Category: Money Moves Markets

The surge in British Retail Consortium sales growth from an annual 0.6% in March to 6.3% in April can be explained by Easter timing effects. The last such timing discrepancy (i.e. Easter falling in April in the current year but in March in the prior year) occurred in 2006. Annual sales growth rose by 8.2 percentage points between March and April 2006 – much larger than this year’s 5.7 pp increase.

While the April numbers are badly distorted, high-street spending has nevertheless proved resilient in recent months: the official retail sales volume index rose by 1.0% (not annualised) in the first quarter. Economists have suggested various reasons, including lower mortgage interest bills, the VAT reduction, falling energy prices and larger consumer cut-backs in other areas (e.g. car buying and eating out).

Monetary analysis offers an alternative explanation: the liquidity squeeze has been focused on companies rather than households so economic weakness has been driven by capital spending rather than consumption. As the chart shows, inflation-adjusted growth in “retail” M4 – i.e. currency in circulation and retail bank deposits – has picked up since late 2008 and tends to lead high-street sales.

While stable consumption is helpful, an economic recovery requires a reversal of recent cuts in corporate spending. Corporate money trends, however, remain weak: M4 holdings of private non-financial corporations fell by 1.7% in real terms (i.e. relative to the RPI) in the year to March. The MPC’s expanded QE operation will, hopefully, boost aggregate M4 growth and thereby corporate liquidity in the months ahead.

Earlier posts argued that the MPC and consensus were underestimating the inflationary impact of exchange rate weakness (e.g. here). Recent figures have indeed been worse than expected: annual CPI inflation averaged 3.0% in the first quarter versus a 2.7% projection in the February Inflation Report. The MPC will reportedly revise up its forecasts in the May Report released on Wednesday.

However, stability in sterling’s effective index since late 2008 – if sustained – promises a reduction in imported inflationary pressures later this year. The annual increase in manufactured import prices may already have peaked at 16% in December (March figures are due tomorrow) – see first chart. Base effects suggest a big slowdown in late 2009 barring another sterling accident.

April CPI numbers next week will benefit from cuts in household energy tariffs. In addition, the British Retail Consortium’s food and non-food price indices registered lower rates of change in April than March and correlate reasonably closely with the corresponding CPI goods components – second chart. Slower food price gains were also suggested by April producer input cost numbers – third chart.

Growth in M4 excluding “intermediate other financial corporations” – the best measure of the broad money supply, also referred to as “adjusted M4” – rose slightly during the first quarter but remains below a level likely to be consistent with trend economic expansion and on-target inflation over the medium term. The latest figures probably influenced the MPC’s decision this week to expand QE.

Annual growth in adjusted M4 edged up from 3.5% in December to 3.9% in March – see first chart. The recovery is more impressive in real terms: deflated by retail price inflation, the annual change has moved up from a low of -0.7% in September to 4.3% in March. This supports expectations that the economy will stabilise during the second half.

Adjusted M4, however, probably needs to grow by 6-7% per annum over the medium term to be consistent with the inflation target. This assumes potential GDP growth of 2% and a decline in velocity of 2.5% pa, in line with the mean over 1992-2004, when inflation averaged close to 2%. Faster expansion than 6-7% is arguably warranted shorter term to support additional economic growth to close the current large output gap.

During the first quarter alone, adjusted M4 grew at a 5.4% annualised pace. This is higher than a 4.0% increase in M4 excluding all financial corporations (i.e. M4 held by households and non-financial corporations). The difference may partly reflect a boost to money holdings of financial institutions (i.e. excluding intermediate OFCs) from the Bank’s QE gilt purchases in March. Detailed figures show significant rises in M4 deposits of securities dealers and investment / unit trusts during the first quarter, partly offset by a fall in insurance companies’ and pension funds’ cash.

Credit expansion is weaker than monetary growth. The annual increase in M4 lending excluding intermediate OFCs (and adjusted for the effect of securitisations) slid further to 2.8% in March from 4.6% in December, although the quarterly change recovered from -2.0% annualised to 2.3%. A key reason for expanding QE is to prevent the slowdown in credit from pulling down monetary growth.

It is difficult to disentangle demand and supply effects on credit weakness. One indication of supply restriction, however, is that credit utilisation rates (i.e. the proportion of arranged facilities actually drawn down) rose further in most industries during the first quarter – second and third charts. Banks are honouring existing lending agreements but appear reluctant to sanction an expansion of credit lines.

Previous posts have discussed the possibility of a V-shaped “Zarnowitz” rebound in global industrial activity – e.g. here. A sharp recovery in new orders indices in the latest round of purchasing managers’ surveys is consistent with the early stages of such a pick-up – see first chart. For the scenario to develop, however, credit conditions must ease and solid monetary growth must be sustained.

As expected, the April Federal Reserve survey of senior bank loan officers showed a reduction in the net percentage reporting a tightening of lending standards on commercial and industrial lending. The fall was smaller than in the equivalent UK survey but larger than in the ECB’s Eurozone poll. The US reading suggest a stabilisation of industrial output over coming months but needs to improve further to be consistent with a strong recovery – second chart. This is likely if the recent better tone in credit markets is sustained.

The Fed survey also reported a big decline in demand for commercial and industrial loans, which some commentators interpreted as a negative economic signal. This slump, however, is probably connected with heavy destocking, as well as a fall in borrowing to finance share buy-backs. The stocks cycle is now turning, lifting activity and potentially credit demand, while buy-backs are of limited relevance for economic prospects. In any case, credit trends tend to follow not lead output – commercial and industrial loans and the ratio of consumer installment credit to personal income are components of the Conference Board’s US lagging economic index.

Credit weakness is of concern only if it translates into slower growth in the money supply, which leads the economic cycle (M2 is included in the Conference Board’s leading index). Annual growth in G7 real narrow and broad money measures stood at 11% and 7% respectively in March, suggesting ample liquidity to support a strong economic recovery. Shorter-term trends, however, are less favourable: US M2 rose at an annualised rate of just 2% in the latest 13 weeks, while Eurozone M3 contracted between December and March – third chart.

For a Zarnowitz scenario to play out, money measures need to reaccelerate. This is more likely in the US, where the impact of weak credit demand may fade and the Fed’s bond-buying operations will continue to provide a boost, than in Euroland, with the ECB still refusing to embrace QE. (Purchases of covered bonds of €60 billion announced yesterday amount to less than 1% of Eurozone annual GDP and the ECB appears to be planning to sterilise the impact on the monetary base.)

The recent rebound in business surveys was presaged by a rise in the equity earnings revisions ratio (the difference between the numbers of analyst upgrades and downgrades expressed as a proportion of the total number of estimates) – fourth chart. The recovery in this ratio has stalled in recent weeks and, like the money numbers, bears close watching: any relapse could signal less favourable business survey results over the summer, possibly associated with another “growth scare” in markets.

The MPC’s announcement of an expansion of QE has come earlier than expected but is warranted by recent news – particularly the disappointing money numbers for March discussed in an earlier post.

The Bank of England will expand its QE operation from £75 billion to £125 billion by extending the current buying programme by a further two months to early August. Purchases are running at about £25 billion a month, with the total currently at £52 billion. The MPC has scope to boost the programme by a further £25 billion within the existing £150 billion authority granted by the Treasury.

The MPC’s statement sounds more hopeful on the economy, noting “promising signs that the pace of decline has begun to moderate”. This suggests that next week’s Inflation Report will retain the optimistic recovery profile shown in February – the MPC’s forecasts could be similar to the Treasury’s, which have been widely ridiculed. CPI inflation has recently been well above the Bank’s projections but the statement claims that a fall below the 2% target is still likely later this year, reflecting favourable food and energy price effects and a sharp easing in pay pressures amid rising economic slack.

Even after today’s expansion, the UK’s QE operation is smaller than the equivalent US initiative. The Federal Reserve is committed to buying up to $2 trillion of securities by the end of 2009, equating to 14% of US annual GDP. The Bank of England’s new £125 billion target amounts to 9% of UK GDP.

The MPC-ometer is designed to predict the outcome of each month’s MPC meeting based on incoming economic news and financial market developments. The model, like the consensus, forecasts no change in either Bank rate or quantitative easing plans today. The balance of news over the last month, however, is judged to be slightly dovish, suggesting the MPC may announce an expansion of QE in June when the current £75 billion asset purchase programme reaches completion.

The MPC-ometer includes both growth and inflation indicators. Growth news has been mixed: GDP plunged 1.9% in the first quarter but business and consumer surveys showed a surprisingly large improvement in April, while financial market conditions have eased. Inflation indicators have weakened since last month: the headline CPI increase remains above target but average earnings growth fell to an annual 0.1% in the three months to February and a large majority of manufacturers plan price cuts, according to the April CBI industrial trends survery.

The MPC could, in theory, lower Bank rate further from its current 0.5% level – the Federal Reserve has set a target of 0%-0.25% for US official rates. The Committee, however, judges that a further reduction would deliver little if any economic stimulus, reflecting a likely negative impact on banks’ profits and willingness to extend credit. Any further easing of monetary policy should therefore take the form of stepped-up QE; the Chancellor has already granted the MPC authority to expand the programme to £150 billion.

The Bank of England is on track with plans to buy £75 billion of securities, mostly gilts, by early June. March monetary figures, however, showed a disappointing initial impact from QE: the broad money supply M4 rose by just 0.2% from February, with cash held by non-financial corporations falling. This reflects two factors. First, the Bank appears to have bought more gilts from banks and overseas investors than domestic non-banks in March – only UK non-banks’ money holdings are included in M4. Secondly, the positive monetary impact of QE was offset by a fall in bank lending to the private sector (a small rise in sterling loans being offset by a contraction of foreign currency credit).

The Bank had bought only £17 billion of securities by the end of March so it is too early to conclude that QE is failing to achieve the MPC’s monetary goals. Unless April money numbers show a pick-up, however, the Committee should extend the buying programme at its June meeting, probably for a further three months. Super-low interest rates are providing support to the economy but stronger money supply growth is needed to lay the foundations for a sustainable recovery.

Broad money figures for March show a disappointing initial impact from QE. It is too early to make a firm judgement but the numbers suggest that Bank of England asset purchases will need to be expanded beyond the planned £75 billion by early June to boost monetary growth sufficiently to support a sustained economic recovery. (The Bank has Treasury authority to buy up to £150 billion.)

Monetary trends are best monitored using the Bank of England’s adjusted M4 measure excluding “intermediate other financial corporations” – this removes distortions due to the financial crisis but includes investing institutions’ money holdings, which should be inflated by a successful QE operation. The Bank of England does not release its monthly adjusted M4 estimates but the aggregate is likely to have been little changed in March, since overall M4 rose by only 0.2% on the month, while M4 excluding all financial corporations declined by 0.1%. (The Bank will publish March quarterly data for its adjusted M4 and M4 lending measures on 8 May.)

The Bank of England bought £15 billion of gilts in March, equivalent to 0.9% of adjusted M4. There are two possible reasons why the money numbers have shown little response. First, the Bank may have bought securities mainly from banks and overseas investors rather than domestic non-bank investors – only money holdings of the latter are included in M4. Secondly, a positive impact from QE may have been offset by other influences on M4, such as weak bank lending to the private sector.

Both factors were in play in March. Statistics on gilt transactions by sector show that Bank purchases of £15 billion were balanced by net sales of £7 billion by overseas investors, £6 billion by domestic non-banks and £2 billion by banks – see table. So the direct impact of purchases on M4 was only 40% (i.e. £6 billion out of £15 billion). (The outstanding stock of gilts was little changed in March, with DMO issuance offset by a large redemption. This may have affected the sectoral pattern of transactions.)

Meanwhile, credit weakness was a significant drag on M4: sterling bank lending to households and non-financial corporations, adjusted for securitisations, rose by only 0.2% in March and there was a large repayment of net foreign currency borrowing by UK residents. In addition, while domestic non-bank investors reduced their gilt holdings by £6 billion, they bought £21 billion of other forms of public sector debt, including £10 billion of Treasury bills. The overall public sector contribution to monetary growth – including the impact of the public sector net cash requirement, the Bank’s purchases and other debt transactions – was therefore only £6 billion, or 0.4% of adjusted M4.

While this month’s numbers are disappointing, money trends have improved significantly since last autumn: M4 excluding financial corporations rose at a 4.0% annualised pace in the three months to March after just 0.8% during the the fourth quarter. Annual growth slipped to 2.5% in March but in real terms – relative to retail price inflation – has recovered from a low of -0.6% in October to 2.9% now. This is consistent with improving economic prospects but a further pick-up is needed to lay the monetary foundations for a recovery.

The MPC is likely to wait until its June meeting before deciding to expand its QE operation, partly because it would be unwise to make a judgement about its impact on the basis of just one month’s data, and partly because an expansion of the programme would probably take the form of an extension of buying for a further three months, rather than a step-up in the weekly pace of purchases.

Eurozone monetary statistics for March and the latest survey of bank loan officers suggest an urgent need for the ECB to embrace US / UK-style quantitative easing at its meeting next week.

Broad money M3 has contracted over the last three months, pulling annual growth down to a five-year low of 5.1% – see first chart. The liquidity squeeze remains focused on the corporate sector, with M3 deposits of non-financial companies 1.2% lower than a year ago.

In terms of the credit counterparts, M3 weakness reflects a recent fall in bank lending to the private sector – second chart. A similar decline in the US has been offset by the expansionary impact of the Fed’s securities purchases, so US M2 has continued to grow, albeit at a slower pace than in late 2008 – see last post.

The latest bank loan officer survey shows a fall in the net percentage tightening credit standards on corporate loans but the decline was much less than in the Bank of England survey released in early April – third chart. The equivalent US survey is due next week; the Fed’s statement yesterday referring to “some easing of financial conditions” hints at favourable results.

US money measures accelerated sharply when the Federal Reserve embarked on quantitative easing in late 2008, buying commercial paper and mortgage-backed securities. Three-month growth in the broader M2 aggregate reached an annualised 24% in December – see first chart. The monetary injection laid the foundations for the March / April rally in equities and recent improved economic news.

M2, however, began slowing in early 2009 and has actually fallen over the last four weeks, bringing the three-month rate of change down to 3%. Annual growth remains solid at 8% but has retreated from 10% in January.

Recent M2 weakness has not reflected any slowdown in Fed securities purchases. At its March meeting, the Fed announced a big expansion of its buying plans to a potential $2 trillion by the end of 2009 – second chart. This would imply $1.25 trillion of purchases over the remaining eight months of the year, or about $35 billion per week. Recent buying has been on roughly this scale.

Unlike the ECB and Bank of England, the Fed does not publish a “counterparts analysis” of the drivers of M2 growth but it appears that the expansionary impact of official securities purchases has been offset by a recent contraction in bank lending to the private sector. Commercial bank loans and leases outstanding have fallen at an annualised 5% rate over the last three months – third chart.

On further analysis, this contraction mainly reflects declines in commercial and industrial loans and advances under sale-and-repurchase agreements. Corporate lending has been depressed by recent heavy destocking while the fall in repo advances is consistent with other evidence of investor deleveraging. With the stocks cycle turning, and investor risk appetite beginning to revive, lending trends could improve going forward.

M2 trends are not yet ringing alarm bells but a further slowdown would question the sustainability of recent equity market gains and tentative economic improvement.

The Treasury’s medium-term fiscal forecasts appear to rest on optimistic assumptions about future borrowing costs. On reasonable alternative assumptions, public sector net interest payments could rise to 3.9% of GDP by 2013-14 versus an official projection of 3.0%.

The Treasury’s forecasts for debt interest have received limited scrutiny partly because they are buried within the detail of the Budget documents. Medium-term projections for public sector net interest as a percentage of GDP can be derived from Table C2 of the Financial Statement and Budget Report (FSBR) as the difference between public sector net borrowing and the “primary balance”. These forecasts can be converted into nominal terms using money GDP assumptions from Table C1.

To derive the Treasury’s unpublished assumptions about future borrowing costs, it is necessary to put these public sector net interest numbers onto a general government gross basis by adding back estimated interest receipts and adjusting for public corporations. The gross interest projections can then be compared with published numbers on gross government debt to derive an average interest yield.

According to the FSBR, public sector net interest will rise from 1.6% of GDP in 2009-10 to 2.6% in 2010-11 and 3.0% in 2011-12 – see first chart. A further small increase to 3.1% in 2012-13 is then reversed in 2013-14, when the proportion returns to 3.0%. This stabilisation raises suspicion, since general government gross debt is projected to rise by 17% in the two years to the end of 2013-14.

To generate this profile, the Treasury must be assuming a fall in the interest yield on government debt in 2012-13 and 2013-14. The FSBR projections are consistent with the yield averaging less than 4% in the three years to 2013-14, far below projected money GDP growth of more than 6% per annum over this period – second chart.

The bulk of outstanding debt consists of fixed-coupon gilts. The interest yield in a particular year is a weighted average of the rates on existing debt and new borrowing – not just to cover the budget deficit but also to finance gilt redemptions and roll over the stock of Treasury bills. For the average yield to fall after 2011-12, as implied by the FSBR forecasts, the interest rate on new borrowing in 2012-13 and 2013-14 would have to be well below 4% – a rough calculation suggests an average of about 3% over the two years.

The charts present an alternative scenario for the average yield and net interest as a percentage of GDP based on the assumption that the interest rate paid on new borrowing in 2011-12, 2012-13 and 2013-14 is equal to the projected rate of money GDP growth in each year (i.e. 6.0%, 6.2% and 6.1% respectively). This generates a gradual rise in the interest yield to 4.9% by 2013-14. While significantly higher than the 3.8% implied by the Treasury’s forecast, this is below the 5.2% average between 2004-05 and 2007-08 (when money GDP grew more slowly than projected for the three years to 2013-14).

On this alternative scenario for the average yield, net interest as percentage of GDP rises to 3.9% of GDP by 2013-14 against the Treasury’s projection of 3.0%. More pessimistic scenarios are clearly feasible, based on investor concerns about inflation and / or solvency pushing new borrowing costs above the rate of money GDP growth.

A higher interest bill would imply either a greater squeeze on non-interest spending or, more likely, further fiscal slippage. According to the Treasury’s forecasts, real current spending will rise by 0.7% per annum in the three years to 2013-14. Stripping out interest costs, however, the rate of growth is just 0.2% pa. On the alternative scenario presented here, real non-interest spending would need to fall by 0.7% pa over this period to make room for higher debt-servicing costs, assuming no further upward revision to plans.