Category: Money Moves Markets

One of my themes this year has been that the US economy would outperform Europe.

Between the fourth and second quarters, US GDP rose by an annualised 1.8% versus 1.0% in the Eurozone and 0.6% in the UK.

Preliminary third-quarter US figures released yesterday show a 0.3% annualised decline but the UK fall was much larger, at 2.1%. Coming Eurozone numbers look set to show a performance closer to the UK than US.

The US figures were depressed by Hurricanes Gustav and Ike and a strike at Boeing. The Federal Reserve estimated these factors depressed industrial production by 2.75% in September, implying a 0.9% impact on the third-quarter average, or 3.6% annualised. Industrial production accounts for 16% of GDP so this will have cut annualised GDP growth by 0.6%. This ignores effects on other sectors. In other words, the preliminary third-quarter growth estimate would have been slightly positive without the disruptions.

US GDP will decline in the fourth quarter but I still think prospects are worse in Europe.

David Blanchflower joined the MPC in June 2006, when money and credit growth were booming. The last move in official rates had been a cut (in August 2005). Blanchflower opposed the quarter-point rises in August 2006, November 2006 and January 2007. In March 2007, he voted for a cut. Had his view prevailed, the credit bubble would have been larger and its subsequent bursting even more destructive.

Bizarrely, in May 2007 Blanchflower joined the MPC majority in voting for a fourth quarter-point rise, implicitly accepting that his opposition to the previous 75 bp increase had been misguided.

Blanchflower resumed his calls for lower rates from October 2007, voting for a reduction at every meeting since then. The MPC did cut in quarter-point moves in December 2007, February 2008 and April 2008. These declines arguably had little effect because the monetary transmission mechanism was broken.

Blanchflower apparently wishes the MPC had emulated the Fed’s rate-slashing, although it is debatable whether this has helped either the economy or financial markets. The main impact was to push the dollar lower, contributing to soaring commodity prices and higher inflation. The inflation spike squeezed real incomes and was partly responsible for the 3.1% annualised decline in US consumer spending in the third quarter.

Rising inflation has also been a major economic drag in the UK. Earlier large rate cuts would probably have caused an even greater plunge in the sterling exchange rate and a higher inflation peak.

A large cut is now warranted because 1) inflationary pressures have eased, 2) rates are being reduced in other economies, limiting the risk of a further plunge in sterling and 3) the recent support package for the banks increases the chances that policy easing will be transmitted to borrowers.

Blanchflower’s opposition to higher rates in 2006-07 was harmful. He was prescient in forecasting that the financial crisis would lead to major economic weakness but this does not imply that earlier large rate cuts were the correct policy prescription.

The dramatic negative shift in the economic outlook resulting from the post-Lehman freezing of money and credit markets is confirmed by detailed monetary statistics for September released today.

Forget the headline annual increases of 12.4% and 14.2% in broad money M4 and bank lending (excluding securitisations) – these have been hopelessly distorted by a rerouting of interbank business through non-bank financial intermediaries. For a truer read, look at M4 and lending excluding “other financial corporations” (OFCs). Annual increases in these measures dropped to 5.0% and 6.8% respectively in September – the lowest since 1999/2000.

It gets worse. In the last three months, M4 and lending ex OFCs grew at annualised rates of just 2.8% and 2.3% – see charts.

The non-OFC private sector comprises households and non-financial corporations. Companies are under severe financial pressure. Their M4 holdings dropped again in September and are down 3.8% over the last year – the largest annual fall since 1980. Meanwhile, their access to credit has been curtailed at a time when working capital needs are likely to have been boosted by the economic downturn. Outstanding bank credit contracted in the three months to September.

Narrow money developments are equally concerning. M1, comprising currency in circulation and instant-access deposits, rose by just 0.1% in the year to September – the lowest annual increase since 1969. Real M1 contracted by 4.7%, the largest fall since 1980.

With the September figures unlikely to capture the full impact of the freeze, monetary trends clearly warrant a large cut in Bank rate next week. My MPC-ometer continues to project a reduction of 75-100 basis points, with a full-point move likely if three-month LIBOR is above 5.75% at the time of the meeting.

Unsurprisingly, the latest Bank of England Financial Stability Report continues to play down the role of monetary and regulatory policy failures in creating the conditions for the financial crisis.

The Bank’s view, like that of former Fed Chairman Alan Greenspan, is that current woes mainly reflect reckless behaviour by banks and other financial institutions, which wise central bankers and regulators were apparently largely powerless to resist.

In the UK context, the story goes as follows. In the early 2000s British banks embarked on a major balance sheet expansion, offering credit to consumers and companies on loose terms. Domestic deposit inflows failed to keep pace with the faster growth of lending, so banks bridged the shortfall by borrowing in international wholesale markets. They also allowed their asset expansion to run ahead of increases in equity, resulting in a rise in leverage. By the time the US subprime crisis broke, banks’ funding and capital structures had been fatally weakened.

So far, so convenient. The story can, however, be told in a different way. In an effort to avoid a phantom recession, the MPC lowered interest rates to well below a “neutral” level in the early 2000s. Credit expansion duly accelerated, boosting domestic demand and the current account deficit. A larger deficit is a mirror-image of an increased net inflow of capital. In this case, the inflow was channelled through the banking system, thereby partly financing the increase in lending. Meanwhile, regulators failed to raise concerns about the rise in banks’ equity leverage, since their preferred measure of capital strength – the now-discredited ratio of Tier I capital to “risk-weighted assets” – remained stable and well above the internationally-agreed minimum.

The competing accounts are not merely of academic interest. The Bank’s self-absolving emphasis on the role of excessive bank risk-taking has contributed to its reluctance to perform its traditional lender-of-last-resort function as well as the penal design of the recent “rescue” plan. This approach will no doubt succeed in achieving Mervyn King’s expressed goal of making banking “boring” but arguably at significant and unnecessary cost to the economy.

Euroland monetary statistics for September confirm a weak economic outlook and diminishing inflation risks:

• The liquidity ratio of non-financial corporations (defined as their M3 deposits divided by bank loans repayable within five years) is at its lowest level since 2003 and seems to be following the earlier plunge in the UK ratio – see first chart. Corporate liquidity is a key influence on business investment and hiring.

• Narrow money M1 grew by an annual 1.2% in September, up slightly from July / August but otherwise the lowest on record since 1971 – second chart. Real M1 contracted by 2.3%, a fall exceeded only in 1973-74 and 1980-81. (A note in the latest ECB Monthly Bulletin shows that real M1 growth tends to lead turning points in GDP with a variable lag averaging four quarters.)

• Broad money M3 growth slowed to an annual 8.6% in September from 8.8% in August. Excluding financial intermediaries, the increase was lower, at 8.0%. Household money demand has been boosted by the flat yield curve and a rise in risk aversion, with large inflows to time deposits in recent months. Corporate money growth has slowed significantly.

• Credit expansion also continues to moderate, to an annual 10.1% from 10.8% in August. Recent growth has been partly involuntary, reflecting non-financial corporations and financial intermediaries drawing down previously agreed facilities. Credit should slow more sharply as this effect wanes.

The ECB’s assessment that monetary and credit expansion poses upside risks to price stability is unsustainable. Recent trends support the case for an early further cut in official rates.

The 0.5% decline in GDP in the third quarter understates the scale of recent economic deterioration. A weighted average of monthly series for services and industrial output in July was slightly above its May / June average. The economy appears to have fallen off a cliff in August and September as the financial crisis escalated.

The GDP decline is consistent with an average path derived from the 1974-75, 1979-81 and 1990-91 recessions – see the chart below and the previous post for more details. The average path would involve GDP falling by 2-2.5% between the second quarters of 2008 and 2009, moving sideways over the following year and recovering by 2.5% in the year from the second quarter of 2010. Output would regain its recent peak level only in 2011.

This profile would imply an annual decline in GDP of 1.7% in 2009 followed by growth of just 0.4% in 2010 – significantly weaker than current consensus forecasts of -0.2% and 1.2% respectively (as reported by Consensus Economics Inc).

Incorporating the third-quarter fall into the MPC-ometer confirms the forecast of a cut in official rates of 75-100 basis points on 6 November. The model favours a full-point move if three-month LIBOR is still above 5.75% at the time of the meeting.

One way of “benchmarking” the current recession is to compare it with an average of the last three – 1974-75, 1979-81 and 1990-91. Based on the analysis below, an average recession path would involve GDP falling by 2-2.5% between Q2 2008 and Q2 2009, moving sideways over the following year and recovering by 2.5% in the year from Q2 2010. This would imply an annual decline in GDP of 1.7% in 2009 followed by growth of just 0.4% in 2010 – significantly weaker than current consensus forecasts of -0.2% and 1.2% respectively (as reported by Consensus Economics Inc).

Economists typically use quarterly GDP data to determine the timing and magnitude of recessions. However, GDP is sometimes distorted by strikes and other disruptions to normal economic activity. For example, GDP peaked in Q2 1973 and fell in each of the subsequent three quarters but much of this weakness reflected industrial action in the coal mining industry, culminating in the three-day week in Q1 1974. The analysis below uses a strike-adjusted measure of GDP, incorporating information on working days lost in industrial action, to calculate the depth of prior recessions. In addition, a judgement is made that the mid 1970s recession began in Q4 1974 rather than Q3 1973.

The first chart overlays the path of strike-adjusted GDP before, during and after the last three recessions on the current cycle. GDP is assumed to have peaked in Q2 2008 and the prior peaks are rebased and aligned to this starting point.

When the mid 1970s recession is dated to start in 1974 rather than 1973, it looks similar in magnitude and duration to the 1990-91 decline. However, the subsequent recovery was much swifter in the 1970s, probably because sterling’s membership of the ERM constrained monetary easing in the later episode.

The peak-to-trough fall in GDP was significantly larger in 1979-81 – 6.2% versus 2.8% in 1974-75 and 2.5% in 1990-91. This dismal performance, however, was the mirror-image of much stronger growth in the year before the GDP peak – 5.3% against 0.3% and 1.6% respectively. Relative to its value four quarters before the peak, GDP troughed at similar levels in 1981 and 1991, with a slightly larger decline in 1975.

This last point suggests calculating a benchmark future path by averaging the performance of GDP relative to its level four quarters before the peak across the three cycles, rather than relative to the peak itself. The result is shown in the second chart and is the basis for the description of an average recession path given earlier.

As argued in previous posts, the current recession could be less severe than the last three, because the preceding boom was smaller, interest rates have risen by less and the exchange rate has been unusually weak. Such mitigating factors, however, will be overridden if current financial paralysis persists. Detailed monetary statistics for September to be released next Wednesday will provide further information on the damage to economic prospects from the financial freeze.

A week before the October MPC meeting the MPC-ometer forecast a quarter-point rate cut – at odds with the majority view of no change in a Reuters poll. By the time of the decision the projection had changed to half a point, allowing for the “shock” from escalating financial turmoil – see here.

Minutes of the special MPC meeting on 8 October confirm that recent financial events have resulted in a fundamental shift in the Committee’s thinking. The focus now is on averting the “tail risk” of a severe recession and significant inflation undershoot. In terms of the MPC-ometer, this shift can be captured by “switching on” the shock variable that played a key role in explaining the MPC’s behaviour after the 9/11 terrorist attacks.

The model’s forecast will also depend importantly on Friday’s third-quarter GDP report as well as consumer and business surveys to be released around month-end. Assuming a quarterly GDP decline of 0.2% and unchanged survey responses, the -ometer suggests a three-quarter-point cut at the next meeting on 5/ 6 November.

As discussed in previous posts, an alternative version of the model assumes the MPC targets interbank interest rates rather than Bank rate. This projects a full-point Bank rate cut in November if three-month LIBOR is above 5.75% at the time of the meeting (fixed at 6.04% today).

Both versions suggest the MPC will go on hold in December and January if the November forecasts prove correct.

For comparison, the overnight indexed swap curve currently discounts a 62 basis point cut by 6 November with further falls of 14 bp in December and 17 bp in January.

The UK’s bank recapitalisation plan is unlikely to lead to a near-term revival in credit and money growth. Indeed, the initial impact of the scheme will be to reduce the broad money supply M4, implying a need for offsetting monetary easing measures, including interest rate cuts.

The negative M4 impact arises because a portion of the additional gilts and Treasury bills being issued to finance the recapitalisation will be bought by the non-bank private sector, implying a transfer of money out of bank deposits included in M4 into government coffers. If the entire £37 billion were raised from private non-banks – admittedly unlikely – M4 would be cut by 2.0%, before allowing for second-round effects.

This negative impact would be offset if banks used the funds injected by the government to increase their lending. However, the aim of the scheme is to raise capital ratios to a new higher level that banks will be required to maintain over the medium term, rather than provide them with “excess” capital to support additional balance sheet expansion. In other words, any increase in lending may depend on further capital-raising – arguably made more difficult by the stringent terms of the “rescue”.

The negative impact on M4 would be avoided if the government were to fund the recapitalisation by borrowing from the Bank of England but this would be at odds with current institutional arrangements and EU Treaty obligations discouraging central bank lending to governments.

The Debt Management Office plans to increase sales of gilts and Treasury bills by £30 billion and £7 billion respectively in 2008-09. There is a strong case for boosting the amount to be raised from Treasury bills, since these are more likely to be purchased by banks themselves, thereby avoiding a transfer of funds out of M4 deposits.

Headline M4 expansion rose to an annual 12.2% in September but continues to be badly distorted by the financial crisis. Underlying growth – excluding the contribution of non-bank financial intermediaries – fell from 13.6% to 6.5% between June 2007 and June 2008 and is likely to have slipped further more recently (September data will be available in early November). Underlying M4 probably needs to expand by 6-8% per annum to keep inflation on track to meet the 2% inflation target over the medium term. (This assumes trend GDP growth of about 2.5% and a decline in M4 velocity of 2-3% pa, in line with the average over 1992-2004, when inflation was close to 2%.)

The liquidity ratio of UK insurance companies and pension funds – their holdings of money and short-term paper expressed as a percentage of their total financial assets – is at its highest level since 1975, implying institutions have ample firepower to deploy in markets when confidence returns.

Liquidity stood at £182 billion at the end of the second quarter, £31 billion up on a year before and equivalent to 8.4% of assets, the highest since the bottom of the equity bear market in 1990 – see chart. With the subsequent fall in asset values, the ratio is now likely to be about 9.5%, above the 1990 peak and a level exceeded only in 1974-75, after a plunge in share prices of more than 70%.

The latest Merrill Lynch global fund manager survey confirms high sideline liquidity, with a net 49% of respondents overweight cash – the highest since this question began to be asked in 2001.