Category: Money Moves Markets

Global economic activity has rebounded more strongly than most commentators expected over the last six months. A post last week suggested that this recovery would soon be reflected in a significant improvement in labour market indicators.

The US Conference Board this week reported that its employment trends index – a composite of eight labour market leading indicators – rose for the second consecutive month in October. In the last five US recessions the index bottomed between one and four months before non-farm payroll employment. With its recent low reached in August, this suggests a trough in payrolls by December.

The first chart shows the three-month change in payrolls together with an alternative labour market gauge based on three indicators excluded from the Conference Board measure – the ISM manufacturing employment index, the monthly tally of job-cut announcements by Challenger, Gray and Christmas, and the NFIB small firm hiring plans index. This also suggests an imminent employment trough.

In the UK, promising indicators include the strong Markit / REC job placements index highlighted in last week’s post and a further reduction in the net percentage of households expecting higher unemployment in the EU Commission consumer survey – see second chart.

Improving labour market indicators will boost confidence in the sustainability of the economic recovery while calling into question current super-loose monetary policies. In other words, better news for Main Street in early 2010 will represent the first real test of the liquidity-driven rally in markets.

The central projection in the November Inflation Report implies that current monetary policy is the loosest – in terms of calibration to achieve the inflation target over the medium term – in the 12-year history of the Monetary Policy Committee. The forecast casts further doubt on last week’s decision to expand asset purchases by another £25 billion to £200 billion.

In the August Report, the MPC projected that inflation would be 2.17% and rising in two years’ time based on unchanged interest rates and £175 billion of asset-buying. A key issue in the run-up to last week’s meeting was how the Committee could justify further easing against the background of this forecast.

Today’s Report provides the answer: the forecast was ignored. The new two-year-ahead projection based on unchanged policy is about 2.3% (estimated from the fan chart). The increase from August is partly due to rolling the forecast forward one quarter but also reflects an upgrade to GDP prospects based on the lower level of the exchange rate and stronger global demand, as well as the further expansion of asset purchases.

At 30 basis points, the positive deviation of the two-year-ahead central forecast from the target is the most since the MPC’s inception in 1997 – see chart. The previous largest excess, of 27 basis points, occurred in the May 2004 Report. The MPC raised interest rates in May, June and August 2004.

The MPC’s remit is to set policy to achieve the inflation target “at all times”. It might be justified to ignore two-year-ahead prospects if inflation were forecast to be persistently below target before or after two years. This, however, is not the case: the central projection is above 2% during the first half of 2010, below 2% between mid 2010 and mid 2011, and above 2% from the second half of 2011.

Another possible defence of current policy settings is that inflation risks are weighted to the downside. The Report, however, states that risks are balanced at the two-year horizon and an inspection of the fan chart does not suggest a significant downward skew to shorter-term forecasts.

The inconsistency between its forecast and last week’s further easing poses a risk to the MPC’s credibility. Markets, for example, may worry that the Committee is retreating from a pure focus on the inflation target, or placing more weight on avoiding an undershoot than an overshoot, although this would be in conflict with its remit.

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COMMENT:
AUTHOR: Econoclast
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DATE: 11/12/2009 08:12:04 AM

I agree with your argument and also believe this could start to undermine the Bank’s credibility. But I think there are three explanations for what it’s doing:

1. Given the uncertainty about where we are and the forecasts for 2010, an additional chunk of QE is ‘insurance’ against downside risks that – if realized – would be more intractable than upside risks.

2. I don’t buy the ‘hyperinflation’ argument, but might the Bank be aiming to create a little unexpected inflation, which together with a weaker pound, will help to erode debt burdens?

3. Perhaps the Bank knows that there is one obvious downside risk to its forecasts that it can’t talk about – fiscal tightening. For monetary policymakers, it makes sense to anticipate this and we have to hope that fiscal policymakers get on with it before markets question their credibility more openly.

The monetary approach to economics argues that “excess”money – the difference between the supply of money and the demand to hold it – is a key influence on spending and financial investment decisions. Assuming that the (unobservable) demand for money is stable, shifts in “excess” money will reflect changes in money supply growth.

Money demand, however, has been unstable in 2008 and 2009. The financial crisis led to an increase in liquidity preference as investors scrambled to sell “risky” assets. More recently, desired cash levels have fallen in response to low interest rates and reviving markets. Strong inflows to US and UK equity and bond mutual funds are one sign of reduced money demand.

The chart shows six-month growth in US broad money M2 together with a six-month running total of flows into or out of US funds, expressed as a percentage of M2. A strong inverse relationship is apparent since the start of 2008. The recent monetary slowdown and pick-up in fund inflows is the mirror-image of late 2008, when a surge in M2 accompanied record outflows.

The implication is that buoyant M2 growth in late 2008 overstated support for the economy and markets from “excess” money because the demand for cash was temporarily elevated by a flight from “risky” assets. Conversely, recent M2 weakness may not imply “deficient” money because liquidity preference has fallen back.

Rather than M2 itself, the sum of money growth and mutual fund flows – the third line in the chart – may provide a better guide to shifts in “excess” money. This indicator has performed well recently: it weakened sharply from mid 2008, warning of a deepening recession, but recovered late last year and in early 2009, foreshadowing the revival in markets and the economy.

Some monetarist economists claim that recent M2 stagnation signals renewed economic weakness in 2010. The indicator incorporating mutual fund flows, however, remains at a healthy level, suggesting monetary underpinnings for an ongoing recovery. This message is supported by more upbeat narrow money trends – see previous post.

Producer price figures for October raise further concerns about inflation prospects. “Core” output prices – i.e. excluding food, beverages, petroleum and tobacco – rose by 0.3% on the month following a 0.5% September gain, pushing annual growth to a six-month high of 2.0%.

Recent solid monthly increases are unusual for this time of year. The chart shows annual growth together with a three-month rate of change based on an attempt to adjust the raw numbers for seasonal variation. This latter series has surged to an annualised 7% – the highest since July last year.

This pick-up conflicts with the official and consensus view that large-scale excess capacity will pull core inflation lower, offsetting upward pressure from the weak exchange rate, rising commodity input costs and supply-chain disruptions due to insufficient working capital. Companies may be attempting to push through faster price increases under cover of the further fall in the pound since the summer and the coming hike in VAT.

The Monetary Policy Committee has delivered a minimal further easing of policy by raising its gilt-buying programme by £25 billion to £200 billion. The additional purchases will be spread over three months, implying a slowdown to half the recent pace, and no additional authority beyond £200 billion has been requested. The message seems to be that this will be the final slug barring an economic shock. The statement contained no reference to any change in current arrangements for paying interest on bank reserves.

Today’s decision is questionable in two respects. First, an additional £25 billion of buying spread over three months will have minimal effects relative to a policy of suspending purchases now. If the MPC really believes that further stimulus is required, the debate should have been between £50 billion and £75 billion, as it was in August.

Secondly, the suggestion that additional buying is warranted by the MPC’s updated inflation projection lacks credibility. In August, it forecast that inflation would be above 2% and rising in two years’ time. Since then, inflation outturns have been higher than expected, sterling has weakened and commodity prices have strengthened. By lowering its projection, the MPC appears to be placing even more weight on a simplistic “output gap” inflation model, despite its recent forecasting failure.

The economic surprise of the last six months has been the strength of the rebound in global industrial activity. The surprise of the next six months could be the speed of the turnaround in labour markets.

A fundamental reason for optimism is the impressive recovery in company finances, which should encourage more expansionary behaviour. In the US, the corporate financial balance – the difference between retained earnings and capital spending – has moved from a deficit of 2.1% of GDP in the first quarter of last year to a surplus of 1.1% by this year’s second quarter. Excluding the third and fourth quarters of 2005, which were distorted by a one-off repatriation of foreign profits to take advantage of temporary tax incentives, this is the highest since the fourth quarter of 1960. The financial balance is a leading indicator of employment – see first chart. The equivalent UK balance has also moved into surplus.

Trends in temporary employment often provide early warning of changes in labour demand. US “temporary help” jobs fell by just 2,000 in September versus a prior six-month average of 26,000. The American Staffing Association’s staffing index, moreover, has recovered strongly in recent weeks, suggesting that Friday’s payrolls report for October will show a rise in temporary jobs – second chart. (The index is a survey-based measure of demand for short-term and contract workers; the series in the chart has been adjusted for seasonal variations.)

In the UK, the Markit / Recruitment and Employment Confederation Report on Jobs survey for October released today showed a further recovery in demand for both temporary and permanent staff. The permanent placements index is well above the break-even 50 level, suggesting a stabilisation and recovery in private-sector employment over coming quarters – third chart. Purchasing managers’ employment indices – coincident rather than leading indicators – remained below 50 in October but improved from September.

The strong consensus in favour of central bank policies staying “loose for long” rests on a forecast of continuing labour market weakness. An earlier-than-expected return of jobs expansion would boost confidence in the sustainability of the economic recovery but could signal the end of the liquidity-driven rally in markets.

The percentage balance of consumers expecting higher inflation over the next year has risen from -5% in July to +4% in October, according to the EU Commission survey. The current balance, while still depressed by historical standards, is the highest since November last year – see chart.

It is tempting to discount the recent increase as a reflection of the coming VAT hike. The latest Citigroup / YouGov survey, however, shows that longer-term inflation expectations have also firmed, with the average forecast rising from 2.8% in January to 3.2% in October.

There is a danger that expectations are moving higher partly because of doubts about the Bank of England’s ability or willingness to achieve the 2% inflation target over the medium term. The Bank’s inflation forecasts have been consistently too low in recent years while its gilt-buying may have raised concerns about policy independence.

The survey measures are influenced by current inflationary trends and have historically correlated more closely with retail than consumer prices. Headline RPI inflation is likely to rise from -1.4% in September to 3% or more by next spring as a result of the VAT hike and unfavourable energy, house price and mortgage rate effects – see previous post.

Inflation expectations are an important influence on the Bank’s policy decisions – the EU Commission measure is a component of the “MPC-ometer” model for forecasting interest rate changes described in earlier posts. The recent increase is a further argument against an expansion of gilt purchases at this week’s meeting.

Recent posts have argued that the Bank of England should not and probably will not expand asset purchases at its meeting this week. A range of evidence suggests that monetary conditions are sufficiently and possibly excessively loose. The Bank, meanwhile, faces difficulty in justifying a further extension given medium-term inflation prospects.

By contrast, 43 out of 62 economists polled by Reuters last week expect more asset-buying, with the majority split between a £25 billion and £50 billion increase. The Sunday Times Shadow MPC, which is often a good guide to the Bank’s thinking, is also strongly in favour of an extension – see David Smith’s blog for details.

This week’s purchasing managers surveys for October are likely to be an important influence on the decision. As mentioned last week, earnings revisions pointed to strong results; the manufacturing survey this morning duly surprised positively, with the leading new orders component rising to its highest level since January 2004.

The companion survey covering the larger services sector will be released on Wednesday. Suppose, however, that the new business component is unchanged from its September reading. A weighted average of manufacturing new orders and services new business would then reach its highest level since September 2007 – two months after the final interest rate increase in the last tightening cycle. 

The chart shows Bank rate together with this new business indicator, with the last data point incorporating the services assumption. The MPC has eased policy only once with the indicator at or above its implied October level – in February 2001. Consumer price inflation, however, was then below 1% (and undistorted by VAT effects) while the US economy was entering, not exiting, a recession.

Proponents of keeping Bank rate at its current 0.5% level for a sustained period argue that substantial economic slack will bear down on inflationary pressures, risking an undershoot of the 2% target over the medium term. There is no dispute that output is currently below potential; the issues are the size of the gap, its “coefficient” in an inflation model and possible offsets from other factors.
 
Most methods for estimating potential output assign a large weight to recent actual data. This is problematic during recessions, when some business activities contract on a permanent basis as capacity is scrapped. Unusually severe credit restriction in the current downturn may have magnified this capacity effect.

Some recent business surveys cast doubt on claims that companies have scope to boost output significantly, at least without a rise in marginal costs. In the latest CBI industrial trends survey, for example, the percentage of firms citing plant capacity as a factor limiting output was close to its long-run average. The implied disagreement with output gap estimates, such as those produced by the OECD, is unusually large – see chart. (There is a similar divergence between US gap estimates and ISM survey evidence of lengthening delivery times, indicating supply bottlenecks.)
 
A generalised “Phillips curve” inflation model should include not only the output gap but also its rate of change, inflation expectations, the exchange rate, global commodity prices and the real level of indirect taxes. The last three factors have been the key drivers of inflation movements in recent years. If sterling continues to weaken, commodity prices remain underpinned by rapid emerging-world growth and indirect tax increases bear a significant burden of necessary fiscal adjustment, these factors may continue to outweigh the disinflationary impact of economic slack.

UK monetary statistics for September are much better than they look on first inspection. The Bank of England’s preferred broad money measure – M4 excluding “intermediate other financial corporations” – fell sharply on the month, resulting in a third-quarter contraction of 1.7% at an annualised rate. This would seem to argue strongly in favour of a further expansion of asset purchases at next week’s MPC meeting.

On closer analysis, however, the quarterly decline was entirely due to “non-intermediate” financial corporations running down their money balances. Insurance companies, pension funds, trusts and other fund managers reduced their M4 holdings by £10 billion last quarter, presumably reflecting increased confidence in financial market prospects.

M4 excluding all financial corporations, i.e. money holdings of households and non-financial companies, rose by 0.3% in September and 3.8% annualised in the third quarter – the fastest since the second quarter of 2008. This should encourage Bank policy-makers, indicating that liquidity created by official gilt-buying is filtering down to “end-users” responsible for spending decisions.

As well as increasing their sterling deposits, non-financial firms continued to add to foreign currency holdings while repaying sterling and foreign currency bank loans. Accordingly, the corporate liquidity ratio, i.e. money holdings divided by bank borrowing, rose further to a two-year high – see first chart. This ratio is a leading indicator of business investment and hiring.

Further encouraging features of the data include a pick-up in narrow money M1 and a continuing recovery in mortgage approvals for house purchase, suggesting that net mortgage lending will rise to £2 billion a month or higher by late 2009.

Meanwhile, EU Commission consumer survey results for October also released today showed a further strong improvement in confidence, which has now returned to its long-run average. Confidence has recovered much faster than in other major economies – second chart.