Category: Money Moves Markets

Markets are assuming that interest rates will remain at unusually low levels for a sustained period. Forward rates extracted from the government yield curve imply a Bank rate of about 3.5% in five years’ time – well below its 5.1% average since the MPC’s inception in 1997. These expectations reflect the consensus view that the current deep recession will result in very low inflation, and possibly deflation, over the medium to long term. Yet this consensus may be questioned on several grounds.

One important uncertainty is the longer-term inflationary impact of the huge exchange rate decline since 2007. Many commentators argue that sterling was significantly overvalued in 2007, implying reduced inflationary repercussions from its subsequent plunge. The claim, however, is dubious: a real trade-weighted exchange rate index calculated by JP Morgan was only 7% above its 1985-2006 average at its peak in January 2007 but has since fallen 19% below it. Such a large undershoot is unlikely to be sustained and can be corrected either by a recovery in sterling or higher UK relative inflation. Suppose the real exchange rate returns to its 1985-2006 average over 10 years. If inflation were to bear the full burden of adjustment, UK manufacturing prices would have to rise by 2.2% per annum more than prices elsewhere.

A second possible weakness in the consensus view is the assumption that the recession will produce a large decline in “core” inflation. There are two issues: the prospective size of the negative “output gap” – the difference between actual and “potential” GDP – and the sensitivity of core price trends to this gap. Actual GDP is falling substantially but the credit crunch is also likely to have damaged supply potential, reflecting business failures, investment cut-backs and a possible rise in “structural” unemployment (if workers displaced from bubble sectors prove ill-equipped for employment in other activities). Meanwhile, core inflation could prove less responsive to a widening output gap than suggested by econometric models estimated on data including the inflationary 1970s and 1980s. Core price trends showed limited acceleration when actual GDP was above potential over 2006-08, raising the possibility of a similarly modest response to economic slack.

Medium-term inflation prospects will depend critically on monetary trends. The broad money supply, M4, adjusted for distortions due to the financial crisis, probably needs to grow by 6-7% per annum to be consistent with the 2% inflation target. (This assumes potential GDP growth of 2% and a decline in velocity of 2.5% per annum, in line with the average over 1992-2004, when inflation averaged close to 2%.) The Bank of England’s adjusted M4 measure rose by an annual 3.8% in December – the latest available published figure – but growth should be pushed up to the required level, or higher, by the Bank’s securities purchase programme: planned buying of £75 billion by the end of June is the equivalent of 4.5% adjusted M4 and the MPC has authority to expand the scheme by a further £75 billion. Monetary expansion should also be supported by gilt purchases by commercial banks, partly reflecting regulatory pressure to increase liquidity reserves. Bank buying totalled £26 billion between November and January, up from just £4 billion in the prior 12 months.

International influences on UK inflation will reflect global monetary trends. The Swiss National Bank has also embraced quantitative easing over the last month, while the US Federal Reserve and Bank of Japan are further expanding securities purchase operations. The Fed’s latest plans are particularly notable, involving potential buying of $1.46 trillion over the remainder of 2009 – equivalent to 18% of the M2 money supply. Annual M2 growth has accelerated from 5.5% in August last year to 9.8% by February and could reach 20% later in 2009 if these plans are implemented in full. A similar pick-up is under way in China, with annual M2 expansion rising from 14.8% in November to 20.5% in February. Based on the Friedmanite view that money leads prices by about two years, these trends suggest rising global inflation from late 2010. Friedman emphasised the variability of lags, however, and a faster transmission is possible if monetary acceleration fuels renewed commodity market speculation.

A more esoteric reason for thinking that inflation, rather than deflation, is the greater longer-term risk is historical evidence of a long cycle in prices – the Kondratyev cycle. There have been four major peaks in world prices or inflation since 1800, spaced an average of 54 years apart – see chart. With the last climax occurring in 1974, this cycle suggests inflation should have reached a major trough 27 years later in 2001, to be followed by an upswing to a new peak in 2028-29. Historically, there have been significant shorter-term variations around the long-run trend so the current inflation decline does not invalidate the hypothesis that a secular upswing is under way. The theoretical basis of the long cycle is unclear but the notion that the balance of pressures is shifting gradually to the upside is plausible, based on factors such as faster global money growth since the 1990s, rising resource demand from giant emerging economies and a prospective surge in government debt, which may weaken political support for low-inflation targeting.

—–
COMMENT:
AUTHOR: Ian Copelin
EMAIL: ian.x.copelin@jpmorgan.com
IP: 170.148.215.157
URL:
DATE: 03/27/2009 09:31:20 AM

What season (and where in that season) do you see us at present? Your journal chart would imply that winter finished around 2000 and therefore we are in spring. Having Googled ‘Nikolai Kondratieff’, the descriptions on the internet, imply that we are probably still in winter.

Most diagrams of the Krondratyev cycle show very clear ‘V’ shapes movements – but obviously with a 50-60 year chart it could in reality be more of a U or W bottom. From your research how quickly does the interest rate/inflation cycle turn?

Is the Krondratyev cycle applicable to equity markets, and if so, does it follow the same wave or is there a time lag?

—–
COMMENT:
AUTHOR: Simon Ward
DATE: 04/03/2009 02:31:12 PM

Some analysts argue that the last Kondratyev peak was in 1980, when US CPI inflation topped. I do not favour this interpretation because it would imply that the cycle has lengthened to 60 years (the previous peak was in 1920). In any case, WPI inflation peaked on schedule in 1974.

On my interpretation, the cycle trough was in 2001 (27 years or one half-cycle after 1974) and we are currently in the “spring” phase. On the alternative interpretation of a 1980 peak and a 60-year cycle, the trough is scheduled for 2010 and we are still in “winter”. However, this is difficult to square with the commodity price boom of recent years.

Kondratyev’s observation of a cycle was based on interest rates as well as prices. UK long-term yields peaked in 1974, consistent with my cycle dating. However, US yields peaked in 1981, supporting the alternative interpretation. Yields in both countries recently reached new lows, which could be evidence that we are still in “winter”. I am interpreting the decline, roughly seven years after the Kondratyev trough in 2001, as the mirror-image of the yield rise in 1981, seven years after the 1974 Kondratyev peak. Yields embarked on a secular decline in 1981; are they now on the brink of a long-term upswing?

Kondratyev himself did not refer to stock markets but other analysts have suggested that there are two equity cycles per Kondratyev cycle: spring = reflation = bullish; summer = inflation = bearish; autumn = disinflation = bullish; winter = deflation = bearish. If you accept this, the current bear market argues that we are still in winter. However, I am unsure about the linkage with stocks and prefer to date the cycle based on price data.

Central bank surveys of bank loan officers are a key gauge of the success of recent policy initiatives in easing credit conditions.

In the last US survey, conducted in January, the net percentage of banks reporting tighter credit standards on loans to firms remained close to its historic high. This indicator correlates closely with the yield spread of non-investment-grade corporate bonds over Treasuries – see first chart.

The April survey is due for release in early May. As the chart shows, however, the equivalent UK indicator from yesterday’s Bank of England credit conditions survey fell significantly between November / December and February / March. A similar drop in the US indicator would suggest better prospects for high-yield bonds.

The UK improvement may have been exaggerated by country-specific factors, such as government agreements with Lloyds Banking Group and the Royal Bank of Scotland to expand lending and the Bank of England’s purchases of corporate securities. Nevertheless, recent policy actions should contribute to at least some fall in the US indicator.

The net tightening percentage, inverted, is also a good leading indicator of the economy – see second chart – so a fall would boost recovery hopes.

The current global recession is shockingly severe. Does this imply an increased risk of “depression” or will an equally-dynamic recovery unfold later in 2009?

The first chart below updates a comparison of the current fall in industrial output in the Group of Seven (G7) economies with the three largest declines over the prior 50 years. Output is now about 18% below its peak in February 2008 – significantly greater than the biggest previous drop of 12% in 1974-75.

In the three prior cycles there was an inverse relationship between the size of the peak-to-trough output fall and the time taken to retrace it – the bigger the decline, the faster the recovery. It took 31 months for output to regain its peak level in the mid 1970s but 49 months in the early 2000s, when production fell by “only” 7%.

Commenting on an earlier post, a reader noted that the areas between the curves and the 100% horizontal line look similar. This area measures the cumulative percentage loss of output relative to its peak monthly level. This cumulative loss is shown in the second chart. The reader’s observation is correct. The loss was 186% over 1974-76, 181% over 1980-83 and 163% over 2000-04 – a remarkably narrow range.

So a bigger peak-to-trough decline may not imply that a recession is significantly worse in terms of cumulative output loss. There may be natural forces tending to equalise this cumulative loss across cycles. This observation, however, may apply only to “normal” recessions. Once the output fall exceeds a certain amount, the dynamics may change, resulting in a recession developing into a depression or slump.

The case for a V-shaped revival later in 2009 is that this tipping point has yet to be reached and unprecedented monetary and fiscal policy stimulus will strongly reinforce natural recovery tendencies. Optimistic indicators include a surge in inflation-adjusted narrow money growth – third chart – and a widening gap between sales and production – fourth chart – suggesting a potential big boost from the stocks cycle.

The cumulative loss approach outlined above can be used to generate a forecast path for G7 industrial output in an optimistic economic scenario. Specifically, assume that:

1. The cumulative output loss in the current recession / recovery cycle is 200% (i.e. slightly greater than over 1974-76).
2. February 2009 proves to be the trough.
3. Output subsequently recovers at a constant rate.

These assumptions define the forecast path shown in the fifth chart, which implies a return of output to its February 2008 peak by June 2010.

A key argument against a V-shaped rebound in output is that credit supply constraints will short-circuit natural recovery tendencies and render policy stimulus ineffective. Surveys of bank loan officers will be important for judging if credit conditions are easing, boosting economic prospects. The latest Bank of England survey, released today, was encouraging – final chart.

Services sector output data released today confirm that the economy continued to contract rapidly in early 2009. A monthly GDP estimate based on services and industrial output fell a further 0.6% in January, to stand 1.4% below its fourth-quarter average – see first chart. Monthly GDP has now declined by 4.2% from its peak last April.

The January result suggests GDP will fall by more in the first quarter than implied by the central projection in the Bank of England’s February Inflation Report – second chart.

The GDP decline should slow as the recent big drag from destocking abates. More promising monetary trends, if sustained, warrant hopes of a recovery in GDP from late 2009, though probably from a significantly lower level than implied by the Bank of England’s central projection.

The current recession could yet prove less severe than the catastrophic 1979-81 downturn. GDP would have to fall a further 2.4% from its estimated January level to match the quarterly peak-to-trough decline in the early 1980s.

UK monetary conditions were starting to improve even before the MPC embarked on “quantitative easing”, according to Bank of England data for February released today. Economic news is likely to remain grim for most of 2009 but the monetary foundations are being laid for a 2010 recovery.

Key features of today’s data include:

• Broad money M4, excluding holdings of financial corporations, grew by an annual 3.0% in February, up from 2.9% in January. This conceals a big rise, of 2.4% or 10.0% annualised, in the latest three months – see first chart.

• M4 holdings of non-financial corporations jumped by 5.3%, or 23.0% annualised, in the three months to February. Corporate money holdings are still down 2.1% from a year before but this compares with a 5.9% decline in November. The recovery is greater in real terms and suggests less pressure for retrenchment – second chart.

• Bank lending to non-financial corporations has also recovered, rising 1.6% in January / February combined. The larger rise in money holdings, however, has pushed the corporate liquidity ratio (money holdings divided by bank borrowing) up to its highest level since May 2008.

• Narrow money is weaker than broad money, with M1 – currency in circulation and overnight / sight deposits – up by just 0.3% in the year to February. The rise over the last three months, however, was 2.2% or 9.1% annualised.

• “Underfunding” has contributed to the recent pick-up in broad money – “sterling net lending to the public sector” accounted for 1.0 percentage points of the increase in M4 in January and February combined. This reflects purchases of gilts and Treasury bills by commercial banks, motivated partly by regulatory pressure to boost liquidity reserves. With QE kicking in, underfunding will rise further.

While the fall in GDP in the fourth quarter has been revised from 1.5% to 1.6%, the expenditure breakdown is less negative than last month. On the new figures, the stocks cycle accounts for the entire decline in GDP last quarter. GDP excluding stocks actually rose by 0.1%, with falls in consumer spending and investment offset by higher government consumption and stronger net exports.

The big drag from stocks suggests the decline in GDP peaked last quarter. Destocking amounted to 1.3% of constant-price GDP – the largest since the fourth quarter of 1990. This was two quarters into the last recession, when GDP was 70% through its peak-to-trough decline. GDP weakness over coming quarters will be driven by investment and consumer spending.

Other notable features of the data released today include:

• GDP fell by 2.0% in the year to the fourth quarter but gross national income (GNI), which includes net income from abroad, plunged by an estimated 4.0% – the biggest annual fall since 1980. (Constant-price GNI is calculated by deflating current-price GNI using the GDP deflator.)

• The household saving ratio surged to 4.8% in the fourth quarter, the highest since the first quarter of 2006 and up from a low of -1.2% in the first quarter of last year. The ratio is likely to rise further – it has averaged 6.8% since 1985 – but the significant adjustment to date reduces downside risks to consumer spending.

• The figures do not support deflation claims. The price deflator for gross value added – which excludes the impact of the VAT cut – rose by 1.2% from the third quarter to stand 3.3% higher than a year before.

• Private financial corporations’ operating surplus surged 36%, or £5.1 billion, last quarter, apparently reflecting a rise in banks’ net interest receipts. As explained in a previous post, the operating profits – not reported earnings – of the Lloyds Banking Group and the Royal Bank of Scotland will be counted as public sector income from October last year, reducing public net borrowing. (The reclassification has yet to be reflected in public finances data.)

• The current account deficit was just 1.7% of GDP in 2008 – inconsistent with claims that sterling was “grossly overvalued” before its recent plunge.

Recent talk of imminent deflation has been highly misleading. Headline CPI and RPI inflation have been artificially depressed by the December VAT cut, falling world energy prices and interest rate reductions. Underlying inflation has been picking up in response to the plunge in the exchange rate. February numbers released today confirm the trend and cast doubt on the MPC’s forecast of a big decline in the headline CPI rate later in 2009.

Despite a favourable impact from lower energy costs, annual CPI inflation rose from 3.0% in January to 3.2% in February. This was well above both the consensus expectation of 2.6% and a February Inflation Report projection of 2.7% for the first quarter. Inflation would be significantly higher but for December’s VAT cut: the CPI at constant tax rates rose an annual 4.2% in February.

Underlying inflation is often measured by the CPI excluding unprocessed food and energy. The annual rate of change of this index rose from 1.9% to 2.3% between January and February. Without the VAT cut, the February figure would have been over 3% – above the peak of 2.8% in August / September last year.

The culprit is the plunge in sterling and a resulting surge in non-energy import costs – manufactured import prices rose an annual 14% in January. In his latest explanatory letter, Bank of England Governor Mervyn King notes that “much of the strength of the outturn appears to be concentrated in components where a large share of goods is imported”.

In his last letter, in December, Mr. King suggested that he would next have to write when annual CPI inflation fell below 1% later in 2009. The MPC, like the consensus, has underestimated the inflationary impact of sterling’s slump. Recent cuts in energy tariffs and rising economic slack will pull inflation lower but sub-1% readings are unlikely barring a significant exchange rate recovery. Headline inflation will rebound sharply in early 2010 as VAT and energy benefits reverse.

Martin Wolf of the Financial Times has argued that the UK’s real exchange rate was “grossly overvalued” before the recent plunge, which represents a “move towards equilibrium” (see comments to previous post). The evidence presented below suggests the degree of overvaluation was modest and sterling is now “grossly undervalued”, with unfavourable implications for future UK relative inflation performance.

The first chart shows J P Morgan’s real broad trade-weighted exchange rate index, based on a common-currency comparison of UK manufacturing prices (ex. food and energy) with prices in 46 developed and emerging economies. The index was 14% above its 1970-2006 average at sterling’s peak in January 2007. This average, however, is biased downwards by a very low real exchange rate in the 1970s, when UK trade performance was damaged by non-price factors such as poor quality and supply unreliability. Relative to an average calculated over 1985-2006, the deviation was 7% in January 2007. The subsequent fall has pushed the index 19% below this average to the lowest level since 1978.

Exchange rate overvaluation should be reflected in a worsening trade balance. The second chart shows the goods and services balance excluding oil expressed as a percentage of current-price GDP. The trade position deteriorated significantly over 1997-2001 following a large rise in the exchange rate between 1996 and 1998. Once sterling stabilised, however, so did the trade deficit, suggesting that, after an initial negative impact, UK suppliers adjusted to the higher currency. If the pound had been “grossly overvalued”, UK firms would have continued to lose market share, implying further deficit widening.

The third chart shows the percentage of CBI manufacturing companies citing price competitiveness as a constraint on exports. Firms may interpret the survey question as asking whether they are able to win orders at the current level of the exchange rate, in which case responses will also reflect non-price influences on competitiveness. Consistent with this, the CBI measure suggests a smaller degree of undervaluation in the 1970s than the J P Morgan real exchange rate index. It also supports the view that UK manufacturers adjusted successfully to the 1996-98 appreciation, with an initial rise in the measure reversed over 2000-03. In contrast to the J P Morgan index, the CBI series was close to its 1972-2006 average in January 2007. It is currently at its lowest level since 1974.

Previous posts have argued that sterling’s plunge may deliver little net stimulus to the economy, partly reflecting adverse effects on banks’ capital and funding. Unless reversed, it will also result in higher UK inflation than elsewhere. The real exchange rate is unlikely to remain at its current very depressed level over the longer term. A recovery can occur either via nominal appreciation or higher relative inflation. A return of the J P Morgan index to its 1985-2006 average over 10 years, coupled with a stable nominal exchange rate, would imply UK manufacturing prices rising 2.2% per annum faster than in competitor countries.

Postscript: The previously-documented pattern of sterling weakening when Bank of England Governor Mervyn King gives a speech was repeated last week. Mr. King spoke on Tuesday evening; the effective index fell by 1.4% between the closes on Monday and Wednesday.

As argued in previous posts, current exceptional circumstances justify action by central banks to boost broad money supply growth to 10% or so temporarily in order to support an economic recovery. For this reason, the asset purchase schemes introduced by the Federal Reserve last autumn and the Bank of England this month are welcome.

The scale of the expansion of the Fed’s buying programme announced yesterday, however, threatens to push money growth well above 10% for a sustained period. While US recovery prospects are further enhanced, so is the medium-term risk of higher inflation and market disruption as the Fed is forced to withdraw unprecedented liquidity support at short notice.

Since last autumn the Fed has bought $241 billion of commercial paper, $44 billion of agency securities (i.e. issued by Fannie Mae, Freddie Mac and the Federal Home Loan Banks) and $217 billion of agency mortgage-backed securities (MBS). The total of $502 billion amounts to 6.1% of the M2 money supply and 4.4% of the broader money measure discussed in an earlier post.

The Fed had scope to buy a further $339 billion of agency debt / MBS under previous plans. It has now expanded the buying programme by up to a further $1.15 trillion, comprising $100 billion of agency securities, $750 billion of MBS and $300 billion of Treasuries. Future purchases could therefore total $1.489 trillion – 18.0% of M2 or 13.0% of broad money.

M2 grew by 9.8% in the year to February, while the broad money measure rose by 6.5% during 2008. The Fed may not utilise its full buying potential but if it did annual M2 / broad money growth could rise to 15-25%. Such rapid expansion is neither necessary for an economic recovery nor desirable for medium-term inflation and market stability.

Trade figures for January released today show little evidence of the economic benefits promised by the many advocates of exchange rate devaluation.

Contrary to the script, net exports appear to be exerting a drag on the economy in early 2009. Excluding oil and erratic items, export volumes in January were 8% below their fourth-quarter level versus a 5% decline in imports.

Meanwhile, manufactured import prices climbed a further 1% in January to stand 14% higher than a year before. Ongoing sterling weakness suggests the annual rate of change will remain in double-digits – see chart. As argued previously, the import price surge has lifted underlying inflation, thereby partly offsetting the boost to real incomes from lower energy prices and the VAT cut.

The weaker exchange rate may also have worsened the credit crunch by encouraging foreigners to reduce their sterling bank deposits and eroding banks’ capital ratios by inflating the sterling value of their foreign currency assets. Foreign net lending in sterling to UK-based banks fell by £63 billion between August and January. Credit constraints may have prevented some exporters from taking full advantage of the falling currency.

Sterling has weakened again following last week’s MPC decision to embark on “quantitative easing”. While this policy change is warranted, it carries inflationary risks from a possible further large fall in the exchange rate. These risks would have been reduced by smaller interest rate cuts, greater fiscal discipline and less “talking down” of the currency by policy-makers.

—–
COMMENT:
AUTHOR: Martin Wolf
EMAIL: webrequests@newstaram.com
IP: 217.196.237.120
URL:
DATE: 03/18/2009 02:46:32 PM

Did anybody say it was a panacea? This is surely a straw man. It is better than the alternative.

—–
COMMENT:
AUTHOR: Simon Ward
DATE: 03/18/2009 03:17:58 PM

I disagree that it is better than the alternative. By reducing domestic purchasing power and exacerbating the banking crisis, the fall in sterling has been negative for the economy.

Official encouragement of currency depreciation has been reminiscent of Japan’s attempt to reflate its economy via a lower exchange rate in the late 1990s. This worsened a credit crunch by forcing capital-constrained banks to cut back domestic lending to compensate for a higher yen value of their foreign assets.

The policy even failed to stimulate trade – the yen’s depreciation helped to topple other Asian currencies and resulting deep recessions damaged Japanese exports. Similarly, sterling’s plunge may have contributed to the Eastern European currency crisis and pressure for devaluation elsewhere.

—–
COMMENT:
AUTHOR: Martin Wolf
EMAIL: webrequests@newstaram.com
IP: 217.196.237.120
URL:
DATE: 03/18/2009 03:22:47 PM

I don’t see any deliberate sterling policy. The currency does what it does. When I talk about the costs of the alternative, I include, of course, the costs of trying, vainly, to stop it falling. That would presumably include higher interest rates.

In the longer run, the recovery of the UK must include a substantial rise in net exports. That certainly required a fall in what I have long considered a grossly overvalued real exchange rate. So this is, beyond doubt, a move towards equilibrium. Obviously, its effects will take time to work through.

I do not think it is the responsibility of the UK to consider the impact on the central and eastern European countries that have made absolutely classic macroeconomic policy errors, particularly encouraging very large-scale foreign currency borrowing.