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The surprisingly dovish February Inflation Report suggested a shift in the Bank of England’s priorities towards supporting growth in the face of coming fiscal tightening rather than achieving its formal remit target of a 2% annual CPI increase “at all times”. The Bank, of course, justified its stance by projecting a future fall in inflation but its forecasts have little credibility, having been overshot persistently in recent years.

Markets, it appears, agree that the Bank’s inflation-fighting commitment has softened. The yield gap between conventional and index-linked gilts of between five and 15 years’ maturity – a proxy for long-term market inflation expectations – has risen steadily from a short-term low the day after the Inflation Report, yesterday reaching its highest level since October 2008. US market-implied inflation expectations are little changed over the same period  – see first chart.

Sterling, meanwhile, has fallen by 4% both against the US dollar and in trade-weighted terms since the Report. Coupled with renewed strength in dollar commodity prices, this has resulted in an 11% surge in industrial raw material costs, as measured by the Journal of Commerce index in sterling terms – second chart. Input costs are 60% higher than a year ago.

The Bank is now in a bind. Markets are rebelling against its dovish shift and their reaction further increases the risk of a sustained inflation overshoot, warranting consideration of an early Bank rate hike. This would be highly contentious given the imminent election and weather-depressed economic reports but policy inaction could result in an extension of recent market moves, ultimately forcing the Bank’s hand.

The view expressed in prior posts that the global economic recovery will be sustained through 2010 rests on improvements in corporate liquidity feeding through to a pick-up in business investment and hiring, with rising employment supporting consumer incomes and spending. Recent US and UK evidence is consistent with firming labour demand.

In the US, non-farm payrolls fell by 171,000 in the three months to February but last month’s number was depressed by snow storms that prevented some existing employees and new hires from turning up for work. An alternative payrolls measure based on households’ assessment of their employment status is likely to have been less distorted by weather effects and rose by 292,000 over the last three months – see first chart. A catch-up gain in headline payrolls is possible this month.

Leading indicators have improved further: a measure based on the ISM manufacturing employment index, the NFIB small firm hiring plans index and the Challenger-Gray-Christmas lay-offs tally has risen to a level historically consistent with three-month payrolls growth of between 250,000 and 500,000 – second chart.

In the UK, job vacancies rose by a surprisingly-strong 11% in the three months to January from the prior three months, a pick-up confirmed by the Market jobs survey – third chart. Vacancies correlate with GDP so this suggests that underlying economic momentum, abstracting from weather effects, strengthened around year-end – final chart.

Current low monetary growth will not prevent inflation overshooting the 2% target because the velocity of circulation of money is rising fast in response to negative real interest rates. The Bank of England should raise interest rates to stem the fall in the demand to hold money and slow the pick-up in velocity.

Nominal GDP rose at an annualised rate of 3.9% during the second half of 2009 while the broad money supply – as measured by M4 excluding money holdings of non-bank financial intermediaries – fell by an annualised 1.2%. The velocity of circulation of money, therefore, increased by an annualised 5.1% – the largest two-quarter gain since 1999.

The velocity rise is the counterpart of a reduction in the demand to hold money by households and financial institutions, driven partly by a recovery in confidence but more importantly by the negative post-tax real return on bank deposits, which is encouraging a rebalancing of portfolios. Record mutual fund inflows are evidence of this portfolio shift: retail investors bought a net £1.8 billion of unit trusts and OEICs in January, bringing the 12-month running total to £26.4 billion, equivalent to 2.7% of household money holdings, according to Investment Management Association figures released yesterday – see chart.

Post-tax real interest rates were last negative for a sustained period in the 1970s. M4 velocity rose at an average annualised rate of 4.7% over 1974-79.

The 2% inflation target is consistent with nominal GDP growth of 4-5% per annum over the medium term, assuming trend real economic expansion of about 2.5% pa. If velocity were to continue to rise by about 5% pa, this would imply no room for any increase in the money supply. A policy of expanding asset purchases to achieve a positive rate of monetary growth would be misguided, leading to an inflation overshoot.

M4 excluding intermediaries’ money holdings rose by an annualised 1.9% in the three months to January. On current velocity trends, therefore, money growth may already be too strong to achieve the 2% inflation target. Rather than expanding asset purchases, the Bank of England should be considering raising interest rates to stem the flow of funds out of bank deposits and restrain the pick-up in velocity.

UK government debt has a longer average maturity than the international norm. Official figures, however, overstate the advantage because they fail to account for the “maturity transformation” implied by the Bank of England’s gilt-buying.

According to the Debt Management Office (DMO), the average maturity of gilts and Treasury bills outstanding was 13.5 years at the end of 2009. This figure, however, includes £190 billion of gilts bought by the Bank of England, representing 23% of the stock of debt held outside the DMO.

The market has, in effect, exchanged these gilts, with an average maturity of about 10 years, for central bank reserves, which are repayable on demand. The relevant metric for assessing refinancing risk is the average maturity of the market’s combined holdings of debt and reserves, not that of the stock of debt including the Bank’s gilts. This is significantly lower, at about 11 years, down from 14 years in mid 2008 – see chart.

The Bank of England pays Bank rate on reserves. This results in an interest saving when Bank rate is below the initial yield on purchased gilts, as at present. The Bank, however, might be forced to tighten monetary policy aggressively in the event of a funding or exchange rate crisis. This would be instantly reflected in the combined government / Bank interest bill.

The UK’s “true” debt maturity is still significantly longer than for other major countries – the US is at the low end of the range, with an average maturity of publicly-held marketable debt, including bills, of about four years. The gap, however, is much smaller than a year ago and would erode further if the Bank were to extend its gilt-buying programme.

An ICM poll published over the weekend reported a rise in the Conservative lead over Labour to nine percentage points from seven points in mid February, against the recent trend. This has not been confirmed by other pollsters – BPIX reported a further narrowing to just two points – but is consistent with the prediction of the economic polling model discussed in prior posts, beginning in December.

In this model, the governing party’s poll position relative to the main opposition depends positively on wage and house price growth and negatively on inflation, unemployment and interest rate changes. The model predicted a big narrowing of the poll gap in late 2009 and early 2010 but has been suggesting that the Conservatives would pull ahead again into the spring, mainly reflecting the negative impact of higher inflation on Labour’s popularity. A caveat, however, was that voters might blame the Bank of England rather than the government for faster price rises.

The approach, of course, can be criticised as reductionist and the model’s historical fit is far from perfect. It will, however, be interesting to monitor poll developments against its forecast of a widening of the Conservative / Labour lead to 11-12 percentage points in May (based on a rise in retail price inflation to 4.5% by March and stability of the other inputs).

If the model is to be believed, a Conservative majority is likely and Labour will rue not calling an early March election.

Irish 10-year gilts are currently trading on a yield spread of 150 basis points (bp) over Bunds, down from a peak of 270 bp a year ago and compared with 300 bp for Greek bonds. This seems modest compensation for the financial risks. Irish and Greek spreads were similar as recently as November.

Ireland gained plaudits for a tough December Budget that cut the projected 2010 general government deficit from 13.5% of GDP to 11.6%. Following the further measures announced this week, however, Greek plans are more ambitious, targeting a budget shortfall of 8.7% of GDP this year.

Ireland’s stability programme envisages a decline in the deficit to 2.9% of GDP by 2014, a reduction of 8.7 percentage points over four years. This looks impressive but assumes €5.5 billion of unspecified future fiscal retrenchment. On current policies, the 2014 deficit would be 5.6% of GDP.  This compares with UK general government borrowing of 4.6% of GDP in 2014-15 projected in December’s Pre-Budget Report.

Within general government, the Exchequer or central government deficit is projected to decline by 26% in 2010. The shortfall in January and February, however, was 15% higher than a year before. Current spending fell by 5% but current receipts were down by 18%. Ireland is lagging the global recovery – the OECD’s leading index is up by 3% over the last 12 months compared with gains of 10% and 9% for its Eurozone and UK indices. With the UK accounting for more than a fifth of trade, recent sterling weakness against the euro is unwelcome.

Ireland’s banking system is critically dependent on ECB life support. Central Bank of Ireland lending to banks was €98 billion at the end of January, the equivalent of 60% of annual GDP. This represents 13% of total Eurosystem lending to banks compared with Ireland’s 2% share of Eurozone GDP. The Bank of Greece’s lending to banks amounts to 20% of Greek GDP while numbers for Spain and Portugal are much lower – see previous post.

A renewal of market worries about Ireland would be expected to be reflected in a withdrawal of funds from its banking system, necessitating increased ECB support. Irish central bank lending is down from a peak of €130 billion in June 2009 but rose in December and January. This bears monitoring: an increase in lending in mid 2008 preceded a sharp rise in the Irish / German yield spread – see chart.

The “MPC-ometer”, discussed in numerous posts between 2007 and early 2009, is designed to predict monthly Monetary Policy Committee decisions based on incoming economic and financial data. The model suggests that policy tightening will soon be necessary, barring new “shocks”. This contrasts with the message of the February Inflation Report but news may force the MPC to execute a swift U-turn. An attempt to maintain inappropriately loose policy settings could accelerate sterling’s slide, further undermining the credibility of the Report‘s forecast of lower inflation.

The MPC-ometer is designed to predict the weighted-average interest rate vote of the Committee’s members. For example, if five want to raise official rates by 25 basis points (bp) while four prefer no change, the weighted-average vote is +14 bp (five-ninths of 25). If it is assumed that votes are either for no change or a move of 25 bp – reasonable under “normal” economic and financial conditions – then the model forecasts an actual rate change when the weighted-average prediction is greater than +12.5 or less than -12.5 bp. Introduced in September 2006, the MPC-ometer performed well over the subsequent two and a half years, correctly signalling the month and direction of 12 out of 13 rate movements – two more than the mean economists’ forecast from the monthly Reuters poll.

The MPC-ometer’s 12 inputs were selected on the basis of statistical analysis and can be grouped into indicators of economic activity, inflation and financial market conditions. The inflation sub-set is largest, comprising the latest headline annual increases in consumer prices and average earnings as well as several measures of expectations. Activity indicators include GDP growth and business / consumer confidence while credit spreads and movements in share prices and the exchange rate are used to gauge financial conditions.

A review of its forecasts during the period of unchanged rates since last March indicates that the MPC-ometer has continued to provide guidance about policy decisions. Specifically, it predicted further easing moves in May and August, months in which the MPC announced a £50 billion expansion of asset-buying plans. The model suggests that the MPC regards £50 billion of additional purchases as equivalent to a reduction in Bank rate of about 17 bp. On this basis, the £200 billion programme has substituted for a further rate cut of about 70 bp.

The weighted-average interest rate vote forecast by the model was negative between April and November last year, consistent with a residual easing bias. It rose, however, to +3 bp in December and +10 bp in January before falling back to +2 bp in February in response to preliminary figures showing GDP growth of only 0.1% in the fourth quarter. The forecast has rebounded to +12 bp in March, reflecting higher inflation, further gains in business and consumer confidence – both now well above long-run average levels – and upwardly-revised GDP expansion of 0.3% last quarter.

The MPC-ometer suggests, therefore, that as many as four members will vote to tighten policy this week. The February Inflation Report and more recent MPC communications indicate that such an outcome is highly unlikely. The current divergence between the model’s forecast and MPC behaviour raises three possibilities.

First, the model may be signalling an imminent shift in the Committee’s thinking. It has sometimes been “early” historically. Economic news and market developments since the Report was prepared have weakened the case for retaining an easing bias and may have emboldened members concerned about excessive policy laxity.

Secondly, the model may simply have broken down. Estimated on data since the MPC’s inception in 1997, it may be failing to capture the full range of influences on monetary policy in the wake of a deep recession. This argument, however, is weakened by the similarity of the model’s prediction and the latest vote of the Sunday Times Shadow MPC, which also has a good forecasting record. Three Shadow MPC members voted to raise Bank rate by half a percentage point this month – see David Smith’s blog for the minutes.

This leads on to the third possibility, which is that the MPC’s historical reaction function, rather than the MPC-ometer, has broken down. The Committee has, in effect, shifted to “inflation targeting lite”, downplaying the requirement of its remit to achieve the 2% inflation target, defined by the consumer price index without exclusions, “at all times” in favour of supporting an economic recovery and promoting fiscal tightening by promising a monetary-policy “pay-off”. Market suspicions of such a shift may be contributing to current sterling weakness.

GDP fell by 6.2% between the first quarter of 2008 and the third quarter of 2009 before recovering in the fourth quarter. The drop exceeds the peak-to-trough decline of 6.0% during the 1979-81 recession.

The recent GDP reduction, however, was magnified by a large fall in oil and gas production, reflecting reserves depletion. Oil output rose during the 1979-81 recession, when the North Sea was coming on stream.

With North Sea production driven by supply capacity rather than domestic or global demand, it may be more appropriate to focus on non-oil output when comparing economic weakness across cycles.

On this basis, the recent recession was less severe than 1979-81: the peak-to-trough fall in non-oil “gross value added” is currently estimated at 5.8% versus 6.4% – see chart.

This note examines the outlook for consumer and retail price inflation in 2010-11 from a “monetarist” perspective. The approach is to build up a forecast by considering in turn “core” inflation, VAT effects, food and energy prices and owner-occupied housing costs (relevant for the RPI).

The conventional “Keynesian” approach is to model core inflation as a function of the “output gap” with some allowance for the effect of exchange rate movements on import prices. The trouble with this is that the output gap is difficult to measure, particularly in real time, while currency movements are largely unpredictable. The consensus view, embodied in the MPC’s Inflation Report forecast, is that a large negative gap has opened up and will persist in 2010-11, exerting sustained downward pressure on core inflation. Yet the financial crisis may have damaged supply capacity by more than the consensus assumes, by raising the cost of capital, disrupting its efficient allocation and reducing the sustainable size of the financial sector – the Treasury has cited estimates of a negative effect on potential GDP of up to 6%. History suggests that caution is warranted: an overestimate by policy-makers of the degree of economic slack contributed to the inflationary upsurge in the 1970s.

An alternative approach is to base a forecast for core inflation on the simplistic monetarist rule-of-thumb that the money supply leads prices with a variable lag averaging about two years. The monetarist rule has arguably performed much better than output gapology in recent years: a large fall in core inflation in the late 1990s was preceded by a major monetary slowdown, while faster money growth forewarned of the inflationary overshoot of 2007-08. The late 1990s disinflationary episode can be used to calibrate the possible impact of recent monetary weakness on core inflation. Annual growth in broad money M4 fell from 11.9% to 2.8% between Q4 1997 and Q3 1999 – a 9.1 percentage point drop. Annual core inflation – as measured by the CPI excluding unprocessed food and energy – subsequently declined by 1.9 percentage points to a low of just 0.1% in July 2000. So the “elasticity” of inflation to monetary growth was 0.21 (i.e. 1.9 divided by 9.1). Recent monetary trends are best measured by the Bank of England’s adjusted M4 measure, excluding money holdings of financial intermediaries. Its annual growth rate fell from 11.6% in Q3 2006 to 3.6% in Q4 2008, rebounding to 4.2% in Q1 2009. Assuming that Q4 2008 was the low – reasonable given the positive impact of Bank of England gilt purchases in Q2 and Q3 2009 – the monetary slowdown suggests an eventual fall in annual core inflation of 1.7 percentage points (i.e. multiplying the money growth decline of 8.0 percentage points by the inflation elasticity of 0.21).

A major difference, however, between the late 1990s and now is a higher starting level of core inflation. The CPI excluding unprocessed food and energy rose by an annual 2.1% in May compared with 2.0% in February 1998, when the prior big slowdown began. However, recent numbers have been flattered by the temporary cut in the main rate of VAT from 17.5% to 15% last December. Assuming average pass-through of 60%, the core CPI measure would have risen by an annual 2.9% in May in the absence of the VAT change, down from a peak of 3.0% in February. (The 60% assumption may be conservative – the Office for National Statistics has estimated that 70% of prices collected from shops had been reduced to reflect the lower VAT rate in January.) Applying the predicted 1.7 percentage point fall in annual core inflation to the 3.0% February peak, the monetarist approach suggests an eventual trough of 1.3% – well above the 0.1% low reached in 2000. Assuming a two-year lead of money on prices, this trough could be reached around the end of 2010, with the recent recovery in monetary growth reflected in higher core inflation in 2011.

The outlook for headline CPI and RPI inflation will also depend on future VAT effects, food and energy prices and housing costs. The forecasts below assume that the planned return in the main VAT rate to 17.5% from January 2010 goes ahead, again with average pass-through of 60%. A further 1 percentage point increase is pencilled in for January 2011, on the basis that higher VAT will bear some of the burden of future fiscal consolidation. Unprocessed food inflation – still running at an annual 9.3% in May – is assumed to fall significantly by the end of 2009 but to remain positive, reflecting a judgement that the large increase in prices over 2007-09 reflected a “structural” shift. Following a modest further cut in retail tariffs later this year, energy prices are similarly projected to trend gradually higher. For the RPI forecast, the components linked to house prices are assumed to stabilise from late 2009 after a 20% drop from the peak. Finally, the average mortgage interest rate – currently 3.6% – is projected to fall slightly further over the remainder of 2009 before recovering by about 1 percentage point during 2010, reflecting an assumed rise in Bank rate from 0.5% to 2.5% next year.

The results of this exercise are shown in the chart. Annual CPI inflation falls from its current 2.2% towards 1% by autumn 2009, reflecting favourable food and energy price effects, but rebounds to about 3% in early 2010 as VAT is hiked. Slower core trends gradually reverse this increase and inflation moves temporarily below 2% again in early 2011 as a result of VAT effects (i.e. a smaller rise in 2011 than 2010), before drifting higher later in the year in lagged response to the current pick-up in monetary growth. Mirroring the CPI profile, the annual RPI change moves deeper into negative territory into the autumn but increases much more sharply in 2010, with the VAT increase compounded by a big turnaround in the housing costs component, reflecting both unfavourable base effects and higher mortgage rates. Annual RPI inflation peaks at about 3.5% in late 2010, slowing temporarily during the first half of 2011 as housing effects wane.

Two features of this forecast are worth emphasising. First, the CPI profile is significantly higher than the central projection in the May Inflation Report, which shows average inflation of 1.5% this year, 0.9% in 2010 and 1.3% in 2011. The difference mainly reflects the sustained disinflationary influence of a negative output gap in the Bank of England’s forecasting model, although assumptions about VAT and commodity prices may also contribute. The MPC’s recent forecasting record warrants some scepticism about its current prognosis: the central projection for annual CPI inflation one year ahead has been too low in 15 out of 17 Inflation Reports between February 2004 (after the inflation target was switched to the CPI from RPIX) and February 2008, with a mean forecast error of 0.7 percentage points.

Secondly, the swing in RPI inflation between 2009 and 2010 is unusually large and may have negative economic implications. Wage growth has slowed sharply since the onset of the recession in spring 2008 but it is unclear whether this reflects labour market flexibility or is simply a response to annual RPI falls. A pick-up in wage settlements as RPI inflation rebounds in 2010 would cast doubt on the MPC’s view that economic slack will drive core price trends significantly lower. On the other hand, continued weak wage growth would imply a squeeze on real disposable incomes, potentially undermining prospects for consumer spending and an economic recovery.

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COMMENT:
AUTHOR: Chris Spencer
EMAIL: newstudents@christopherspencer.co.uk
IP: 84.92.150.76
URL:
DATE: 08/13/2009 12:04:21 PM

I found the article interesting and readable and the arguments make sense.As a complete amateur in economics I can only use intuition but the conclusions of the report happily are consistent with my decision to hold on to my large holding in NS&I index linked savings certifates.

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COMMENT:
AUTHOR: Mary Dunn
EMAIL:
IP: 88.108.119.9
URL:
DATE: 11/06/2009 08:45:41 AM

I am a Chartered Financial Planner and often use Cash Flow modelling for a number of my clients, I found the article very interesting and exactly what I was looking for. Readable, understandable and justified. Thank you very much.

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COMMENT:
AUTHOR: Brian
EMAIL:
IP: 89.243.20.135
URL:
DATE: 11/19/2009 08:37:11 PM

As increases in my Civil Service pension are based on the previous September’s RPI figure, I welcome the prospect of a possible 3% rise in 2011 compared to the 0% in 2010……..’Every little helps’, goes the saying.

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COMMENT:
AUTHOR: Glauco H. Ayres
EMAIL:
IP: 86.170.111.249
URL:
DATE: 12/15/2009 08:53:48 AM

This is an interesting read. I indeed like the monetarist approach to understanding the causes of inflationary/deflationary pressures in our economy. As one of the chief negotiators for my Union I need to keep up with the economic outlook for years to come and I am certainly looking for further advice to enlighten my options. Thank you.

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COMMENT:
AUTHOR: C Worthy
EMAIL:
IP: 86.150.24.126
URL:
DATE: 02/03/2010 11:16:26 PM

I see little chance of inflation peaking at 3.5% later in 2010. With China wizzing away and using its power to buy raw materials, RPI inflation is more likely to peak at between 6 to 9% in June. I am not sure after that.

Cuthbert

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COMMENT:
AUTHOR: lee mcvey
EMAIL: l.mac54@yahoo.com
IP: 92.40.53.94
URL:
DATE: 03/01/2010 08:51:08 PM

The fiscal stimulas package used by the government to boost consumer spending has caused the RPI to rise erratically and falsely, which is a short term way for the government to demonstrate a recovery in the economy but long term will devalue the strenghth of the pound. But Labour are only interested in short term gains so they can win the election in May. The UK is heading for a massive fall, if the Tories gain power Labour will blame it all on them and return to power in 4 years, when recovery will be more likely after the Tories have weathered and rode the storm!