Category: Money Moves Markets

The spread between UK banks’ average lending and deposit rates – a measure of their net interest margin – remained close to its historical low in January, according to estimates derived from Bank of England data published today. The spread stood at 2.08%, little changed from 2.09% in September before the MPC began slashing Bank rate and well below its average of 2.77% over 1999-2008 – see chart.

Some commentators accuse banks of widening margins by increasing the spread between lending rates and Bank rate, particularly for new and refinancing borrowers. The effect, however, has been offset by a rise in deposit rates relative to Bank rate. For example, the spread between Bank rate and the average rate paid on interest-bearing sight (i.e. instant access) deposits from households fell to just 0.47% in January versus an average of 2.20% over 1999-2008. In effect, banks have been forced to charge borrowers more in order to keep deposit rates high enough to retain funds.

The sight deposit rate stood at just 1.14% in January, a level that does not fully reflect the 0.5 percentage point reduction in Bank rate to 1.5% at the start of the month. The MPC cut by a further 0.5 pp in February and the consensus expects another 0.5 pp this week. If this is delivered, banks will face a choice between lowering sight deposit rates almost to zero, thereby risking a significant outflow of funds in favour of government-sponsored savings (National Savings / Northern Rock), or allowing a further narrowing of the Bank / deposit rate spread, with negative implications for profitability. Either way, their ability / willingness to lend may be impaired.

The MPC discussed possible adverse effects of a larger Bank rate cut at the February meeting. “There was a great deal of uncertainty about what would happen to banks’ and building societies’ willingness to lend at low levels of interest rates. It was possible that the negative impact on profitability could be significant for some banks as Bank rate fell further. Taking that into account, a majority of members concluded that a cut of 50 basis points was appropriate this month.”

If a sub-1% Bank rate was judged inappropriate last month, despite the MPC’s forecast of a significant inflation undershoot over the medium term, it would seem difficult to justify a further cut this week. Contrary to popular assertion, there is no technical requirement to reduce Bank rate towards zero before embarking on asset purchases designed to boost the money supply – see previous post for more discussion.

The Bank of England’s central forecast, based on an unchanged 1% Bank rate, implies a further decline in GDP of about 1.9% from the fourth quarter of 2008 to a bottom in the third quarter of 2009. It then embarks on a strong recovery, rising by 3.2% in the year to the third quarter of 2010. Risks to this forecast, however, are judged to be “weighted heavily to the downside”. Indeed, the Bank’s mean projection – which takes into account this skew – entails a further 2.7% fall by the third quarter of 2009, with slower growth of 1.9% in the subsequent year.

The Bank’s forecasts can be cross-checked against the monetary leading indicator model described in earlier posts. This predicts GDP three quarters in advance based on current and lagged values of interest rates (three-month LIBOR), real money supply growth (both narrow and broad measures), the corporate liquidity ratio (companies’ bank deposits divided by their bank borrowing), the yield spread between corporate bonds and gilts, the effective exchange rate and share prices. The model’s forecasts can be expressed either as a probability of the economy being in recession (defined as an annual fall in GDP) or a numerical growth prediction.

The model supports the Bank’s forecast that recessionary forces will abate in late 2009. Based on available first-quarter data, the recession probability estimate falls significantly between the third and fourth quarters of 2009 – see chart – while the numerical projections imply a small GDP rise in the final quarter. However, the model casts doubt on the Bank’s forecast of a subsequent solid recovery. On the assumption that the input variables remain at their current values over the remainder of 2009, GDP is projected to grow by only 1.2% in the year to the third quarter of 2010 – well below the Bank’s central and mean forecasts of 3.2% and 1.9% respectively.

With the scope for further interest rate stimulus exhausted, a revival in monetary growth represents the best hope of achieving an outcome more in line with the Bank’s projections. The model can be used to assess the possible impact of the MPC’s new initiative to boost the money supply by buying gilts and other securities, financing purchases by creating new bank reserves. Suppose the programme results in a five percentage point rise in the annual growth rates of both broad and narrow money by the end of the third quarter of 2009. With all other input variables unchanged, the model forecasts GDP growth in the subsequent year of 2.2% – 1.0 percentage points higher than in the “base case”. This understates the impact because the monetary acceleration would be likely to affect other model inputs favourably: the corporate liquidity ratio would probably rise, while credit spreads might narrow and share prices rally as investors with higher cash balances deployed funds.

How big would Bank asset purchases have to be to have a monetary impact of five percentage points? Excluding deposits of “intermediate other financial corporations”, the broad money supply M4 stood at £1.7 trillion at the end of December so a 5% boost implies an increase of £85 billion. The Bank’s buying, however, will have a direct impact on M4 only if securities are purchased from domestic non-bank investors – essentially, insurance companies and pension funds, non-financial companies and households. Purchases from banks will increase M4 only if their lending rises as a result – far from guaranteed given current capital constraints and risk aversion. Assuming that one-third of the securities bought by the Bank is acquired from banks or overseas investors, the programme might need to amount to at least £125 billion to have the desired monetary impact.

The upcoming MPC meeting is intriguing. Despite an Inflation Report forecast showing annual CPI inflation far below target in the medium term if Bank rate remains at 1%, only David Blanchflower voted for a reduction of more than 0.5 percentage points in February. This suggests other MPC members believe that cutting Bank rate below 1% would have a negligible or even negative impact on the economy. The Report explains that, in the event of a further cut, banks might fail to pass on the reduction; alternatively, their interest margins would be squeezed, damaging earnings and lending capacity. If most MPC members held this view in February, as the vote suggests, it would seem logically inconsistent for those individuals to support a cut at this month’s meeting.

Some commentators have suggested that an unchanged 1% Bank rate would conflict with the MPC’s plans to finance asset purchases by creating new bank reserves. They argue that an expansion of reserves will push very short-term interest rates towards zero, undermining the main objective of the Bank of England’s money market operations – “to implement monetary policy by maintaining overnight market interest rates in line with Bank rate”. This appears to be incorrect. Under current arrangements, banks choose the level of reserves they wish to hold on average each month and are remunerated at Bank rate on balances close to these targets. In theory, the Bank could coordinate with banks to raise targets progressively so that reserves created by asset purchases continue to earn interest at Bank rate. In addition, the Bank could limit any decline in market rates by allowing banks to make greater use of its operational standing deposit facility, which pays Bank rate minus 25 basis points; this level would then act as a floor for overnight rates. The facility is intended to accommodate unexpected “frictional” payments shocks rather than a structural excess of reserves but the scale of its usage recently suggests that the Bank has adopted a liberal interpretation of this requirement. (Deposits averaged £5 billion during the December maintenance period versus reserve balances of £45 billion.)

Revised figures show that GDP fell by 0.02% between the first and second quarters of 2008, having previously been estimated to have risen marginally. So the recession began in the second not third quarter of last year.

A monthly GDP estimate can be calculated using output data for industry and services, which together account for 93% of total activity. This peaked in April, implying that the recession began in May last year – see chart.

After a 1.6% plunge in November, monthly GDP fell by a further 0.4% in December, to a level 0.8% below the fourth-quarter average. In other words, GDP would decline by 0.8% in the first quarter even in the unlikely event of activity stabilising in early 2009. For comparison, the Bank of England’s central forecast implies a 1.1% first-quarter drop.

The expenditure breakdown is not particularly reliable at this stage but suggests that inventory liquidation accounted for much of the 1.5% fall in GDP in the fourth quarter. Domestic final demand contracted by a smaller-than-feared 0.5%, with a large – but presumably temporary – rise in government spending providing support.

The GDP price measures are also subject to significant revision but do not support deflation claims. The deflator for gross value added at basic prices – which corrects for the depressing effect of the VAT cut – rose by 1.2% on the quarter for a 3.6% annual gain. (See here for more on inflation.)

On the face of it, Northern Rock is suffering significantly higher delinquencies on its mortgage lending than the industry average. According to yesterday’s 2008 results preview, residential loans more than three months in arrears were 2.92% of the total number of loans at the end of December, which compares with an industry figure of 1.87% (reported by the Council of Mortgage Lenders last week).

The Northern Rock number, however, has been inflated by its policy of encouraging borrowers to refinance their loans with other lenders. The number of mortgages in the Granite pool fell by 30% during 2008, a figure likely to be representative of the bank as a whole. With other banks tightening lending criteria, only Rock’s more credit-worthy customers will have been able to refinance elsewhere and it is reasonable to assume that most of these borrowers have continued to service their loans.

Accordingly, when comparing Rock’s arrears performance with the industry average, it may be more appropriate to express the number of cases as a proportion of the total including those who have moved to other lenders, i.e. the number at the end of 2007 rather than 2008. Adjusting for a 30% fall, this reduces the three months plus arrears proportion at the end of December to 2.05% – only slightly higher than the industry figure.

One way of moving borrowers off arrears is to repossess their homes. Properties accounting for 0.66% of the loans in the Granite pool at the end of 2007 were repossessed during 2008, which compares with an industry repossession rate of 0.34% last year. Northern Rock has therefore contained the rise in its arrears proportion by a relatively aggressive repossessions policy but the effect has not been large.

Arrears nationally are likely to continue to rise rapidly during 2008 – see here – and it is possible that Northern Rock’s relative performance will deteriorate more significantly in the process. Its rapid expansion during the late stages of the boom and an above-average loan-to-value ratio are reasons for pessimism but Rock avoided subprime lending and – unlike Bradford & Bingley – has limited exposure to the buy-to-let sector, where arrears are rising more rapidly.

Earlier posts on Northern Rock can be found here and here.

House price falls have pushed the national rental yield up to its long-run average, suggesting housing is now fairly valued by historical standards. However, if the yield were to overshoot the average by the same extent as it undershot during the boom – a not unreasonable assumption – house prices would fall by a further 16% from current levels.

The national rental yield is derived from national accounts data by dividing the sum of actual rents paid by households and imputed rents of owner-occupiers by the value of the housing stock. It averaged 3.59% between 1965 and 2007. The national yield is lower than alternative measures because it includes subsidised social housing, takes account of vacant properties and is calculated using end-period prices.

The most recent official figures are for 2007, when the yield stood at 2.84%. House prices fell by 18% in the year to December 2008, according to the Halifax index. Applying this decline to the value of the housing stock at end-2007, and taking into account rental growth of 5% in 2008, the rental yield is estimated to have risen to 3.63% by the end of last year – see first chart.

The end-2007 yield was 0.75 percentage points below the long-run average. If the yield were to overshoot by the same amount during the current downturn, rising to 4.34%, house prices would fall by a further 16% from their December 2008 level, assuming constant rents. The implied decline would obviously be larger to the extent that rents fall, as suggested by the last Royal Institute of Chartered Surveyors residential lettings survey – second chart.

A further fall of 16% would imply a peak-to-trough decline in inflation-adjusted house prices similar to the early 1990s housing downturn – see here.

The Council of Mortgage Lenders (CML) today reported a rise in the number of mortgages more than three months in arrears from 167,000 in September to 219,000 in December. As a proportion of the 11.7 million outstanding mortgages, this represents an increase from 1.42% to 1.87%.

In its December forecast, the CML projected a further rapid rise in over three months arrears cases during 2009, to 500,000 or 4.4% of outstanding mortgages by year-end. The Bank of England, in its October Financial Stability Report, has also suggested that the arrears proportion would reach 4.4% in a “severe” economic scenario.

The recent and projected large rise mainly reflects the impact of the recession on homeowner incomes. Other factors include: a lack of refinancing options for those facing payment difficulties, especially given house price falls; government efforts to reduce repossessions, implying that more borrowers remain in arrears; and the arithmetic impact of lower interest rates on the calculated number of missed payments.*

How does current and prospective arrears performance compare with the housing downturn of the early 1990s? The CML series on over three months arrears begins in 1995 but earlier figures exist for cases more than six months overdue. The statistical relationship between the two series can be used to “backcast” the three months plus arrears proportion for earlier years – see first chart.

Three points are notable. First, arrears performance was worse at the comparable stage of the last recession. GDP had fallen for two quarters by the end of 2008, when 1.87% of mortgages were three months or more in arrears. In December 1990, also after two quarters of GDP contraction, the estimated proportion – based on the backcast – was 3.2%.

Secondly, the over three months arrears proportion is estimated to have reached 6.3% in the early 1990s, well above the 4.4% level projected by the CML and Bank of England (although the CML may expect a further increase in 2010).

Thirdly, arrears peaked in December 1992, five quarters after the trough in GDP and around the same time as unemployment. Even assuming an economic recovery from late 2009, this suggests that the arrears proportion will remain on an upward trend until late 2010, or even beyond.

The key reason for expecting arrears performance to be less bad than in the early 1990s is a much lower level of income gearing. Household interest payments as a proportion of disposable income peaked at 11.9% in the third quarter of 1990 but reached only 7.9% at the top of the recent interest rate cycle and should fall to 4% or lower as a result of rate cuts – second chart.

*To explain this effect, consider a borrower whose monthly payment obligation falls from £800 to £200 because of lower interest rates. An unchanged arrears amount of £800 rises from the equivalent of one month’s payment to four, resulting in the mortgage being included in the three months plus total.

UK labour demand is weakening rapidly, as evidenced by data released yesterday showing a 26% slump in the stock of job vacancies between March and December 2008.

The recent pace of decline is faster than during the recession of the early 1990s but less rapid than over 1974-76 and 1979-81 – see chart. In other words, while confirming a serious employment recession, vacancies have yet to indicate a downturn on the scale of the mid 1970s or early 1980s.

In the three prior recessions, the stock of vacancies reached a trough 18-24 months after peaking having fallen between 52% and 69%. This suggests a further decline of 35-58% from the December level, with a bottom between September 2009 and March 2010.

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COMMENT:
AUTHOR: Emily Bagley
EMAIL:
IP: 195.50.81.249
URL:
DATE: 02/17/2009 04:38:41 PM

Please could you let me know where you got this data from regarding the slump in the number of vacancies?

Many thanks.

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COMMENT:
AUTHOR: Simon Ward
DATE: 02/18/2009 04:31:54 PM

The latest information is published in the labour market statistics first release. I obtained historical data via Thomson Datastream. The figures for the last three recessions relate to vacancies at job centres. This series was discontinued in 2001 and replaced by a survey of employers.

The MPC voted 8-1 for the cut of half a percentage point in Bank rate earlier this month, with David Blanchflower again dissenting in favour of a full-point move.

The fact that only Blanchflower wanted a larger reduction, despite Inflation Report forecasts showing annual CPI inflation well below target over the medium term, is significant. Most MPC members appear to accept that a further cut in Bank rate would provide little additional stimulus and might even have an adverse economic impact by reducing banks’ earnings and lending capacity. (This argument was made in an earlier post.)

Quantitative action rather than Bank rate cuts must therefore bear the burden of further monetary easing. The surprise here is that the Committee has already instructed the Governor to seek Treasury authority to conduct purchases of gilts and other securities financed by creating new bank reserves. Assuming approval is granted, a decision to begin unsterilized buying is likely to be taken at the next meeting on 5 March.

My MPC-ometer, like the consensus, predicted the half-point February decline. The model is not able to incorporate the diminishing effectiveness of reductions as Bank rate approaches zero so may overestimate the MPC’s inclination to cut further. It currently suggests a quarter-point fall at the March meeting; as always, consumer and business surveys released around the end of the month will be an important influence on the final forecast.

Contrary to the consensus interpretation, recent inflation news has been distinctly poor, with the cut in VAT and lower fuel prices masking a deteriorating underlying trend due to surging non-energy import costs.

The superficial view is that prices are slowing fast, with annual headline consumer price inflation down to 3.0% in January from a peak of 5.2% last September. However, using the CPI at constant tax rates, which adjusts for the reduction in VAT, the decline has been much smaller, from 5.0% to 4.1%. Moreover, this fall is fully explained by a drop in energy price inflation.

Underlying inflation is often measured by the CPI excluding unprocessed food and energy. The annual increase in this index declined from 2.8% to 1.9% between September and January but would have risen – to an estimated 3.0% – without the VAT reduction.

The culprit is the officially-sanctioned plunge in the exchange rate and a resulting large rise in non-energy import costs (import prices of manufactured goods climbed 14% in the year to December). Today’s Office for National Statistics release notes upward contributions to annual CPI inflation from a range of categories dependent on foreign suppliers, including games and toys, furniture, household and personal appliances and package holidays.

The recession will restrain domestically-generated inflation but higher import costs may continue to have an offsetting impact, barring a significant exchange rate rally. Energy effects will ensure a further fall in the headline CPI increase over coming months but the decline may disappoint MPC and consensus expectations and inflation will rebound in early 2010 as VAT and energy benefits reverse.

The plunge in the exchange rate has worsened the credit crunch by damaging banks’ capital ratios.

In its October Financial Stability Report, the Bank of England estimated that the tier 1 ratios of Barclays, Lloyds TSB and HBOS would stand at over 11%, 12.1% and 12.0% respectively after last autumn’s capital-raising. However, Barclays recently reported a ratio of only 9.7% at the end of 2008 while Lloyds HBOS has indicated a group outturn “in excess of 9%”. These levels are well above the Financial Services Authority’s minimum of 6-7% but imply a much smaller cushion than previously thought.

The declines appear to be due less to losses than strong growth in risk-weighted assets – the denominator of the tier 1 ratio. This growth in turn reflects both higher risk weightings – caused by the unhelpful pro-cyclicality of Basel Accord rules – and the decline in the exchange rate, which has boosted the sterling value of foreign-currency assets. (The sensitivity of capital ratios to currency movements reflects a mismatch between capital – held mostly in sterling – and assets, which contain a large foreign element.)

Current UK exchange rate policy is reminiscent of Japan in the late 1990s. With US approval, the Japanese authorities engineered a large fall in the yen in an effort to reflate the economy via net exports. However, 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.