Category: Money Moves Markets

My ECB-ometer shifted from a tightening to an easing bias between late 2007 and early 2008, reflecting weaker economic news and financial market stresses. In early March, as the credit crisis moved towards a climax, it suggested a 40% chance of a rate cut at that month’s ECB meeting. The move has since reversed, however, as markets have normalised and inflation indicators have worsened.

Based on available data, the model suggests a 30% chance of a hike in official rates at next week’s ECB meeting – see chart. This compares with a small probability of a cut last month. The change is due to a combination of strong first-quarter GDP numbers, a further deterioration in both survey- and market-based measures of inflation expectations and a rebound in M3 growth. These developments have offset weakness in survey activity indicators.

It is too soon to expect a reappearance of “vigilance” but next week’s policy statement and press conference could signal a hawkish bias.

Market interest rate expectations have shifted dramatically as investors have reassessed near-term inflation prospects (discussed here). As recently as mid April, the gilt repo curve discounted a further fall in Bank rate to 4.0% by the end of 2008. By the time the Inflation Report was prepared in early May, the implied year-end level had risen to 4.6%. Poor April inflation data and the hawkish tone of the Report extinguished remaining hopes of reductions and the repo curve currently suggests a greater-than-50% probability of a quarter-point hike by December.

Market rates are now starkly at odds with economists’ forecasts, which have adjusted much less to recent news. In a Reuters poll conducted in mid April, 53 out of 56 respondents projected a further fall in Bank rate by the end of 2008, with a mean forecast of 4.43%. By mid May, the number expecting a decline had fallen to 45 out of 53, with the mean rising to 4.61% – still consistent with at least one quarter-point reduction. Strikingly, higher near-term expectations have been balanced by a lowering of projections further ahead – the mean forecast for the third quarter of 2009 fell from 4.37% to 4.33% between the April and May surveys.

So who is right – the market or economists? One way of approaching this question is to use the “MPC-ometer” model described in earlier posts to forecast Bank rate decisions over the remainder of 2008 assuming the economy performs in line with the MPC’s expectations. Specifically, suppose 1) GDP growth and CPI inflation follow the paths shown in the unchanged rates scenario in the May Inflation Report, 2) business and consumer confidence fall to levels consistent with the growth projection and 3) all other components of the MPC-ometer – including inflation expectations, earnings growth, equity prices and the effective exchange rate – remain at current levels. On this basis, the model indicates a 65% probability of rates remaining at 5.0% until the end of 2008, with a 35% chance of a quarter-point cut.

Put another way, economists’ expectations of one or two more quarter-point reductions before the end of 2008 depend on either growth and / or inflation undershooting the MPC’s forecasts or other components of the model shifting in a favourable direction. Neither seems particularly likely. The MPC’s growth projections are already downbeat, with GDP forecast to rise by just 0.9% in the year to the first quarter of 2009, while its expectation of a 3.7% peak in annual CPI inflation looks conservative. (This assumes a further 15% rise in retail electricity and gas costs but current wholesale energy prices suggest a larger increase.) Of the other model components, consumer inflation expectations and earnings growth are unlikely to fall back while the headline CPI rate is climbing, although a weaker economy may temper business price-raising plans. Lower equity prices and / or a rally in the exchange rate could boost easing hopes but neither carries strong weight in the MPC’s decisions, according to the model.

Monetary trends are also important for judging prospects for further rate cuts. Broad money M4 has continued to grow rapidly in recent months but appears to have been distorted by the credit crisis. Concerned about counterparty risk, banks have reduced traditional unsecured interbank lending in favour of secured loans, particularly gilt reverse repos. Unsecured lending is excluded from M4 but increasing repo activity may have boosted the aggregate because it is intermediated by the London Clearing House (LCH), which is classified as part of the non-bank private sector. The Bank of England has constructed a modified M4 measure excluding money holdings of the LCH and other financial corporations used to conduct interbank business (see p.18 of the May Inflation Report). This rose by 9.0% in the year to March and by 6.1% annualised in the latest six months (see chart) versus comparable growth rates of 11.9% and 9.6% for total M4. The gap between the two measures is likely to widen as a result of Special Liquidity Scheme (SLS) introduced in late April, which should significantly boost interbank repo transactions. It will therefore be important to focus on the adjusted measure rather than headline M4 to assess monetary conditions over coming months. (Unfortunately, the new measure is available only on a quarterly basis, with the next reading for June due in early August.)

Summing up, the MPC-ometer analysis supports market scepticism about economists’ forecasts of further Bank rate cuts later in 2008 but suggests a reduction is more likely than a rise. On this basis, current longer-term money market rates offer value – particularly unsecured rates, since credit / liquidity spreads should be capped by the SLS. Monetary trends are also consistent with a stable policy stance but a further slowdown in adjusted M4 would suggest improving medium-term inflation prospects, warranting consideration of a rate cut in late 2008 or early 2009.

Discussions about how far house prices could fall often confuse two issues – the extent of current overvaluation and the possibility that a serious economic downturn will result in prices undershooting “fair value”. This post focuses on the former.

According to widely-quoted IMF research (here, p.11), UK prices rose by nearly 30% more than justified by “fundamentals” between 1997 and 2007. Some commentators – including the MPC’s David Blanchflower (here, p.5) – have used this 30% figure as a measure of current overvaluation. As David Smith of the Sunday Times pointed out in a recent column, this is incorrect because the reference is the level of prices in 1997, not “fair value” at present. Adjusting for price growth since 1997, the IMF calculations imply 15% overvaluation currently.

The IMF approach may be questioned. The definition of “fundamentals” includes affordability, income growth, interest rates, credit growth, equity prices and population trends. The relevance of credit expansion and equity prices for sustainable valuation is debatable. In addition, no allowance is made for constraints on the supply of housing – likely to have been a more significant factor in the UK than in other countries recently experiencing house price booms.

Popular comparisons of the house price to earnings ratio with its long-run average significantly overstate current overvaluation. The first chart shows one such measure – the value of the housing stock divided by household disposable income. The ratio clearly trends higher over time, reflecting factors such as improving quality, the pressure of an expanding population on constrained supply and a high income elasticity of demand for housing.

Rather than its long-run average, the log-linear trend of the ratio is probably a better guide to current “fair value”. On this basis, prices were 10% overvalued at the end of last year versus an 85% deviation relative to the average.

An alternative and superior approach is to use rents rather than earnings as the basis of comparison. Rents already embody fundamental influences on housing demand and supply. Moreover, a potential homebuyer does not face a choice between consuming housing services or retaining earnings for other purposes – the decision is rather whether buying is financially preferable to renting.

The second chart shows a measure of the rental yield on housing derived from the national accounts – actual and imputed owner-occupied rents as a percentage of the value of the housing stock. The yield stood at 3.0% at the end of 2007 against a long-run average of 3.6%, suggesting price overvaluation of 20%.

However, this figure overstates the need for prices to fall to restore value, for two reasons. First, rents are growing solidly – by 7.7% on the national accounts measure in the year to the fourth quarter. The trend seems likely to persist, with the latest RICS letting agents’ survey reporting strong tenant demand and expectations for rents – see third chart. Secondly, low real yields on competing assets – particularly government bonds – may mean the “equilibrium” rental yield is below its long-run average.

Based on the above, a house price decline of 10% by 2009 could be sufficient to restore valuations to a sustainable level. This is consistent with modelling work by academics John Muellbauer and Anthony Murphy, reported in Thursday’s Financial Times.

A larger fall is certainly possible – based on the rental yield, prices have typically undershot their sustainable level by 10-20% during serious economic downturns. However, any such decline would create another attractive entry point for longer-term investors.

Today’s Wall Street Journal argues that three-month dollar LIBOR fixings compiled by the British Bankers’ Association (BBA) may understate true interbank borrowing costs by as much as 30 basis points. The suggestion is that some banks on the BBA panel are failing to report actual borrowing rates for fear of alerting markets to financing difficulties.

The chart below shows the spread between three-month dollar and sterling LIBOR fixings and an average of offer rates quoted by the interdealer brokers ICAP and Tullett Prebon – these should reflect actual borrowing costs The BBA dollar fixings do indeed look low relative to broker rates, although the divergence is smaller than suggested in the WSJ article – 14 basis points yesterday. However, the issue is much less significant for sterling rates, with a gap of just 1 bp yesterday.

The divergence in dollar rates is puzzling but seems unlikely to reflect BBA banks deliberately understating borrowing costs, since this would be expected to affect sterling rates by a similar amount.

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COMMENT:
AUTHOR: Manoj White
EMAIL: manoj_freeman@yahoo.com
IP: 59.184.134.24
URL:
DATE: 05/21/2008 09:21:12 PM

The BBA is already planning to restructure the Libor, it is reported by bloomberg and International Herald Tribune. But the important question is: what is the implication of the recast of Libor on other markets, especially the emerging markets. Because, the companies in the emerging markets, which borrow from overseas markets, will have to pay higher borrowing costs. The Libor recast will also result in a hit on the margins of the banks in the emerging countries, which are intermediaries basically.

A post in March gave a list of reasons for expecting stock markets to rally. (A modified version of this piece appeared on the Telegraph website and elicited a torrent of hostile comment from enraged bears.) The MSCI World index (in dollars) has since risen by 10% and the FTSE 100 by 14% (to yesterday’s close). Is optimism still warranted?

One of the reasons for expecting a rally was that equities were then discounting an enormous amount of bad news. The first chart below updates an earlier comparison of the performance of world stocks in the current cycle with historical “soft” and “hard” landings – see here. At their March lows markets were fully priced for a hard landing scenario.

Following the rally, investors appear to be assigning roughly equal weight to the soft and hard landing scenarios. I still think a hard landing will be avoided, at least in 2008, but market levels are no longer hugely misaligned with economic fundamentals.

Another bullish argument was that plentiful global liquidity would be redeployed in equity markets as investors’ fears of financial meltdown abated. The second chart updates measures of G7 liquidity and risk aversion, last discussed here.

Liquidity remains ample although the indicator may be overstating the position because money supply figures have been distorted by the credit crisis. As expected, risk aversion has fallen and should continue to move lower barring further financial accidents. So the liquidity / risk backdrop still looks supportive.

The recent rally has been led by the energy and materials sectors but this pattern may be unsustainable, since further commodity price gains would threaten global growth prospects. A continuation of the uptrend in markets may therefore require a rotation of strength into other sectors, particularly beaten-up financials.

The third chart updates the comparison of the performance of US financial stocks during the current subprime crisis with the savings and loan crisis of the late 1980s, last discussed here. If the similarity persists – a big if – financials should soon embark on a strong recovery, which could sustain the uptrend in market indices.

Summing up, there are reasons to remain constructive on equities but some caution is warranted after the recent strong rally. Continuation of the uptrend is likely to require a stabilisation or modest setback in commodity prices along with a better performance of financial stocks.

At some point this summer, Mervyn King, the Bank of England governor, faces an unenviable task. For the second time in his tenure, he will have to write an open letter to the chancellor explaining why inflation has risen more than one percentage point above the 2% target and describing what the Bank’s Monetary Policy Committee plans to do about it.

Why have the institutional arrangements designed to anchor UK inflation failed for a second time?

In an accounting sense, the increase in Consumer Prices Index inflation since mid 2007 can be largely explained by rising global prices of food and energy. The deeper question, however, is why these higher prices have not been offset by slower rises or falls in prices for other products and services, as would be expected if monetary policy had been correctly calibrated to meet the inflation target.

Regrettably for its reputation, it is clear the MPC allowed excessively loose monetary conditions to develop between 2005 and 2007. Bank rate was cut inappropriately in 2005 and maintained below its neutral level until 2007. During this period, investors’ risk appetites significantly increased. The result was a prolonged period of buoyant money and credit expansion.

In the three years to December 2007, the ratio of the broad money supply, M4, to nominal gross domestic product (GDP) rose by 22 per cent. A comparable increase has occurred only twice since 1945 – the early 1970s and late 1980s. Both episodes were characterised by rampant demand and output growth, a widening current account deficit and a subsequent large rise in inflation. These “Barber” and “Lawson” monetary booms – named after the chancellor of the day – were followed by damaging recessions. The UK has now had an “MPC boom”, again with painful consequences

The MPC discussed rapid money and credit growth at its meetings in 2006 and 2007 but played down the dangers . Members argued that the build-up in money balances was concentrated in the financial sector so would not result in a significant boost to demand for goods and services.

While economic growth has been strong, it has been lower than in the early 1970s and late 1980s, implying less pressure on supply capacity. The MPC view, however, neglected the possibility that “excess” money would flow across the foreign exchanges, leading to a sharp decline in sterling, thereby exacerbating upward pressure on import costs. The concentration of liquidity in the financial sector, accompanied by a large rise in overseas sterling deposits, increased this risk. The effective rate has fallen by 13% since July 2007 – similar to the “pound in your pocket” devaluation of 1967. In addition, monetary buoyancy may have contributed directly to rising inflationary expectations.

The upshot is that official neglect of monetary warning signals has once again been followed by an unexpectedly large rise in inflation although details of the transmission mechanism differ from earlier episodes. In effect, loose domestic monetary conditions have accommodated or even supplemented the inflationary impact of rising global costs.

How should policy now respond? Some commentators have urged the MPC to “look through” the current overshoot on the grounds that a weakening economy will return inflation to target in two years’ time. Even if this were assured, the argument neglects the MPC’s requirement to meet the target “at all times”. While policy actions have their greatest impact at longer horizons, they also affect shorter-term prospects so it is wrong to focus solely on where inflation may be two years ahead.

The recent painful tightening in credit market conditions should, in time, contribute to much slower monetary growth. The headline CPI rate, however, is set to rise significantly further and firms and employees may build a higher trend level of inflation into their price- and wage-setting behaviour.

The danger of inflationary expectations becoming dislodged from the 2% target is greater now than in April 2007 when Mervyn King wrote his last exculpatory letter. In 2007, CPI inflation returned to target four months after reaching the 3.1% threshold. Now, it is likely to remain above 2% until late 2009, barring a significant decline in commodity prices.

This means that interest rate doves who think there is scope for further monetary loosening currently are misguided if they wish the Bank to restore its anti-inflation credentials. Any future reduction must be conditional on evidence of a moderation in monetary expansion and inflation expectations. The short-term economic pain implied by such a policy is outweighed by the potential costs of failing to return inflation sustainably to the 2% target over the medium term.

An edited version of this article appears in today’s Financial Times.

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COMMENT:
AUTHOR: michael crowley
EMAIL: mjcrowley@eircom.net
IP: 213.190.148.130
URL:
DATE: 05/19/2008 01:30:16 PM

Hopefully, the MPC will be as spectacularly successful at meeting its inflation target over the next ten years as it has been over the past decade. Between 1997 and 2003 RPIX inflation averaged 2.4%, in line with its target. Since 2004, incidentally, it has averaged 2.7%, which is in line with the target of 2.8% for RPIX that would be consistent with the current CPI target of 2%.As for the latter itself, it has averaged 2.1% since 2004. To talk of institutional arrangements having failed to anchor inflation is as absurd as it is wrong. There is no reason to doubt the MPC.

The May Inflation Report is markedly more pessimistic about both inflation and growth than in February and confirms that early further interest rate cuts are off the MPC’s agenda:

1. The central projection based on unchanged rates shows CPI inflation at or above 3% for a year, peaking at 3.7% in the fourth quarter. The fan chart suggests a 30% probability of a peak at or above 4%.

2. The central forecast is on target at the two year horizon assuming unchanged rates, having been significantly below (1.77%) in the February Report. Moreover, risks to this forecast are judged to lie on the upside, having been viewed as balanced in February.

3. Annual GDP growth now troughs at 0.9% in the first quarter of 2009 in the central forecast on unchanged rates, compared with a February low of 1.4%. However, a significant rebound is still projected by 2010 – it is unclear why given reduced prospects of interest rate cuts.

4. The GDP fan chart suggests a 15% chance of an annual contraction in the first quarter of 2009. This implies a significant probability of two negative GDP quarters over the next year – perhaps around 30%.

The one silver lining in the Report is that its forecasts are sufficiently pessimistic to create the possibility of favourable economic surprises over coming months.

Today’s inflation figures are shocking but should not have come as a complete surprise given recent warning signals. The details show few redeeming features. Eight of the 11 main categories contributed to the increase in the annual headline rate. The only significant negative contributions were from clothing/footwear and transport – the latter mainly reflecting an erratic fall in air fares.

My previous forecast was that inflation would reach the 3.1% letter-writing level in July, peaking at 3.5% in September and remaining above 3% until February 2009. This was at the top end of economists’ expectations but now looks too low. A 4% peak now looks plausible if retail energy prices are hiked by a further 20% later this year, as widely expected.

The view that the Bank of England’s Monetary Policy Committee should continue to cut interest rates because a weakening economy will ensure inflation is back below target in two years’ time is questionable, to say the least. For one thing, the MPC’s remit is to hit the target “at all times” – its actions have less effect at short horizons but still have some impact, so it is wrong to focus solely on the two-year-ahead forecast. More importantly, a nonchalant MPC response to a significant and prolonged overshoot risks undermining its inflation-fighting credibility. Inflation expectations are already showing signs of detaching from the target; if firms and workers build a higher trend level of inflation into price- and wage-setting behaviour, the forecast return to 2% or lower two years ahead is unlikely to occur.

In the last Reuters interest rate poll, conducted before the May MPC meeting, New Star was one of only three houses expecting Bank rate to be held at 5.0% for the remainder of 2008. A near-term cut now looks extremely unlikely barring recessionary signals from activity data.

Recent posts have warned that a surprising surge in inflation could put paid to hopes of early further interest rate cuts. A “triple whammy” of bad news this morning suggests this risk may be crystallising:

1. Factory-gate prices jumped 1.4% in April to stand 7.5% higher than a year ago – the largest annual increase since 1985. The “core” annual rise – excluding food, beverages, tobacco and petroleum products – was 4.6%, a 13-year high.

2. Import prices surged a further 1.9% in March, pushing their annual increase up to 10.3% – approaching the peak of 13.7% reached in 1993 following sterling’s expulsion from the ERM. With the effective exchange rate down by 2% since March and world prices of imported commodities continuing to climb, a further rise is certain.

3. Energy supplier Centrica announced a fall in margins in its residential business to below long run target levels, despite price increases in January. It warned that it would “take the necessary action to deliver reasonable margins in the retail business”, supporting forecasts that residential tariffs will rise by at least a further 10% later in 2008.

New projections in Wednesday’s Inflation Report may show annual CPI inflation peaking at close to 4% later this year and remaining at or above the 3.1% letter-writing threshold for six months or more (see here).

While surging world commodity prices have been the key factor driving inflation higher, the impact has been magnified by a 13% fall in the effective exchange rate from a peak last July – equivalent in magnitude to the 1967 devaluation, when Harold Wilson famously claimed “the pound in your pocket” would be unaffected. Many economists have cheered on this decline, arguing it was necessary to “rebalance” the economy away from consumer spending. In a speech in January, Mervyn King talked approvingly of a drop of almost 10% in the effective rate by then, adding helpfully that “ financial markets are pricing in a significant probability of a further decline”.

With the broad money supply M4 having risen 22% more than nominal GDP over the last three years, and the exchange rate sharply weaker, the surprise is that economists should be surprised by current inflationary problems.

My current projection shows annual consumer price inflation above 3% between July 2008 and January 2009, peaking at 3.5% in September. This is based partly on an assumed further 10% rise in household electricity and gas tariffs. Recent press reports have, however, suggested a much larger rise in retail energy prices.

The chart below shows the CPI component covering “electricity, gas and miscellaneous energy” together with 12-month moving averages of wholesale natural gas and oil prices. The averages remove volatility and seasonal influences and are a reasonable guide to the trend in suppliers’ purchasing costs. They have been projected forward assuming prices remain at current seasonally-adjusted levels.

The moving averages peaked in mid 2006 and fell significantly to a trough in the third quarter of 2007. Household tariffs followed, topping in February 2007 and reaching a low last October. Wholesale gas and oil prices have since surged: if current levels are sustained the 12-month moving averages will be 50-60% above their 2006 peaks by early 2009.

The CPI component rose by 11.9% between October and March but is only 1.9% above its February 2007 peak. Recent experience suggests pass-through from wholesale to retail prices of between a quarter and a half. This suggests a further rise in household tariffs of between 10% and 25% will be needed if current wholesale prices are sustained.

A rise of 25% rather than 10% in retail energy prices would result in a mechanical boost of 0.5 percentage points to annual CPI inflation in late 2008 and early 2009. The actual impact would be smaller because the implied squeeze on consumer spending would slow price rises for other goods and services. Even so, the scenario could involve headline inflation peaking at close to 4% and remaining above 3% for as long as nine months, necessitating three explanatory letters.

I am sticking with a 10% figure for the moment, partly on the view that current wholesale prices may not be sustained. Next week’s May Inflation Report will reveal the assumption used by the MPC. Inflation projections could be revised up by more than the market expects, raising doubts about the scope for interest rate cuts.