Category: Money Moves Markets

Federal Reserve Bank credit – the Fed’s lending to banks, dealers, other central banks and AIG plus its holdings of securities – has soared by $850 billion, or over 90%, since 11 September, just before Lehman’s failure. Importantly, the Fed has chosen not to sterilise fully the impact of this expansion on banks’ reserves – their deposits held at the Fed. Reserves and currency in circulation constitute the monetary base. The average level of the base in the fortnight to 8 October was 17% higher than four weeks earlier.

Real monetary base expansion tends to lead economic activity so the recent pick-up could suggest improving growth prospects – see first chart. Historically, however, major swings in base money have been driven by the currency component rather than bank reserves. The hope is that banks holding excess cash in their accounts at the Fed will be more willing to lend to other banks and the wider economy but many commentators believe the Fed is “pushing on a string”.

The Fed is copying the Bank of Japan’s 2001 policy of “quantitative easing”, which involved the central bank buying government bonds in order to flood the banking system with liquidity. Real monetary base growth peaked at an annual 38% – see second chart. Commentators were similarly sceptical of any impact on financial behaviour or economic activity but growth recovered in 2002, while the rate of contraction of bank lending slowed, although these improvements may have reflected other factors.

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COMMENT:
AUTHOR: EQ
EMAIL: equityquant@gmail.com
IP: 76.181.239.178
URL:
DATE: 12/02/2008 11:55:00 PM

Do you know the parameters under which Thomson calculates "real" M1? Is it M1 in its entirety adjusted for inflation? The currency portion of M1 adjusted for inflation? I’m sort of curious. Thanks in advance.

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COMMENT:
AUTHOR: Simon Ward
DATE: 12/03/2008 10:34:19 AM

The inflation adjustment is made to M1 in aggregate, not just the currency component.

Reflecting fears of financial meltdown, UK savers withdrew cash from bank and building society accounts at a record pace in October. According to Bank of England data published today, households’ M4 money holdings fell by £5.2 billion, compared with an average rise of £5.6 billion over the prior 12 months. The cash withdrawn from banks appears to have been reinvested mainly in National Savings products and Treasury bills, which attracted £4.7 billion and £12.3 billion respectively – also records.

Other key features of the detailed monetary data for October include:

• M4 excluding money holdings of financial corporations slowed to an annual growth rate of 3.6% – the lowest since 1993.

• In addition to the decline in household deposits, M4 holdings of non-financial private corporations fell again, to stand 5.2% lower than a year before. This suggests ongoing severe pressure on profits – likely to be reflected in significant cuts in jobs and investment.

• Consistent with anecdotal evidence of a reduction in credit availability, bank borrowing by non-financial corporations grew at an annualised rate of just 2.4% in the three months to October, compared with a 10.7% rise in the prior year.

• Narrow money M1 – currency plus instant-access deposits – fell by 1.8% in the year to October, the largest annual decline since 1969. This compares unfavourably with recent trends in the US and Euroland, where M1 has been picking up.

• Banks replaced traditional interbank loans with purchases of bills issued by other banks and backed by the government under the Credit Guarantee Scheme. Market loans to other banks fell by £34.2 billion in October, while purchases of bank bills soared to £17.5 billion.

• The estimated spread between the average interest rate received on banks’ and building societies’ M4 lending and the rate paid on M4 deposit liabilities – a proxy for their net interest margin – fell slightly to a new low. Banks need a wider margin to enable them to rebuild capital to support higher lending.

The monetary data confirm a grim near-term economic outlook and warrant a further rate cut at this week’s MPC meeting. However, calls for Bank rate to fall quickly to 1% or even lower are questionable. Considerable stimulus is already in the pipeline in the form of the 2 percentage point reduction since September, a 17% fall in sterling’s effective rate over the last year and a projected rise in cyclically-adjusted public borrowing of 4.3% of GDP in 2008-09 and 2009-10 combined. The authorities’ efforts should now focus on improving the transmission mechanism and taking direct action to lift money and credit growth. Specifically, the Debt Management Office could fund the deficit partly by borrowing from banks, boosting M4, while the Bank of England could emulate the Fed by buying commercial paper and mortgage-backed securities, thereby easing credit supply.

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COMMENT:
AUTHOR: Simon Ward
DATE: 12/02/2008 11:39:54 AM

It doesn’t really drain funds from the system because if the government raises more through NSI it can issue fewer gilts. If the investors who would have bought the gilts hold their funds on deposit, there is no overall loss to the banking system, although particular banks could suffer an outflow.

MPC members have argued that Bank rate cuts and fiscal policy must bear more of the burden of supporting the economy because the “bank credit channel” of monetary policy is impaired. The logic is indisputable but the optimal solution is surely to take direct action to revive credit supply.

In the US, mortgage giants Fannie Mae and Freddie Mac, now under government control, are maintaining lending while the Fed has started to buy commercial paper and mortgage-backed securities on a large scale. The Fed’s recent actions have contributed to the three-month LIBOR / OIS spread falling to 1.8% – well below the UK level of 2.2% – while there are tentative signs of a pick-up in monetary growth.

In the UK, by contrast, state-run Northern Rock is on course to cut outstanding loans by £25-30 billion in 2009 while the Bank of England remains resolutely opposed to Fed-style direct lending to firms and households. Government plans to expand support for small firm credit and offer guarantees on mortgage securities backed by new loans are promising but cannot fully substitute for use of the central bank’s balance sheet.

The Bank’s intransigence is an extension of its refusal to offer lender-of-last-resort support to the banking system on other than penal terms – the special liquidity scheme is much more expensive to access than equivalent Fed or ECB facilities. The penal approach was also in evidence in Mervyn King’s recent suggestion that banks will be forced to raise still more capital if they refuse to expand their lending. The Bank’s October Financial Stability Report contained a detailed discussion of why the government’s £50 billion recapitalisation plan would be sufficient to cushion banks against losses over the next five years even in a severe macroeconomic scenario and assuming a low level of underlying future profits. Mr. King’s apparent U-turn is puzzling and threatens to undermine the confidence-building effects of the rescue package.

Cuts in interest rates reduce the opportunity cost of holding money in more liquid forms. Narrow money M1 – currency and checkable deposits – usually picks up relative to broader measures like M2 and M3. This is a sign that the change in interest rates is affecting behaviour and often precedes a recovery in economic activity.

US real M1 typically leads turning points in the economic cycle by 6-12 months – see first chart. Its annual rate of change bottomed in May and moved up sharply in September and October. Recent figures may have been artificially boosted by a flight of cash from money market funds. However, a further recovery in November and December would suggest an approaching trough in economic activity.

Eurozone figures released today also show M1 picking up, with a particularly large rise in October – see second chart. UK data will be available on Monday.

Note that M1 – unlike the monetary base – does not include bank reserves held at the central bank, so is not directly affected by “quantitative easing”.

Revised third-quarter GDP figures released today confirm a 0.5% quarterly decline. From the expenditure side, a 2.4% fall in capital spending contributed 0.4pp to the GDP drop, with consumer spending, inventories and trade each adding a further 0.1pp. The only positive was a rise in government consumption, contributing 0.2pp.

The extent of the weakness in capital spending was surprising given business investment figures released yesterday, showing a decline of only 0.2%. This suggests a large fall in housing investment, consistent with starts data and anecdotal evidence.

National Statistics also released September figures on services output. This series can be combined with industrial production to create a monthly GDP proxy – the two sectors account for 93% of gross value added. The chart below shows quarterly GDP with this monthly indicator.

The July reading of the monthly series was equal to the second-quarter average. The quarterly GDP decline reflected marked weakness in August and September, partly due to the escalating financial crisis. Monthly output fell by 0.8% in August and September combined.

The late-quarter deterioration implies a negative carry-over into the fourth quarter – September output was 0.3% below the third-quarter average. Together with recent very weak business surveys, this suggests a GDP decline of more than 0.5% in the current quarter.

The strategy is to finance a short-term giveaway with a long-term rise in income taxes. It is doubtful that this will amount to much of a “stimulus” to spending and activity.

The changes to national insurance were a major surprise, raising £3.8 billion in 2011-12. Other measures targeting top earners will garner a further £2.2 billion in that year.

The economic forecasts underlying the fiscal projections are optimistic – GDP falls by just 0.25% in 2008-09 and 0.5% in 2009-10 before climbing 2% in 2010-11 and 3% in 2011-12. This implies a mild recession by historical standards, against emerging evidence.

A key risk is that the economy has not regained sufficient momentum by 2010 to withstand programmed large tax rises. Government debt will embark on an explosive path if these increases are postponed.

The VAT cut contributes to the annual RPI change moving deep into negative territory – minus 2.25% by September 2009. However, a rapid rebound is then forecast, to 2.5% in September 2010, with the VAT reversal and higher excise duties contributing.

Servicing the growing debt eats significantly into resources – debt interest is forecast to rise from 1.3% of GDP in 2009-10 to 2.5% in 2012-13. The risk is of a larger increase as huge near-term borrowing needs put upward pressure on real yields.

Total debt issuance by the Debt Management Office is now projected at £161 billion, more than double the Budget forecast of £79 billion. The authorities have rejected advice to “underfund” the deficit in order to boost dangerously low broad money growth.

Most economists support the government’s plans to expand borrowing over and above the rise entailed by operation of the “automatic stabilisers”. However, a larger deficit does not necessarily imply a “fiscal stimulus”.

A standard economic principle is that most consumers base their level of spending on their income expectations over the long term rather than current earnings. Current income is a key factor only for those households with no savings or unable to obtain credit.

It follows that a temporary tax cut applied across all households and to be paid for by higher future taxes is unlikely to have a significant impact on consumption. Measures targeted at savings-short, credit-constrained households would have a greater chance of success but even in this case the rise in spending of those benefiting would be partly offset by cut-backs by other consumers anticipating lower future post-tax income.

This is not to say fiscal actions financed by higher borrowing can never deliver a short-term stimulus. However, policies must be designed to enhance the economy’s supply potential over the longer term, thereby warranting higher long-term income expectations. Examples include cuts in marginal tax rates, which stimulate entrepreneurship and effort, and public investment in projects promising a high long-term return (e.g. transport infrastructure).

A temporary cut in VAT fails the test of being targeted at households more likely to spend any windfall gain and has no positive impact on the economy’s long-term supply potential. Consumption of higher-value items will rise in the months before the lower rate is withdrawn but fall by exactly the same extent afterwards. The temporarily higher demand will be met either from imports or a rundown of stocks, with no impact on domestic production.

The longer-term “multiplier effect” of this VAT jiggling is likely to be close to zero.

Of course, higher borrowing may also have monetary effects – a rise in the deficit financed by bank borrowing would boost the money supply, thereby representing a “net injection of cash to the economy”. However, the same positive monetary impact could be achieved simply by underfunding the existing deficit, without a need for yet further fiscal “largesse”.

The breakdown of the traditional interbank market has resulted in a huge expansion of secured lending between banks channelled through non-bank financial intermediaries. The money holdings and borrowings of these intermediaries are included in M4 and M4 lending, which have been artificially inflated as a result.

This shift began well before the introduction of the special liquidity scheme (SLS) in April but it is reasonable to assume that most of the subsequent increase in intermediaries’ business with banks has been associated with lending secured on Treasury bills obtained under the scheme.

Between April and September M4 rose by £131 billion, of which £123 billion was accounted for by financial intermediaries. M4 grew by a further £43 billion in October, again probably largely due to intermediaries (no breakdown is available). This suggests SLS usage of about £165 billion by the end of October. This may be an underestimate, since the M4 numbers exclude business channelled through foreign-based intermediaries.

No sectoral analysis is yet available for M4 in October. However, the provisional release contains a split between “retail” and “wholesale” M4, with the retail component approximating to money holdings of households.

Inflation-adjusted retail M4 leads retail sales and overall consumer spending – see chart. Its annual growth rate fell to a new low in October, though has not yet turned negative, as it did in the early 1990s. An optimistic interpretation is that consumption is unlikely to be as weak as during the last recession. However, this is of limited comfort: spending fell in six out of seven quarters in that recession, with a peak-to-trough decline of 3.3%.

Monday’s Pre-Budget Report will be accompanied by a revision to the Debt Management Office’s financing plans for 2008-09. The DMO could support broad money growth by cutting planned gilt issuance and boosting sales of Treasury bills. Unfortunately, there is little sign such action is being contemplated.

When the authorities fund a budget deficit by selling gilts to the non-bank private sector, there is no net impact on the money supply – the injection of funds due to the deficit is offset by a transfer of cash out of bank deposits to pay for the new gilts.

Treasury bills are more likely to be bought by banks than non-banks. When banks provide funding there is no transfer of cash out of deposits held by non-banks so the injection due to the deficit is reflected in an increase in the money supply.

Under current plans the DMO will sell £116 billion of debt in 2008-09, comprising £110 billion of gilts and £6 billion of Treasury bills. Gilt sales have totalled £74 billion in the year to date, implying a further £36 billion by the end of March. The £116 billion full-year target is likely to be raised next week, reflecting a higher official forecast for public net borrowing. Suppose funding of £50 billion will be required over the remainder of 2008-09. If the DMO were to raise this amount by selling Treasury bills to banks rather than gilts to non-banks, broad money – measured by adjusted M4 (i.e. excluding deposits of financial intermediaries) – would expand by about 3%.

Annual growth in adjusted M4 was just 3.7% in September, according to the Bank of England (see chart 1.3 on p.11 of the November Inflation Report). On reasonable assumptions, a rate of increase of 6-8% per annum is compatible with achievement of the inflation target over the medium term. Replacing gilt issuance with Treasury bill sales over the remainder of 2008-09 would offset the impact of credit weakness on monetary growth, reducing the risk of a future inflation shortfall.

Economic models are prone to break down under extreme conditions. My MPC-ometer did not forecast the 150 bp Bank rate cut in November but it did indicate a larger reduction, of 75-100 bp, than expected by most economists – see here.

The December forecast will depend importantly on consumer and business survey results released around the end of the month. However, based on current information, the model suggests a cut of no more than 50 bp. A significant minority of economists expects a larger move, according to a Reuters poll conducted last week.

One property of the model is that the data hurdle for policy easing becomes higher as the absolute level of rates falls. Other factors holding it back from predicting a larger move are the recent further slump in the exchange rate and the MPC’s tendency to concentrate action in Inflation Report months.

Minutes of the November meeting released today indicate the MPC believes a further cut of more than 50 bp is warranted by the Inflation Report projections. However, these projections are subject to revision to take account of the fall in sterling (currently 6% below the level assumed in the Report) and fiscal loosening to be announced in the Pre-Budget Report. In addition, some MPC members argued that staggering a further reduction could help to support confidence as the economy weakens.