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Broad money trends remain weak: M4 excluding money holdings of non-bank financial intermediaries was unchanged in January and has contracted at a 1.9% annualised rate over the last six months. This weakness, however, is compatible with both a solid economic recovery and inflation overshooting the 2% target.

The key monetary driver of the business cycle is the corporate liquidity ratio – companies’ money holdings divided by their bank borrowings. This ratio is a major influence on firms’ decisions about capital spending and employment, with the latter driving household income and, in turn, demand. In contrast to aggregate broad money, corporate M4 rose by an annualised 4.6% in the six months to January.

The corporate liquidity ratio forewarned of the recession in 2007 at a time when aggregate money and credit were still rising strongly. It reached a low in early 2009 and has recovered significantly, suggesting an imminent pick-up in business spending and hiring. Excluding the struggling real estate sector, the ratio is above its average level since the late 1990s – see chart.

Firms have been able to rebuild their liquidity despite weak aggregate M4 growth because of a fall in the demand to hold money by households and institutional investors. This partly reflects a revival in confidence in markets; in addition, the negative real post-tax return on bank deposits may be triggering a major rebalancing of portfolios.

The current monetary environment resembles the aftermath of the 1974-75 recession. GDP rose by 6% in the first two years of the subsequent recovery despite a 6% contraction in the real broad money stock. The corporate liquidity ratio increased strongly before this upswing as household and institutional money demand fell in response to negative real interest rates. Inflation accelerated as the recovery developed.

The 1976 sterling crisis was caused partly by fiscal laxity – public sector net borrowing reached 7.0% of GDP in 1975-76 – but monetary policy was also too loose, with interest rates held below inflation and the deficit financed largely through the banking system. Current Bank of England policy is identical to that pursued by the monetary authorities in 1975-76 and carries a significant risk of similarly inflationary consequences.

Consumer confidence continued to strengthen in February, reaching a seasonally-adjusted -2 – well above the average of -9 since 1990 and the highest since February 2006. The rise was driven by improved expectations about the labour market and wider economy. A solid consumption recovery may already be under way – see first chart.

The confidence rise supports the view that the recent narrowing of the Conservative / Labour poll lead reflects economic factors, as discussed in the last post.

Interestingly, consumers’ inflation expectations, having risen in prior months, stabilised in February, despite retail price inflation accelerating to an annual 3.7% in January – second chart. Households may have been influenced by the dovish forecasts in the latest Inflation Report, even though the Bank of England failed to predict the current spike. With RPI inflation likely to rise significantly further, this stabilisation may prove temporary. Retailers’ price expectations are notably stronger than consumers’ – second chart.

The confidence revival contrasts with weak news on business investment, which fell by a further 5.8% in the fourth quarter. Provisional investment estimates, however, are often revised substantially and the large decline is difficult to reconcile with rises in capital goods production and imports last quarter.

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COMMENT:
AUTHOR: Jan Luthman
EMAIL: jan.luthman@wcgplc.co.uk
IP: 193.227.201.118
URL:
DATE: 02/26/2010 12:00:02 PM

"Households may have been influenced by the dovish forecasts in the latest Inflation Report"

Errrmmm – no. A few fund managers may have been influenced, but, in the real world of whitevanman and OK magazine, households do NOT study BoE Inflation Reports. Sorry.

Revised fourth-quarter GDP figures confirm that a recovery is under way while nominal income is growing at a rate consistent with the inflation target, arguing against any further expansion of asset purchases.

Key points:

• GDP rose by 0.3% last quarter versus an originally-estimated 0.1%, with market-sector output up by 0.4%.

• Consumer spending rose for the second consecutive quarter, by 0.4%. A further increase in consumer confidence in early 2010, to above its long-run average, suggests a continuing recovery.

• A 5.8% fall in business investment was offset by a slower rate of destocking so total spending by companies was down by 0.9%. Improving corporate liquidity should support outlays and hiring in early 2010 – vacancies rose by 11% over November-January from the prior three months.

• GDP at current market prices rose by 1.1%, or 4.5% at an annualised rate, last quarter. Gross value added at current factor cost – a measure of aggregate wages and profits – grew by 6.0% annualised. The 2% inflation target is consistent with nominal income expansion of about 4.5% per annum over the medium term.

• GDP finished the quarter strongly: a monthly proxy based on services and industrial output was 0.4% above its quarter average in December – see chart. This reduces the risk of a first-quarter relapse although January is likely to have been depressed by bad weather.

Today’s news, however, may not result in a further improvement in Labour’s poll ratings. Historical analysis indicates that the popularity of the governing party is sensitive to changes in retail price inflation – a further rise to about 4.5% this spring may outweigh the poll impact of better GDP.

The US monetary base rose to another new high in the week to Wednesday – see chart – but the forecast in a previous post of a further large increase into the spring is no longer valid because of a Treasury / Federal Reserve decision this week to expand the supplementary financing programme (SFP) from its current $5 billion to $200 billion.

Under the SFP, the Treasury issues additional Treasury bills and deposits the proceeds with the Fed. The expansion of the programme means that the Fed will be able to finance remaining purchases of mortgage-backed securities (MBS) without creating new bank reserves, included in the monetary base.

While the monetary base is unlikely to rise much further, the recent expansion may have a positive impact on markets near term. Financing MBS buying by issuing Treasury bills rather than creating reserves, moreover, arguably makes little difference – the transaction still results in an increase in market liquidity while bills may be bought by banks and regarded as a close substitute for reserves.

It would have been more straightforward for the Fed to have sterilised the monetary base impact of MBS purchases by other means, e.g. selling Treasury securities from its portfolio, conducting reverse repos or raising reserve requirements. Officials were presumably concerned that such actions would suggest a tightening of monetary policy so chose the more circuitous route of SFP expansion instead.

Recent commodity price gains and sterling weakness are putting strong upward pressure on manufacturers’ input costs.

The Journal of Commerce industrial commodity price index – covering 18 materials used in manufacturing production including crude oil and natural gas – rose to a new recovery high last week. In sterling terms, the index is now 6% above the peak reached in May 2008, when the pound was at $1.95 – see first chart.

The second chart shows annual rates of change of the official producer input price series and the sterling-based Journal of Commerce index. Sterling commodity prices are 55% higher than a year ago – the largest gain since 1974. Input price inflation – an annual 8% in January – may rise to 20% or more this spring.

With output and orders recovering, the low level of sterling reducing competition from foreign producers and the Bank of England signalling no intention to tighten policy despite high inflation, manufacturers are likely to pass these increases on rather than absorb them in margins.

The rise in the Fed’s discount rate from 0.5% to 0.75% will apply to $15 billion of outstanding primary and secondary credit loans, as of Wednesday. Such lending peaked at about $112 billion in October 2008.

The US monetary base, meanwhile, rose by a further $53 billion in the week to Wednesday, to a record $2.13 trillion – see chart. The increase reflected Fed securities puchases and an outflow of cash from the Treasury’s account at the central bank, factors that offset a fall in lending under the term auction facility. (The monetary base comprises currency in circulation and banks’ reserve balances at the Fed.)

Remaining securities buying and the completion of recent transactions should result in a further expansion of the monetary base, even allowing for paydown of discount window loans and other emergency lending – see previous post.

The Fed may begin to reverse its super-loose monetary stance this summer but the discount rate hike is a false alarm.

Consumer price inflation rose to an annual 3.5% in January, in line with the consensus expectation. The figure appears to have been rounded up, since the index levels in January 2009 and January 2010 were 108.7 and 112.4 respectively, implying an increase of 3.4%. The outturn was higher than forecast in a previous post mainly because food price inflation unexpectedly accelerated – British Retail Consortium and producer output price figures had suggested a slowdown.

The rise in the headline rate from 2.9% in December is explained by the return of the standard VAT rate to 17.5%. The Office for National Statistics and the Bank of England have estimated that the cut to 15% in December 2008 reduced the CPI by about 0.7%. Assuming the same reverse effect, the headline rate may have fallen to 2.8% in the absence of the hike. (The 1.7% annual rise in the CPI at constant tax rates is misleading because it assumes that the VAT increase was passed on in full.)

CPI inflation may fall back to about 3% over coming months, partly reflecting vehicle fuel base effects and lower gas prices. The Bank’s forecast, however, of a sustained decline to about 1% by early 2011 is no more credible than its projection a year ago that inflation, then 3.1%, would fall to 1.3% by the first quarter of 2010. The Bank is probably continuing to overemphasise the role of the “output gap” in the inflationary process while underestimating upward pressure on tradable goods prices from the low real exchange rate. The forecast also ignores likely further indirect tax hikes after the election while assuming a stabilisation of commodity prices and sterling.

Governor King’s latest explanatory letter to the Chancellor refers to monetary policy being set “to keep inflation close to the 2% target in the medium term”. The Bank’s remit, however, is to achieve 2% “at all times”, although allowance is made for temporary departures due to “shocks and disturbances”. Governor King suggests that the VAT hike and rising energy prices represent “shocks” but the tax change was known when the Bank made its February 2009 forecast while higher commodity prices were a predictable consequence of global economic recovery.

Interpreting the remit to imply that the target applies only “in the medium term” allows the Bank maximum discretion in setting policy. When such discretion results in a persistent inflation overshoot, however, such as the 2.8% per annum rise in the CPI in the four years to January, there is a risk of expectations diverging from the target. A rise in market and / or survey-based inflation expectations could yet derail the Bank’s dovish approach.

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COMMENT:
AUTHOR: Jeremy Dufton
EMAIL:
IP: 85.158.139.100
URL:
DATE: 02/17/2010 03:40:58 PM

At the risk of being accused of being really sad or really pedantic, I suspect the rounding anomaly you speak of arises because each individual monthly index level is rounded but the published annual changes are based on the unrounded indices. If, say, 108.7 was actually 108.66 and 112.4 was actually 112.44 then the annual rate would be 3.47%. Or 3.5%.
Love the blogs, Simon, very insightful, please keep them coming.

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COMMENT:
AUTHOR: Simon Ward
DATE: 02/18/2010 03:52:58 PM

Thanks Jeremy – a better explanation than I managed.

The ability of Greece and other struggling Eurozone countries to remain within EMU may depend as much on ECB support as any multilateral assistance arranged between governments.

Banks in a country perceived to be at risk of being forced out of EMU are likely to suffer an outflow of funds. The banks, in turn, will attempt to cover any funding shortfall by increasing their borrowing from the ECB.

Under current generous arrangements, banks are able to borrow from the ECB in unlimited amounts at a fixed rate against collateral rated down to BBB-. ECB President Trichet’s confirmation in January of the central bank’s intention to return the minimum collateral requirement to its pre-Lehman level of A- at the end of 2010 contributed to recent pressure on weaker sovereigns.

ECB support has, until now, mitigated sovereign debt problems, since banks in Greece and elsewhere have been able to purchase bonds issued by their national governments and use them as collateral to obtain cheap central bank funding. Without bank buying, yield spreads would have widened earlier and by more.

ECB lending to banks via monetary policy operations rose from €465 billion in mid 2007 to €750 billion by the end of last year. There was a simultaneous increase in banks’ reserves at the ECB from €183 billion to €396 billion, partly reflecting the circulation of funds obtained by weaker banks back to stronger institutions, which redeposited them with the central bank.

Net ECB lending to banks, therefore, rose from €281 billion in mid 2007 to €354 billion by the end of 2009.

It is reasonable to suspect that this net lending has been directed disproportionately to banks in weaker Eurozone economies. The ECB does not publish a breakdown but an indication of country exposures can be obtained from balance sheet statements of national central banks.

The Bank of Finland, for example, is likely to lend only to Finnish banks. In some countries, the balance sheet statement explicitly separates transactions with domestic and other Eurozone banks.

The chart shows estimates of net lending by national central banks to local banks in the original 11 Eurozone members plus Greece (which joined in 2001) at the end of 2009, derived from these balance sheet statements. The blue bars are actual figures while the red bars are the amounts that would be implied if total ECB lending were distributed according to GDP weights.

The excess of the blue over the red bar, therefore, is a measure of the extent to which banks in a particular country are unusually reliant on ECB support.

Irish and Greek banks stand out as especially dependent on ECB funding. They account for one-third of total ECB net lending versus a combined GDP weight of 5%. Irish banks are borrowing an amount equivalent to 46% of Irish annual GDP; the corresponding figure for Greece is 17%.

The Central Bank of Ireland’s net lending is inflated by transactions with international banks located in Dublin’s International Financial Services Centre. Excluding institutions with predominantly foreign business, however, the total still amounts to €67 billion or 41% of GDP.

Net lending to Spanish banks is also above the implied level but amounts to a much-lower 5% of Spanish GDP. Borrowing by Portugese banks is in line with the Eurozone average while Italian banks appear to be net lenders to the ECB, i.e. their reserves exceed their borrowing.

Surprisingly, net lending to banks by the Bundesbank is greater than implied by Germany’s GDP share. In this case, however, the balance sheet statement does not separate transactions with domestic and other Eurozone institutions – the total may conceal loans to banks headquartered in weaker Eurozone countries.

Greek banks may have suffered a further outflow of funds as a result of the current crisis. Reliance on ECB funding may soon approach the Irish level.

The ECB must continue to offer unlimited support if a full-scale run on banking systems in weaker Eurozone economies is to be avoided. The plan, however, to raise the minimum collateral requirement back to A- at the end of the year suggests that some within the central bank oppose a further increase in its exposure to dubious credits and could baulk at a massive Greek rescue operation.

A previous post suggested that consumer price inflation would rise to an annual 3.4% in January and average 3.2% in the first quarter. This now looks too high, for three reasons.

First, the British Retail Consortium (BRC) shop price survey for January showed a rise in non-food goods inflation from an annual 1.4% in December to 1.9% – smaller than expected given the return of the standard VAT rate to 17.5%. A larger proportion of retailers than previously thought may have either raised prices before January or absorbed the increase in margins, although the latter effect could prove temporary.

Secondly, CPI food inflation probably slowed in January. The annual increase in the BRC food price index fell from 3.7% in December to 2.9%. Similarly, producer output prices for food and beverages rose an annual 1.1% last month, down from 1.8% in December – see chart.

Thirdly, the 7% cut in gas tariffs by British Gas – effective immediately – is likely to be followed by other suppliers over coming weeks, implying a reduction of 0.15% in the CPI.

Petrol prices will have a large upward effect – an estimated 0.25 percentage points – on the CPI annual rate in January, reflecting both a rise last month, partly due to the VAT hike, and a fall in January 2009.

Based on the above, CPI inflation may rise to an annual 3.2% in January before falling back to 2.9% in February and March, implying a first-quarter average of 3.0%.

Bank of England Governor Mervyn King will be able to explain a move above 3% as the result of the VAT hike and petrol price effects. The bigger issue is the stickiness of “core” price trends: the CPI excluding unprocessed food and energy rose by 2.9% in the year to December and at a similar annualised rate over the last three months (adjusting for seasonal influences).

With the economy recovering, the “output gap” smaller than generally assumed and the weak exchange rate exerting upward pressure on goods prices, core inflation may continue to frustrate MPC and consensus hopes of a significant slowdown. Coupled with further indirect tax hikes after the election, this may keep headline CPI inflation well above the 2% target for the foreseeable future.

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COMMENT:
AUTHOR: Mark Davies
EMAIL: marklanedavies@gmail.com
IP: 92.156.67.222
URL:
DATE: 02/09/2010 08:49:40 PM

Simon, How will this affect your earlier General Election prediction ?

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COMMENT:
AUTHOR: Simon Ward
DATE: 02/16/2010 03:14:51 PM

The change is too small to have much effect. Update: January CPI inflation was 3.5% rather than 3.2% because food prices unexpectedly accelerated, although this may be temporary.

The Riksbank’s latest forecasts for the Swedish economy are remarkably similar to the Bank of England’s projections for the UK in the February Inflation Report. Unlike the Bank, however, the Riksbank last week signalled that it expects to begin raising interest rates in the summer or early autumn.

Sweden, like the UK, targets 2% inflation. The consumer price index at fixed mortgage rates (CPIF) rose by 2.7% in December, well above both the target and the Riksbank’s previous forecast. It expects a decline to 1.2% by January 2011, however, followed by a gradual rise back to 2% by late 2012. This assumes that the repo rate is hiked from its current level of 0.25% to 2.0% by August 2011.

The Bank of England releases its forecast numbers on Wednesday but the fan charts in the Inflation Report imply CPI inflation of more than 3% in the current quarter followed by a decline to about 1% in early 2011 and a rise back to 2% in late 2012 (mean projection). This is based on market expectations of an increase in Bank rate to 2.1% by the third quarter of 2011.

The similarity of the two forecasts is illustrated by the charts, taken from the Inflation Report and Riksbank Monetary Policy Report respectively.

Spare capacity is probably similar in the two economies. From a peak in the first quarter of 2008, GDP had fallen by 5.9% in Sweden and 6.0% in the UK (5.6% excluding oil and gas extraction) by the third quarter of last year. As in the UK, Swedish unemployment has risen by less than most forecasters, including the Riksbank, expected.

Both central banks project a solid economic recovery. The Riksbank forecasts GDP growth of 2.3% in 2010, 3.4% in 2011 and 3.5% in 2012. The Financial Times estimates that the Bank’s mean projection is for increases of 1.3%, 3.0% and 2.9% respectively. While the UK numbers are lower, the OECD thinks that potential growth was 0.4-0.5% per annum slower in the UK than Sweden over the last five years.

The Bank’s inflation forecast is probably optimistic relative to the Riksbank’s, for three reasons: inflation is starting from a higher level, which is likely to influence expectations; sterling has been much weaker than the Swedish krona, suggesting continuing upward pressure on tradable goods prices; and the UK’s much-worse public finances guarantee further large rises in indirect taxes.

According to the Riksbank:

The information received since December indicates a continued normalisation of the financial markets and a somewhat stronger development of the economy. All in all, this means that the risk of a major setback in the recovery of the economy has declined and that the upturn therefore rests on more solid ground. There may thus be a need to adjust monetary policy to more normal conditions somewhat sooner than was assumed in December. The current assessment of the Executive Board of the Riksbank is that the repo rate will be increased in the summer or early autumn.

Compare and contrast with the closing sentences of Bank of England Governor King’s statement at last week’s Inflation Report press conference:

Output has stabilised and confidence has recovered. The additional money created by the asset programme will continue to boost the economy for some time to come. But the nature of the headwinds means that the recovery is likely to be slow. And there is much uncertainty – about both the outlook for the world economy and the strength of domestic spending. Although the MPC last week announced a pause in its programme of asset purchases, it is far too soon to conclude that no more purchases will be needed. So the Committee will keep its options open, and further purchases will be made if they prove necessary to keep inflation on track to meet the target in the medium term.

The Bank of England’s optimistic inflation forecast and its unwillingness to signal the possibility of future tightening may be further evidence of a shift to “inflation targeting lite”, in which the formal requirement to hit the 2% target “at all times” is downplayed in favour of supporting growth and encouraging politicians to believe that necessary fiscal restriction will be rewarded by maintenance of super-low interest rates.