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Eurozone monetary trends continue to weaken, signalling an economic slowdown this spring and summer and casting doubt on the wisdom of the coming official interest rate hike.

The headlines look favourable, with the broader M3 money supply measure rising by 0.5% in February, pushing annual growth up from 1.5% to 2.0%. The trend, however, has deteriorated in recent months, with six-month expansion falling from a peak of 3.5% annualised in August to 1.1% in January and just 0.6% in February.

Narrow money M1, moreover, contracted in the six months to February, by an annualised 0.8% – the first six-month decline since August 2008, when the economy was in freefall.

Recent trends, of course, look much worse in real terms, with consumer price inflation boosted by energy and food price increases.

Real M1 is a good leading indicator of economic activity. It contracted from late 2007 ahead of the onset of the recession in spring 2008 and surged in late 2008 before a GDP recovery from mid-2009 – see first chart. Real M3 has been much less reliable, although the two measures are currently giving an identical message.

M1 comprises currency in circulation and overnight deposits. The ECB provides a geographical decomposition of overnight deposits but not currency. As the second chart shows, real deposit weakness was initially focused on peripheral economies – defined here as Greece, Ireland, Italy, Portugal and Spain – but has now spread to the core. The fall in business expectations in today’s Ifo survey for March probably marks the start of a sustained decline.

The Chancellor set out ambitious goals of creating the most competitive tax system in the G20 and making the UK the best place in Europe for business but his ability to deliver on these aims was undercut by a negative reappraisal of the state of the public finances by the Office for Budget Responsibility. Despite an undershoot in 2010-11, the OBR raised its deficit projections for subsequent fiscal years, with the 2015-16 shortfall increasing from 1.0% to 1.5% of GDP, reflecting both lower economic growth and a worse structural position.

Mr Osborne, therefore, was forced to find further savings to finance his priorities: the net cost of the measures announced is just £10 million in 2011-12 and a cumulative £30 million by 2015-16. He managed, nonetheless, to spring some favourable surprises, including a 1 pence per litre cut in fuel duty (costing £1.9 billion in 2011-12), a faster reduction in corporation tax (£425 million in 2011-12 rising to £1.075 billion in 2015-16), reform of the controlled foreign company rules (£840 million by 2015-16) and a further £630 rise in the personal allowance from next year (£1.05 billion in 2012-13). These giveaways were financed by a higher supplementary charge on North Sea oil profits (raising £1.78 billion in 2011-12), another attack on avoidance and evasion (£985 million in 2011-12), switching to CPI indexation of direct taxes from next year (£105 million in 2012-13 rising to £1.08 billion in 2015-16), a reduction in national insurance contracted-out rebates (£640 million in 2012-13) and the introduction of a carbon price floor from 2013-14 (£1.41 billion in 2015-16).

While there is an element of “robbing Peter to pay Peter”, the impression is that the Chancellor has played a poor hand skilfully, and the Budget may earn political plaudits. Its short-term macroeconomic impact, however, will be negligible.

The OBR’s negative reassessment of fiscal prospects is a direct consequence of the Bank of England’s failure to control inflation: the upward revision to the deficit forecasts is due to higher spending that, in turn, “primarly reflects the impact of our higher inflation forecast on social security and debt interest payments”. Debt interest is now projected to rise from £43.1 billion in 2010-11 to £66.8 billion in 2015-16, £3.7 billion higher than in November and equivalent to 3.5% of GDP.

Financing plans show net gilt sales of £120.0 billion in 2011-12, only £7.8 billion lower than in 2010-11 despite a projected fall in public sector net borrowing from £145.9 billion to £122 billion. Gilt funding needs have been boosted by the surprise announcement of a £6 billion increase in the foreign exchange reserves. The sum is small but the policy change is interesting, suggesting a desire for greater protection in the event of future sterling weakness.

CPI inflation rose from 4.0% in January to 4.4% in February, above the consensus forecast of 4.2% but in line with the projection made in a post a month ago. The chart presents an updated profile for 2011 and 2012, based on the same assumptions as in the prior post. Inflation is forecast to fluctuate in a 4.2-4.5% range over the summer and autumn before subsiding from late 2011 as base effects turn favourable. It remains well above the 2% target in 2012, however, averaging 2.5%.

Risks to this forecast are judged to lie on the upside. In particular, the assumption that core prices (i.e. excluding energy and unprocessed food) increase at a 2.25-2.5% annualised pace may prove too low, based on recent evidence that inflation expectations are becoming detached from the target. Further increases in energy and food prices, of course, are also possible.

With February’s 4.4% outturn projected to be repeated in March, inflation is on course to average 4.2-4.3% in the first quarter – above the Bank of England’s forecast of 4.1% in the February Inflation Report.

Doves claim that inflation would be below target but for indirect tax rises and higher food and energy costs. The Office for National Statistics estimates that full pass-through (unlikely) of tax increases would have boosted the CPI by 1.7 percentage points over the last year. Above-average rises in food and energy prices arithmetically account for a further 1.1 percentage points of current inflation.

Subtracting these effects from the 4.4% headline rate to argue that “true” inflation is below 2%, however, is intellectually flawed. Had taxes remained stable and food and energy prices risen more modestly, consumers would have had more cash to spend on other goods and services, the prices of which would have increased correspondingly faster.

The fundamental cause of above-target inflation has been strong growth in nominal demand, in turn reflecting excessively loose monetary conditions. “Gross final expenditure” – domestic consumption and investment spending plus exports – rose by a nominal 7.2% in the year to the fourth quarter of 2010 and would have increased by nearly 8% but for December’s bad weather. This compares with average expansion of 5.5% per annum in the first 10 years of the MPC’s existence (i.e. between 1998 and 2007).

Recent evidence confirms that the prolonged inflation overshoot is feeding through to longer-term expectations and pay settlements. The median level of settlements in manufacturing and private services was 2.9% in the three months to January, according to Incomes Data Services, a level that, if sustained, suggests a pick-up in private-sector regular earnings growth from an annual 2.1% in January to 3.6% by the end of 2011 – see previous post. Faster labour cost expansion could push core inflation higher in late 2011 and 2012 even as imported inflationary pressures ease.

The Bank of England has identified a rise in inflation expectations as a key risk in each of the last three Inflation Reports. The Bank’s latest inflation attitudes survey suggests that, at least among UK households, this risk is crystallizing, with two- and five-year expectations moving significantly higher in addition to the more volatile year-ahead measure – see first chart.

Interest rate doves, therefore, have shifted tack, arguing that rising expectations matter only to the extent that they influence wage- and price-setting. In a recent speech, the MPC’s Adam Posen claimed that “observed recent movements in short-term household inflation expectations will not affect wage bargaining, and so will not push up inflation outcomes”. Dr Posen expects pay growth to remain stable in 2011 and 2012.

Private-sector regular earnings (i.e. excluding bonuses) rose by 2.1% in the year to January. This increase, however, reflected an average wage settlement of only 1.7% during 2010. According to pay research firm Incomes Data Services, the median settlement level moved up to 2.9% in both manufacturing and private services in the three months to January. If sustained, this implies a significant rise in earnings growth during the course of 2011.

The second chart compares annual growth in regular earnings with a 12-month moving average of settlements. The difference is “pay drift” – the additional boost to earnings from pay progression, interim adjustments and restructuring outside the annual review. (Pay drift also reflects changes in average weekly hours, which fell during the recession but recovered in 2010.)

If the median settlement level remains at 2.9%, and pay drift returns to its 2005-07 average of 0.7 percentage points, annual growth in private-sector regular earnings will rise to 3.6% by the end of 2011. If, in addition, bonuses pick up in response to stronger productivity and corporate profits, total pay expansion could reach 4% – too high for achievement of the 2% inflation target over the medium term. (Private-sector productivity is unlikely to grow by more than 2% per annum on average while unit labour costs probably need to rise by less than 2% pa to meet the target, allowing for imported inflationary pressures.)

Overnight concerted intervention to weaken the yen has met with some initial success but there is no expectation that other G7 members will commit significant sums, let alone alter their monetary policies, in support of this effort. Effective yen suppression may require vast Japanese sales and much more aggressive monetary loosening.

As discussed in yesterday’s post, the medium-term impact of the Tohoku Pacific earthquake and tsunami is to cut Japan’s saving surplus and put upward pressure on real interest rates and the yen. This may be regarded as a benign process by which capital is attracted back to the country to finance the massive reconstruction effort.

A large offsetting loosening of monetary policy is required to offset this natural tendency for the yen to rise. The Bank of Japan today promised “powerful” monetary easing but its only significant announcement to date has been a modest ¥5 trillion expansion of its asset purchase programme. (Temporary liquidity injections into the banking system do not qualify as monetary loosening.) Foreign currency intervention has a similar monetary impact to securities buying so would be effective if conducted on a large enough scale.

The wisdom of such action, however, may be questioned. Facing its worst disaster since the second world war, the Japanese state is increasing its liabilities not to finance reconstruction but in order to purchase foreign government securities, principally Treasuries, thereby aiding the funding of the large US fiscal deficit. The main beneficiary of a weaker yen will be Japan’s multinational export companies, which are unlikely to divert an increase in their profits to the stricken region. Higher raw material imports necessary to support rebuilding and allow a shift away from nuclear electricity generation, meanwhile, will be more expensive.

The suggestion is not entirely frivolous.

The Tohoku Pacific earthquake and tsunami have destroyed supply capacity but will boost demand beyond the short term as a massive reconstruction programme begins. A rise in demand relative to supply implies a fall in Japan’s saving surplus and upward pressure on real interest rates. Higher real yields, in turn, push the yen higher relative to its long-run equilibrium value. Unless this long-run equilibrium simultaneously falls (e.g. because of a permanent rise in the risk premium investors demand to hold Japanese assets), this suggests a stronger yen.

Higher real interest rates and a stronger currency are the means by which capital is attracted to finance reconstruction. This capital inflow is the counterpart of the fall in the saving (i.e. current account) surplus.

The upward pressure on the yen could be neutralised by a sufficiently large loosening of monetary policy. The Bank of Japan, however, is unable to reduce interest rates (its target for the uncollateralized call rate is 0-0.1%) and has yet to expand QE significantly. (The additional ¥5 trillion of asset purchases announced this week will be spread over the 14 months to June 2012, implying a monthly rate of less than $5 billion at the current exchange rate.)

The extent of any rise in the yen will depend on the policy response but a target of ¥67 against the dollar has some “technical” attractions:

• The yen strengthened from ¥98.6 before the Great Hanshin earthquake of 17 January 1995 to an intraday low of ¥79.75 on 19 April, a decline of 19.1%. The yen closed at ¥82.9 on 10 March, the day before the Tohoku Pacific earthquake. A 19.1% fall from this level targets ¥67.1.

• The yen’s behaviour echoes that of the S&P 500 index in early 2009. The S&P rallied from temporary support at 805 before breaking this level in a final plunge to an intraday low of 666. The yen, similarly, rallied from a low of ¥80.4 in late October but has now breached this support.

• The yen weakened from ¥102.0 to ¥123.8 between January 2005 and June 2007, a rise of ¥21.8. A Fibonacci 2.618 multiple of ¥21.8 is ¥57.0. A ¥57.0 fall from the June 2007 high targets ¥66.8.

The latest official statistics indicate that labour demand is improving gradually, confirming recent survey evidence, including a rise in the Monster index of online job vacancies.

The labour force survey (LFS) measure of employment rose by 32,000 in the three months to January from the prior three months, with a 77,000 gain in private workers offsetting losses of 45,000 in the public sector (including 6,000 in the publicly owned banks). Full-time employment, moreover, rose by 75,000, outweighing a 43,000 decline in part-time working.

The improvement is confirmed by the workforce jobs measure, which rose by 77,000 in the fourth quarter. (This counts positions rather than people employed.) The LFS measure of workers with second jobs jumped by 41,000 in the latest three months – evidence, perhaps, of people seeking additional employment to offset the squeeze on real earnings from higher taxes and commodity prices.

Claimant-count unemployment, meanwhile, fell by 10,000 in February, maintaining the recent downward trend and suggesting that the economy remains on an expansion path despite weather-related GDP volatility – see first chart.

The three-month moving average of vacancies fell slightly in February but was 24,000 higher than in November, although two-thirds of this increase is attributed to hiring in connection with the 2011 Census.

The main disappointment in the figures is a 0.1 percentage point rise to 8.0% in the LFS unemployment rate in the three months to January as the labour force grew by more than employment. The LFS figures, however, often lag the claimant-count measure, suggesting a stabilisation or decline over coming months – second chart.

Government job cuts are progressing much faster than projected by the Office for Budget Responsibility. General government employment fell by 63,000 during the second half of 2010 compared with the OBR’s November forecast of a decline of 40,000 by March 2012.

The FSA’s latest Statistics on Mortgage Lending, released today, reports that 31.49% of residential mortgages outstanding were at fixed rates at the end of the fourth quarter of 2010, implying 68.51% at variable rates.

The form sent to lenders asks them to split outstanding balances between fixed and variable rates. There is no reason to think that respondents would wrongly classify balances that have moved from a fixed rate to the lender’s standard variable rate in the former category.

The FSA statistics are similar to those collected independently by the Bank of England. In its December Financial Stability Report, the Bank stated that “around two thirds of outstanding mortgages in the United Kingdom have floating interest rates, somewhat above the average over the past five years”.

The Bank’s figures extend back to 2004, when the floating-rate proportion was 73%, according to an article published in March 2010. It fell to a low of 52% in 2007.

Monthly estimates can be derived from the Bank’s statistics on average mortgage interest rates – see chart. The rise in the floating-rate portion has slowed recently. The FSA reports that fixed-rate lending accounted for 45.93% of new mortgages in the fourth quarter of 2010, up from 37.39% in the first quarter.

The claim that 90% of mortgage borrowers are exposed to a rise in Bank rate appears to be incorrect. The pass-through of higher official rates to standard variable rates, moreover, may be smaller than in the past, partly reflecting the current record 3.5 percentage point spread (i.e. the average SVR was 4.02% in February, according to the Bank).


Leading indicators are signalling a slowdown in emerging-world growth, confirming an earlier analysis based on monetary trends – see post in November. The loss of momentum is likely to be associated with a stabilisation or reversal in industrial commodity prices – unless the Federal Reserve embarks on “QE3”.

Emerging-world growth has been a key driver of commodity price movements in recent years. The first chart shows the strong positive correlation between six-month changes in E7 industrial output and the Journal of Commerce industrial commodity price index. (The E7 refers here to the BRIC economies plus Korea, Mexico and Taiwan. The JoC index tracks 18 materials used in manufacturing production including crude oil and natural gas.)

The six-month change in the JoC index rose from a low of -2% in October to 23% in February, mirroring an increase in six-month industrial output expansion from 2.2% (not annualised) in September to 6.1% in January (the latest available month).

Industrial output growth, however, is likely to have peaked in February. The second chart shows the relationship with a conventional leading index (based on the OECD indices for six of the E7 countries and a national index for Taiwan) and a proprietary “leading indicator of the leading index”. The latter is more useful, signalling turning points in six-month output expansion an average of four months in advance.

This “double-lead” indicator peaked in October and has fallen for three successive months, suggesting that industrial output momentum will decline from a high in February at least through May. The slowdown, in fact, is likely to extend well into the second half, based on a continued deceleration of real narrow money M1 – third chart.

A set-back in commodity prices would reverse a recent drag on G7 real incomes, supporting domestic demand. As previously discussed, however, monetary trends also suggest a G7 slowdown from this spring, as a loss of momentum in Euroland offsets continued US strength.



Based on yesterday’s close of 11,985, the Dow Industrials index has fallen 3% from a peak on 18 February but is still 7% above the “six-bear average” path derived from recoveries after prior large declines – see first chart and previous post for more details.

The six-bear average has proved a reasonable guide to the trend in the Dow since the March 2009 trough. The average fluctuates between 11,100 and 11,600 until the autumn, when it slips below 11,000.

Examining the individual components, five of the six prior recoveries suggest a fall from the current level by year-end – see green lines in first chart. In one case, however, the Dow embarked on a final blow-off to a level equivalent to 16,000 currently – top line. (This refers to the rise from the bear market low in November 1903.)

As previously discussed, monetary trends are signalling a peak in global growth this spring. Momentum peaks are often associated with weakness in risk assets, including equities. G7 annual real narrow money growth, moreover, remains below industrial output expansion, a condition historically associated with sub-par equity returns. These considerations support the cautious message from the six-bear average, suggesting a defensive investment stance.

A short-term spurt higher, however, cannot be ruled out, based on the ongoing injection of liquidity by the US authorities. Banks’ reserves at the Federal Reserve rose by a further $66 billion to $1.36 trillion in the week to Wednesday and are on course to reach $1.7 trillion, or more than 11% of GDP, by mid year, assuming that the Fed completes QE2 and the “supplementary financing program” is reduced to $5 billion and remains at this level. Bears, therefore, may wish to keep positions light until the Fed’s liquidity boost is nearer completion.