Category: Money Moves Markets

The MPC’s interest rate cuts have reduced aggregate net interest payments by UK households by 1.8% of their income since the fourth quarter of 2007, according to first-quarter national accounts released last week. This net figure, however, conceals an even larger income transfer from savers to borrowers within the household sector.

Net interest payments peaked at a record 2.2% of gross primary income (i.e. employee compensation plus net property income) in the fourth quarter of 2007 but had fallen to just 0.4% by the first quarter of 2009 – see chart. The 1.8 percentage point decline breaks down into a fall in payments by borrowers of 5.9% of total income, offset by a decline in interest receipts of savers of 4.1% of income.

Expressed in money terms, lower interest rates have given a £60 billiion per annum boost to borrowers’ spending power since the fourth quarter of 2007, financed by a £42 billion cut in savers’ income and an £18 billion loss in the rest of the economy.

Of course, a separation into “borrowers” and “savers” is simplistic because most households have incurred secured or unsecured debt and own some liquid savings. However, it is reasonable to assume that the 32% of households who own their home outright owe little and account for the bulk of savings. (The 32% figure comes from the 2008 NMG Research survey conducted for the Bank of England.)

These wealthy “savers” may also have above-average income. Assuming that they account for 50% of total household income, this would suggest that the group has suffered an income hit of as much as 8% since late 2007 as a result of the collapse in interest rates. On the same rough assumptions, “borrowers” may have enjoyed a windfall of up to 12% of their income.

It might be argued that the income transfer is warranted because mortgage borrowers have suffered a capital loss on their homes. However, this is true only of people who have bought property since 2004 – well under half of borrowers and less than 20% of households. Moreover, savers may have even more wealth tied up in housing than borrowers.

Inflation is often claimed to be bad for savers and good for borrowers. Fear of deflation has had the same effect, by inducing the MPC to reduce interest rates to miniscule levels. The saving ratio has risen recently but this reflects a fall in new borrowing rather than increased financial investment. Savers may understandably feel that the odds are stacked against them.

A previous post used Bank of England effective interest rate data to show that – contrary to the consensus perception – UK banks’ aggregate net interest margin on sterling business remained stuck close to a record low. The margin, however, was expected to improve gradually as high-cost term funding was refinanced at lower rates and banks began to benefit from wider spreads on new lending.

May effective rate statistics released last week are consistent with this story. The average interest rate charged on M4 lending was unchanged on the month, while the average rate paid on M4 deposits declined, mainly reflecting falls on time deposits and notice accounts – see chart. The spread, or net interest margin, therefore rose to its highest level since January.

This may, in fact, understate the improvement in net interest income since banks have also benefited from a falling cost of wholesale funding needed to plug the £490 billion gap between M4 lending and deposits. The spread between three-month unsecured and secured interbank borrowing rates has fallen from 120 to 50 basis points since the start of 2009.

Higher net interest income is needed to provide resources to cover write-offs and support future lending. The current M4 lending / deposit rate spread of 2.1 percentage points compares with an average of 2.8 over 1999-2008. A return to this average would boost UK bank’s pre-tax profits by £14 – 17 billion per annum.

The Office for National Statistics this week revised the fall in UK GDP in the first quarter from 1.9% to 2.4% but monthly figures on output in the services and production sectors – which account for 93% of GDP – indicate that the pace of contraction slowed during the quarter and the economy may have stabilised in April.

The chart shows official quarterly GDP, rebased to the peak level in the first quarter of 2008, together with a monthly proxy based on the services and industrial output data. The proxy was unchanged in April – the first month not to register a decline since September. The monthly numbers are subject to revision but the April reading is consistent with better purchasing managers’ survey results, which improved further in May and June.

The monthly proxy was 0.3% below its first-quarter average in April so the preliminary second-quarter GDP estimate released on 24 July is likely to show a further fall. This should, however, be the smallest since a 0.1% drop in the second quarter of 2008.

Today’s Financial Times contains another downbeat article about the UK’s QE. One fund manager quoted is disappointed that no effect on RPI trends is yet apparent. Since the latest RPI number refers to a period only two months after QE started, while monetary changes typically take two years to have their full impact on prices, this might be considered unsurprising.

Another interviewee correctly links an assessment of the success of QE with money supply figures. Unfortunately, he proceeds to ignore the recent broad money pick-up, referring instead to weakness in bank lending to non-financial corporations. Money and credit are routinely confused in discussions of QE, with few commentators aware that money leads the economy while credit lags.

Contributors to the FT article may not have read the Bank of England’s excellent explanation of the aims and mechanics of QE, available on its website. As well as expanding QE to £150 billion at next week’s meeting, the MPC might consider stepping up its education programme.

Further evidence that QE is beginning to work is provided by the Bank’s second-quarter Credit Conditions Survey released today, showing that a majority of banks made more credit available to mortgage borrowers and companies over the last three months, with a further improvement expected this quarter.

The results of similar surveys in other major economies are usually expressed in terms of the net percentage of banks tightening rather than loosening credit. When the Bank’s survey is converted to the same format, the UK results compare favourably – see chart for corporate lending responses. This reflects the combined impact of QE and lending commitments made by the Lloyds Banking Group and the Royal Bank of Scotland as a condition of their participation in the Asset Protection Scheme. (The UK is the first country to publish a second-quarter survey.)

The Wall Street Journal argues that the ECB’s alternative to QE – supplying banks with unlimited funds on favourable terms – is superior to the Fed’s and Bank of England’s asset purchases on the basis that the effects are similar and the ECB will be able to exit the strategy without causing market disruption.

With due respect, the effects are not similar: the ECB’s banking system loans have no direct impact on the broad money supply and may not even inflate the monetary base. The difference is highlighted by May monetary statistics. While UK broad money has risen at a 6.7% annualised rate so far this year – see yesterday’s post – Eurozone M3 has contracted by 0.8% annualised.

Credit trends are weak in both economies: Eurozone bank lending to the private sector has risen by just 0.4% annualised so far in 2009. In the UK, however, QE has resulted in a large “public sector contribution” to monetary growth – equivalent to 4.9% of the broad money supply in the first five months. With the ECB relying on banks using cheap liquidity to buy government securities, the public sector contribution has been much smaller in Euroland – 0.9% of M3.

Eurozone M3 has also been depressed by a shift of funds into longer-maturity financial instruments to take advantage of the steep yield curve.

Current monetary trends suggest that the UK economy will recover from late 2009 while Euroland continues to flounder.

Bank of England gilt purchases have contributed to a significant pick-up in broad money growth but this has yet to be reflected in higher cash balances of non-financial corporations, according to May monetary statistics released today. However, corporate liquidity should improve as companies continue to take advantage of more favourable market conditions to issue new shares and bonds.

The Bank of England’s monthly proxy for its favoured broad money measure – M4 excluding money holdings of financial intermediaries – rose by 0.2% in May after a 1.1% gain in April. Chain-linking the monthly proxy to “official” data showing a 1.5% rise in the first quarter, broad money has risen at a healthy 6.7% annualised rate so far in 2009.

Moreover, this understates liquidity growth because households and companies have increased their holdings of Treasury bills by £18 billion so far this year – equivalent to 1.2% of the Bank’s broad money measure. In other words, a wider aggregate including Treasury bills has risen by over 9% annualised in the first five months.

As expected, the Bank’s gilt purchases have been reflected initially in higher cash balances of financial institutions (i.e. excluding intermediaries). M4 holdings of households and private non-financial companies have risen at an annualised rate of 3.2% so far in 2009, well below the 6.7% increase in overall broad money. (Again, this understates liquidity growth because households and non-financial companies are likely to account for a significant portion of the rise in Treasury bills outstanding.)

Non-financial corporate M4 holdings have risen by just £1 billion, or 0.8% annualised, so far this year, despite sterling capital market issuance of £18 billion. This partly reflects a large-scale repayment of foreign currency borrowing in recent months. Assuming that this slows, corporate liquidity should improve as high financial sector cash balances facilitate further significant issuance. (The Bank’s numbers imply that financial companies’ M4 holdings – excluding intermediaries – have risen by about £25 billion so far in 2009, equivalent to annualised growth of more than 20%.)

The fall in monthly broad money growth from 1.1% in April to 0.2% in May is partly explained by a smaller boost from QE last month, with banks and building societies accounting for £8 billion of the £27 billion of gilts acquired by the Bank of England – see table. Bank purchases from the banking system have no impact on broad money unless banks use the cash released to increase private sector lending.

This QE “leakage”, coupled with the lack of a recovery to date in non-financial companies’ money balances, suggests that the Monetary Policy Committee will expand asset purchases by a further £25 billion to the £150 billion current maximum at its meeting next week, while simultaneously requesting Treasury authority for a higher limit.

The table below provides further evidence that money leads credit around the trough of the economic cycle.

The table dates the lows in the six-month rates of change of UK M4 and M4 lending around the recession troughs in the mid 1970s, early 1980s and early 1990s. Money bottomed about a year before credit in all three cases.

Six-month M4 growth – on the Bank of England’s adjusted measure – appears to have troughed in the fourth quarter of 2008. Based on the historical lead, bank lending could remain weak until late 2009 / early 2010.

Providing recent faster money growth is sustained, an economic recovery can coexist with ongoing lacklustre credit trends. Lending constraints could become an issue as the upswing develops but by that stage banks’ balance sheets and risk appetite may have improved significantly. 

A simplistic monetarist view is that countries with higher rates of inflation-adjusted money supply growth should experience stronger economic and equity market performance.

The first chart shows six-month changes in real broad money across the major developed economies. At the start of 2009, real money trends were much stronger in the US, Canada and Australia than in Japan and Europe.

The second chart shows year-to-date equity market performance for the same group of countries, including the impact of currency fluctuations and expressed relative to the World index. As suggested by money supply growth, Canada and Australia have outperformed significantly, while Japan and Europe ex. the UK have lagged the global average.

China is not included in the charts. Its monetary growth and equity market performance have been stronger than in any of the developed countries shown.

The main deviation from the monetarist relationship so far this year has been the relative weakness of the US stock market, despite monetary strength in late 2008 / early 2009. This may partly reflect a drag from much heavier equity issuance than in other markets. US relative performance could improve as issuance abates, although the monetary backdrop is less favourable than at the start of 2009 – see earlier post.

Real money growth has accelerated in the UK and to a lesser extent Japan since early 2009 while slowing in the Eurozone – first chart. Since the start of the second quarter, UK equities have outperformed the other markets with the exception of Canada. Assuming that monetary trends continue to benefit from QE, UK relative gains could be sustained during the second half.

As reported in today’s FT, British Bankers’ Association (BBA) figures for May show a £200 million fall in sterling lending to private non-financial companies. The report states that “a key objective of the Bank of England’s “quantitative easing” programme … is to encourage more private sector lending”, suggesting that the Bank will be disappointed by the BBA news.

Three points are worth noting. First, a £200 million decline is insignificant, amounting to 0.07% of outstanding BBA member lending to private non-financial companies. Moreover, the BBA statistics cover only 65% of total loans by UK-based banks to non-financial firms, according to Bank of England data. The flow of total lending exceeded the BBA flow by an average of £500 million per month over the six months to April. (The Bank will publish its May data on 29 June.)

Secondly, the key objective of QE is to boost the money supply not lending, although credit trends should revive if the policy succeeds in generating an economic recovery. The Bank of England’s website explanation of QE places money rather than credit at the centre of the transmission mechanism:

Asset purchases increase the supply of money directly into the wider economy which should boost spending. … The seller of an asset to the Bank can spend the new money it receives on goods and services which directly adds to overall spending or it can purchase other assets which will tend to boost asset prices more broadly and provide an indirect spur to spending.

Thirdly, to monitor the impact of QE, the MPC has stated that it 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 list does not include the volume of bank lending to companies, because the MPC recognises that lending weakness may reflect demand factors rather than supply constraints – including firms choosing to raise funds from markets rather than the banks.

The MPC will be encouraged by recent faster money growth, higher corporate equity and bond issuance and signs of a stabilisation in inflation expectations and nominal spending. In assessing the extent of improvement in the “cost and availability of corporate borrowing”, the Committee is likely to place high weight on its second-quarter Credit Conditions Survey, released on 2 July.

Bank of England gilt purchases have contributed to a pick-up in UK broad money growth. In the US, however, M2 expansion has slowed since early 2009, despite ongoing large-scale bond-buying by the Federal Reserve – see first chart. What explains this divergence?

Central bank lending or asset buying has a direct positive impact on the broad money supply only when transactions are conducted with domestic non-banks. One possible explanation for the UK / US monetary divergence is that the Bank of England has been buying securities from non-banks while the Fed has been buying from banks.

Available evidence, however, does not support this interpretation. For example, US flow of funds accounts for the first quarter show that Fed purchases of agency and mortgage-backed securities were more than accounted for by sales by the household sector (which includes domestic hedge funds). Commercial banks’ holdings of such securities were little changed last quarter.

Rather than ineffective bond purchases, the US M2 slowdown appears to reflect two other factors absent in the UK. First, commercial bank credit has contracted by 3% (not annualised) since December 2008. By contrast, UK M4 lending rose by about 2% between December and May (based on the Bank of England’s adjusted measure excluding transactions with financial intermediaries).

Secondly, the monetary impact of the Fed’s bond-buying has been offset by a contraction of its liquidity swap lending to other central banks. Swaps ballooned in late 2008 as policy-makers sought to alleviate an international shortage of dollars. Some of the cash is likely to have flowed back to the US, contributing to faster M2 growth late last year. This process has reversed in 2009: liquidity swap lending has contracted by $405 billion since the start of the year – almost as large as the Fed’s $487 billion combined purchases of Treasuries, agencies, mortgage-backed securities and commercial paper.

As well as contributing to the slowdown in broad money M2, the fall in swap lending has neutralised the impact of the Fed’s bond purchases on the monetary base M0 (i.e. currency plus bank reserves), which has been static since the start of the year. In the UK, however, M0 has surged since the Bank of England embarked on QE, with annual growth recently overtaking the US – second chart.

Slower M2 growth, should it persist, is a threat to US economic prospects but there are grounds for expecting an improvement. Recent credit weakness partly reflects heavy destocking, which is now coming to an end. Similarly, the contraction in the Fed’s swap lending is probably largely complete – the amount outstanding is down to $149 billion from a December peak of $583 billion. As these drags abate, monetary trends should be dominated by the positive impact of ongoing Fed securities purchases.