Category: Money Moves Markets

Northern Rock appears to be repaying its Bank of England loan faster than projected in its restructuring plan. While good news for Ron Sandler & co., Rock’s rapid shrinkage is exacerbating the current mortgage market squeeze, with negative macroeconomic implications.

The restructuring plan projects a 25% repayment of the BoE / government loan in 2008, implying a reduction from £26.9 billion on 31 December 2007 to about £20 billion. According to a trading update on 12 May, the loan had declined to £24.1 billion by 31 March. More recent developments can be estimated from the weekly BoE return. “Other assets” fell by £7.9 billion between 2 April and last week. As well as the Rock loan, this category includes foreign currency lending, which may have declined by £4 billion over this period, judging from information in the latest BoE Quarterly Bulletin (see p.137). A reasonable assumption is that Rock has repaid a further £3-4 billion since the end of March, implying the outstanding loan may already be close to the £20 billion full-year target.

The repayment is likely to have been funded mainly from mortgage redemptions. The restructuring plan projects a fall in Northern Rock’s share of the stock of mortgages from 7.5% at the end of last year to 3.7% by December 2009, implying a nominal reduction of about £20 billion a year in 2008 and 2009. Economy-wide net mortgage lending totalled in £108 billion last year, of which Rock contributed £13 billion. Its U-turn will therefore cut the supply of mortgage loans by over £30 billion in 2008 compared with last year – significantly worsening the impact of the wider credit “crisis”.

The government may be constrained by EU state aid regulations but a less rapid reduction in Northern Rock’s mortgage book would help to reduce the risk of a severe economic downturn.

As detailed in previous posts (e.g. here), my US recession probability indicator peaked just below the 50% “trigger” level in late 2007. The suggestion was that the economy would be very weak in late 2007 / early 2008 but would just skirt a contraction, as defined by the official arbiter, the National Bureau of Economic Research (NBER).

Two months ago 76% of economists surveyed by the Wall Street Journal believed a recession had started. A new survey published today showed the percentage down to 52%, reflecting recent better-than-expected data.

The NBER places particular emphasis on five indicators in determining whether and when a recession has started: GDP, personal income, employment, industrial output and business sales. GDP is regarded as the single best measure but official figures are available only quarterly. Of the four monthly indicators, the NBER assigns greater weight to personal income and employment because they cover the whole economy rather than just the goods sector.

GDP is currently estimated to have grown at annualised rates of 0.6% and 0.9% respectively in the fourth and first quarters. However, these figures could change significantly when annual revisions are published next month. So it is important to track the other four NBER indicators in judging the likelihood of an official recession determination.

The chart below compares recent movements in a composite index of the four indicators with its behaviour during the last seven NBER-defined recessions. The index is derived by rebasing each indicator to equal 1 in the month of a NBER cycle peak and calculating a weighted average. Reflecting their whole-economy coverage, personal income and employment are assigned a 30% weight versus 20% for industrial output and business sales. The current cycle is measured from October 2007 – the latest peak month for the composite index.

The minimum peak-to-trough fall in the index during the last seven recessions was 1.6% (in 2001). It is reasonable to assume this threshold must be reached for the NBER to call a recession now. As at April, the decline from October stood at 0.6%. So the index is consistent with the message from the latest GDP estimates – the economy is not yet sufficiently weak to warrant a recession determination.

My recession probability indicator is giving an “all-clear” signal for late 2008, based on falls in real interest rates and a steeper yield curve, which are judged to outweigh tighter credit conditions. It may be underestimating the negative impact of recent further energy price gains but I continue to expect the US economy to perform better than many fear in 2008, with greater risk of disappointment in Europe. 2009 may be another story, however.

May consumer prices figures are published on Tuesday but Bank of England Governor Mervyn King will already know whether the annual increase reached the 3.1% letter-writing level. Recent news suggests it did, which may explain the lack of any discussion of monetary policy in Mr. King’s speech to the British Bankers Association this week.

Producer output prices accelerated further in May but the aggregate PPI is not generally a good short-term guide to CPI movements. However, the PPI food component correlates closely with consumer prices of processed food and showed a further large rise last month – see chart. If reflected in the CPI, this would add an estimated 0.12 percentage points to the annual increase – sufficient to reach 3.1% assuming no other changes.

Energy prices will have a further upward effect. Electricity and gas prices fell by 2.1% in May 2007 but should have been stable this May, adding 0.07 percentage points to CPI inflation. Meanwhile, the price of unleaded petrol rose by 4.5 pence per litre against a 3.1 pence increase last May, according to the AA, suggesting a further boost of 0.04 pp.

Recent sterling weakness is another possible source of upward pressure. Manufactured import prices rose a further 2% in April to stand 7% above their level in the fourth quarter of 2007.

A 3.1% CPI reading is not a done deal – “core” inflation jumped sharply in April and may partially retrace the increase in May. It would surprising if the decline were sufficient to offset the above upward effects, however.

Markets are now discounting two quarter-point rate rises in the UK over the next year. While I have been more bearish than the consensus about interest rate prospects, I think a retightening of policy would be a mistake and is unlikely to occur.

The foundations of the current inflationary upsurge were laid in 2005-2007, when the broad money supply M4 was allowed to grow at a 12-13% annualised rate. To return inflation to the 2% target over the medium term, the rate of M4 expansion needs to be brought down to 6-8% pa. However, the slowdown should be gradual – a collapse in money growth would risk transforming a painful economic adjustment into an unnecessary bust.

M4 was still rising at an annual rate of 11.1% in April but has been inflated by financial transactions related to the credit crisis – see here. An adjusted measure proposed by the Bank of England grew by 9.0% in the year to March (the latest available month) and at an annualised rate of just 4.8% in the first quarter alone.

This slowdown is contributing to a dangerous liquidity squeeze on companies. Annual growth in M4 holdings of private non-financial corporations (PNFCs) has slumped from a peak of 16.1% last May to 1.0% in April. Relative to retail prices, real PNFC M4 is contracting at the fastest rate since the early 1990s, suggesting a growing risk of a slump in business spending – see chart.

With inflation and inflation expectations rising, the MPC has little choice but to sit on its hands for the foreseeable future. However, the Committee should resist pressure to compensate for its poor decisions in 2005 and 2006 by adopting an unduly restrictive policy stance now.

Bears were cheered by the latest US labour market report, showing a jump in the unemployment rate to 5.5% in May. On closer inspection, however, much of the rise was due to an expansion of numbers seeking work, particularly among people aged 16-24. (The unemployment rate for this group jumped from 11.0% to 13.0%; some reversal is likely next month.)

Employment trends are more relevant for assessing economic growth. Two measures are reported – one based on payrolls and the other on a survey of households (from which the unemployment rate is derived). Payroll employment has been falling since December but the household survey measure has been broadly stable – see first chart. The rate of decline of payrolls has been lower than during the 2001 and prior recessions. Allowing for productivity growth of about 2% annualised, recent developments remain consistent with GDP expansion, albeit sluggish.

Export strength, particularly to the emerging world, continues to support the US economy – the export orders index in the ISM manufacturing survey hit a four-year high in May. The second chart shows industrial output growth in the “E7” major emerging economies together with a composite leading index based on OECD data. (The OECD does not publish a leading index for Taiwan so the national index has been used instead.) Output rose by an estimated 9% in the year to April, which compares with sub-1% growth in the G7. The leading index suggests a  further slowdown over coming months but remains notably stronger than during prior global economic downswings.

As discussed in the last post, inflationary pressures are forcing monetary policy tightening in emerging economies. However, interest rates are currently below a “neutral” level in many countries and in some cases attempts to tighten are being frustrated by an expansion of liquidity due to currency inflows. (China’s foreign exchange reserves rose by $78 billion in April alone.) Policy restriction will eventually lead to a significant slowdown in the emerging world but this is probably a story for 2009-2010 rather than this year.

The further surge in oil prices is casting a cloud over prospects but the evidence to date is that the US and global economies continue to hold up better than most economists expected.

ECB President Trichet yesterday warned of a possible July rate rise, in line with the hawkish message from my ECB-ometer – see here. Any increase is unlikely to mark the start of a new trend, however. One reason is that the ECB’s policy stance is already reasonably restrictive – the current repo rate still exceeds headline CPI inflation and is comfortably above the core rate (i.e. excluding food and energy).

The same cannot be said of the US and many emerging markets. The chart below shows weighted averages of short-term interest rates and CPI inflation in our “E7” grouping of major emerging economies (Brazil, Russia, India, China, Korea, Taiwan, Mexico). Central banks in these countries are in tightening mode but in most cases look well “behind the curve” (exception: Brazil). Officials are reluctant to move aggressively partly for fear of excessive currency strength given the super-low level of US rates.

The Fed’s maxi-ease is creating global not just domestic inflationary headaches.

I have been critical of the Fed’s rate-slashing campaign between September and April. Rather than supporting the economy, the cuts have undermined the dollar and boosted commodity prices, thereby increasing inflationary risks. Fed Chairman Bernanke’s musings this week on the desirability of a stronger US currency appear to represent belated acknowledgement of such criticisms.

Talk is cheap but is the Fed prepared to adopt policies to support the dollar? As the first chart below shows, the US trade position is improving relative to Euroland, laying one of the foundations for a recovery in the dollar versus the euro. However, it may be difficult for the currency to achieve a meaningful gain given the large gap between real policy interest rates in the US – now negative – and Euroland.

One indicator that has provided advance warning of Fed policy shifts historically is the ISM manufacturing delivery times index. Lengthening delivery times signal rising pressure on supply capacity, which may warrant Fed tightening. The index has recently moved into the region associated with rate increases – see second chart. With this indicator and the dollar both suggesting tighter policy, will the Fed move quickly to withdraw stimulus if the economy recovers in the second half, as seems plausible?

My tentative expectation is that global growth indicators will stabilise this summer and improve during the second half, mainly reflecting a revival in the US – see yesterday’s post and here. The latest US purchasing managers’ surveys seem consistent with this scenario. As the first chart shows, the new business indicator rose to a seven-month high in May and is at a level historically consistent with GDP growth of about 2% annualised.

The improvement in the US surveys contrasts with a further deterioration in Europe – particularly the UK. A rotation of growth momentum back to the US would be consistent with my regional monetary conditions indicators, shown in the second chart. It would also fit with the outperformance of US equities relative to Europe year-to-date.

One risk to my global scenario is that European weakness will outweigh any revival in US momentum. Based on the latest surveys, the US effect seems likely to dominate. Also, business confidence is positively correlated across countries – this month’s US improvement could be precursor of a stabilisation in European indicators.

Previous posts have compared annual industrial output growth in the Group of Seven (G7) major economies with soft landing and hard landing scenarios, based on average experience in prior downswings over the last 40 years. I have been expecting an outcome closer to the soft landing path in 2008, with major economic weakness possibly delayed until 2009 / 2010 (see here).

Based on partial data, annual growth appears to have fallen below 1% in April but is still reasonably close to the soft landing scenario – see first chart. As suggested in my last update, the annual change could fall close to zero by mid year, reflecting further credit tightening and commodity cost increases in early 2008.

If the historical comparison is still relevant, growth should show some recovery in the second half and into early 2009. Prospects of such a pick-up have been damaged by the recent oil price surge but my survey-based leading indicator registered a small increase in May, consistent with a possible mid-year trough – see second chart. More data are clearly needed to confirm this scenario.

Historically, recoveries following soft landings have been of short duration, partly because inflationary pressures quickly re-emerge, necessitating policy tightening. As the first chart shows, the soft landing path turns down sharply from early 2009. Any improvement in global economic news during the second half should be regarded as temporary relief.

Like the ECB-ometer (last post), my MPC-ometer has shifted in a hawkish direction over the last month. The May projection was for a 6-3 vote for unchanged rates, with three doves; the outturn was 8-1, with only David Blanchflower voting for a cut. This month the model suggests another 8-1 decision.

Activity indicators have weakened further and are at a level historically consistent with a half-point cut. However, the impact on the forecast has been outweighed by ongoing deterioration in the model’s inflation components. Consumer inflation expectations, manufacturers’ price-raising plans, average earnings growth and future inflation discounted by gilt yields have all risen over the month.

The MPC will not have early access to the May CPI numbers. Given the possibility that these will show a rise in annual inflation to the 3.1% letter-writing level, even those MPC members with an easing bias are likely to be reluctant to join David Blanchflower in voting for a cut this month.

For comparison, the Sunday Times Shadow MPC also voted 8-1 to keep rates on hold this month, following a narrow 5-4 decision last month. The MPC-ometer has a slightly better record over the 20 months since its inception: its average error has been 1.6 quarter-point votes per month versus 2.7 for the Shadow Committee.