Category: Money Moves Markets

By announcing a further £50 billion slug of QE, bringing the total to £175 billion, the MPC has signalled that it places more weight on weak GDP numbers and still-modest broad money expansion than recent stronger business surveys, which suggest an early return to economic growth.

The additional £50 billion of purchases will occur over three months, implying a monthly rate of £16-17 billion, down from about £25 billion in the first phase of QE between March and July.

The decisions to stop QE and restart it a month later have resulted in unnecessary market volatility. The MPC could, instead, have announced a slowdown in buying last month (as some commentators suggested at the time), confirming this reduced pace at today’s meeting.

Banks’ cash reserves at the Bank of England should rise further from their current level of £164 billion as a result of today’s decision but by much less than £50 billion because of an offsetting decline in repo open market operations. Reserves are currently about three times the value of notes and coin circulating in the economy (£54 billion at the end of June), versus a pre-crisis ratio of less than a half.

With cash piling up at the Bank of England, banks have less need to boost their holdings of gilts and Treasury bills to ensure sufficient liquidity in the event of another market seizure. If banks lower their buying or even sell gilts to the Bank, this will offset the positive impact of QE on the broad money supply. (Banks’ holdings of gilts and Treasury bills have fallen slightly since QE began, having risen strongly in late 2008 and early 2009 – see chart.)

The Bank of England’s favoured broad money measure – M4 excluding money holdings of “intermediate other financial corporations” – grew at an annualised rate of only 3.7% during the second quarter despite a large positive impact from official gilt purchases. Coupled with a significant downward revision to the first-quarter rate of increase, from 6.2% annualised to 3.3%, the latest figures imply that monetary trends are less favourable for economic prospects than seemed the case a month ago, on the basis of data up to May.

While today’s report is disappointing, the 3.5% annualised growth rate of the M4 measure during the first half is slightly higher than a 2.7% increase in the second half of 2008. Moreover, a broader liquidity measure including Treasury bills and repo borrowing by the Debt Management Office (a close substitute for bank repos included in M4) has risen by 5.2% annualised so far this year. The large first-quarter revision, coupled with the high volatility of its monthly estimates, suggest that the Bank is still refining its approach to measuring the new aggregate, implying the possibility of further adjustments.

M4 growth remained sluggish during the second quarter because the positive impact of QE was offset by a rise in banks’ “net non-deposit sterling liabilities” and, to a lesser extent, a reduction in their net external and foreign currency lending. The increase in non-deposit liabilities partly reflects banks’ efforts to rebuild capital by retaining profits and issuing long-term debt and equity. However, both of these monetary counterparts show considerable volatility and the negative second-quarter effect may well reverse during the second half.

In assessing the economic implications, it is important to focus on real rather than nominal money supply trends. The annual rate of change of real M4 – relative to the retail prices index – has recovered from a low of -0.7% in the third quarter of 2008 to 4.7% by the second quarter, supporting expectations of economic improvement during the second half. With RPI inflation on course to rebound sharply in 2010, however, nominal money expansion will need to accelerate significantly over the remainder of 2009 to sustain real growth at its current rate.

The Bank’s gilt-buying will have further lagged positive effects on monetary trends during the second half but today’s figures suggest that the MPC should extend asset purchases by at least the further £25 billion currently mandated at its meeting on Thursday. Until broad money growth revives convincingly, there remains a risk that a near-term economic recovery will give way to renewed weakness in 2010-11.

A post in March argued that – contrary to the claims of the FT‘s Martin Wolf and many other commentators – sterling had fallen to a level implying significant and unsustainable undervaluation. This judgement was based partly on evidence from the quarterly CBI industrial trends survey – the percentage of manufacturers citing price competitiveness as a constraint on exports was the lowest since 1974.

Sterling’s effective index has rallied by 14% from its low in late December and by 9% since March. Yet the July CBI survey, released during MoneyMovesMarkets’ absence, shows that exporters remain bullish about their ability to compete: at 41%, the proportion citing price constraints remains far below its 1972-2006 average of 61% – see first chart. Worries about sterling’s rebound aborting an economic recovery are therefore misplaced.

In any case, the July manufacturing purchasing managers’ survey released today shows that domestic demand rather than exports is driving economic improvement. While the overall new orders index jumped to 55.9 last month, its highest level since November 2007, the export orders index was little changed at 48.5. Orders strength suggests an imminent resumption of manufacturing growth – second chart.

Global economic news has been generally encouraging during MoneyMovesMarkets’ absence, with Asian industrial activity, in particular, rebounding impressively, partly on the back of resurgent Chinese domestic demand.

Today’s US second-quarter GDP report continues the hopeful pattern, showing the economy’s contraction slowing to 0.3%, or 1.0% at an annualised rate, from 1.6%, or 6.4% annualised, in the first quarter. Stronger net exports and government outlays partly offset further, though smaller, declines in personal consumption and capital spending.

Destocking rose further to 1.1% of GDP in the second quarter, which appears to be a post-war record (based on earlier data – figures released today extend back only to 1995). With final demand stabilising, firms should resist further declines in inventories, implying a significant boost to production during the second half.

Annual revisions show that the recession has been deeper than previously thought, with the fall in GDP by the first quarter of 2009 now put at 3.7% versus 3.1%. However, GDP is still estimated to have peaked in the second quarter of 2008 – at odds with the National Bureau of Economic Research’s claim that the economy has been contracting since December 2007.

Recent corporate earnings news is consistent with improving global economic momentum. Equity analysts’ revisions ratio, defined as the number of upgrades to 12-month-ahead forecasts minus downgrades expressed as a proportion of the total number of estimates, rose to its highest level since late 2007 last week and suggests further gains in purchasing managers’ new orders indices – see chart.

The 0.3% fall in US GDP last quarter compares favourably with a 0.8% decline in the UK, reported last week. The UK figure, however, is difficult to reconcile with business survey results – better in the UK than the US recently – and labour market indicators (see previous post on vacancies). A comparison with initial GDP estimates in prior recessions suggests that the UK numbers will eventually be revised higher – more on this next week.

Global monetary conditions remain supportive for markets but a further rally in equities could be delayed by rising issuance. Gains also depend importantly on central banks continuing to support money supply growth until private credit expansion revives.

Monetary conditions tightened last year because moderate growth in the G7 broad money supply was insufficient to accommodate higher inflation and a rise in the precautionary demand for money due to the financial crisis. This tightening was evidenced by a contraction in real narrow money M1 – a better measure of cash held for transactions purposes and often more closely related to economic activity and flows into markets.

Conditions began to improve in late 2008 as Federal Reserve asset purchases boosted US broad money, a sharp drop in commodity prices pulled inflation lower and falling economic activity reduced money demand. The emergence of “excess” liquidity was reflected in a strong acceleration in G7 M1 and laid the foundations for both the spring rally in equities and the current incipient economic recovery.

Broad money has slowed again since early 2009, with the impact of “quantitative easing” offset by weak private credit trends. Improving market and economic conditions, however, are likely to have reduced the precautionary demand for money (i.e. the fall in velocity during 2008 may now be reversing). Consistent with liquidity remaining favourable for markets and economies, M1 is continuing to expand faster than broad money.

This positive assessment is subject to two qualifications. First, cash inflows to equity markets could be absorbed by issuance rather than reflected in higher prices. A proxy for the global volume of shares outstanding rose by 1.1% during the second quarter – the biggest gain since the second quarter of 2002. This was influenced by post-stress-test capital-raising by US banks but non-financial companies and banks elsewhere are likely to step up issuance if market conditions allow.

Secondly, monetary conditions could deteriorate if central banks step back from QE efforts before private credit expansion recovers. The Fed’s asset purchase plans imply a further significant boost during the second half of 2009 but prospects for the equivalent UK scheme are uncertain, while the ECB’s alternative approach of supplying liquidity to banks has yet to yield results. With inflation risks viewed as minimal, however, policy-makers are likely to be open to further “unconventional” actions should credit weakness persist.

Job vacancies are a coincident indicator of the economy and a leading indicator of employment and (inversely) unemployment. A 7.7% fall in the outstanding stock in the second quarter was the smallest since a 5.5% decline in the second quarter of 2008, supporting other evidence that GDP contraction slowed sharply last quarter.

The first chart updates a comparison with the last three recessions. The current decline continues to resemble 1989-91 rather than the deeper falls of 1979-81 and 1974-76 (when union power may have constrained layoffs, forcing firms to curb new hiring by more to achieve desired employment levels). Vacancies bottomed 18-24 months after the peak in all three recessions, suggesting that the current fall will end between August 2009 and February 2010.

Other evidence hints at an early trough. For example, the Markit Report on Jobs permanent placements index peaked seven months before vacancies and has been picking up since December, implying a possible vacancies trough in July – second chart. This would be consistent with a stabilisation or small rise in GDP in the third quarter.

(Note: the vacancies statistics for the earlier recessions refer to openings registered at Job Centres. This series was discontinued in 2001 and replaced by a survey of employers.)

Annual CPI inflation fell to 1.8% in June – below the 2% target for the first time since September 2007 – but the figures continue to be flattered by December’s VAT cut. Assuming 60% pass-through, inflation would have been about 2.5% in June in the absence of the reduction. (Note that the “CPI at constant tax rates” measure – which rose an annual 2.9% in June – assumes 100% pass-through.)

The June result benefited from a big decline in annual food price inflation to 5.5% from 8.4% in May. This had been foreshadowed by last week’s producer price numbers, which suggest a further fall – see chart.

“Core” inflation can be measured by the CPI excluding unprocessed food and energy. The annual increase in this measure fell from 2.1% to 1.9% in May but would be about 2.6% without the VAT cut, assuming 60% pass-through.

CPI inflation averaged 2.1% in the second quarter – above the MPC’s 1.9% modal forecast in the May Inflation Report.

Food price inflation has fallen earlier than expected but in other respects today’s numbers are consistent with the forecast presented in a previous post, suggesting that the annual CPI increase will slow to about 1% this autumn before rebounding into 2010. The retail prices index fell by an annual 1.6% in June – the decline may extend to about 2.5% this autumn.

A broad liquidity measure including money-like instruments issued by the public sector has risen at a 10% annualised pace so far in 2009, supporting recovery hopes and justifying the MPC’s caution about expanding the asset purchase facility further. As well as the MPC’s gilt-buying, liquidity has been boosted by increased reliance by the Debt Management Office (DMO) on short-term borrowing to finance the fiscal deficit.

The MPC’s asset purchases are intended to “increase the supply of money directly into the wider economy which should boost spending”, according to the explanation of quantitative easing on the Bank of England’s website. In monitoring the impact, the MPC “will pay close attention to the growth rate of broad money, the cost and availability of corporate borrowing, measures of inflation and inflation expectations, and developments in nominal spending growth”.

The broad money supply is normally measured by M4, which comprises the non-bank private sector’s holdings of notes and coin and a range of sterling-denominated bank instruments including traditional deposits, CDs, securities of up to five years’ original maturity, repos and bills. The aggregate has slowed so far in 2009, rising at a 10.4% annualised rate in the first five months, down from 20.1% during the second half of 2008.

M4, however, has been distorted over the last 18 months by a large increase and more recently a fall in money holdings of financial intermediaries – “intermediate other financial corporations (OFCs)” in the Bank’s terminology – which mainly act as conduits for interbank business. The financial crisis resulted in banks cutting back traditional unsecured interbank lending in favour of secured forms of lending channelled through these intermediaries, facilitated by the operation of the special liquidity scheme.

The MPC is therefore focusing on an adjusted M4 measure excluding these intermediaries’ money holdings. Accurate statistics for this measure are currently compiled only on a quarterly basis but the Bank of England also makes available a “monthly proxy” based on partial information. Combining first-quarter data with proxy numbers for April and May, adjusted M4 grew by 6.8% annualised in the first five months of 2009, up from 3.0% in the second half of 2008.

This adjusted measure, however, understates liquidity growth because it omits the non-bank private sector’s holdings of public-sector financial instruments that are close substitutes for “money” – these holdings have risen substantially over the last year. In particular, Treasury bills and repo borrowing by the DMO are likely to be regarded by investors as having similar characteristics to short-term bank securities and bank repos.

The chart shows annualised growth of adjusted M4 and a broader liquidity measure including holdings of Treasury bills and DMO repos. The growth rates are calculated over six months except for the final data points, which refer to January to May 2009. The broader measure rose by 10.3% annualised over this latter period – much faster than the 6.8% increase in adjusted M4.

In effect, the DMO has been operating its own liquidity creation scheme in parallel with the Bank of England’s asset purchase facility, funding the budget deficit partly by issuing Treasury bills and borrowing on repo rather than selling gilts. The non-bank private sector lent £54.2 billion in these forms in 2008-09 and the first two months of the current fiscal year – equivalent to 28% of the central government net cash requirement over the same period.

A sharp deterioration in money / liquidity trends in late 2007 and early 2008 – particularly after adjusting for inflation – warned of impending economic weakness. The recent pick-up, also more pronounced in inflation-adjusted terms, supports hopes of a recovery from late 2009. It is possible that the MPC is placing some weight on wider liquidity trends, helping to explain last week’s decision to slow asset purchases and defer consideration of a rise in the £125 billion target.

A strong acceleration in global real money supply growth in late 2008 suggested that economic activity would bottom in spring 2009 and recover during the second half – see here and here. Recent news remains consistent with this scenario.

Industrial output in the Group of Seven (G7) major economies fell by 19% between February 2008 and March 2009 but has recovered by 1% by May. This reflects a rebound in Japan, Germany and France, which had suffered more severe declines, offset by a continuing slide in the US, partly reflecting auto sector woes.

Purchasing managers’ surveys show that new orders are stabilising while companies are still cutting stocks. As destocking slows, firms will need to place additional orders with suppliers, who in turn will be forced to raise production. The second-quarter Conference Board Chief Executive Officer survey released earlier this week signals an imminent recovery in US industrial output – see first chart.

The big story of the first half, however, has been the rebound in emerging economies – second chart. Industrial output in seven large emerging economies – the BRICs plus Korea, Taiwan and Mexico – rose by 3% in the six months to May versus a 10% contraction in the G7. Surveys indicate further acceleration.

This “E7” pick-up is not just about China – third chart. Output is on a rising trend in five of the seven economies, the exceptions being Mexico – which will benefit from a US recovery – and Russia. This reflects a rebound in world trade and effective monetary stimulus in economies where banking systems are still functioning normally.

Emerging world strength coupled with improving G7 prospects suggest that a solid “Zarnowitz” recovery in global activity remains possible – see here and here for a discussion. Credit supply constraints in developed economies are not an immediate obstacle to this scenario since credit demand is usually weak in the first year of economic upswings.

There are two key risks. First, labour market deterioration could lead to a further lurch down in consumer spending, aborting the stocks-led industrial recovery. The US June employment report was disappointing but leading indicators give a more hopeful message – for example, the number of job cuts announced last month was the lowest since March 2008, according to outsourcing firm Challenger, Gray and Christmas.

Secondly, real money growth could slow as weak credit trends offset QE and higher commodity prices lift inflation. This is less of a concern in the US and UK – the Fed and MPC are likely to calibrate asset purchases to ensure stability – than the Eurozone, where M3 is stagnant and the effectiveness of the ECB’s QE alternative is in doubt.

There are three possible reasons for the MPC’s decision today to maintain the asset purchase programme at £125 billion, against expectations of an increase.

First, the Committee may judge that the scheme is working as planned and there is no need for a further expansion. Arguments in favour of this view include recent stronger broad money growth and improvements in loan availability reported in last week’s Credit Conditions Survey.

Secondly, and more likely, the MPC is inclined towards an extension but wishes to slow the pace of buying and avoid the impression of an open-ended commitment. The August Inflation Report forecasting round provides a convenient excuse for deferring an announcement, while maintaining the £125 billion cap will automatically cut gilt-buying from £6.5 billion to £4 billion per week.

Thirdly, and least likely, the MPC judges that any positive effects are small relative to possible damage to its inflation-fighting credibility from continuing with the policy.

The absence of any guidance about these alternatives in the MPC’s news release is surprising and may indicate disagreement within the Committee.

A reasonable strategy would be for the MPC to utilise the £25 billion still available under the existing authority in August while spreading purchases over two months, implying a further slowdown to £3 billion per week. Assuming more evidence of positive effects and wider economic improvement, the programme could be suspended at the October meeting.