Category: Money Moves Markets

A post last week suggested that 4% UK broad money growth was sufficient to support a solid economic recovery because the velocity of circulation may be rising. Expressed differently, the demand to hold money may be declining as cash hoarding related to last year’s crisis reverses

One sign of declining money demand is a recent pick-up in mutual fund inflows. Net retail sales of unit trusts and OEICs totalled £14.0 billion in the first seven months of 2009, up from £3.9 billion in all of 2008, according to the Investment Management Association. Sales are on course to reach about £24 billion for the full year, well above the prior annual record of £17.7 billion in 2000.

If a £20 billion rise in mutual fund buying between 2008 and 2009 reflects a reduced demand for money, money supply numbers will understate the growth in cash available to finance economic recovery by £20 billion this year. This is equivalent to 1.3% of the MPC’s favoured broad money measure, M4 excluding cash holdings of “intermediate other financial corporations”.

As the earlier post noted, some monetarist economists argue that QE should be expanded further until broad money growth reaches 6% per annum or higher. With money demand likely to be rising by significantly less than 6% pa, however, this would risk creating excess liquidity, leading to new asset market bubbles and – further ahead – another pick-up in inflation.

Today’s Financial Times Lex column contains an interesting article arguing that US corporate profit margins are far above their long-run average and should “return to the mean relatively quickly”, implying significant risk to current consensus earnings estimates. The article states that corporate profits before depreciation, tax and interest amounted to about 35% of corporate output in the second quarter compared with an average since 1947 of 29%.

On closer inspection, however, the margins measure used appears somewhat odd, in that pre-depreciation profits are compared with net corporate output, i.e. after deducting depreciation. That is, there seems to be an inconsistency in the treatment of depreciation between the numerator and denominator of the ratio.

Two consistently-defined measures of profit margins are 1) profits before depreciation, tax and interest as a percentage of gross corporate output, i.e. before deducting depreciation, and 2) and profits before tax and interest as a percentage of net output. These gross and net measures are shown in the first chart. The gross measure behaves similarly to the series used in the FT article but net margins are currently much less extreme relative to history – 19.4% in the second quarter versus an average since 1950 of 18.1%.

The widening gap between the two measures reflects a trend increase in depreciation as a proportion of output, related to a rising economy-wide capital-output ratio and a shortening average life-span of capital goods. If gross margins were to mean revert, as Lex thinks likely, net margins would fall to the bottom of their historical range.

Economic theory suggests that the income share of capital-owners should be stable over the long run but this refers to their rewards after compensation for the erosion in value of assets due to depreciation. This argues for using net rather than gross margins.

The FT analysis focuses on domestic profits, ignoring the 25% share of total profits accounted for by foreign earnings. The second chart compares total profits net of taxes and adjusted for inflation with a log-linear trend. This suggests that profits were 8% below trend in the second quarter after a 10% first-quarter shortfall – similar to the 13% deviation at the bottom of the last recession.

The slope of the trend-line implies real profits growth of about 3.5% per annum. Assuming 2% inflation, nominal trend profits will be about 18% above the second-quarter actual level by the end of 2010. Consensus hopes of a significant earnings recovery next year are therefore not irrational, providing a near-term economic pick-up can be sustained.

UK broad money – as measured by M4 excluding money holdings of “intermediate other financial corporations” – probably needs to grow by 6-7% per annum over the long run to be consistent with sustainable economic growth and the 2% inflation target. This assumes a decline in the velocity of circulation of about 2% pa, in line with the trend over 1992-2004, when CPI inflation averaged close to 2%. (Trend growth of 2.5% plus 2% inflation and a 2% velocity decline implies a required 6.5% pa increase in broad money.)

In late 2008 annual broad money growth was below 4% and falling. A post in February therefore argued that the MPC needed to buy assets from the domestic non-bank private sector on a scale sufficient to deliver a five percentage point monetary boost. This was estimated to require purchases of at least £125 billion. The following month the MPC announced a purchase programme of up to £150 billion; this was expanded to £175 billion at last month’s meeting.

Broad money has accelerated as a result of this initiative but by less than expected, with a 4.9% annualised increase in the first seven months of the year. Many monetarist economists argue that, unless coming figures improve sharply, the MPC should expand asset purchases further in November and continue buying until money growth reaches at least 6%. (See, for example, the minutes of the last Sunday Times Shadow MPC meeting, available on David Smith’s blog.)

While faster growth is likely to be required over the long run, however, there are reasons for thinking that the recent modest pace of monetary expansion is consistent with a solid recovery in 2010 and does not pose a downside risk to the inflation target. On this view, the MPC should be cautious about expanding asset purchases any further, particularly given uncertainty about the lagged effects of buying to date.

The first point is that slow money growth in 2008-09 is partly just pay-back for excessive strength in earlier years. The annual increase averaged 10% over the three years 2005-07, implying a cumulative deviation from a 6.5% long-run norm of 10-11 percentage points. This has been partly absorbed by a cumulative inflation overshoot of about 3 percentage points but there remains an excess of 7-8 percentage points available to finance future economic growth. If this excess were to be eliminated by the end of 2010, broad money growth over 2008-10 would need to be about 2.5 percentage points below the 6.5% pa norm, i.e. about 4%. Recent trends are broadly consistent with this scenario.

Expressing the same point in a different way, the decline in velocity has averaged 4.5% pa since the end of 2004, much larger than the prior 2% trend. The fall last year may have reflected households and companies hoarding cash because of extreme uncertainty about financial and economic prospects. With interest rates at record lows and markets reviving, this velocity slump may now be reversing, in which case 4-5% money growth is more than sufficient to support a strong recovery and on-target inflation.

A prior post on recent US monetary trends suggested that a recovery in broad money velocity ought to be associated with a shift of funds out of savings accounts into cash and transactions deposits, implying a pick-up in narrow money relative to the broader measure. Consistent with this suggestion, notes and coin in circulation rose by 7.6% annualised over January-August, above the 4.9% growth rate of broad money up to July. Historically, “non-interest bearing M1” – comprising cash and sight deposits with no advertised interest rate – has also conveyed useful information. This measure is not officially recognised but can be calculated from published Bank of England data: annual growth was 23% in July – see first chart. (Note that this does not reflect banks cutting the interest rate on some sight deposits to zero, since the “non-interest bearing” definition covers accounts with no ability to pay interest, not those with a current zero rate.)

Monetarist arguments for a further expansion of asset purchases also cite the small scale of the recovery to date in the corporate liquidity ratio – private non-financial firms’ M4 money holdings divided by their sterling bank borrowing. A wider definition including foreign currency deposits and borrowing has shown a larger pick-up – see chart in previous post – but either version of the ratio is still well below the long-run average. However, a sectoral analysis suggests that deficient liquidity is concentrated in the real estate and construction sectors, while some industries (e.g. manufacturing) have ample cash. The aggregate ratio excluding real estate and construction is in the middle of its historical range – second chart. This supports hopes of an early recovery in business spending (outside the real estate sector) and is also easier to reconcile with national accounts data showing a record corporate sector financial surplus (i.e. undistributed income minus capital spending).

Economists expect no change in Bank rate or QE tomorrow but rumours abound of a change in arrangements for paying interest on cash reserves held at the Bank of England. Banks currently receive Bank rate on all reserves; critics claim this encourages hoarding of cash.

As explained in a prior post, a blanket abolition of interest on reserves would push overnight rates well below Bank rate. One of the objectives of the Bank of England’s money market operating procedures is to keep the two in line. Suspending this objective would undermine the anchor role of Bank rate in current monetary arrangements.

Since interest abolition and a consequent fall in overnight rates would be an effective easing of monetary policy, the decision would need to be taken by the full MPC rather than Bank staffers. If the MPC judges such an easing to be necessary, it is difficult to understand why it would not simply cut Bank rate itself, or indeed why it did not do so last month.

While interest abolition seems unlikely, at least without an accompanying cut in Bank rate, the Bank could conceivably introduce measures to penalise individual banks holding larger-than-average reserves balances, e.g. balances above a certain percentage of sterling assets could receive no interest or attract a charge. The macroeconomic implications of such a change, however, would be negligible.

The OECD’s forecast that UK GDP will contract by a further 0.25% in the third quarter looks even more suspect following today’s industrial output release for July, showing a 0.6% rise from June to a level 0.7% above the second-quarter average.

Services output for July will be published on 30 September but the June number was already slightly above the second-quarter average. Even assuming no rise in July (at odds with more upbeat recent business surveys), the monthly GDP estimate described in previous posts will be 0.2% above the second-quarter level – see chart.

The August minutes contained yet another surprise for MPC-watchers, with three members voting to expand asset purchases by £75 billion rather than the £50 billion favoured by the majority. The difference, however, should not be exaggerated: the Committee agreed that the new purchases should be spread over three months and the size of the programme is unlikely to be revisited before the November meeting, when the MPC will update its quarterly forecasts. If the economy evolves in line with the projections in the August Inflation Report, there will be no justification for continuing gilt-buying and by early 2010 the Committee will be under pressure to start withdrawing monetary stimulus.

A useful summary measure of the implications of the Inflation Report for future policy direction is the MPC’s mean forecast for inflation in two years’ time based on unchanged policies. This forecast fell to a record low of 0.38% in February, signalling that the Committee judged significant further easing to be necessary – the gilt purchase programme was announced the following month, along with a half-point cut in Bank rate. In the May Report, the two-year-ahead forecast was raised to 1.71% but the shortfall from the 2% target indicated that the MPC retained an easing bias. This residual bias partly explains the decision to expand asset purchases further in August.

The August Report, however, suggests that the £50 billion expansion was larger than strictly necessary because the two-year-ahead forecast is now above the target, at 2.17%. This is the first positive deviation since last August and the largest since August 2007 – the MPC last raised Bank rate in July 2007. The Committee’s decision to adopt a looser policy than warranted by its projections appears to reflect a judgement that the economic costs of inflation undershooting the target would exceed those of an overshoot. It has, in effect, taken out temporary insurance against worse-than-expected outcomes.

The emphasis, however, is on “temporary”, since such an approach risks damaging inflation-fighting credibility. Moreover, if the economy performs in line with the MPC’s mean expectations, the deviation between the current policy stance and one calibrated to achieve 2% inflation will widen. The August Report shows mean inflation climbing by 0.2 percentage points between the third quarter of 2011 and the first quarter of 2012 in the forecast based on market-implied interest rates; the increase would be greater if rates are unchanged. So the two-year-ahead projection based on unchanged policies could rise from 2.17% currently to about 2.5% by early next year. A 0.5 percentage point excess over the target would be at the top of the historical range.

Taken at face value, therefore, the August forecasts seem to lay the foundations for a withdrawal of monetary stimulus in early 2010. Of course, with economic recovery at an early stage and unemployment possibly still rising, any such action would be controversial. Moreover, some MPC members may argue for a delay to monitor the impact of the January VAT rise, although an assessment has already been built into the projections. The imminent general election may also affect the Committee’s willingness to follow the logic of its forecasts – political sensitivities may be heightened by the Conservative proposal to transfer responsibility for financial regulation from the Financial Services Authority to the Bank of England.

While the likelihood of policy tightening in early 2010 can be debated, the August Report appears to rule out further loosening unless growth and / or inflation fall significantly short of the MPC’s expectations. This seems unlikely. The GDP forecast based on unchanged policies shows a mean rise of only 1.1% in the year to the second quarter of 2010 but purchasing managers’ indices have recovered close to long-term averages, consistent with annualised growth of more than 2%, while an end to destocking alone will give an arithmetical boost of 1.4 percentage points.

The MPC has revised up its short-term inflation projections significantly since the May Report, now expecting an annual CPI gain of 1.3% in the third and fourth quarters, but this is possibly still too low in light of July’s higher-than-expected outcome of 1.8%. While food price trends are favourable, core inflation may remain disappointingly sticky, reflecting lagged currency effects and – perhaps – a smaller “output gap” and / or lower sensitivity to economic slack than widely assumed. Also worthy of note is a likely strong rebound in retail price inflation from late 2009, which may boost measures of household inflation expectations monitored by the MPC. (See previous post for more discussion of inflation prospects.)

An eventual withdrawal of monetary stimulus is likely to take the form of a rise in Bank rate rather than a reversal of quantitative easing. The Bank of England could drain banks’ excess cash reserves, by selling bills or reducing repo lending, but such action would probably have little economic impact. A run-down of the Bank’s gilt portfolio is unlikely to be possible next year given forecasts that fiscal funding needs will remain gargantuan – unless officials are prepared to risk triggering a major rise in yields. With “quantitative tightening” off the agenda, and given the historically low starting level, rises in Bank rate, when they begin, could be larger than in the initial stages of prior cycles.

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COMMENT:
AUTHOR: Stuart Henshall
EMAIL:
IP: 85.14.77.128
URL:
DATE: 09/07/2009 09:43:09 AM

‘The need for low rates and cash pushed in the economy from the Bank of England is cited as being necessary to counter expected higher taxes – which will put a lid on consumer demand.’

— Is the issue of higher taxes considered in this blog?

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COMMENT:
AUTHOR: Stephen Spurdon
EMAIL:
IP: 82.11.14.159
URL:
DATE: 09/07/2009 01:09:44 PM

Simon. BANG-ON yet again. The fact that the City Page comment took the OECD at face value makes me suspect most of them are asleep at the wheel … which would be a surprise (NOT).
The obvious (since you have pointed them out) deficiencies in OECD/IMF forecasting make it extremely perplexing that they are taken seriously – I suppose it is the case that they say what people want to hear???

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COMMENT:
AUTHOR: Simon Ward
DATE: 09/08/2009 07:33:23 AM

Higher taxes are taken into account but empirical evidence shows that monetary conditions are a more powerful influence on cyclical fluctuations.

The technical abilities of OECD and IMF economists are not in doubt but the institutional structure of the organisations militates against criticism of member countries’ policies. The OECD’s downbeat UK view helps the government to justify current extreme fiscal laxity.

The significance accorded by media commentators to OECD and IMF forecasts remains a mystery. Both were later even than the consensus of economists to recognise last year’s developing recession. Neither predicted the emerging strength of the current recovery, reflected in a V-shaped rebound in industrial output in emerging economies and this week’s upbeat G7 manufacturing surveys.

Both are political bodies and thereby constrained from issuing forecasts implying criticism of member governments’ policies. The IMF’s warnings of financial and economic doom since late 2008 have not been unrelated to its demands for additional funding.

Both organisations have been unaccountably, and so far wrongly, negative on the UK’s relative economic performance, predicting late last year that Britain would suffer the largest annual decline in GDP among the major economies in 2009. Even based on the OECD’s latest forecast that UK GDP will continue to contract during the second half while the US and Euroland recover, the calendar 2009 fall of 4.7% will be smaller than in Germany (4.8%), Italy (5.2%) and Japan (5.6%).

The projected further UK decline, however, is implausible. June data on services and industrial output already suggest a marginal GDP rise in the third quarter. Recent purchasing managers’ surveys are consistent with expansion and stronger than their Eurozone counterparts. Broad money trends are also more favourable in the UK: the 4.9% annualised rise in adjusted M4 between January and July compares with growth of just 0.3% in Eurozone M3.

The OECD bases its UK pessimism partly on the larger role of the financial sector in the economy. Yet the last CBI financial services survey signals that the big recovery in markets since the spring is already contributing to a revival in business volumes, suggesting a positive GDP impact going forward – see chart.

The GDP rises in Germany and France in the second quarter partly reflected temporary “cash for clunkers” effects and pay-back for earlier extreme German weakness. Germany may continue to outperform other EMU members as global trade revives but Euroland as a whole is likely to lag the UK in the coming recovery.

Purchasing managers’ new orders indices support hopes of a strong recovery in G7 industrial activity during the second half – see first chart. This pick-up, however, partly reflects temporary factors such as slower destocking and “cash for clunkers” schemes. Sustained growth will require companies to move out of retrenchment mode and in particular to resume hiring, thereby providing income support for increased consumer spending

Other components of the latest surveys indicate that companies are reacting cautiously to unexpected strength in incoming demand. For example, while the US Institute for Supply Management (ISM) new orders index reached a five-year high last month, employment, inventories and import indices remain below their historical average readings – second chart.

One scenario is that orders strength will fade rapidly, validating firms’ scepticism. This is unlikely: stocks cycle upswings typically last 12-18 months and the current boost should be unusually large given record destocking in late 2008 and early 2009.

Alternatively, firms may wait for higher orders to be sustained for a couple more months before shifting into expansionary mode. This is plausible and would be consistent with behaviour in previous cycles. However, companies may be more risk-averse given recent traumas while restricted credit availability may limit their ability to ramp up production and hiring.

This raises the possibility of a third scenario, in which order flows remain strong but the supply-side response is less dynamic than in prior upswings. As well as a less steep recovery trajectory, this would imply an earlier emergence of supply constraints and upward pressure on prices than suggested by consensus analysis based on highly-uncertain “output gap” estimates.

An indirect measure of US supply pressures is the ISM vendor deliveries index – higher values indicate more firms reporting delivery delays. Interestingly, this rose sharply in August to its highest level since May 2006. Historically, large increases have often preceded rises in US official interest rates, although the index would need to climb significantly further to reach its level before the Fed last began to tighten in June 2004 – third chart.

Weak second-quarter monetary data contributed to the MPC’s decision last month to embark on an additional £50 billion of gilt purchases. July statistics released today are more encouraging, supporting recovery hopes and reducing the chances of further QE expansion.

Key points:

1. The MPC’s favoured broad money measure – M4 excluding money holdings of “intermediate other financial corporations” – rose by a respectable 0.6% in July while first-half growth has been revised up from 3.5% annualised to 4.4%. Broad money increased by 4.9% annualised in the first seven months of 2009.

2. The Bank of England estimates that broad money rose by an annual 3.9% in July, which compares with a 1.2% gain in the retail prices index excluding mortgage interest costs. Implied real growth of an annual 2.6% contrasts with a contraction of 1.1% in Sepember last year and is higher than at the start of the economic recovery in the early 1990s.

3. M4 holdings of private non-financial corporations rose by 0.2% in the year to July – the first annual increase since March 2008. M4 lending to such corporations continued to contract in July, falling 2.9% from a year earlier. However, this partly reflects companies choosing to use the proceeds of recent capital issues to repay bank borrowing.

4. Historically, business spending has been positively correlated with the corporate “liquidity ratio” – M4 holdings divided by lending. Reflecting recent debt repayment, the ratio has recovered to its highest level since March last year. A wider definition including foreign currency deposits and loans has risen by more – see first chart.

5. Credit demand needs to revive to support M4 expansion when QE ends. Excluding remortgaging, mortgage approvals rose by 6% in July to stand 37% higher than a year earlier, suggesting a pick-up in mortgage lending later in 2009 – second chart.

Recent US monetary trends have been mixed, with the broader M2 measure slowing sharply but M1 continuing to grow strongly. The economy should recover solidly during the second half but momentum could falter in early 2010 unless M2 revives.

M1 comprises currency and checkable deposits, while M2 adds small time deposits, savings accounts and retail money funds. M2 has risen at a 2% annualised rate over the last six months versus 12% for M1. The M2 slowdown is partly pay-back for a surge in growth in late 2008 and early this year – see first chart.

M2 was weak earlier last year, contracting in inflation-adjusted terms in the six months to August, just before the financial crisis snowballed. The impact on the economy was compounded by a fall in the velocity of circulation, as households and firms hoarded cash in response to rising perceived risks.

One sign that velocity might be declining was that narrow money M1 was even weaker than M2. M1 is a better measure of transactions money while M2 contains a large savings element and is likely to be boosted disproportionately by an increase in precautionary balances.

Fast-forwarding to the present, the recent M2 slowdown is less worrying because it follows a period of unusual strength and has been accompanied by continued rapid growth in M1, suggesting that velocity is recovering as financial markets normalise and economic uncertainty abates.

M2 weakness will warrant greater concern the longer it persists. Slower destocking and some revival in housing market activity may support credit and money trends later in the year. The Federal Reserve’s securities purchase programme is scheduled to continue until the end of 2009, though its effects have recently been offset by other factors.

The mixed message from recent monetary data is echoed by the Fed’s latest senior loan officer survey. The net percentage of banks tightening credit standards on commercial and industrial loans fell further between April and July but is still far above a level consistent with sustained economic expansion – second chart.