Category: Money Moves Markets

The charts below update an earlier analysis comparing GDP performance in the current recession with the last three – 1974-75, 1979-81 and 1990-91. As before, the GDP measure adjusts for the impact of strikes, while the lower chart also includes Bank of England and Treasury forecasts, contained in the February Inflation Report and November Pre-Budget Report respectively.

GDP in the fourth quarter of 2008 was 2.1% below the peak level reached in the second quarter, according to current Office for National Statistics (ONS) estimates. This compares with a peak-to-trough fall in strike-adjusted GDP of 2.5% in 1990-91, 2.8% in 1974-75 and 6.2% in 1979-81.

As explained here, however, monthly ONS numbers for services and industrial output imply that GDP in December was 1.0% below the fourth-quarter average. In other words, even assuming no further fall in early 2009, first-quarter GDP will be 3.1% below the peak level of the second quarter of 2008. So the current downturn is already deeper than the 1974-75 and 1990-91 recessions.

The Bank of England central forecast, based on a constant 1% Bank rate, entails GDP bottoming in the second / third quarters at a level 3.8-3.9% below the peak, implying a further decline of 0.8% from the estimated December reading. It then embarks on a strong recovery, rising at an annualised rate of about 3.5% over the following six quarters.

Strike-adjusted GDP fell by 6.2% in the 1979-81 recession. This dismal performance, however, was partly a reaction to a 5.3% surge in GDP in the year preceding the peak. With no comparable boom leading up to the current downturn, the Bank of England’s forecast that the current recession will be less severe is defensible, though depends on an improvement in money and credit conditions.

The Treasury forecast looked optimistic even when it was published in November – see here – and has been rendered obsolete by the fourth-quarter GDP estimate. The April Budget will probably be based on a profile similar to the Bank’s latest forecast.

Monetary news has improved recently: nominal money expansion may be stabilising, real growth is reviving as inflation falls and the MPC is finally embracing necessary quantitative action. This supports the Bank of England’s forecast that the economy will trough by the third quarter, though GDP could decline by more than it projects in the interim. However, monetary growth would need to rise substantially to justify the Bank’s projection of a strong recovery from late 2009, particularly with fiscal policy set to tighten next year. On current information, an economic revival is more likely to follow the pattern of the early 1980s and early 1990s, when GDP growth averaged only 1-2% annualised in the six quarters following the recession trough.

An earlier post drew attention to a statistical tendency for the exchange rate to weaken when Bank of England Governor Mervyn King gives a speech or appears at an Inflation Report press conference. In 12 such instances between August 2007 and November 2008, the average daily fall in the sterling effective index was 0.5%.

Mr. King gave a dinner speech on 20 January and presented at yesterday’s press conference. The sterling index dropped by 1.6% on 21 January and 1.5% yesterday. Intriguingly, it also fell on the preceding days – by 2.7% on 20 January and 1.3% on Tuesday. Are markets beginning to anticipate the “King effect”?

Today’s Inflation Report signals that the MPC sees little mileage in further cuts in Bank rate and will soon start buying gilts as well as corporate securities with the explicit aim of boosting the supply of broad money. This shift is significant and welcome but the new policy needs to be implemented swiftly to affect macroeconomic outcomes this year.

The central growth and inflation projections in the Report stretch plausibility, with GDP forecast to recover rapidly from the third quarter and annual CPI inflation below target as far as the eye can see, despite sterling’s plunge and next year’s VAT hike. There is a suspicion that the MPC is downplaying inflation risks to justify its new policy of printing money.

Further points:

• The Report argues that additional cuts in Bank rate might provide little stimulus, either because banks fail to pass them on to borrowers or their own interest margins are squeezed, damaging earnings and lending capacity. The MPC is therefore close to embarking on quantitative action beyond the current Asset Purchase Facility (APF) remit. Specifically, the APF will be expanded in scope and scale and financed by creating bank reserves.

• The Bank of England’s adjusted M4 measure – excluding financial intermediaries – rose by just 3.8% in the year to December. To bring the annual growth rate up to, say, 8%, adjusted M4 would need to expand by about £70 billion. The Bank’s asset purchases are unlikely to have a one-for-one impact on M4 so the buying programme may need to exceed £100 billion to have the required impact on monetary trends.

• While it is difficult to infer precise figures from the chart, the central growth projection based on unchanged interest rates is consistent with GDP declining by about 1.25% and 0.5% respectively in the first and second quarters before stabilising in the third. It then embarks on a strong recovery, rising by more than 0.75% per quarter over the following year. This is not impossible but looks unlikely barring an early substantial pick-up in money growth.

• The central inflation forecast shows the annual CPI increase falling to a trough of about 0.75% in the fourth quarter, recovering to 1.25% in the first quarter of 2010 as the recent VAT cut is reversed but slumping back below 1% later in 2010 and in 2011. The 2010 numbers look suspiciously low given the VAT change and likely lagged effects of the large fall in the exchange rate (manufactured import prices rose 14% in the year to December).

• The Report assumes the December VAT cut lowered the CPI by about 0.75 percentage points. This implies that annual inflation will rise by 0.75 percentage points when the reduction drops out of the annual comparison in December 2009 and by a further 0.75 points when the 17.5% rate is restored in January 2010. Yet the Report forecasts an increase of just half a point between the fourth quarter of 2009 and the first quarter of 2010. Put differently, tax-adjusted inflation would have to fall to 0-0.5% for the 2010 projections to be met.

Industrial output in the Group of Seven (G7) major economies fell an estimated 12% between February and December last year, based on data for six of the seven countries (Canada has yet to publish for December). This is equal to the peak-to-trough decline during the 1974-75 recession – see first chart.

Business surveys signal a further fall in output in early 2009, implying the current G7 industrial slump will soon be the deepest since World War 2.

For a longer perspective, the second chart shows estimated annual average growth rates of G7 industrial output back to the late nineteenth century. The underlying country statistics were assembled from various sources, including an Economist publication One Hundred Years of Economic Statistics.

If annual average G7 output in 2009 were to equal the December level, it would be 9% lower than in 2008 (red line in chart). This would be the largest annual decline since 1938, when the “Roosevelt recession” in the US led to a 10% drop.

However, the current downturn would have to extend hugely in magnitude and duration to be comparable with the depression of the early 1930s. G7 industrial output plunged for three successive years – 9% in 1930, 13% in 1931 and 10% in 1932.

The third chart shows annual rates of change of G7 output and inflation-adjusted broad and narrow money supply measures. While G7 activity will slide further in early 2009, strengthening real money growth continues to offer hope of an improvement in economic trends later in the year.

Some analysts are wrongly claiming that the Bank of England’s asset purchase facility will have no monetary impact. For example, an article in Friday’s Financial Times stated that “the money used to buy the corporate securities will be financed by Treasury sales of government bills rather than the creation of money”.

The simultaneous sale of Treasury bills will ensure no effect on banks’ reserves held at the Bank of England and hence the monetary base M0, implying the scheme does not represent “quantitative easing” in the Japanese sense. Providing Treasury bills are sold to banks, however, while the Bank purchases assets from non-banks, the broad money supply will expand. Banks should indeed absorb much of the increase in the supply of bills, given regulatory pressure to raise their holdings of safe liquid assets.

The potential for the scheme to boost M4 directly is more important than whether it expands the monetary base. M0 growth has already risen significantly as a result of increased Bank of England lending to the banking system, without any noticeable impact on broad money or credit conditions. In the US, wider money measures have accelerated since the Federal Reserve began buying commercial paper and agency securities, having shown little response to earlier initiatives inflating the monetary base.

Another article in the same FT edition claims that quantitative easing can begin only after interest rates have been cut to zero; otherwise “the overnight interest rate in money markets would in any case fall towards zero because commercial banks would find themselves awash with unwanted cash looking for a home overnight”. This is incorrect. Banks are able to deposit excess funds in unlimited amounts at the Bank of England’s operational standing deposit facility, earning interest at Bank rate minus 25 basis points, a level that sets an effective floor for overnight rates.

With the option of underfunding the budget deficit apparently still off the policy agenda, the asset purchase facility represents the best hope for an early and significant revival in broad money growth. Rapidly implemented and suitably expanded, the scheme could lay the foundations for an economic recovery from late 2009.

The tier 1 capital ratios of major British banks would fall below the 6-7% minimum required by the Financial Services Authority if they were forced to write down the value of their mortgage portfolios in line with the market prices of mortgage-backed securities used by the Bank of England in its operation of the special liquidity scheme (SLS). However, actual losses are likely to be a fraction of those implied by these prices, illustrating the absurdity of mark-to-market assessments of capital adequacy.

When the SLS closed on 30 January, the Bank of England held securities with a nominal value of £287 billion as collateral against Treasury bills lent under the scheme. The Bank’s valuation of these securities was £242 billion, implying a discount to par of about 16%. The collateral was mostly in the form of AAA-rated residential mortgage-backed securities and covered bonds. Since AAA tranches suffer impairment only after lower-rated tranches have been wiped out, a 16% discount suggests a much larger expected loss – of perhaps 25% – on the underlying pool of mortgages.

Major banks held £496 billion of residential mortgages on their balance sheets at the end of 2008, according to the British Bankers’ Association. Ignoring additional exposure via off-balance-sheet entities, a write-down of 25% would reduce capital by about £125 billion – sufficient to cut banks’ current aggregate tier 1 ratio of over 11% by more than half.

The chances of actual losses on this scale are miniscule. In the worst year of the early 1990s housing downturn – 1991 – 0.77% of mortgaged properties were repossessed, according to the Council of Mortgage Lenders. Even assuming a repossession rate of 0.77% sustained for 25 years, and a loss given default of 50%, the cumulative reduction in the value of mortgage principal would be less than 10%.

The large deviation of market prices of mortgage-related securities from their likely economic value reflects extreme investor risk aversion and illiquidity. There is a strong case for the Bank of England to use its new asset purchase facility to buy such securities, in addition to corporate bonds and commercial paper. Targeting a wide range of assets would facilitate an early expansion of the facility – necessary if it is to have a meaningful impact on monetary growth.

Sharp falls in annual consumer and retail price inflation in December have prompted claims that the economy stands on the brink of deflation, justifying today’s further reduction in Bank rate to 1.0%. The declines, however, are entirely explained by the 2.5 percentage point cut in VAT, falling energy costs and – in the case of the RPI – lower interest rates. Underlying inflation has yet to show much response to economic weakness.

Annual CPI inflation fell from 4.1% in November to 3.1% in December. Since its first statistical release a fortnight ago, the Office for National Statistics (ONS) has published a December number for the “CPI at constant tax rates” (CPI-CT), i.e. adjusted for the impact of the VAT cut. This incorporates official estimates of the extent to which the reduction was passed on by retailers and other consumer suppliers. Annual CPI-CT inflation actually rose in December, from 3.9% to 4.1% – see chart.

The annual increase in the CPI’s energy component moved lower in December, from 16.7% to 12.2%, mainly reflecting falling petrol prices. If the rate of change had remained at 16.7%, annual CPI-CT inflation would have risen further, to an estimated 4.3%.

To gauge underlying pressures, it is helpful to exclude both energy prices and the effect of the VAT reduction. The annual increase in the CPI excluding energy eased from 3.1% to 2.3% in December. Without the VAT cut, however, the December number would have risen to an estimated 3.4% – equal to the peak reached in August / September.

Annual RPI inflation dropped from 3.0% in November to just 0.9% in December. The ONS does not publish an RPI series at constant tax rates but RPIY – which excludes indirect taxes and mortgage interest costs – rose an annual 3.9% in December, unchanged from November.

The severe recession will rapidly reduce domestic inflationary pressures but the slump in sterling is having an offsetting impact, with manufactured import prices rising by an annual 14% in November (December figures are due next week). Energy price effects will ensure a further significant drop in headline CPI and RPI rates during 2009 but the decline is likely to be smaller than the MPC and consensus expect, while VAT-adjusted non-energy inflation may remain above 2%.

My MPC-ometer projects a further half-point cut in Bank rate to 1.0% tomorrow. This is also the expectation of 61 out of 68 economists, according to a Reuters survey. The model’s forecast is heavily influenced by the 1.5% slump in GDP in the fourth quarter reported a fortnight ago. Further falls in consumer confidence and manufacturing pricing plans and January’s weak stock market performance are also contributory factors.

In my view, another cut in rates is less important than measures to boost underlying broad money growth, which remains too low to support an economic recovery – see here. Improving credit availability is clearly also a priority but credit constraints would be relieved by an increase in the quantity of money circulating in the economy.

The simplest way to boost broad money would be to “underfund” the huge budget deficit, i.e. finance it by borrowing from banks or the Bank of England rather than by issuing gilts. This would not imply a reduction in banks’ capacity to lend to firms and households, because institutions are not required to set aside additional capital against increased lending to the government. Underfunding is a conventional unconventional measure, to use Bank of England Governor Mervyn King’s terminology. It occurred after the early 1990s recession, helping to underpin an economic recovery, and again in 2001-02, when the UK managed to skirt a global downturn.

An alternative to underfunding would be for the Bank of England to use its asset purchase facility to buy securities from non-bank financial institutions and companies. Such purchases would directly boost broad money; by contrast, buying assets from banks has a positive impact only if they respond by increasing lending. The Bank could, for example, buy newly-issued commercial paper or longer-maturity asset-backed securities (more likely to be held outside the banking system).

Whether such transactions boost the monetary base (i.e. currency in circulation and banks’ deposits at the central bank) – thereby qualifying as “quantitative easing” – is of secondary importance. Banks’ unwillingness to lend reflects capital constraints and risk aversion rather than a shortage of cash. Monetary base growth has already picked up significantly as a result of the Bank of England’s expanded lending to the banking system, without any noticeable impact on the broad money supply or credit availability – see chart.

A further interest rate cut could be counterproductive in terms of improving credit availability. Banks need to be able to widen interest margins in order to rebuild capital to support higher lending. As the general level of interest rates approaches zero, however, their ability to lower deposit rates is constrained by increasing competition from government-guaranteed savings products offering full security with little or no loss of income. Forced to lower lending rates to existing borrowers on deals linked to Bank rate or LIBOR, banks may compensate by raising rates charged on new loans.

The Bank of England yesterday reported that banks and building societies had borrowed £185 billion of Treasury bills under the special liquidity scheme (SLS) by the time of its closure on 30 January – broadly consistent with my earlier estimates (e.g. here). The SLS has been superseded by the Bank’s new discount window facility (DWF). Drawings from the DWF will be published quarterly but with a considerable lag – first-quarter figures will be available at the end of June.

The net percentages of senior bank loan officers reporting tighter credit standards on loans to businesses and residential mortgages declined between October and January, according to the Federal Reserve’s latest survey – see first chart. However, the balances remain above the peaks reached in the 1990-91 and 2001 recessions.

The second chart shows the annual rate of change of industrial output and an average of the net percentages of loan officers reporting tighter standards on loans to large / medium and small firms, plotted inverted. Turning points in the latter series lead the industrial cycle. The latest small change is consistent with an approaching trough in the annual rate of decline of output, confirming the message from real money trends – see here.

British-owned banks are being unfairly blamed for a contraction of sterling banking activity by foreign-owned institutions operating in the UK.

Total sterling assets of UK-based banks grew by 8% in the year to December, down from 14% in the prior 12 months, according to Bank of England data. The 8% rise, however, conceals a 15% increase for domestically-owned banks offset by a 3% contraction in sterling assets of foreign institutions, which account for 34% of the amount outstanding.

Foreign banks continued to expand their lending to the non-bank private sector last year, though at a slower pace than British-owned banks. The decline in their total sterling assets reflected a cut-back in lending to other UK banks – this in turn constrained the ability of British banks to extend new credit to households and firms.

Of the 34% foreign share of total sterling assets, “other EU” banks account for 22 percentage points, “other developed countries” 7 pp and the US 4 pp. Last year’s contraction was due to a large fall in assets of banks from “other developed countries”, a category including Swiss, Canadian and Australian institutions, among others. Sterling assets of “other EU” banks grew by 7% during 2008, partly reflecting Santander’s acquisition – via Abbey – of Bradford & Bingley’s savings business. Icelandic banks are also included under “other EU” – their liquidation could affect future data.