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Monetary trends continue to suggest deteriorating Eurozone economic prospects.

Narrow money M1 is a better economic leading indicator than the broader M3 measure; it weakened before the last recession and surged before the recovery. M1 comprises currency in circulation and overnight deposits – forms of money more likely to be related to economic transactions. Six-month M1 growth has slumped from 3.6% (not annualised) in August to 0.2% in January. With CPI inflation picking up, real M1 is contracting at a similar pace to early 2008, just before output cratered – see first chart.

This weakness contrasts with a strong pick-up in US real M1 expansion, which predated the start of QE2 in early November – second chart. Together with US fiscal stimulus – particularly the temporary 100% bonus depreciation allowance – this suggests much faster economic growth in the US than Euroland this year, with possible implications for relative equity market performance and the euro-dollar exchange rate. (A similar monetary divergence in 1991 was associated with superior US equity returns, partly due to a stronger dollar.)

Eurozone M3 trends are also soft, with a rise of only 0.5% in the six months to January, again implying real contraction.

M1 weakness was initially focused on peripheral economies but has now extended to the core, including Germany – third chart. Consensus hopes that German economic strength will insulate core economies from a peripheral “double-dip” look increasingly fanciful. ECB hawks may struggle to gain traction against this backdrop.

The February MPC minutes suggest that Bank rate will rise in two weeks’ time if revised fourth-quarter GDP figures and purchasing managers’ / consumer surveys for February indicate that economic recovery is continuing.

The minutes reveal that Bank of England chief economist Spencer Dale joined Andrew Sentance and Martin Weale in voting for an interest rate hike this month. This is no surprise given his role in preparing the Inflation Report forecast, which signals a need for immediate tightening (see below). Adam Posen maintained his dissent in favour of a £50 billion expansion of QE.

The “MPC-ometer” model forecast a 4-4-1 vote split in February, i.e. four members voting for a quarter-point hike. The actual split was 3-5-1 but Andrew Sentance voted for a half-point move this month, as suggested by his speech last week. The “average interest rate vote”, therefore, was exactly in line with the model’s prediction.

One feature of the model is that the current month’s forecast depends partly on the previous month’s vote. The MPC’s hawkish shift in February, therefore, has pushed the model further in favour of a quarter-point hike in March although there is still a chance that this prediction will be reversed if February’s EU consumer survey (tomorrow), the fourth-quarter GDP revision (Friday) and purchasing managers’ surveys for February (next week) are weak.

This assessment is consistent with the minutes, which reveal that, of the middle group on the MPC, “some thought that the case for an increase had … grown in strength” but “there was merit in waiting to see how indicators of how the economy performed at the start of the year to help assess whether or not the decline in GDP in the fourth quarter presaged sustained economic weakness”.

The waverers could also use current geopolitical unrest as an excuse for delaying action.

The numerical Inflation Report forecasts released today, however, create a strong presumption in favour of an immediate increase. Confirming an initial reading last week, the mean forecast for inflation in two years’ time based on unchanged policy is 2.48%, representing the largest overshoot of the target since February 1998, when official rates were rising sharply (by more than 150 basis points over 14 months).

A post last August suggested that public sector net borrowing excluding the temporary effects of financial interventions (i.e. PSNBex) would undershoot the Office for Budget Reponsibility’s £149 billion projection for 2010-11 by a significant margin, calling into question the necessity of the VAT rise to 20%. This forecast is back on track following favourable January numbers, released today.

PSNBex fell to -£3.7 billion (i.e. a surplus) in January versus £1.3 billion a year earlier. Borrowing in the prior nine months of 2010-11, moreover, was revised down by £1.6 billion.

If seasonally-adjusted borrowing (see chart) is stable at its January level in February and March, the full-year deficit will be £139 billion versus £156 billion in 2009-10.

The large year-on-year improvement was driven by a £6.4 billion rise in central government current receipts, mainly reflecting higher income and corporation taxes, with increased VAT contributing only £700 million. Current receipts are up 8.4% year-to-date versus the OBR’s full-year forecast of 7.1%, suggesting that underlying economic growth is running ahead of its expectations.

In the June Budget, the VAT rise to 20% was projected to raise £2.8 billion in 2010-11 and £12.1 billion in 2011-12. Excluding its impact, PSNBex is on course for a £7 billion undershoot of the OBR’s June projection in 2010-11. Assuming that this carries over to 2011-12, the June borrowing path could have been achieved by calibrating the VAT change to raise about £5 billion rather than £12.1 billion, suggesting a rise to 18.5% rather than 20%.

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COMMENT:
AUTHOR: Mark Davies
EMAIL: marklanedavies@gmail.com
IP: 83.145.122.242
URL:
DATE: 02/22/2011 12:53:45 PM

I understand your viewpoint on having a 'smaller' VAT percentage rise however surely there is also the holistic viewpoint to take in that the Government wishes to move the future Tax system to a more indirect basis while also allowing flexibility to additionally remove or reduce other Business or Personal taxation ? Therefore though the VAT Rate may increase 20% there will also be a planned decrease in Taxation elsewhere to leave a more fiscally balanced approach.
Is this purely a deficit measure because the Lib/Con comments that VAT will stay at 20% would argue against it being just a deficit target question ?

The chart updates a comparison of the rise in the Dow Industrials index from its low in March 2009 with six prior increases following bear markets involving a fall of about 50%. (The six bears bottomed in November 1903, November 1907, December 1914, August 1921, April 1942 and December 1974. The Dow fell by 45-52% into these lows versus a 54% decline between October 2007 and March 2009.)

From its 2009 low until April 2010, the Dow mostly traded above a “six-bear average” of the prior recovery paths. This probably reflected unusually loose monetary conditions due the Federal Reserve’s QE1 securities purchases, totalling $1.725 trillion.

Following the end of QE1 in March 2010, the Dow traded back to and then below the six-bear average. By early July, the index was 10% beneath the average and within 1% of the bottom of the range spanned by the prior recoveries. This suggested a buying opportunity.

The Dow built a base over the summer and took off in September as the Fed signalled QE2, following through with the announcement of a $600 billion securities purchase plan in early November. This liquidity injection, supplemented recently by a rundown of the Treasury’s supplementary financing program (SFP), has pushed the index 11% above the six-bear average – a larger deviation than at the July low.

The Dow is now higher than at the equivalent stage of five of the six prior recoveries. All five of these predecessors suggest a significant fall by year-end, ranging from 10% to 31% from Friday’s close of 12391 (i.e. to between 8500 and 11200).

There is, however, one exception – the rise from the low in November 1903. At the comparable stage of that increase (i.e. in November 2005), the Dow embarked on a 23% surge over 11 weeks to a level equivalent to 16000 currently.

History, therefore, suggests a five-sixths probability of a decline in the Dow but a one-sixth chance of a “moonshot” scenario, involving a final blow-off and subsequent sharp correction.

The Dow’s surge over November 1905-January 1906 occurred after it had breached its previous all-time high, reached in June 1901. The move into new ground may have stimulated buying. Currently, the Dow is still 13% below its October 2007 peak but smaller stocks are close to breaking out – the Russell 2000 index is within 3% of its high. US investors are showing more interest in domestic equities, channelling $12 billion into US-focused stock mutual funds so far this year, according to the Investment Company Institute, following an outflow of $88 billion in 2010.

The “moonshot” scenario could, perhaps, be triggered by the further $450 billion rise in bank reserves implied by the Fed completing QE2 and the SFP falling to $5 billion as planned – see Friday’s post.

Equity investors face a dilemma: the odds favour market weakness but there is an outside chance of a blow-off that would cause a defensively-positioned portfolio to underperform significantly. Any such surge, however, would probably end badly: the January 1906 peak marked the start of another major decline, of 49%, to a low in November 1907.

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COMMENT:
AUTHOR: Mark Davies
EMAIL: marklanedavies@gmail.com
IP: 83.145.122.242
URL:
DATE: 02/22/2011 09:38:05 AM

Hi Simon,

Thank you again for your excellent analysis but though I am no economist I feel we really are in uncharted waters here and that the ‘moon-shot’ scenario is more likely than 1 in 6. The reason for this presumption is that the Fed cannot stop printing money, the US debt is too huge and no foreign Investor will be able to soak up the massive requirement for monthly US debt issuance. The Fed must continue to step in and so QE3, QE4 is very likely…this, I believe, will in turn massively distort the stock market valuation for the next Year. It will lead to the StockMarket being higher than it should be and will potentially depreciate currency which in turn will raise StockMarkets in nominal terms.

I would appreciate your views on this topic.

Regards

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COMMENT:
AUTHOR: Simon Ward
DATE: 02/22/2011 11:25:34 AM

Mark,
I am not sure that the Fed will be forced into QE3, QE4 etc. The UK has managed to fund a similarly-sized deficit without QE2. Bond yields would rise by more in a QE3 scenario because of the inflationary implications. Equities would probably also suffer beyond the very near term.

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COMMENT:
AUTHOR: Mark Davies
EMAIL: marklanedavies@gmail.com
IP: 83.145.122.242
URL:
DATE: 02/22/2011 12:35:48 PM

Firstly, thank you very much for taking the time out to reply to my remark.
Time will tell but in my humble opinion I think QE3 will happen….
Why, and in answer to your response ….
1. We are in a calm before a serious debt crisis storm and so both the US and the UK currently have some time, in the short term; this is why the US is 'managing' its current funding
2. The UK is rightly getting its fiscal house in order at a reasonable pace, however there is no credible Debt reduction Plan in the US, in fact its the opposite.
3. There is a slow but steady loss of confidence in the dollar…please see various noted bureacrats who have raised a global or hard-backed currency. Therefore who is really going to invest in a depreciating currency bond market ? QE3 is the logical answer.
4. Even now Foreigners are spending less money in the US Bond Market
I agree with your remark about Equities being affected in the medium term with QE3 but as stated in the near term this may 'goose' Stocks a final time until the Market loses faith in the Dollar and US economy.
Thanks again.

The mark-to-market profit on the Bank of England’s gilt purchase programme has fallen from an estimated £26 billion in August to £10 billion as gilt yields have risen to a nine-month high – see chart. A further 50 basis point increase in yields would be sufficient to push the scheme into a loss.

Very roughly, a 10 basis point change in yields affects the P&L by £2 billion.

The Bank bought £198 billion of gilts between March 2009 and January 2010, initially of between five and 25 years’ maturity although the range was later widened. The calculations are based on a 15-year gilt. Weighted by the Bank’s monthly purchases, the average 15-year redemption yield was 4.16% over March 2009-January 2010, slightly below the current 4.25%, suggesting a capital loss of about £3 billion.

Capital erosion, however, has been more than offset by net interest income of an estimated £13 billion as the Bank has “played the curve” by creating reserve money on which it has paid Bank rate of 0.5% to finance its higher-yielding gilt portfolio.

The P&L of the purchase programme is not currently included in the fiscal deficit measure targeted by the government – public sector net borrowing excluding temporary effects of financial interventions – but will be when the scheme closes, presumably after the gilts are sold back to the market.

The Bank was right to initiate asset purchases to alleviate a liquidity squeeze in early 2009 although the subsequent expansion of the programme was questionable. It would be unfair to judge the success of the scheme simply on the basis of its final P&L but a large loss would be embarrassing for officials already under attack for their handling of the financial crisis and failure to predict the current inflation overshoot.

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COMMENT:
AUTHOR: Jan Luthman
EMAIL: jan.luthman@wcgplc.co.uk
IP: 86.159.144.134
URL:
DATE: 02/11/2011 10:33:17 PM

At end-2009, the UK had a total net worth, including financial assets, of some £6,669 billion (source, ONS) – or £6.67 trillion in US terminology.
Since the Bank of England embarked on its programme of QE, Sterling has depreciated by anywhere from 20-40% against a range of emerging/developing economy currencies. QE was not responsible for all of that, but it seems not unreasonable to suppose that it was at least a contributory factor.
Even taking the lowest figure of 20%, that represents a diminution in the net worth of the UK of more than £1.3 trillion.
To suggest that QE made a £10bn profit – or, indeed, any profit at all – is, to put it mildly, profoundly misleading.

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COMMENT:
AUTHOR: Simon Ward
DATE: 02/22/2011 11:39:10 AM

A cost / benefit analysis of QE would need to take into account a whole range of considerations but I very much doubt that it was responsible for a 20% fall in sterling, not least because the bulk of the depreciation occurred before the programme started.

US bank reserves at the Federal Reserve rose by a further $72 billion in the week to Wednesday, to $1.22 trillion – just below the peak of $1.23 trillion reached in February 2010 and equivalent to 8.2% of annual GDP. The increase reflected the Fed’s continued QE2 securities purchases and a flow of cash out of the Treasury’s accounts at the central bank, partly due to the rundown of the supplementary financing program* (SFP).

As previously discussed, if the Fed completes QE2 and the SFP falls to $5 billion and remains at this level, bank reserves will reach about $1.68 trillion by mid 2011, barring any offsetting sterilisation actions. This would represent a 69% increase since QE2 started in early November. Reserves would equate to 11.1% of GDP compared with less than 0.1% before the financial crisis – see first chart.

Such a reserves to GDP ratio would be unprecedented in the Fed’s 98-year history. The previous high, of 6.9%, was reached in 1940 as the Fed flooded the system with liquidity after the 1937 Roosevelt recession. On that occasion, the increase in reserves was followed two years later by a surge in CPI inflation into double-digits – second chart.

The prospective reserves to GDP ratio is double the level reached in Japan during its QE experiment in the early 2000s – the ratio peaked at 5.6% in 2004.

The rise in Japanese reserves did not lead to inflation because there was little impact on monetary trends. Growth in the M1 and M2 measures was stable at annual rates of 4-5% and 1-2% respectively in 2004-05.

In the US in the late 1930s, by contrast, M1 and M2 growth started to accelerate soon after the Fed began to inject liquidity in 1937 and reached double-digits in 1939-40.

Fed Chairman Ben Bernanke claims that the current reserves surge will not result in higher inflation. With policy in uncharted territory, he cannot possibly know. Monetary trends are beginning to resemble the US in the late 1930s rather than Japan in the 2000s: M1 and M2 growth have risen from annual rates of 4% and 2% respectively in July last year to 10% and 4% in January. Further M2 acceleration would ring inflationary alarm bells.

*The SFP was instituted as a crisis measure in late 2008 and involved the Treasury issuing additional bills and depositing the proceeds at the Fed for onlending to distressed financial institutions. It reached a peak of $559 billion in November 2008 and was stable at $200 billion between April 2010 and January 2011. In late January, however, the Treasury announced its intention of reducing the SFP to $5 billion in order to slow the rate of increase of the federal debt, which is approaching the legislated ceiling. As of Wednesday, it had fallen to $150 billion. The Fed repays the Treasury by creating new bank reserves.

 

In his most hawkish speech to date, the MPC’s Andrew Sentance dissociates himself from the medium-term inflation forecast in the February Inflation Report (which itself seems to call for an early rate rise – see previous post) while arguing that the Committee’s failure to tighten policy earlier will mean bigger and sharper interest rate rises, with attendant risks to recovery prospects. The speech suggests that Dr Sentance voted for a half-point Bank rate hike at last week’s meeting.

The previously-discussed “MPC-ometer” model, meanwhile, is currently signalling a 70% probability of a quarter-point increase in March but could change significantly depending on the February MPC vote, fourth-quarter GDP revision and consumer / purchasing managers survey results for February. A contributor to the hawkish reading is a further increase in the net percentage of CBI industrial firms planning to raise prices in February (released today), suggesting that CPI goods inflation will rise from 3.8% in January to about 5% – see chart.

The forecasts in the latest Inflation Report are hard to square with the MPC’s decision to leave Bank rate unchanged at its February meeting. This suggests that either rates will rise very soon or the Committee’s commitment to achieving the 2% target over the medium term has weakened.

Bank of England Governor Mervyn King’s interpretation of the MPC’s remit is that policy should be set to achieve 2% inflation over the medium term, taking into account any skew of risks. A summary measure of whether the Committee is on track to deliver this objective is the mean two-year-ahead forecast based on unchanged interest rates and asset purchases. (The mean forecast, unlike the central projection, incorporates the risk skew.)

Chart 5.13 of the Report shows that, on this unchanged policy assumption, the Committee’s central expectation is for inflation of 2.1-2.2% in two years’ time but risks are judged to be skewed significantly to the upside. The mean forecast, therefore, is about 2.5% (estimated from the chart – the underlying numbers are released with a week’s delay). The implied 0.5% overshoot of the target is the highest in any Inflation Report since 1997-98, when official rates rose by more than 150 basis points over 14 months – see chart.

Further information is provided by the alternative forecast in chart 5.1 based on market interest rate expectations, implying quarter-point rises roughly every three months starting in May. Even on this basis, the mean two-year-ahead forecast appears to be above 2%, taking into account the upward risk skew. The Inflation Report, therefore, is signalling a need for even faster tightening than the market now discounts.

The out-of-consensus view here has been that the MPC would use the February Inflation Report to signal a strong tightening bias, following through with a hike in March, barring data shocks. The new projections are consistent with this forecast but the balanced rhetoric of Governor King at the press conference is not. The February minutes will reveal more but, for now, the suspicion is that the Committee is split down the middle, with the Governor struggling to keep the hawks at bay.

Despite some downbeat headlines, there are glimmers of hope in the latest labour market numbers.

The number of employees rose in three months to December from the overlapping September-November period. This follows a recovery in vacancies, which increased further in the three months to January – see first chart. The vacancies rise accords with surveys of labour demand, such as the Monster index discussed in a prior post, although National Statistics attributes much of the recent pick-up to temporary hiring associated with the 2011 Census.

Also encouraging was a shift from part- to full-time employment, resulting in a rise in average weekly hours. With employee numbers increasing, aggregate hours worked in the latest three months were the highest since November 2008-January 2009.

Claimant-count unemployment edged higher in January but the three-month moving average has fallen since the autumn, suggesting that the recent increase in the Labour Force Survey measure will prove temporary – second chart.

The UK’s high inflation rate is not simply the result of “one-off” factors but reflects an overly-loose monetary policy stance that has resulted in rapid growth in nominal spending. An early rise in interest rates is necessary to prevent the overshoot being built into inflationary expectations, which would make an eventual return to target more painful to achieve.

This article is continued on the Financial Times website.