterling terms, the index is now 6% above the peak reached in May 2008, when the pound was at $1.95 – see first chart.

The second chart shows annual rates of change of the official producer input price series and the sterling-based Journal of Commerce index. Sterling commodity prices are 55% higher than a year ago – the largest gain since 1974. Input price inflation – an annual 8% in January – may rise to 20% or more this spring.

With output and orders recovering, the low level of sterling reducing competition from foreign producers and the Bank of England signalling no intention to tighten policy despite high inflation, manufacturers are likely to pass these increases on rather than absorb them in margins.