Category: Money Moves Markets

I have updated the ECB-ometer forecast for tomorrow’s meeting, last discussed here. Despite elevated inflation indicators, weakness in yesterday’s services PMI and last week’s consumer survey have contributed to a fall in the “average interest rate recommendation” from -2 bp to -6 bp. While insufficient to generate a forecast of a rate cut (recommendation of below -12.5 bp required), this suggests the ECB should now have an easing bias.

The ECB’s behaviour in 2001 may provide guidance on how the central bank will manage a shift from its current hawkish stance to an eventual rate cut. In January 2001 the policy statement in the ECB’s Monthly Bulletin talked of “upside risks to price stability which warrant close monitoring” – a similar formulation to that used in recent press conferences. The February Bulletin retained a reference to “close monitoring” and upside dangers but stated that “risks to price stability … appear more balanced”. In March “close monitoring” was replaced by an assurance that the Governing Council was “firmly committed to price stability”. This in turn was softened to “will continue to focus on maintaining price stability” in April, after which the repo rate was finally cut by 25 bp in May.

As now, inflation was a constraint on early action in 2001, with the annual increase in consumer prices hitting a high of 3.1% in May, the month of the first cut. The ECB-ometer’s forecasts also looked similar in early 2001 – see chart. One key difference was the euro, which had fallen significantly against other major currencies in 1999 and 2000.

If 2001 is a guide, the ECB may begin the shift towards easing by modifying tomorrow’s statement to indicate that risks to price stability remain on the upside but are diminishing because of slowing growth. This would be consistent with an eventual cut some time in the second quarter. A more dramatic shift in language is probably needed to signal the possibility of earlier action.

Two important pieces of US economic news have been released over the last 24 hours.

The first was the Fed’s quarterly survey of senior loan officers, conducted during the first half of January. As expected, this reported a further significant tightening of credit standards across all types of loan. The first chart below shows an indicator of corporate credit conditions derived from the survey. (It is an average of the percentage balances of officers reporting tighter standards on commercial and industrial loans to large / medium and small firms.) This indicator has warned of recessions historically by moving through 35. The latest reading is just below the “trigger” level.

The second chart plots the corporate credit conditions indicator together with a measure of the slope of the Treasury yield curve (the gap between the three-month Treasury bill rate and the average yield on bonds of over 20 years’ maturity). An inverted yield curve signals restrictive monetary conditions and is usually associated with a tightening of credit standards. The curve has been steepening recently, suggesting credit conditions could ease, though probably not until the second half of 2008.

The second piece of news was the ISM non-manufacturing survey for January, which reported shocking declines in current activity and new business. The third chart shows GDP growth with a weighted average of the ISM non-manufacturing new business and manufacturing new orders indices. The relationship is far from perfect but the ISM indicator suggests a contracting economy in early 2008.

Recent data have been weaker than I expected but a self-reinforcing downturn is not inevitable. Inventories are low, net exports should remain supportive and companies have yet to announce large-scale layoffs – see fourth chart. Loosening monetary conditions and fiscal stimulus suggest any decline will be short-lived and conditions will improve as the year progresses.

My MPC-ometer forecasts an “average interest rate decision” of -14 bp at this week’s MPC meeting. This is below the -12.5 bp threshold for action and suggests a 5-4 split in favour of a quarter-point cut.

As discussed in recent posts, the story is that activity indicators are firmly in rate-cutting territory but are being offset by the highest household and business inflation expectations since the MPC’s inception.

A quarter-point reduction is expected by the overwhelming majority of economists. Interestingly, the Sunday Times Shadow MPC also voted 5-4 to cut.

Could the MPC surprise with a no change decision? In theory, the MPC-ometer’s -14 bp forecast would be consistent with five votes for unchanged, three votes for a quarter-point cut and one vote (presumably by David Blanchflower) for half a point. However, three-way splits on the MPC are rare (the last one occurred in May 2006), so I have discounted this possibility.

NEWS ALERT: Nonfarm Payrolls Sank 17,000 in January, First Drop in Four Years

Actually, August was originally reported as a 4,000 drop but has since been revised to show a 74,000 gain.

Similarly, private payrolls were originally reported to have declined by 13,000 in December but are now estimated to have risen by 54,000.

So is the fall for real this time? Perhaps but another upward revision should not be ruled out. Weak withholding tax receipts and a surge in jobless claims in the latest week are concerning but both the household and ADP survey employment measures registered solid gains in January. The household measure has diverged significantly from non-farm payrolls recently – see chart.

On balance, I still think recent data are consistent with a flat rather than contracting economy.

My concerns about manufacturing weakness were borne out by today’s purchasing managers’ survey, showing a fall in the key new orders index below the 50 level separating expansion and contraction. However, the output prices index simultaneously reached a new record high in its nine-year history.

There was a similar divergence in yesterday’s EU Commission consumer confidence survey. Respondents were more bearish on the economy and their own financial prospects, while the buying climate for major items fell to a 17-year low. My retail sales leading indicator now suggests a fall in spending in early 2008 – see first chart below.

All aboard for a 50 bp rate cut next week? Not so fast. Consumer perceptions of past and future inflation surged further, to record levels since the MPC’s inception. In isolation, this suggests rates should be rising not falling – see second chart.

It doesn’t get easier for the MPC. I shall post the MPC-ometer’s forecast on Monday.

The chart below shows the real level of the US Fed funds rate, defined with respect to the annual change in the consumption price index excluding food and energy – the Fed’s favoured inflation measure. After yesterday’s cut the real Fed funds rate stands at just 0.8%.

Real Fed funds peaked at a lower level in the current cycle than before the last six recessions. This has been one factor preventing my recession probability indicator from breaching the 50% “trigger” level.

As the chart shows, a real Fed funds rate of 0.8% was reached only near or even after the end of prior recessions. (In one case – the 1981-82 recession – it bottomed well above this level.) The shortest interval between the onset of a recession and real Fed funds reaching 0.8% was five months (in 1980). 

Pessimists argue that the economy entered a recession in November or December. Employment trends will be a key influence on the determination of the official arbiter, the National Bureau of Economic Research. Tomorrow’s offical numbers will provide more information but the solid ADP payrolls report for January suggests employment has yet to turn down, implying the pessimists’ case is weak.

The Fed has embarked on an extraordinary monetary policy experiment, cutting official rates to post-recessionary levels when there is still little compelling evidence that a contraction has actually started.

One risk with this strategy is that the Fed is squandering ammunition that would be better reserved until significant economic weakness is confirmed. Premature easing may have boosted inflationary pressures with little positive impact on the real economy – see here.

The alternative risk is that the Fed is too pessimistic about economic prospects and combined monetary and fiscal stimulus will produce a strong rebound later in 2008, pushing inflation further above target. Anyone under any illusions about the Fed’s superior forecasting ability should read Chairman Bernanke’s monetary policy testimony to Congress in February 2006, containing the memorable phrase “a modest softening of housing activity seems more likely than a sharp contraction”.

Political and Wall Street pressure on the Fed is enormous but I think these risks warranted more measured cuts.

The headline balances from January’s CBI distributive trades survey are unremarkable, suggesting a slowdown but not collapse in retail spending. However, some worrying developments are buried in the detail of the report.

Specifically, wholesale traders have reported a sharp rise in stock levels in December and January and have cut back their orders with suppliers accordingly. Few economists bother to look at these series but weakness in wholesale orders usually signals deteriorating manufacturing prospects – see chart below.

I still favour a moderate growth slowdown this year rather than serious economic weakness but this is troubling news. Let’s see if there is any confirmation in the January purchasing managers’ manufacturing survey due on Friday.

Recent falls in share prices of US financial companies can be compared with the bear market associated with the savings and loan crisis of the late 1980s.

According to a General Accounting Office study, the S&L crisis cost $160 billion to resolve, equivalent to 2.9% of US GDP in 1989, when the bear market in financial stocks began. The equivalent percentage of GDP in 2007 would be $400 billion.

Will the subprime crisis inflict damage on this scale? Some estimates of the eventual losses are even higher but care is needed in the comparison, for two reasons. First, S&L damage was largely confined to the US, whereas foreign institutions have borne a significant portion of subprime losses. Secondly, the GAO estimate refers only to the cost of the rescue operation and excludes losses suffered by creditors and equity-holders of insolvent S&Ls.

It seems reasonable to assume that losses suffered by US financial institutions as a result of the subprime debacle may approach but will not exceed those of the S&L crisis. On this basis, the late 1980s bear market in US financial stocks may represent a “worst case” scenario for current events.

The chart below overlays the 1989-90 fall in US financial share prices on the current decline. (It is based on weekly closes and the peaks in February 2007 and October 1989 have been aligned and rebased to equal 100.) Four observations are:

1. Financial share prices would have to fall a further 15-20% from current levels to match the 1989-90 decline.

2. The comparison suggests a bottom may be in place by March.

3. Share prices recovered strongly in late 1990 and 1991, regaining their prior peak within nine months of the trough.

4. The 1990 recovery began following five cuts totalling 125 bp in the Fed funds rate; the funds rate has already declined by 175 bp in the current easing cycle and markets expect a fifth reduction this week.

Risks remain high but the 1989-91 experience suggests a significant buying opportunity is brewing.

Has the Federal Reserve received new information, not yet in the public domain, that might justify Tuesday’s shock interest rate cut?

One of the stated reasons for the move was that “credit has tightened further for some businesses and households”. The Fed conducts a quarterly credit conditions survey of senior loan officers at banks, with the latest results due to be released in early February. Officials are likely to have been given an early view.

The chart below shows an indicator of corporate credit conditions derived from this survey that has warned of recessions historically. (It is an average of the percentage balances of loan officers reporting tighter standards on commercial and industrial loans to large / medium and small firms.) On the last reading, the indicator was rising but still significantly below the historical recession “trigger” level. Has it surged further in early 2008?

Even if it has, I still think the Fed acted unwisely by appearing to have been panicked by global equity market falls. Investors are now banking on further action at next week’s meeting, creating another dilemma for policy-makers.

The MPC voted 8-1 for unchanged rates at this month’s meeting, a less dovish outcome than forecast by my MPC-ometer. However, the minutes suggest greater concern about a weakening economy than poor near-term inflation prospects, while some members appear to have delayed voting for a cut in order to avoid back-to-back moves and because of the imminent February forecasting round. A reduction looks highly likely next month but economic and financial indicators would have to deteriorate dramatically over the next two weeks to generate an MPC-ometer forecast of a 50 bp move.

The Eurozone purchasing managers surveys weakened slightly further in early January – see chart. Feeding the relevant components into my ECB-ometer model produces an average interest rate recommendation of -2 bp for the February ECB meeting – consistent with a shift to a mild easing bias but insufficient to generate a forecast of an actual rate cut (see here and here for more explanation of the model). The Governing Council is likely to issue a more balanced policy statement at the next meeting but it may be several months before a consensus forms in favour of lower rates.

Of course, both the MPC and ECB could be forced to accelerate action if equity markets continue to spiral lower.