Category: Money Moves Markets

The charts below update forecasts for consumer and retail price inflation presented in a previous post. Recent CPI outturns have been in line with the earlier projection but RPI figures have been higher than expected, partly reflecting house price gains. (House prices enter the RPI via a component measuring housing depreciation costs.)

The new forecasts are based on the same underlying approach as described in the earlier post but assumptions about food, energy and house prices have been updated. In addition, the projection for CPI inflation excluding unprocessed food and energy over the next year has been raised slightly to take account of recent exchange rate weakness. (At yesterday’s close of 77.5, sterling’s effective rate was 7% below the level assumed in the August Inflation Report.)

From its September level of 1.1%, annual CPI inflation is projected to rise sharply to nearly 3% in January before drifting lower over the remainder of 2010. The increase reflects unfavourable energy price base effects and the reinstatement of a 17.5% standard rate of VAT from January. The VAT change is assumed to add 0.5% to the CPI – equal to an estimate by the Office for National Statistics of the initial impact of last December’s reduction to 15%.

The projections are arguably conservative in two respects. First, energy utility tariffs are assumed to fall by 5% around the end of 2009, reflecting government pressure on suppliers to pass on earlier reductions in wholesale gas prices. Gas costs, however, have rebounded recently while companies may continue to resist cuts on the basis that profits need to rise to finance huge future investment requirements. Without a reduction, the January inflation rate might hit the 3.1% level necessitating an explanatory letter from Bank of England Governor King.

Secondly, annual inflation excluding unprocessed food and energy prices, and adjusted for the VAT effect, is projected to fall to 1.5% by the end of 2010 in lagged response to slower monetary growth, explaining the drift lower in the headline rate later next year. This compares with a current estimated rate of 2.5%. Core inflation has recently proved stickier than most forecasters expected and this could continue, particularly if the exchange rate remains weak.

The projections are significantly higher than those published by the Bank of England in the August Inflation Report – this shows average inflation of 2.1% in the first quarter of 2010, falling to 1.5% by the fourth quarter assuming an unchanged level of Bank rate. With recent figures above its expectations, and the pound much weaker, the Bank is likely to revise up its near-term forecasts once again in the November Inflation Report.

RPI inflation will rise even more sharply than the CPI measure, reflecting unfavourable mortgage rate and house price base effects in addition to the factors cited above. From -1.4% in September, the headline rate is forecast to rise to more than 3% next spring based on an unchanged Bank rate, with higher levels obviously implied by any increase in official rates. (The alternative scenario in the chart assumes that the average mortgage rate rises by half the amount of the change in Bank rate, consistent with the roughly 60% share of variable-rate loans in total mortgage debt outstanding.) The projections are based on house prices stabilising at current levels – probably again conservative, particularly if Bank rate remains at 0.5%.

The fall in annual CPI inflation to 1.1% in September reflected energy base effects and lower food prices and was in line with a forecast presented in an earlier post. Inflation is likely to climb sharply over the next few months, with a risk that it breaches 3% in January, necessitating an explanatory letter from Bank of England Governor King to the Chancellor

At the August Inflation Report press conference, Mr King stated that it was “more likely than not” that he would have to write a letter explaining an undershoot of 1% later in 2009. Because of the favourable energy base effect, any such shortfall was expected to occur in September. With the odds in favour of a rebound in October and beyond, an undershoot letter is now unlikely.

Despite the fall in September, inflation averaged 1.5% in the third quarter, comfortably above the Bank’s forecast of 1.3% made just two months ago. Coupled with the recent plunge in the exchange rate, this should lead the Bank to revise up its near-term projections once again in the November Inflation Report. It currently forecasts average inflation of 1.3% and 2.1% in the fourth and first quarters.

While the 1.1% September outturn is well below the 2% target, the shortfall is entirely explained by lower energy costs and last December’s VAT reduction. Core CPI inflation – excluding energy, food, alcohol and tobacoo – was 1.7% last month and would probably stand at 2.3-2.4% in the absence of the VAT change (based on official estimates of its impact).

The Bank, like the consensus, thought CPI inflation would fall by much more than it has this year – the May Inflation Report projected a drop to just 0.4% in the fourth quarter. Forecasting models gave too little weight to the impact of sterling’s decline while placing overreliance on highly-uncertain estimates of the “output gap” and its influence on pricing decisions. (These issues were discussed in a post in March.)

With CPI inflation overshooting its projections, and the core VAT-adjusted rate above the 2% target, today’s numbers do not warrant a further expansion of the Bank’s quantitative easing programme next month. As argued in a post last week, there is evidence that the Bank’s gilt-buying is creating excess liquidity in the economy and a further monetary injection could lead to an accelerating decline in the currency.

Last week’s gains in equity and commodity prices, and the further fall in the dollar, followed a moderately disappointing US employment report the previous Friday. This reinforced expectations that the Federal Reserve will maintain rates near zero and continue to supply ample liquidity for the foreseeable future. Comments last week by Fed Chairman Bernanke on exit strategy and National Economic Council Director Summers favouring a strong dollar failed to dent this consensus.

The current sensitivity of markets to the Fed’s liquidity provision was discussed in an article by Andy Kessler published in the Wall Street Journal in July. The article included a chart showing a correlation this year between the Dow Jones industrial average and a weekly monetary base measure calculated by the St Louis Fed. (The monetary base comprises currency in circulation and banks’ reserve balances with the Fed.)

An updated version of the chart is shown below, with the start date moved back to September last year – the monetary base began to surge following Lehman’s collapse. The apparent relationship has continued since the summer, with the Dow’s new rally highs last week accompanied by the weekly base moving above its May peak.

The theoretical basis of the relationship is questionable and it is unlikely to survive over the medium term. Markets, however, are unusually sensitive to news about the Fed’s policy stance currently and many investors seem to be interpreting the weekly monetary base as a real-time indicator of policy-makers’ intentions.

The Fed’s ongoing securities purchases will tend to expand the base further although the impact could be offset by other factors, such as reduced emergency lending to the banking system or a moderation in the public’s demand to hold currency. The weekly numbers may continue to hold exaggerated significance for both bulls and bears.

The strong consensus in favour of the Fed staying “loose for long” rests on a forecast that employment will continue to decline into year-end, resuming growth only in early 2010. The key risk for liquidity-driven markets is an earlier-than-expected return of jobs expansion. Perversely, any “good” labour market news will warrant increased investor caution.

The 1976 sterling crisis was triggered by a blow-out in the fiscal deficit and excessively loose domestic monetary conditions, caused partly by government borrowing from the banking system. Sound familiar?

Fiscal concerns reflected a rise in public sector net borrowing to 7.0% of GDP in 1975-76 – far below the 12.4% officially projected for the current financial year.

The IMF rescue in late 1976 involved a currency stabilisation programme based on limits on “domestic credit expansion” (DCE). This is defined as bank lending to the private sector plus the portion of the fiscal deficit not financed by selling debt to domestic non-bank investors. The focus on DCE was appropriate because much of the liquidity created by credit buoyancy was flowing overseas, so money supply statistics did not fully reflect the scale of monetary laxity.

This perspective is relevant currently because of evidence that liquidity created by the Bank of England’s quantitative easing (QE) programme has been flowing abroad, putting downward pressure on sterling. The table presents recent data on the relationship between DCE and money supply growth. The right-hand column covers the period from April to August, during which the Bank bought £120 billion of gilts.

The contractionary effect of liquidity outflows on broad money is captured by the “external and foreign currency counterparts”. The impact amounted to £49 billion over the five months – significantly larger than the £24 billion increase in broad money over the same period.

It is possible that outflows would have occurred in the absence of QE. The external counterparts, however, had a positive monetary impact in the prior 12 months to March 2009. The timing of the swing into negative territory, and the consistent contractionary influence in each of the five months covered, suggests a linkage with QE.

This analysis supports the argument in a previous post that the Bank’s gilt-buying is creating excess liquidity, which is being reflected in buoyant asset prices and sterling weakness but is not apparent from the broad money supply data. If the Bank expands QE further, the currency decline could accelerate.

The chart shows sterling’s trade-weighted index together with the contribution of public sector DCE to annual broad money growth – a negative correlation is apparent. This contribution is now 10 percentage points, the highest since – 1976. 

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COMMENT:
AUTHOR: Nigel Taylor
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IP: 193.169.14.66
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DATE: 10/08/2009 11:41:04 AM

Thanks Simon, at last someone has started to look at the correlation between now and 1976.It took at least 5 years to get out of that hole. It appears there could be further industrial unrest from the Unions to come. George Osbourne’s honest speech will "fan the flames", however whether we sink into a 3 day working week is another matter. This does not bode well for our currency and in my opinion the current feel good factor could easily evaporate.

Industrial and manufacturing output figures for August were shocking, showing falls of 2.5% and 1.9% respectively from July to new lows for the recession. If the figures are to be believed, UK manufacturers are bucking the trend of global recovery, despite the supposed big boost from the plunge in the pound. The US, Japan and Spain have reported industrial output gains of 0.8%, 1.8% and 1.1% respectively in August (Germany and France publish later this week).

There are reasons for doubting the figures, including the discrepancy with manufacturing purchasing managers’ survey results and the uniformity of declines across industries, suggesting a problem with seasonal or working-day adjustments. The numbers, however, will feed directly into the first estimate of third-quarter GDP released on 23 October – this may now show little if any growth (although later upward revisions are probable).

Hopes of the UK economy “rebalancing” towards a manufacturing-led recovery in response to a lower exchange rate look even more tenuous. An economic revival remains dependent on the much larger services sector, with financial services playing a key role. Fortunately, recent business surveys suggest that service industries are performing much better than manufacturing – see yesterday’s post – although this has yet to receive confirmation by official services output data.

The recent slide in sterling began on the day the Bank of England announced a £50 billion expansion of its quantitative easing programme. The timing is unlikely to be coincidental. The Bank’s gilt-buying may be creating excess liquidity in the economy, helping to explain surging asset prices as well as the fall in the pound.

The suggestion that monetary conditions are over-expansionary is controversial since broad money supply trends remain sluggish, with the Bank’s favoured measure growing at an annualised rate of only 4% so far in 2009. The impact, however, of supply trends on markets and the wider economy depends on the velocity of circulation of money. Having plunged in 2008 and early 2009, velocity may now be recovering.

Velocity is inversely related to the demand to hold money. A flight from markets as the financial crisis snowballed from late 2007 led to a big increase in money demand but this move is reversing as confidence returns and investors become disenchanted with record-low deposit rates. Despite weak supply growth, therefore, households, firms and institutions may be holding more money than they desire. Their efforts to remove the excess involve an increase in investment in markets and spending in the economy.

The current monetary backdrop echoes conditions between late 2005 and mid 2007 but excess liquidity was then the result of buoyant money supply expansion rather than weak demand. Excess money magnified the credit bubble while causing strong economic growth and, later, a significant inflation overshoot.

This inflationary process, however, was short-circuited when the bubble burst in late 2007. With banks curtailing credit expansion, the money supply slowed sharply while money demand boomed as investors fled risk assets. Excess liquidity in early 2007 was replaced a year later by a deficiency of supply relative to demand. This shortage exacerbated market and economic weakness as households and firms sought to boost cash levels by liquidating investments and cutting spending.

Official support for the banking system and the Bank’s gilt-buying have succeeded in stabilising money supply growth this year while money demand has eased, initially in response to interest rate cuts and more recently as confidence and risk appetite have revived. Several recent developments support the view that excess liquidity is now present.

First, households and companies have been shifting funds out of savings accounts into currency and accounts used for transactions purposes – a typical precursor of increased financial investment or spending. A narrow money measure comprising notes and interest-free current accounts has surged at an annualised rate of 46% so far in 2009.

Another sign of reduced money demand is the strong pick-up in mutual fund inflows, with retail sales of unit trusts and OEICs on course to surpass the 2000 record this year. Institutions have also been putting cash to work, with purchases of securities back up to 2007 levels in the spring quarter.

The deployment of funds by investors has allowed non-financial companies to issue bonds and shares in record amounts, using the proceeds partly to pay down more expensive bank debt. Their liquidity ratio – UK bank deposits divided by loans – has recovered to pre-recession levels, supporting hopes of a revival in business spending.

Higher-than-anticipated cash levels may partly explain markedly more optimistic consumer and business surveys. Consumer confidence has risen by much more in the UK than other major economies, supporting a linkage with the Bank’s unusually aggressive easing.

Finally, while asset prices are influenced by other factors, the strength and breadth of gains are consistent with monetary laxity. In addition to the fall in the pound, recent outperformance of gilts and UK property suggests looser conditions than in other economies.

What are the policy implications? If excess liquidity is present the economy is likely to recover faster than the Bank expects while inflation may continue to overshoot its forecasts, partly owing to renewed sterling weakness. This argues strongly against further easing and suggests that some withdrawal of monetary stimulus may be needed early in 2010 to keep the Bank’s projection for inflation in two years’ time in line with the 2% target.

Calls for a further extension of gilt-buying in November based on weak broad money trends are misguided. It would be unfortunate if officials, having ignored the monetary dimension while the bubble inflated, now place overreliance on broad money numbers when a range of other evidence indicates loose policy. A further monetary boost would risk creating another boom-bust in asset prices and the economy. With sterling already on the ropes, it could also precipitate a full-scale currency crisis.

Purchasing managers’ surveys for September were encouraging, with further gains in services output and new business offsetting slippage in the corresponding manufacturing indices. A weighted average of services new business and manufacturing new orders is only slightly below its long-term average, supporting hopes of GDP growth of 2% annualised or more during the second half – see first chart. (The rise in the PMI indicator had been foreshadowed by recent better corporate earnings news – see previous post.)

The suggestion that the recovery is being led by services rather than manufacturing – in contrast to widespread expectations of “rebalancing” to be induced by a plunging exchange rate – is supported by the CBI’s quarterly surveys of financial services, business and consumer services and manufacturing. The balance of manufacturing firms expressing greater optimism has recovered to the middle of its historical range but the corresponding balances in the two services surveys are at multi-year highs – second chart.

The six biggest bear markets in the Dow Jones industrial average in the 100 years before the October 2007-March 2009 decline were 1973-74, 1937-42, 1929-32, 1919-21, 1909-14 and 1906-07. The 1929-32 fall was by far the largest at 89% while the other five ranged between 45% and 52%. The 2007-09 bear involved a 54% slump. (For reference, the Dow decline over 2000-03 was “only” 38%.)

The chart compares the 2007-09 decline and subsequent recovery with the four peacetime bears, i.e. excluding the 1909-14 and 1937-42 falls, which were influenced in their later stages by the world wars. The peak levels of the Dow were rebased to 100 and the earlier cycles aligned with the October 2007 top.

At the March 2009 low the Dow was much weaker than at the equivalent stage of the 1906-07, 1919-21 and 1973-74 bear markets and was tracking the 1929-32 decline. The recent recovery, however, has moved the index above the four prior cycles.

The 1906-07, 1919-21 and 1973-74 bears were comparable in terms of magnitude and duration and the subsequent recoveries were also broadly similar. A repeat performance in the current cycle would involve the Dow rising to within 5-15% of its October 2007 peak by the end of 2010, implying an index level of 12000-13500.

Some pessimistic commentators draw a comparison between the recent recovery and the failed rally of November 1929-April 1930 – see the rise in the bottom, black line between late 2007 and mid 2008. The Dow climbed 48% versus a recent trough-to-peak increase of 50% before embarking on a further devastating decline.

Even ignoring policy differences, the comparison is dubious because the 1929-30 failed rally began only two months into the bear market and three months into the recession, before the full consequences of the bursting of the prior credit bubble were apparent. The March 2009 bottom, by contrast, followed a long economic and market decline and was characterised by very weak investor expectations.

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COMMENT:
AUTHOR: kagiso
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IP: 94.196.245.152
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DATE: 10/02/2009 11:14:45 PM

Mmmm, including the ’73 data without adjusting for inflation doesn’t meet your usual impeccable standards. Deflating puts the current peak at 2000 rather than 2007 and the ’73 peak was actually back in ’66. Although real prices in 1982 were above 1973 the real increase from ’73 to ’82 was derisory. This secular bear market is still very young.

Recent posts have argued that the consensus is misreading the monetary data and underestimating the degree of stimulus to asset markets and the wider economy from the current policy stance. News this week supports the view that economic performance and prospects are improving significantly.

First, a monthly GDP estimate based on services and industrial output data rose by 0.1% in July after a 0.3% June gain, to stand 0.2% above its second-quarter average – see first chart. With business surveys suggesting a further recovery and upward revisions possible, GDP may have grown by as much as 0.5% in the current quarter (preliminary figures will be released on 23 October).

Secondly, the EU Commission measure of consumer confidence vaulted higher in September and is now only marginally below its long-term average. UK confidence has recovered much more strongly than in other major economies – second chart. In addition to becoming more optimistic about the economy and their own finances, households are signalling reduced concern about labour market weakness, suggesting that unemployment could peak earlier than many expect.

Thirdly, the number of upgrades to company earnings forecasts by equity analysts is exceeding downgrades by a widening margin, which is usually a sign of rising economic momentum. The “revisions ratio” (i.e. net upgrades divided by the total number of earnings estimates) correlates with business surveys and suggests further improvement in forthcoming purchasing managers’ indices – third chart.

UK broad money growth remained sluggish in August but narrow money posted another strong gain, corporate liquidity continues to improve and mortgage lending is recovering. These developments suggest that the broad money numbers understate monetary support for the economy, i.e. the velocity of circulation may now be rising.

1. M4 excluding “intermediate other financial corporations” rose by 0.2% in August, down from 0.4% in July, with the decline probably due to smaller Bank of England gilt purchases (£12 billion versus £23 billion). Incorporating downward revisions to earlier numbers, broad money grew by 4.0% annualised in the first eight months of the year.

2. By contrast, “non-interest-bearing M1” – comprising cash and interest-free current accounts – rose by 1.8% in August, giving a year-to-date annualised gain of 46%. As discussed in recent posts, narrow money strength relative to broad money is often an indicator of a pick-up in velocity. (Note: non-interest-bearing M1 includes only current accounts with no advertised interest rate, i.e. it is not distorted by the rate on some accounts being cut to zero.)

3. Private non-financial corporations’ cash and deposits rose last month, with a small fall in their M4 holdings offset by a rise in foreign currency assets. With bank borrowing little changed, a foreign-currency-inclusive measure of the liquidity ratio rose further to its highest level since October 2007 – see first chart.

4. M4 lending excluding intermediate OFCs slumped by 0.5% last month but this was entirely due to financial corporations, whose borrowings are often volatile. Lending to households and private non-financial corporations rose by 0.1%.

5. Net mortgage lending recovered to £1.0 billion in August while the value of mortgage approvals for house purchase reached its highest level since April 2008. The number of approvals, however, was marginally lower than in July, indicating that the lending pick-up is weighted towards higher-value homes – second chart. Net lending remains on course to recover to about £2 billion over coming months – see earlier post.