Category: Money Moves Markets

The “credit counterparts” arithmetic shows how changes in the broad money supply, M4, are related to other components of the banking system’s balance sheet, including lending to the private and public sectors. Public sector lending – also termed the “public sector contribution” – has been much larger than the rise in M4 since March 2009, reflecting the Bank of England’s gilt-buying. This has led some commentators to claim that broad money will plunge if the purchase programme is stopped.

Such analysis, however, ignores important interactions between the credit counterparts. Official gilt-buying, while inflating public sector lending in recent months, has had simultaneous negative effects on other counterparts. The net boost to M4 has probably been modest, arguing against a significant negative impact from a suspension of purchases. With the demand to hold money depressed by negative real deposit rates, there should be sufficient monetary fuel to support an ongoing economic recovery.

The Bank’s gilt purchases can result in a negative impact on other credit counterparts in the following ways:

• An overseas investor selling to the Bank may hold the proceeds on deposit at a UK bank or use them to repay borrowing. This is recorded as a negative flow under “external and foreign currency counterparts”.

• A UK non-bank seller of gilts may repay bank borrowing or buy goods or assets from another UK resident who then repays debt. Bank lending to the private sector is correspondingly reduced.

• Alternatively, the non-bank seller may invest in newly-issued bank bonds or equities, resulting in a negative impact under “net non-deposit liabilities”.

• Official gilt purchases financed by the Bank creating reserves may cause banks to buy fewer gilts, since reserves are a close substitute. The rise in the public sector contribution is then smaller than the official purchases.

A reversal of the last effect may be particularly important in limiting any negative impact on M4 from a suspension of the Bank’s operations. Banks bought £26 billion of gilts between November 2008 and January 2009 but their holdings have risen by just £1 billion since the Bank announced its purchase scheme last February. A return to the earlier pace of accumulation would substitute for official buying on the recent scale.

A previous post argued that more favourable voter perceptions of the economy would result in a further narrowing of the Conservative poll lead over Labour near term, increasing fears of a hung parliament. This shift, however, would be reversed from early 2010, reflecting sharply-rising inflation. Economic factors, therefore, argued for Labour calling an early election rather than delaying until the last moment.

Recent polls support the first part of this forecast: the last five results reported on the excellent ukpollingreport.co.uk show a Tory lead of between 7 and 9 percentage points – below the 10 point gap widely regarded as necessary to guarantee a majority. Economic perceptions seem to be driving this move: the EU Commission’s consumer confidence measure vaulted higher in January to its highest level since November 2007.

The earlier forecast was based on statistical analysis of Guardian / ICM polling data since the early 1980s. The results indicate that the position of the governing party relative to the main opposition depends positively on average earnings and house price growth and negatively on retail price inflation, unemployment and changes in interest rates – the chart shows fitted values of a model based on these factors.

According to this analysis, Labour is benefiting from rising house prices and the lagged impact of last year’s low inflation while the labour market has become less negative, with unemployment and earnings growth stabilising. The model predicts a Tory lead of only 2 percentage points based on economic factors – the 7 to 9 point gap may reflect other influences that are working to Labour’s disadvantage.

Labour strategists are counting on economic developments continuing to boost the party’s support but the model suggests that the positive impact is peaking. On plausible assumptions about the inputs – including a rise in retail price inflation to 4-5% this spring – the poll gap is forecast to widen to 9 percentage points by May. If non-economic influences result in Labour continuing to underperform the model’s predictions, this would be consistent with an outright Tory victory.

The fundamentalist wing of the monetarist school will be concerned by December money supply data, showing growth of only 1.1% in adjusted M4 (i.e. excluding holdings of non-bank financial intermediaries) over the last year and a small contraction over the latest three months. This weakness, however, is unlikely to signal an economic relapse because the demand to hold money has fallen in response to negative real interest rates and reviving confidence. Put differently, slow M4 expansion is being offset by a pick-up in the velocity of circulation, following a collapse before and during the financial crisis.

Key points:

The sectoral breakdown shows that weakness in adjusted M4 has been concentrated in the financial sector, with money holdings of insurance companies, pension funds and other investment managers down significantly since late 2008. This is likely to reflect a voluntary reduction in cash as institutions have become more confident about market prospects.

Non-financial M4 – i.e. money holdings of households and private non-financial corporations – rose by 2.6% in the year to December and at the same annualised rate over the latest three months.

The demand to hold money of households, like that of institutions, has been depressed by paltry yields and a revival of risk appetite. Household M4 rose by £23 billion during 2009 but retail inflows to unit trusts and OEICs are likely to have exceeded £25 billion (IMA figures for December are released tomorrow), up from just £4 billion in 2008.

Lower demand by institutions and households has allowed non-financial corporations to boost their liquidity despite slow aggregate money supply expansion. Corporate M4 rose by 4.2% in the year to December and by 6.2% annualised over the last three months. The liquidity ratio – sterling and foreign currency money holdings divided by bank borrowing – stabilised in December but has recovered significantly from its late 2008 low.

Broad money fundamentalists neglect a recent pick-up in narrow money M1 (notes and coin plus sight deposits), which rose an annual 7.2% in December. An increase in M1 relative to M4 is consistent with a recovery in velocity, with people shifting funds from savings accounts and time deposits into instant-access accounts in anticipation of increasing spending on goods and services or assets. M1 gave better warning of the recession than M4.

Bank rate is currently 1.9 percentage points below the annual increase in retail prices – the largest negative divergence since 1980. The shortfall will widen significantly further by the spring. The last sustained period of negative real rates, in the 1970s, was associated with a trend increase in M4 velocity – by 4.7% per annum on average over 1974-79. If velocity is embarking on another trend rise, slow broad money growth offers limited reassurance that inflation will return to target over the medium term.

The Treasury, OECD and IMF believe that the UK “output gap” – the shortfall of GDP from its trend or potential level – is currently between 5% and 7%. Two alternative approaches, however, suggest a much smaller gap, of about 2%, helping to explain why inflation has overshot official and consensus forecasts.

The three organisations estimate current trend output by extrapolating an underlying path based on historical data and applying an ad hoc adjustment for the negative impact of the financial crisis. Such estimates amount to little more than a guess and will be revised, probably significantly, in light of future output developments.

The first alternative approach utilises the “Okun’s law” relationship of the output gap and the deviation of unemployment from its non-accelerating-inflation rate (the NAIRU). Based on history, the recent rise in unemployment looks too small to support estimates of a gap of up to 7%, barring an unlikely fall in the NAIRU.

Specifically, an analysis of UK data since the early 1970s indicates that each 1 percentage point rise in unemployment is associated with a 1.56% fall in output relative to trend. The unemployment rate increased by “only” 2.5 percentage points between the first quarter of 2008 – immediately before the recession – and the fourth quarter of last year, suggesting a 3.9% decline in output relative to trend (1.56 times 2.5). The OECD estimates that GDP was 1.9% above trend in the first quarter of 2008. Using this as a starting point, the implied shortfall last quarter was only 2.0% – see chart.

The second approach uses business survey information on capacity and labour constraints to gauge the position of GDP relative to trend. The percentages of CBI manufacturing firms reporting shortages of plant capacity and skilled labour were summed and the resulting series rescaled to match OECD output gap data since the early 1970s. This approach also yields a current estimate of about 2% – the chart shows a full history.  

These alternative approaches imply that either current official GDP figures overstate the decline during the recession or damage to supply capacity from the financial crisis has been greater than assumed by most forecasters. Both are probably true. For the entire divergence to be explained by the supply factor, trend output would need to have fallen by more than 2% between the first quarter of 2008 and late 2009 versus the OECD’s assumption of a 3.1% increase.

The Bank of England claims that the current inflation overshoot will prove temporary because a “large amount” of spare capacity will exert downward pressure on domestic price trends. If the output gap is only about 2%, however, the effect will be much weaker than it expects, implying that a tightening of its policy stance will be necessary to secure a return of inflation to target.

Eurozone broad money M3 fell by an annual 0.2% in December but the decline was entirely due to a contraction in financial institutions’ money holdings: M3 held by households and non-financial corporations rose by 3.6% – see first chart.

Within non-financial M3, corporate money growth picked up further to an annual 5.5%. With debt repayment continuing, measures of the corporate liquidity ratio have surged, suggesting improving prospects for business investment and hiring – second chart.

Previous posts discussed the notion – originally advanced by Andy Kessler in a Wall Street Journal article last year – that changes in the Fed’s liquidity supply, reflected in the US monetary base, were driving market movements. The recent swoon in equities and rally in the dollar followed a contraction in the base between late November and early January – see first chart.

Previous commentary downplayed, wrongly, the significance of this decline because it reflected a build-up of cash in the US Treasury’s account at the Fed, partly due to TARP repayments, rather than efforts by the central bank to drain liquidity. This effect was expected to reverse in early 2010 as the Treasury ran down its cash balance to finance the swollen deficit.

The latter process is under way and the monetary base has risen for three consecutive weeks. The Treasury’s balance in its “general account” at the Fed has fallen from $187 billion at the end of December to $127 billion yesterday but should decline significantly further over coming weeks – the balance averaged about $45 billion last autumn. Coupled with the cash injection from securities purchases, this should more than offset any liquidity contraction caused by an unwinding of the Fed’s special operations.

The equity market set-back has resulted in sentiment measures shifting from overbought to – in some cases – significantly oversold. The annual rate of change of G7 real M1 remains, for the moment, above that of industrial output, implying a still-supportive macro liquidity backdrop. With the US monetary base recovering, the odds favour a rally in markets into the spring, possibly accompanied by a reversal or consolidation of the dollar’s recent gains.

This assessment would be wrong if the economy were tipping over into a “double dip” – liquidity would then flow into bonds rather than equities while the dollar might benefit from a flight to (perceived) safety. The recovery, however, appears on track, with early figures suggesting another solid gain in G7 plus emerging E7 industrial output in December – second chart.

The MPC’s inflation-targeting remit contains an ambiguity: it requires the Committee to achieve the target “at all times” while allowing for temporary departures due to “shocks and disturbances”. Judging from remarks in a speech last week, Bank of England Governor Mervyn King plans to exploit this ambiguity to underreact to this year’s inflation overshoot.

Extending arguments in his five explanatory letters of 2007-09, Governor King absolves the MPC of responsibility for higher inflation due to “temporary price level factors”, which he defines to include exchange rate depreciation, global commodity price rises and indirect tax hikes. Such effects, he suggests, can be ignored as long as there is a “large amount” of spare capacity and monetary growth is low.

The speech does not address the issue of why the disinflationary impact of the “output gap” has, to date, been much weaker than the Bank forecast. The assertion that low money supply growth ensures that inflation will return to target is also simplistic – an alternative view is that there is “excess” money despite slow supply expansion because the demand to hold money is falling in response to negative real interest rates and reviving risk appetite.

The phrase “temporary price level factors” is misleading: sterling depreciation, commodity price gains and excise duty increases, unless reversed, have a permanent impact on prices. Governor King means, of course, that the effect on inflation is temporary. Yet these factors will plausibly continue to exert upward pressure over the medium term.

Take sterling. The real effective exchange rate is currently 8% below its pre-crisis long-term average (calculated over 1970-2006). Suppose, reasonably, that it returns to this average in five year’s time. If the nominal exchange rate is stable, this implies UK manufacturing prices rising by 1.7% per annum more than in competitor countries. Such a differential would lift UK CPI inflation by about 0.5% pa relative to the overseas trend (based on the 31% weight of “non-energy industrial goods” in the CPI).

Commodity price gains in recent years have been largely driven by industrial expansion and rising food spending in emerging economies, trends that will persist. Fiscal adjustment, meanwhile, will necessitate further hikes in indirect taxes, with a rise in the standard rate of VAT to 20% widely expected during the next parliament.

In sum, the three factors could plausibly boost the CPI by about one percentage point per annum over the next five years. If the MPC were to exclude the effect when setting policy, this would imply a de facto raising of the inflation target from 2% to 3%.

How the MPC interprets its remit may be as important for the interest rate outlook this year as the evolution of inflation and output. In effect, Governor King is advocating downgrading the “at all times” requirement while shifting to a “core” inflation operational target (i.e. a Canadian-style approach). This warrants wider debate, both within and outside the MPC.

The preliminary GDP estimate for the fourth quarter was disappointing, showing growth of only 0.1%, although there are grounds for expecting an upward revision. A key issue is whether supply-side weakness is contributing to the sluggish recovery – this implies a deterioration in the growth / inflation trade-off.

Key points:

• GDP was held back by a decline in North Sea production: gross value added excluding oil and gas rose by 0.2%.

• The preliminary estimate appears to incorporate an assumption of a fall in GDP in December after rises in September and November and a flat October. A monthly GDP proxy based on services and industrial output data was 0.2% above its third-quarter average in October / November combined – see chart. The assumed December decline is based on limited information and may be revised away. (The third-quarter preliminary estimate also incorporated a fall in the final month of the quarter, subsequently revised to an increase.)

• Quarterly growth of only 0.1% sits uneasily with labour market data. The last post drew attention to a significant rise in vacancies in the fourth quarter; in addition, aggregate hours worked in the economy grew by 0.7% in the three months to November from the previous three months. Barring a significant upward revision to GDP, this suggests a further fall in productivity last quarter: official figures show a 1.6% decline in economy-wide output per hour in the year to the third quarter. Poor productivity performance has contributed to the recent rise in inflation by pushing up unit labour costs despite slowing wage growth.

• The key policy variable for the MPC is not real but nominal GDP – a fourth-quarter nominal estimate will be published in a month’s time (26 February). In the third quarter, nominal GDP rose by 1.1%, or 4.5% annualised, even as real output contracted by 0.2%. Inflation indicators suggest another strong increase last quarter despite a disappointingly small recovery in real activity.

As foreshadowed in a post two weeks ago, December inflation numbers again surprised unfavourably, with the headline CPI rate jumping to 2.9% from 1.9% in November. This confirms the earlier forecast of a rise above 3% in early 2010, necessitating a sixth explanatory letter from Bank of England Governor Mervyn King to the Chancellor.

The previously-targeted inflation measure, the RPI excluding mortgage interest payments (RPIX), rose to 3.8% last month – this would already have triggered a letter under former rules, requiring explanation of a deviation of more than one percentage point from 2.5%.

The annual rate of change figures for last month are the first since November 2008 not to be distorted by the December 2008 VAT cut. They show headline CPI inflation far above the 2% target, with the bulk of the deviation due to “core” trends – the CPI excluding energy, food, alcohol and tobacco rose an annual 2.8% last month. The Bank of England’s forecasts in early 2009 implied that core inflation would by now have fallen beneath 1% under the influence of the mythical “output gap”. The impact of economic slack on price trends, however, has been swamped by pass-through of higher import costs due to the 27% fall in the effective exchange rate between July 2007 and March 2009 – a plunge actively promoted by Bank policy-makers.

The November Inflation Report predicted that CPI inflation would average 2.7% in the first quarter of 2010; this forecast will need to be raised significantly in the forthcoming February Report. On the conservative assumption that December’s unfavourable surprise partly reflected firms adjusting prices in advance of the return of the standard VAT rate to 17.5% in January, CPI inflation may rise to 3.4% in January before falling back in February and March, averaging 3.2% for the quarter.

The pick-up in RPI inflation is proving even sharper than forecast last summer, partly because house prices have recovered more strongly than assumed. From 2.8% in December, the headline rate may reach 4-5% this spring. Historically, rising RPI inflation has had a negative impact on the poll position of the governing party – see previous post.

Governor King will be able to explain the January move in CPI inflation above 3% as the result of the VAT reversal. The persistent and significant divergence of core inflation from the 2% target, however, is more troubling and casts doubt on the sustainability of the current policy stance.

In the November Inflation Report, the two-year-ahead modal CPI inflation forecast based on an unchanged Bank rate and £200 billion of asset purchases was 2.35% – the furthest above target in the MPC’s history. The Bank argued that it was justified in setting policy “too loose” for the medium term because inflation would fall significantly below 2% in the interim. Such an undershoot is now unlikely, implying that the MPC must advance its timetable for tightening if a destabilising rise in inflationary expectations is to be avoided.

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COMMENT:
AUTHOR: Andrew Oxlade
EMAIL: editor@thisismoney.co.uk
IP: 195.234.243.2
URL: http://www.thisismoney.co.uk
DATE: 01/20/2010 10:49:08 AM

Hi Simon,
Love the commentary. So do you still believe rates will rise in March?

Thanks
Andrew
Editor
Thisismoney.co.uk

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COMMENT:
AUTHOR: Simon Ward
DATE: 01/25/2010 12:47:37 PM

I still expect rates to start rising in the spring as inflation, growth and housing market data continue to surprise on the upside. The MPC-ometer discussed in previous posts indicated that March was possible, depending on data flow – will update soon (after tomorrow’s GDP report).

The preliminary fourth-quarter GDP estimate published on Tuesday will be an important influence on near-term MPC decision-making. The surprise fall in third-quarter GDP (of 0.4% according to the preliminary estimate, subsequently revised to 0.2%) was probably the swing factor in the November decision to expand asset purchases by a further £25 billion.

Available output evidence is consistent with a GDP rise of 0.4-0.5% last quarter. A weighted average of industrial and services production was 0.25% above its third-quarter level in October. Industrial output rose a further 0.4% in November, while business surveys suggest that services activity strengthened into quarter-end.

Labour market trends hint at an upside surprise. The chart shows a scatter plot of quarterly changes in GDP (vertical axis) and job vacancies (horizontal). The rise in vacancies last quarter was the largest since the third quarter of 2007 and – based on the estimated trendline – is consistent with a GDP increase of 0.85% (red square on line).