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Commentators often claim that interest rates must be kept low because fiscal tightening has yet to begin in earnest. This is misleading. Public sector net borrowing, adjusted for the economic cycle, is on course to fall by a whopping 1.8% of GDP between 2009-10 and 2010-11. If the economy is shown to be growing solidly in early 2011, the fiscal excuse for continued monetary laxity will look increasingly lame.

In its November update the Office for Budget Responsibility (OBR) projected that cyclically-adjusted net borrowing would fall from 8.8% of GDP in 2009-10 to 7.6% in 2010-11 and 5.3% in 2011-12. So fiscal restriction was forecast to amount to 1.2% of GDP this year, rising to 2.3% in 2011-12.

Recent headline numbers, however, have surprised favourably: the Institute for Fiscal Studies suggests that borrowing is on course to fall to £139 billion in 2010-11 versus the OBR’s forecast of £148.5 billion and £156.4 billion in 2009-10. The £9.5 billion shortfall is equivalent to 0.6% of GDP and appears to reflect a structural improvement rather than stronger-than-expected economic growth (at least on current ONS GDP estimates).

Cyclically-adjusted net borrowing, therefore, may be about 7.0% of GDP in 2010-11 rather than the OBR’s 7.6%, representing a 1.8 percentage point reduction from 2009-10. If so, the further decline needed to achieve the OBR’s projection of 5.3% in 2011-12 would be 1.7 points. The government’s borrowing goals, in other words, can be achieved without stepping up the pace of fiscal tightening between 2010-11 and 2011-12.


China’s February trade deficit of $7.3 billion is further evidence that the economy is overheating and casts doubt on the wisdom and sustainability of RMB appreciation.

Analysts argue that the monthly figures are volatile and attribute the February deficit to the timing of the Lunar New Year holiday, expecting the balance to return to a substantial surplus. A deficit of $7.2 billion in March 2010 proved a one-off, with the surplus soaring to $28.7 billion by July.

Such claims, however, ignore a steady underlying deterioration in recent months. The chart compares the headline monthly balance with a three-month moving average of a seasonally-adjusted estimate. The latter was stable at about $12 billion at the time of the last monthly deficit in March 2010 but has fallen sharply recently, reaching zero in February.

This deterioration reflects a surge in import volumes and prices on the back of strong domestic demand.

China’s inflationary boom is the product of loose domestic monetary conditions rather than an undervalued exchange rate. The correct response is to rein in monetary expansion and restore positive real interest rates rather than attempt to suppress inflation through Nixon-style price controls. The exchange rate may rise temporarily as part of this process but the normal pattern is for currencies of overheating economies to weaken as boom turns to bust.

Loose monetary policy has resulted in strong growth in nominal (i.e. current-price) spending over the last year but this has served to boost imports and inflation more than real domestic production. Higher interest rates would cool nominal spending expansion but could improve the split between real GDP growth and inflation / imports.

Doves argue that the MPC should maintain super-low rates because the economic recovery remains shaky. Monetary policy, however, operates by affecting nominal demand rather than real GDP directly.

“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).

One-quarter of gross expenditure, however, is on imports, which surged by 15.4% in the year to the fourth quarter. So nominal GDP – spending on domestically-produced goods and services – grew by a more modest 4.3%.

With inflation – as measured by the GDP deflator – running at an annual 2.8%, the increase in real GDP was reduced to just 1.5% (about 2% adjusted for the weather effect).

So imports and inflation ate up nearly 6 percentage points of the 7.2% growth in nominal spending in the year to the fourth quarter, resulting in a disappointing rise in real domestic production.

As noted by the MPC’s Andrew Sentance, the recent gap between nominal spending and real GDP growth is the largest, except for two quarters in 2006 when trade numbers were distorted by missing trader VAT fraud, since the Lawson boom of the late 1980s – see chart.

Doves argue that the MPC should keep the pedal to the metal to ensure that real economic expansion is sustained. If inflationary expectations ratchet up, however, the pass-through from nominal spending to real production could weaken further. Tighter policy would slow nominal spending expansion but, by ensuring that the current inflation overshoot proves temporary, would improve prospects for a sustained economic recovery.

The ECB has signalled a likely rate rise in April but there is a much stronger case for monetary policy tightening in the US.

Real narrow money, M1, rose by 3% (not annualised) in the US in the six months to January versus a 1% contraction in Euroland – see first chart. M1 comprises currency and checkable / overnight deposits and is usually a better leading indicator of the economy than broader measures. The current divergence suggests that US growth will remain strong during 2011 while the Eurozone is about to slow sharply.

US M1 buoyancy cannot be attributed simply to QE2. Growth started to pick up last spring well before the Federal Reserve signalled another round of securities purchases. M1 does not include bank reserves at the Fed, which have risen 30% since QE2 started.

The US M1 pick-up has fed through to stronger economic expansion, an improving labour market and rising capacity pressures. Core inflation, meanwhile, is bottoming. A leading indicator of monetary policy based on changes in unemployment and core inflation and the ISM manufacturing supply bottlenecks measure has moved into the tightening zone for the first time since 2007 – second chart. (Caveat: the current Fed may behave differently.)

Central banks rarely commence policy tightening when narrow money is weak (whether or not they monitor it). The ECB’s hawkishness recalls Bank of Japan rate rises in 2000 and 2006, which occurred against a backdrop of slowing (not contracting) real M1 and were subsequently reversed as the economy turned down. (In defence of the BoJ, economic weakness mainly reflected global rather than domestic developments.)

Note that M1 often slows after the first increase in interest rates, as money-holders switch out of demand deposits into higher-yielding time deposits and savings accounts. Such a portfolio shift may have limited implications for economic growth so M1 weakness may coexist with further rate rises (e.g. the US in the mid 2000s).

The February MPC minutes revealed that, in addition to the three members voting for an immediate interest rate rise, at least two others believed that the case for an increase had strengthened. The question for the waverers this month is “why wait?”

The Inflation Report clearly signals the need for a rise, with the mean forecast for inflation two years’ out based on unchanged policies the furthest above the target since 1998. The economy has rebounded in early 2011, wage settlements have firmed and broad money is growing faster. With Eurozone official rates – 50 basis points higher than in the UK – set to rise, continued procrastination risks renewed sterling weakness and further upward pressure on import prices.

The February services PMI, admittedly, was modestly disappointing but still signals expansion, with rising optimism. Manufacturing, meanwhile, is booming and construction has proved surprisingly resilient (confirmed by today’s fourth-quarter orders number). Price pressures are elevated across sectors. The relative weakness of consumer services is consistent with the MPC’s desire to see the economy rebalance in favour of manufacturing and investment.

The MPC-ometer model is marginally in favour of a rise this month. The forecast average interest rate vote is +14 basis points, up from +8 bp in February. This is consistent with Andrew Sentance repeating his call for a 50 bp increase, four other members voting for 25 bp and Adam Posen maintaining his dissent in favour of a £50 billion expansion of asset purchases (assumed to be equivalent to a 25 bp cut). The forecast is borderline and the model sometimes moves one month early. The Governor’s opposition to higher rates, however, looks increasingly futile.

Some economists have revised down their 2011 GDP growth forecast in the light of the 0.6% fourth-quarter fall. This is questionable. To the extent that last quarter’s decline was due to December’s bad weather, the effect will be to shift production from 2010 to 2011, resulting in faster growth this year.

The Office for National Statistics estimates that the weather effect reduced GDP by 0.5% in the fourth quarter. This implies a negative impact of 0.125% for the year as a whole. Assume that two-thirds of the production shortfall is recouped in 2011, with the remaining third representing a permanent loss. The net effect would be to boost annual growth between 2010 and 2011 by 0.2 percentage points (offset by a 0.125 point reduction to 2010 expansion).

The economists, presumably, are revising down their 2011 growth forecast because underlying GDP performance was supposedly weak last quarter, with this negative surprise outweighing the positive arithmetical impact of the weather disruption. The view here remains that the ONS estimate of a 0.1% fall in weather-adjusted GDP is too pessimistic – either the 0.6% headline decline will be revised up or the negative weather impact was significantly larger than assumed.

Job vacancies are typically a good coincident indicator of GDP. The Monster index of online job postings rose to a new post-recession high in January, suggesting a solid underlying economic recovery – see first chart. (Confirming the improvement in labour demand, the Reed job index – more timely but with a shorter history than the Monster index – surged in February.) An indicator based on changes in claimant-count unemployment gives a similar message – second chart.

Monthly GDP rose by 3.6% in February and March 2010 following a snow-related 1.5% drop in January. A similar or larger rebound is likely following December’s 2.0% decline, implying first-quarter GDP growth of more than 1% (assuming no upgrade to the current fourth-quarter estimate). With monetary trends looking more promising, the forecast in a previous post of GDP growth of about 2.5% this year is maintained.

In a speech last June, the MPC’s Adam Posen stated that it was “difficult to attribute the rise in inflation in the UK solely or even primarily to “one-off” factors like VAT, past sterling depreciation, or energy prices”. Instead, “the most logical and empirically reasonable explanation for inflation creep is some unanchoring of inflation expectations, caused by the series of above target outcomes for UK inflation in recent years”.

Such views suggested some common ground with his hawkish MPC colleague Andrew Sentance but Dr Posen has long since moved on. In a speech last week he claimed that, but for sterling depreciation, core inflation excluding indirect taxes and energy “would have been below its long-run trend (that assumed consistent with meeting target headline CPI inflation in the future)”. Meanwhile, “long-term inflation expectations … remain anchored”.

Dr Posen changed his policy position in September last year, soon after the US Federal Reserve signalled its intention of launching QE2 asset purchases. In a speech at the end of that month, he called for similar action in the UK, not on the basis of any new data but because “policymakers should not settle for weak growth out of misplaced fear of inflation”. He registered his first vote in favour of such a policy at the October MPC meeting.

Dr Posen is a close academic colleague of Fed Chairman Bernanke and shares his view that the post-crisis environment is fundamentally deflationary, echoing Japan in the 1990s and the US and Europe in the 1930s. With this prior, it is hard to conceive of data developments that would persuade him to vote for policy tightening any time soon. Dr Posen, however, may face a dilemma later this spring if, as seems likely, the Fed shifts to neutral and signals no further extension of QE.

Growth in the Bank of England’s favoured broad money measure accelerated to an annualised 4.9% in the three months to January – above a level likely to be consistent with achievement of the 2% inflation target over the medium term.

The Bank’s Governor, Mervyn King, has repeatedly cited sluggish broad money growth as a reason for nonchalance about the current inflation overshoot. This ignored the possibility that the velocity of circulation of money would rise in response to the negative real interest rates imposed by the Bank – an increase in velocity has the same economic impact as monetary expansion. Velocity has indeed picked up, climbing 2.1% during 2010 – the largest annual rise since 1979.

The February Inflation Report addressed the velocity issue for the first time (see box on p.17), conceding that under current circumstances a given rate of broad money growth could be associated with a faster increase in nominal GDP. Achievement of the inflation target requires nominal GDP to expand by 4.5-5% per annum (assuming a trend real growth rate of 2-2.5%), so this suggests maximum allowable broad money expansion of about 4%. Absent evidence of a slowdown in the recent velocity increase, it would be safer to aim for a lower number.

As well as weakening a key argument of rate rise opponents, faster broad money expansion supports the view that fourth-quarter GDP weakness was erratic and the economy will grow solidly during the first half of 2011. Also encouraging is a strong reacceleration of the narrow measure “non-interest-bearing M1” (comprising currency and traditional current accounts), which often leads domestic spending. NIB M1 surged by 31% annualised in the three months to January.

The pick-up in broad money has been driven by bank lending to the public rather than private sector – banks bought £10.2 billion of gilts in January and £21.6 billion in the latest three months, adding 5.6% to annualised broad money growth. Bank purchases compensated for foreign gilt sales of £1.5 billion in January – the largest outflow since April 2009. 

Sunday Telegraph columnist Liam Halligan notes that US recessions since the early 1970s have been preceded by a spike in oil prices, defined as a sharp rise of 80% or more. Spot Brent crude has risen from a low of $67.4 per barrel in late May last year to $112.5 on Friday – a 67% gain. The 80% threshold would be reached by a further increase to $121.3. Should investors fear another US – and global – downturn?

A monetarist view is that oil spikes lead to recessions because they raise the general level of prices, thereby deflating real money balances, with monetary contraction in turn causing consumers and firms to cut spending. The extent of the increase necessary to cause a downturn, therefore, depends on 1) the sensitivity of the general price level to changes in oil costs and 2) the rate of monetary growth when the spike occurs.

The impact of a given oil price increase on consumer budgets has fallen since the 1970s. US consumer outlays on energy goods and services accounted for 5.8% of total spending in the fourth quarter of 2010 versus an average of 7.3% over 1971-80. The current share, however, is up from 4.3% in 2002 – the lowest in annual data extending back to 1929.

The chart shows six-month growth in G7 narrow money and consumer prices (both seasonally adjusted). Monetary expansion has accelerated recently, reflecting US strength – see previous post. Real growth has been slowed by a pick-up in inflation but is still running at a solid pace by historical standards. The current relationship is very different from 2000 and 2007, before the last two US and global recessions, when a combination of slower nominal monetary expansion and rising inflation resulted in a contraction in real money.

The current level of oil prices should cause inflation to rise further but is unlikely to push it above the recent rate of money growth. The completion of US QE2, meanwhile, may keep monetary expansion elevated through mid-year, despite weakness in Euroland (previous post). Against this backdrop, oil prices would probably need to rise by significantly more than Mr Halligan’s suggested 80% to create a squeeze on real money balances sufficient to trigger another recession.

Put differently, the risk of a recession depends importantly on whether the oil price spike is due to an actual or feared supply shock or also reflects easy money and strong global demand. The current surge seems partly related to monetary loosening – prices broke out to new post-recession highs soon after the Fed embarked on QE2 last November. This suggests that, relative to prior episodes, there will be a larger boost to inflation and a smaller negative impact on economic activity.

Today’s fourth-quarter GDP revision contains little news but may incline MPC waverers towards waiting for more data on the performance on the economy in early 2011 before voting for a rise in Bank rate.

Last quarter’s GDP fall was revised down from 0.5% to 0.6%, mainly reflecting a larger decline in services output, concentrated in business services and finance. The change in gross value added excluding oil and gas extraction, however, remained at -0.5%.

The Office for National Statistics continues to claim that December’s bad weather depressed GDP by 0.5% over the quarter, implying that the economy would have contracted by 0.1% in its absence – slightly more pessimistic than its previous interpretation that underlying economic performance was “flattish”.

The view here remains that the ONS view is too bearish and that GDP was on course to rise by about 0.25% last quarter before the weather hit:

• A GDP estimate based on monthly output data for industry, services and construction (comprising 99% of GDP) rose by 0.4% in the three months to November from the previous three months – see chart.

• The average level of the monthly estimate in October and November was 0.1% higher than in the third quarter while November business surveys were signalling expansion in December.

• The expenditure measure of GDP, before incorporating ONS consistency adjustments, fell by -0.4% last quarter. The “official” GDP number is based mainly on output-side information at this stage of the estimation process but the expenditure figure may, on this occasion, be more reliable, suggesting underlying GDP growth of 0.1% – higher if the ONS estimate of a 0.5% negative impact from the weather is too low.

Despite the December weather hit, nominal domestic spending grew by 6.2% in the year to the fourth quarter – faster than in the five years before the recession (i.e. during the credit bubble) and above a level consistent with achievement of the 2% inflation target over the medium term.

A reasonable scenario remains that monthly GDP changes over January-March 2011 will mirror those in the three months following the weather-related slump in January 2010. This would imply a 1.1% GDP rise in the first quarter, assuming no further revision to the fourth-quarter estimate.

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COMMENT:
AUTHOR: Jeremy Dufton
EMAIL: jeremydufton@ukpml.co.uk
IP: 85.158.138.19
URL:
DATE: 02/25/2011 01:19:06 PM

Imapct on the MPC-ometer, Simon?

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COMMENT:
AUTHOR: Jeremy
EMAIL:
IP: 81.187.127.137
URL:
DATE: 02/25/2011 02:44:59 PM

Any comment on M4ex contraction in Q4?