Blog

The US monetary base rose again in the week to Wednesday, consistent with the forecast in Tuesday’s post – see first chart. As previously discussed, markets have recently been sensitive to fluctuations in the base so this pick-up may support a near-term rally in equities, possibly accompanied by a weaker or stable dollar.

The reversal of the year-end contraction in the US monetary base may also have contributed to a recent resumption of capital inflows to Hong Kong. Under the currency board arrangement such inflows automatically expand the territory’s own monetary base – first chart.

A post in October suggested that the Dow industrial index might follow a path similar to the recoveries after the 1906-07, 1919-21 and 1973-74 bear markets. The second chart provides an update: the Dow recently moved below the range spanned by the three rebounds, hinting at a buying opportunity.

One caveat to a positive view is that annual growth in G7 real money supply M1 is likely to cross below that of industrial output expansion this spring – historically, equities have underperformed cash on average under such circumstances. This analysis, however, allows for near-term market gains before the macro liquidity backdrop turns less favourable.

Markets are also concerned that China’s policy tightening – banks’ reserve requirement ratios were raised by a further 50 basis points today – will lead to a hard landing for its economy. This hinges on whether a large positive “output gap” has already developed – if so, much higher inflation is inevitable and the authorities will be forced to slam rather than tap on the brakes.

Output gap estimates are even flakier for China than elsewhere but two pieces of evidence suggest that the economy is not yet “overheating”: industrial output is slightly below its trend over the last 10 years – third chart – while companies were not reporting skilled labour shortages late last year – fourth chart. A managed slowdown may still be possible.

The February Inflation Report is more dovish than expected but the Bank of England has failed to provide an explanation of the significant inflation overshoot relative to its forecasts, casting doubt on the credibility of its current projections. The suggestion is that the forecast is being adjusted to fit the policy rather than vice versa.

Key points:

• While forced to raise its near-term inflation profile, the Bank has revised down its medium-term forecasts: the two-year-ahead modal projection based on unchanged policies is now below 2% versus 2.35% in the November Report. It is difficult to believe that this change was warranted by the modest downward revision to its growth forecast, which continues to envisage a solid recovery.

• Governor King’s claim that the current overshoot relative to the Bank’s forecasts can be explained by higher energy prices is unconvincing. The February 2009 Report projected inflation of 1.3% in the first quarter of 2010 based on unchanged policies. If the Bank had used its current energy price assumptions, the forecast would have been about one percentage point higher, i.e. 2.3%. Inflation is now expected to be about 3.3% this quarter, despite a much larger GDP fall than the Bank predicted last February. In other words, there is an unexplained forecast error of at least a percentage point.

• The most likely explanation for this error is that the Bank overestimated the disinflationary impact of economic slack while underestimating upward pressure on traded goods prices from exchange rate depreciation. The cut in the medium-term inflation forecast, however, suggests that the emphasis on the “output gap” has, if anything, increased. The Bank, meanwhile, continues to assume that the impact of sterling weakness will be temporary; the alternative view is that the low real exchange rate will exert further upward pressure on UK goods prices relative to the global trend over the medium term.

• A likely significant rise in indirect taxes after the election will boost inflation relative to the Bank’s forecasts. In a recent speech, Governor King suggested that the MPC would ignore “temporary price level factors” – defined to include commodity price rises, sterling depreciation and tax increases – when setting policy. It is debatable whether such an approach is compatible with the MPC’s remit, which is to achieve the 2% target, defined by the consumer price index without any exclusions, “at all times”.

A previous post argued that how the MPC interprets its remit would be as important for the interest rate outlook this year as the evolution of inflation and output. Today’s Report reinforces suspicion of a shift to “inflation targeting lite”, involving downplaying “exogenous” upward influences on inflation and placing more weight on forecasts and discretion. Accordingly, any policy tightening is now unlikely before May at the earliest.

The recent set-back in markets may partly reflect worries about a withdrawal of liquidity support by the Federal Reserve and other central banks. Such concerns are premature: the US monetary base is likely to reach a new high this spring.

The Fed plans to complete its purchases of about $1.425 trillion of agency debt and mortgage-backed securities by the end of March. As of last week, its balance sheet contained $1.135 trillion of such securities, implying $290 billion yet to be added.

Payment for this $290 billion will be made by crediting banks’ reserve accounts at the Fed, which – together with currency – constitute the monetary base. Other things being equal, therefore, the base will rise from its current level of $2.037 trillion to $2.327 – a 14% increase.

The Fed, however, is simultaneously closing several liquidity support operations, including the term auction facility, the commercial paper funding facility and swap arrangements with other central banks. Lending under these facilities totalled $47 billion last week. In addition, banks may choose to repay the $16 billion of discount window loans still outstanding.

The $290 billion addition to the monetary base from securities purchases, therefore, will be offset by a repayment of up to $63 billion of emergency support, suggesting a net increase of $227 billion or 11% – see table.

The Fed, in theory, could sterilise this injection, by selling Treasury securities or running down “other” assets, asking the Treasury to hold more cash in its account, or conducting reverse repurchase agreements (included in “other” liabilities). Officials, however, are likely to view a further expansion of the monetary base as desirable given ongoing worries about the sustainability of the revival in the economy and markets.

US labour demand is recovering but firms remain cautious, preferring to use existing workers more intensively and employ temporary staff rather than expand permanent jobs.

January figures show that non-farm payrolls were essentially flat over the last three months: the establishment survey measure fell by 0.1% while an alternative measure from the household survey rose by 0.1% – see first chart. With the average workweek lengthening from 33.0 to 33.3 hours, however, aggregate hours worked in the private sector grew by 1.0% – the largest increase since late 2006. Firms, meanwhile, added a record 205,000 “temporary help” jobs over the last three months.

Global industrial output should continue to recover solidly in early 2010, judging from OECD leading indices for December, also released today – second chart.

As expected, the Monetary Policy Committee voted to suspend reserves-financed asset purchases at £200 billion while maintaining Bank rate at 0.5%.

The key passage in the accompanying statement is:

On balance, the Committee believes that the prospect is for a gradual recovery in the level of activity. The recession has probably impaired the supply capacity of the economy, but the scale and persistence of the fall in output means that a substantial margin of under-utilised resources is likely to remain for some time to come. That is likely to mean that inflation will fall below the target for a period.

The comparable passage in November was:

On balance, the Committee believes that the prospect is for a slow recovery in the level of economic activity, so that a substantial margin of under-utilised resources persists. That will continue to bear down on inflation for some time to come, offset in the short run by the impact of the past depreciation of sterling.

The changes are subtle but possibly significant. The Bank appears to be signalling that it underestimated supply-side damage from the financial crisis and recession, implying that the “output gap” – while “substantial” – is smaller than previously assumed. Accordingly, spare capacity is now judged likely to result in inflation declining “for a period” rather than “for some time to come”. The Bank, however, continues to forecast a temporary undershoot of the target, although few will be convinced given its recent record.

The statement makes the following reference to the recent inflation surge:

CPI inflation has risen sharply to well above the 2% target, reaching 2.9% in December. That rise was largely accounted for by higher petrol price inflation and the reduction in the main VAT rate a year earlier dropping out of the calculation.

While it is true that December’s sharp rise was largely due to petrol prices and the VAT base effect, it is highly misleading to suggest that the significant overshoot of the 2% target reflects these factors. The standard VAT rate was 15% in both December 2008 and December 2009, while core inflation – excluding food, alcohol and tobacco as well as petrol and other energy prices – has risen to an annual 2.8%.

The “credit counterparts” arithmetic shows how changes in the broad money supply, M4, are related to other components of the banking system’s balance sheet, including lending to the private and public sectors. Public sector lending – also termed the “public sector contribution” – has been much larger than the rise in M4 since March 2009, reflecting the Bank of England’s gilt-buying. This has led some commentators to claim that broad money will plunge if the purchase programme is stopped.

Such analysis, however, ignores important interactions between the credit counterparts. Official gilt-buying, while inflating public sector lending in recent months, has had simultaneous negative effects on other counterparts. The net boost to M4 has probably been modest, arguing against a significant negative impact from a suspension of purchases. With the demand to hold money depressed by negative real deposit rates, there should be sufficient monetary fuel to support an ongoing economic recovery.

The Bank’s gilt purchases can result in a negative impact on other credit counterparts in the following ways:

• An overseas investor selling to the Bank may hold the proceeds on deposit at a UK bank or use them to repay borrowing. This is recorded as a negative flow under “external and foreign currency counterparts”.

• A UK non-bank seller of gilts may repay bank borrowing or buy goods or assets from another UK resident who then repays debt. Bank lending to the private sector is correspondingly reduced.

• Alternatively, the non-bank seller may invest in newly-issued bank bonds or equities, resulting in a negative impact under “net non-deposit liabilities”.

• Official gilt purchases financed by the Bank creating reserves may cause banks to buy fewer gilts, since reserves are a close substitute. The rise in the public sector contribution is then smaller than the official purchases.

A reversal of the last effect may be particularly important in limiting any negative impact on M4 from a suspension of the Bank’s operations. Banks bought £26 billion of gilts between November 2008 and January 2009 but their holdings have risen by just £1 billion since the Bank announced its purchase scheme last February. A return to the earlier pace of accumulation would substitute for official buying on the recent scale.

A previous post argued that more favourable voter perceptions of the economy would result in a further narrowing of the Conservative poll lead over Labour near term, increasing fears of a hung parliament. This shift, however, would be reversed from early 2010, reflecting sharply-rising inflation. Economic factors, therefore, argued for Labour calling an early election rather than delaying until the last moment.

Recent polls support the first part of this forecast: the last five results reported on the excellent ukpollingreport.co.uk show a Tory lead of between 7 and 9 percentage points – below the 10 point gap widely regarded as necessary to guarantee a majority. Economic perceptions seem to be driving this move: the EU Commission’s consumer confidence measure vaulted higher in January to its highest level since November 2007.

The earlier forecast was based on statistical analysis of Guardian / ICM polling data since the early 1980s. The results indicate that the position of the governing party relative to the main opposition depends positively on average earnings and house price growth and negatively on retail price inflation, unemployment and changes in interest rates – the chart shows fitted values of a model based on these factors.

According to this analysis, Labour is benefiting from rising house prices and the lagged impact of last year’s low inflation while the labour market has become less negative, with unemployment and earnings growth stabilising. The model predicts a Tory lead of only 2 percentage points based on economic factors – the 7 to 9 point gap may reflect other influences that are working to Labour’s disadvantage.

Labour strategists are counting on economic developments continuing to boost the party’s support but the model suggests that the positive impact is peaking. On plausible assumptions about the inputs – including a rise in retail price inflation to 4-5% this spring – the poll gap is forecast to widen to 9 percentage points by May. If non-economic influences result in Labour continuing to underperform the model’s predictions, this would be consistent with an outright Tory victory.

The fundamentalist wing of the monetarist school will be concerned by December money supply data, showing growth of only 1.1% in adjusted M4 (i.e. excluding holdings of non-bank financial intermediaries) over the last year and a small contraction over the latest three months. This weakness, however, is unlikely to signal an economic relapse because the demand to hold money has fallen in response to negative real interest rates and reviving confidence. Put differently, slow M4 expansion is being offset by a pick-up in the velocity of circulation, following a collapse before and during the financial crisis.

Key points:

The sectoral breakdown shows that weakness in adjusted M4 has been concentrated in the financial sector, with money holdings of insurance companies, pension funds and other investment managers down significantly since late 2008. This is likely to reflect a voluntary reduction in cash as institutions have become more confident about market prospects.

Non-financial M4 – i.e. money holdings of households and private non-financial corporations – rose by 2.6% in the year to December and at the same annualised rate over the latest three months.

The demand to hold money of households, like that of institutions, has been depressed by paltry yields and a revival of risk appetite. Household M4 rose by £23 billion during 2009 but retail inflows to unit trusts and OEICs are likely to have exceeded £25 billion (IMA figures for December are released tomorrow), up from just £4 billion in 2008.

Lower demand by institutions and households has allowed non-financial corporations to boost their liquidity despite slow aggregate money supply expansion. Corporate M4 rose by 4.2% in the year to December and by 6.2% annualised over the last three months. The liquidity ratio – sterling and foreign currency money holdings divided by bank borrowing – stabilised in December but has recovered significantly from its late 2008 low.

Broad money fundamentalists neglect a recent pick-up in narrow money M1 (notes and coin plus sight deposits), which rose an annual 7.2% in December. An increase in M1 relative to M4 is consistent with a recovery in velocity, with people shifting funds from savings accounts and time deposits into instant-access accounts in anticipation of increasing spending on goods and services or assets. M1 gave better warning of the recession than M4.

Bank rate is currently 1.9 percentage points below the annual increase in retail prices – the largest negative divergence since 1980. The shortfall will widen significantly further by the spring. The last sustained period of negative real rates, in the 1970s, was associated with a trend increase in M4 velocity – by 4.7% per annum on average over 1974-79. If velocity is embarking on another trend rise, slow broad money growth offers limited reassurance that inflation will return to target over the medium term.

The Treasury, OECD and IMF believe that the UK “output gap” – the shortfall of GDP from its trend or potential level – is currently between 5% and 7%. Two alternative approaches, however, suggest a much smaller gap, of about 2%, helping to explain why inflation has overshot official and consensus forecasts.

The three organisations estimate current trend output by extrapolating an underlying path based on historical data and applying an ad hoc adjustment for the negative impact of the financial crisis. Such estimates amount to little more than a guess and will be revised, probably significantly, in light of future output developments.

The first alternative approach utilises the “Okun’s law” relationship of the output gap and the deviation of unemployment from its non-accelerating-inflation rate (the NAIRU). Based on history, the recent rise in unemployment looks too small to support estimates of a gap of up to 7%, barring an unlikely fall in the NAIRU.

Specifically, an analysis of UK data since the early 1970s indicates that each 1 percentage point rise in unemployment is associated with a 1.56% fall in output relative to trend. The unemployment rate increased by “only” 2.5 percentage points between the first quarter of 2008 – immediately before the recession – and the fourth quarter of last year, suggesting a 3.9% decline in output relative to trend (1.56 times 2.5). The OECD estimates that GDP was 1.9% above trend in the first quarter of 2008. Using this as a starting point, the implied shortfall last quarter was only 2.0% – see chart.

The second approach uses business survey information on capacity and labour constraints to gauge the position of GDP relative to trend. The percentages of CBI manufacturing firms reporting shortages of plant capacity and skilled labour were summed and the resulting series rescaled to match OECD output gap data since the early 1970s. This approach also yields a current estimate of about 2% – the chart shows a full history.  

These alternative approaches imply that either current official GDP figures overstate the decline during the recession or damage to supply capacity from the financial crisis has been greater than assumed by most forecasters. Both are probably true. For the entire divergence to be explained by the supply factor, trend output would need to have fallen by more than 2% between the first quarter of 2008 and late 2009 versus the OECD’s assumption of a 3.1% increase.

The Bank of England claims that the current inflation overshoot will prove temporary because a “large amount” of spare capacity will exert downward pressure on domestic price trends. If the output gap is only about 2%, however, the effect will be much weaker than it expects, implying that a tightening of its policy stance will be necessary to secure a return of inflation to target.

Eurozone broad money M3 fell by an annual 0.2% in December but the decline was entirely due to a contraction in financial institutions’ money holdings: M3 held by households and non-financial corporations rose by 3.6% – see first chart.

Within non-financial M3, corporate money growth picked up further to an annual 5.5%. With debt repayment continuing, measures of the corporate liquidity ratio have surged, suggesting improving prospects for business investment and hiring – second chart.