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Previous posts discussed the notion – originally advanced by Andy Kessler in a Wall Street Journal article last year – that changes in the Fed’s liquidity supply, reflected in the US monetary base, were driving market movements. The recent swoon in equities and rally in the dollar followed a contraction in the base between late November and early January – see first chart.

Previous commentary downplayed, wrongly, the significance of this decline because it reflected a build-up of cash in the US Treasury’s account at the Fed, partly due to TARP repayments, rather than efforts by the central bank to drain liquidity. This effect was expected to reverse in early 2010 as the Treasury ran down its cash balance to finance the swollen deficit.

The latter process is under way and the monetary base has risen for three consecutive weeks. The Treasury’s balance in its “general account” at the Fed has fallen from $187 billion at the end of December to $127 billion yesterday but should decline significantly further over coming weeks – the balance averaged about $45 billion last autumn. Coupled with the cash injection from securities purchases, this should more than offset any liquidity contraction caused by an unwinding of the Fed’s special operations.

The equity market set-back has resulted in sentiment measures shifting from overbought to – in some cases – significantly oversold. The annual rate of change of G7 real M1 remains, for the moment, above that of industrial output, implying a still-supportive macro liquidity backdrop. With the US monetary base recovering, the odds favour a rally in markets into the spring, possibly accompanied by a reversal or consolidation of the dollar’s recent gains.

This assessment would be wrong if the economy were tipping over into a “double dip” – liquidity would then flow into bonds rather than equities while the dollar might benefit from a flight to (perceived) safety. The recovery, however, appears on track, with early figures suggesting another solid gain in G7 plus emerging E7 industrial output in December – second chart.

The MPC’s inflation-targeting remit contains an ambiguity: it requires the Committee to achieve the target “at all times” while allowing for temporary departures due to “shocks and disturbances”. Judging from remarks in a speech last week, Bank of England Governor Mervyn King plans to exploit this ambiguity to underreact to this year’s inflation overshoot.

Extending arguments in his five explanatory letters of 2007-09, Governor King absolves the MPC of responsibility for higher inflation due to “temporary price level factors”, which he defines to include exchange rate depreciation, global commodity price rises and indirect tax hikes. Such effects, he suggests, can be ignored as long as there is a “large amount” of spare capacity and monetary growth is low.

The speech does not address the issue of why the disinflationary impact of the “output gap” has, to date, been much weaker than the Bank forecast. The assertion that low money supply growth ensures that inflation will return to target is also simplistic – an alternative view is that there is “excess” money despite slow supply expansion because the demand to hold money is falling in response to negative real interest rates and reviving risk appetite.

The phrase “temporary price level factors” is misleading: sterling depreciation, commodity price gains and excise duty increases, unless reversed, have a permanent impact on prices. Governor King means, of course, that the effect on inflation is temporary. Yet these factors will plausibly continue to exert upward pressure over the medium term.

Take sterling. The real effective exchange rate is currently 8% below its pre-crisis long-term average (calculated over 1970-2006). Suppose, reasonably, that it returns to this average in five year’s time. If the nominal exchange rate is stable, this implies UK manufacturing prices rising by 1.7% per annum more than in competitor countries. Such a differential would lift UK CPI inflation by about 0.5% pa relative to the overseas trend (based on the 31% weight of “non-energy industrial goods” in the CPI).

Commodity price gains in recent years have been largely driven by industrial expansion and rising food spending in emerging economies, trends that will persist. Fiscal adjustment, meanwhile, will necessitate further hikes in indirect taxes, with a rise in the standard rate of VAT to 20% widely expected during the next parliament.

In sum, the three factors could plausibly boost the CPI by about one percentage point per annum over the next five years. If the MPC were to exclude the effect when setting policy, this would imply a de facto raising of the inflation target from 2% to 3%.

How the MPC interprets its remit may be as important for the interest rate outlook this year as the evolution of inflation and output. In effect, Governor King is advocating downgrading the “at all times” requirement while shifting to a “core” inflation operational target (i.e. a Canadian-style approach). This warrants wider debate, both within and outside the MPC.

The preliminary GDP estimate for the fourth quarter was disappointing, showing growth of only 0.1%, although there are grounds for expecting an upward revision. A key issue is whether supply-side weakness is contributing to the sluggish recovery – this implies a deterioration in the growth / inflation trade-off.

Key points:

• GDP was held back by a decline in North Sea production: gross value added excluding oil and gas rose by 0.2%.

• The preliminary estimate appears to incorporate an assumption of a fall in GDP in December after rises in September and November and a flat October. A monthly GDP proxy based on services and industrial output data was 0.2% above its third-quarter average in October / November combined – see chart. The assumed December decline is based on limited information and may be revised away. (The third-quarter preliminary estimate also incorporated a fall in the final month of the quarter, subsequently revised to an increase.)

• Quarterly growth of only 0.1% sits uneasily with labour market data. The last post drew attention to a significant rise in vacancies in the fourth quarter; in addition, aggregate hours worked in the economy grew by 0.7% in the three months to November from the previous three months. Barring a significant upward revision to GDP, this suggests a further fall in productivity last quarter: official figures show a 1.6% decline in economy-wide output per hour in the year to the third quarter. Poor productivity performance has contributed to the recent rise in inflation by pushing up unit labour costs despite slowing wage growth.

• The key policy variable for the MPC is not real but nominal GDP – a fourth-quarter nominal estimate will be published in a month’s time (26 February). In the third quarter, nominal GDP rose by 1.1%, or 4.5% annualised, even as real output contracted by 0.2%. Inflation indicators suggest another strong increase last quarter despite a disappointingly small recovery in real activity.

As foreshadowed in a post two weeks ago, December inflation numbers again surprised unfavourably, with the headline CPI rate jumping to 2.9% from 1.9% in November. This confirms the earlier forecast of a rise above 3% in early 2010, necessitating a sixth explanatory letter from Bank of England Governor Mervyn King to the Chancellor.

The previously-targeted inflation measure, the RPI excluding mortgage interest payments (RPIX), rose to 3.8% last month – this would already have triggered a letter under former rules, requiring explanation of a deviation of more than one percentage point from 2.5%.

The annual rate of change figures for last month are the first since November 2008 not to be distorted by the December 2008 VAT cut. They show headline CPI inflation far above the 2% target, with the bulk of the deviation due to “core” trends – the CPI excluding energy, food, alcohol and tobacco rose an annual 2.8% last month. The Bank of England’s forecasts in early 2009 implied that core inflation would by now have fallen beneath 1% under the influence of the mythical “output gap”. The impact of economic slack on price trends, however, has been swamped by pass-through of higher import costs due to the 27% fall in the effective exchange rate between July 2007 and March 2009 – a plunge actively promoted by Bank policy-makers.

The November Inflation Report predicted that CPI inflation would average 2.7% in the first quarter of 2010; this forecast will need to be raised significantly in the forthcoming February Report. On the conservative assumption that December’s unfavourable surprise partly reflected firms adjusting prices in advance of the return of the standard VAT rate to 17.5% in January, CPI inflation may rise to 3.4% in January before falling back in February and March, averaging 3.2% for the quarter.

The pick-up in RPI inflation is proving even sharper than forecast last summer, partly because house prices have recovered more strongly than assumed. From 2.8% in December, the headline rate may reach 4-5% this spring. Historically, rising RPI inflation has had a negative impact on the poll position of the governing party – see previous post.

Governor King will be able to explain the January move in CPI inflation above 3% as the result of the VAT reversal. The persistent and significant divergence of core inflation from the 2% target, however, is more troubling and casts doubt on the sustainability of the current policy stance.

In the November Inflation Report, the two-year-ahead modal CPI inflation forecast based on an unchanged Bank rate and £200 billion of asset purchases was 2.35% – the furthest above target in the MPC’s history. The Bank argued that it was justified in setting policy “too loose” for the medium term because inflation would fall significantly below 2% in the interim. Such an undershoot is now unlikely, implying that the MPC must advance its timetable for tightening if a destabilising rise in inflationary expectations is to be avoided.

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COMMENT:
AUTHOR: Andrew Oxlade
EMAIL: editor@thisismoney.co.uk
IP: 195.234.243.2
URL: http://www.thisismoney.co.uk
DATE: 01/20/2010 10:49:08 AM

Hi Simon,
Love the commentary. So do you still believe rates will rise in March?

Thanks
Andrew
Editor
Thisismoney.co.uk

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COMMENT:
AUTHOR: Simon Ward
DATE: 01/25/2010 12:47:37 PM

I still expect rates to start rising in the spring as inflation, growth and housing market data continue to surprise on the upside. The MPC-ometer discussed in previous posts indicated that March was possible, depending on data flow – will update soon (after tomorrow’s GDP report).

The preliminary fourth-quarter GDP estimate published on Tuesday will be an important influence on near-term MPC decision-making. The surprise fall in third-quarter GDP (of 0.4% according to the preliminary estimate, subsequently revised to 0.2%) was probably the swing factor in the November decision to expand asset purchases by a further £25 billion.

Available output evidence is consistent with a GDP rise of 0.4-0.5% last quarter. A weighted average of industrial and services production was 0.25% above its third-quarter level in October. Industrial output rose a further 0.4% in November, while business surveys suggest that services activity strengthened into quarter-end.

Labour market trends hint at an upside surprise. The chart shows a scatter plot of quarterly changes in GDP (vertical axis) and job vacancies (horizontal). The rise in vacancies last quarter was the largest since the third quarter of 2007 and – based on the estimated trendline – is consistent with a GDP increase of 0.85% (red square on line).

The Bank of England’s favoured broad money measure – M4 excluding money holdings of “intermediate other financial corporations” (i.e. companies classified as non-banks that act as a conduit for interbank business) – contracted by 0.7% in October following a 0.8% September decline. This suggests a serious monetary deficiency that threatens to abort an economic recovery.

On closer examination, however, these falls are entirely explained by a large drop in M4 held by other financial corporations (OFCs) not classified as “intermediate”. By contrast, the combined money holdings of households and non-financial corporations – i.e. M4 excluding all OFCs – rose by 0.3% and 0.2% respectively in September and October, with annual growth reaching an eight-month high of 2.9%. This suggests that liquidity created by official gilt-buying is filtering down to “end-users” responsible for spending decisions.

The large fall in money holdings of “non-intermediate” OFCs, moreover, appears to be an artefact of the Bank of England’s seasonal adjustment procedure. This grouping includes insurance companies and pension funds, investment and unit trusts, other fund managers and securities dealers. M4 holdings contracted by a seasonally-adjusted £29 billion, or 9%, in September and October (see Bankstats table A2.2.3, T6, column 4). Yet non-seasonally-adjusted figures show a decline of only £5 billion (derived by summing changes for the listed industries in table C1.1, T95-96). The £24 billion discrepancy accounts for the entire decline in M4 excluding intermediate OFCs in September and October.

An alternative approach is to use the non-seasonally-adjusted money holdings of “non-intermediate” OFCs when calculating the M4 measure. This is defensible on two grounds: it is unclear why these holdings should exhibit a seasonal pattern and there is insufficient history to estimate reliable monthly seasonal factors. On this basis, M4 excluding intermediate OFCs rose by 0.3% in October after a 0.2% September drop. While still weak, this is probably consistent with economic growth since the demand to hold broad money has been depressed by low deposit rates and reviving risk appetite.

Other features of the October monetary data support optimism about economic prospects. Narrow money M1 has accelerated strongly, rising at a 16% annualised rate over the last three months – see chart. Meanwhile, there were further rises in October in the corporate liquidity ratio (i.e. non-financial companies’ sterling and foreign currency money holdings divided by their bank borrowing) and mortgage approvals for house purchase, to their highest levels since September 2007 and March 2008 respectively. 

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COMMENT:
AUTHOR: Giles
EMAIL: gileswilkes@googlemail.com
IP: 217.34.50.8
URL: http://www.freethinkingeconomist.com
DATE: 01/11/2010 11:09:24 AM

This is a very late question, so I would not be at all surprised if it went unanswered.

But given how M4 is created whenever there is a loan, how is it possible for the M4 lending/M4 ratio to be substantially above 1?

I can understand how it can for the corporate sector: i.e. Company A gets a $100 loan from Bank B to invest. It spends $50 of the deposit created on an asset from non-corporate private sector. The seller of the asset acquires $50. M4 is still $100; corporate liquidity ratio is 0.5; non-corporate private sector now has $50 more. If that $50 does not return to the corporate sector, for some reason, then corporate liquidity suffers.

Is this an accurate description of how corporate liquidity can fall?

many thanks

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COMMENT:
AUTHOR: Simon Ward
DATE: 01/18/2010 02:55:47 PM

Every loan creates an equivalent liability on the other side of the balance sheet but this will not necessarily be an M4 deposit. For example, if the company taking out the loan buys inputs from a foreign firm the cash may show up as a foreign deposit, not included in M4. Or, in your example, the seller of the asset may use the proceeds to buy newly-issued bank equity – this purchase would reduce M4 and thereby cancel out the increase due to the loan. M4 lending is higher than M4 currently because UK banks relied partly on foreign borrowing to fund the domestic credit boom of the last decade.

Since its buying programme began in March, the Bank of England has swallowed up more gilts than the Debt Management Office (DMO) has issued. So which sector of the market has reduced its holdings?

The table, derived from Bank of England and DMO data, shows issuance and transactions by sector between March and October, with the prior eight months included for comparison. The Bank’s buying exceeded DMO net sales by £26 billion in the latest eight months. The counterpart was a £24 billion decline in holdings of the “non-bank private sector”. The combined holdings of overseas investors, banks and building societies were little changed.

The non-bank private sector comprises households, non-financial companies, insurance companies and pension funds, and other financial institutions. A monthly breakdown is not available but quarterly figures show that insurers and pension funds bought £12 billion of gilts between April and September, non-financial corporate holdings were little changed while households and other financial institutions sold £6 billion and £35 billion respectively.

The other financial category includes unit and investment trusts, other fund managers, including hedge funds, and securities dealers. Limited further information is available but the recent sales are likely to have been dominated by hedge funds and dealers.

These other financial firms have successfully traded the gilt market in recent years. They were heavy buyers before and during the financial crisis, boosting their holdings from £45 billion at the start of 2006 to £137 billion by the end of 2008. The 10-year benchmark yield averaged 4.7% over this period.

They started to unload their position in the first quarter of 2009 as the Bank began buying. Sales accelerated during the second and third quarters, when the 10-year yield averaged 3.7%. Their holdings had fallen to £96 billion by the end of September.

Gilt market optimists argue that the ending of the Bank’s buying programme will be offset by stepped-up demand from insurance companies, pension funds and banks. Inflows to insurers and pension funds, however, have been weak while their liquidity ratio has fallen significantly – see chart. Banks’ need to increase their holdings of liquid assets, meanwhile, has been satisfied recently by a rise in their reserve balances at the Bank of England – see memo line in table.

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COMMENT:
AUTHOR: Peter Norman
EMAIL: peter@gendan.co.uk
IP: 86.128.180.98
URL:
DATE: 01/13/2010 05:13:13 PM

Simon, it seems to me that the BoE and DMO have rigged the gilt market for the last 10 months through the QE scheme. Even though the Maastricht Treaty forbids signed-up governments financing their debt by printing money, GoBro has worked around the law by backdoor trickery. The apparent “new issues” of £200bn gilt, meant to cover government deficit, went nowhere. All this money is now in the economy in the form of cash and reserve balances – the same result as a blatant money printing policy akin to Mugabe’s Zimbabwe. I’d say there’s no way the BoE can unload their gilt stockpile back to the market in the next 10, maybe 20 years. The MPC and BoE are intent on sucking in some of this money over-supply by issuing BoE bills (more commissions for the boys in braces!). Money Supply drifts further into uncharted waters.
After a year with no genuine buyers in the gilt market, next month the DMO has to find some, and at record levels (£200bn plus a year). Those who dumped their gilt holdings last year should soon be able to buy them back with a profit.

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COMMENT:
AUTHOR: Simon Ward
DATE: 01/18/2010 01:16:06 PM

The first £125 billion of QE was justified on the basis that "money printing" was needed to offset "money destruction" caused by contracting bank balance sheets. With the banking system clearly stabilised by last summer, however, the further QE expansions announced in August and November were questionable and, by keeping gilt yields comfortably low, may have contributed to the government’s decision to postpone fiscal tightening. Sales of bills by the Bank of England do not reverse QE – in particular, they have no contractionary impact on the M4 money supply. Bills will be auctioned so there will be no commission windfall.

A post last May suggested that house prices were bottoming, in contrast to consensus expectations at the time of a further 10-15% decline. This proved insufficiently upbeat. The Halifax index had already troughed in April and rose by 9%, or 14% annualised, over the subsequent eight months to December. The Nationwide index was also 9% above its low by December.
 
The first chart compares the quarterly evolution of real house prices since the peak in the third quarter of 2007 with their development after three prior major tops, in 1973, 1979 and 1989. (The comparison is based on the Nationwide measure, which has a longer history than the Halifax, deflated by the retail prices index.) Up to the first quarter of last year, the fall in real prices was closely tracking the major declines of 1973-77 and 1989-96. This suggested a further loss of 15-22% – roughly consistent, given inflation, with the consensus forecast for nominal prices.
 
After the first quarter, however, real prices moved sharply higher to converge with the less severe 1979-82 decline.
 
What explains the sudden shift from early 2009? The cut in Bank rate from 5.0% in September 2008 to 0.5% in March 2009 led to a steep drop in mortgage interest bills, reducing delinquencies and forced selling. Household interest payments fell from 10.5% of disposable income in the third quarter of 2008 to 6.9% a year later. This is close to the historical low (since 1987) of 6.7% in the first quarter of 2002.
 
Perhaps the decision to embark on quantitative easing in February 2009 also contributed to the shift. This may have boosted longer-term inflationary expectations, thereby increasing the attraction of housing as a store of real value relative to other assets, particularly cash savings.
 
If real house prices were to continue to follow their path after 1979, they would rise by 4% in the year to the fourth quarter of 2010 and 7% in the subsequent year. Assuming retail price inflation of 3%, the cumulative nominal gain over the two years would be 18% – sufficient for the Nationwide measure to surpass its 2007 peak by late 2011.
 
Such a scenario would imply housing remaining expensive by historical standards. As argued in the previous post, the “national rental yield” is a better measure of valuation than the house price to earnings ratio. This yield ended 2009 at about 3.4% versus a long-term average of 3.6%, implying overvaluation of about 5% – see second chart. (The yield rose slightly during 2009, despite the recovery in house prices, because of rapid growth in the national accounts rents measure.)
 
Historically-high valuations, however, may prove sustainable as long as real interest rates remain low or – in the case of cash rates – negative. The gap between the rental yield and the real yield on long-term index-linked gilts is at a record high – second chart.
 
The housing market recovery would be at risk if the MPC were to restore a positive real level of official interest rates. The consensus view, however, is that Bank rate will remain below both current inflation and the 2% target throughout 2010.

First, the annual rate of change of G7 real money supply M1 remains far above that of industrial output. As detailed in a previous post, world equities have outperformed dollar cash by 11.1% per annum on average when this condition has been met. Real money growth, however, could cross below output expansion this spring – see first chart.

Secondly, the US monetary base, having fallen in late 2009, is rebounding – second chart. A Wall Street Journal article last year by Andy Kessler argued that changes in the Fed’s liquidity policy, reflected in the monetary base, were driving equities and other markets. The decline from late November was the result of a build-up of cash in the US Treasury’s “general account” at the Federal Reserve, partly due to repayments of TARP funds; this reduced banks’ reserves at the Fed. The Treasury, however, is now deploying this cash, reversing the impact: the general account balance rose from $13 billion on 25 November to $167 billion on 6 January but had fallen to $124 billion by 13 January.

Thirdly, US Treasury yields have fallen since the start of the year as investors have pushed back expectations for Fed tightening in the wake of last week’s December employment report. The two-year yield is down by about 25 basis points.

Fourthly, US retail interest in equities remains muted but could pick up as economic news continues to improve. Equity mutual funds suffered a further outflow in December and early January, in contrast to substantial – but slowing – buying of bonds.

Some commentary has claimed that this week’s Royal Institution of Chartered Surveyors (RICS) survey for December signals renewed housing market weakness. Hardly. The survey suggests a slowdown in price gains – unsurprising given a 14% annualised rise in the Halifax index over the last eight months – but a further increase in turnover.

True, the buyer enquiries index has fallen significantly from its peak in June last year. It remains, however, firmly in positive territory, consistent with further gains in mortgage approvals and transactions – see first chart. The new instructions index, meanwhile, has picked up recently but is still below buyer enquiries, suggesting that demand continues to outstrip supply.

Commentators have also interpreted the British Retail Consortium (BRC) December sales survey, showing a rise in annual sales growth from 4.1% to 6.0%, as evidence of a pick-up in consumer spending. The increase, however, may have been due to higher inflation rather than stronger volumes – the annual gain in the BRC’s shop price index accelerated from 0.2% to 2.2% in December.

Manufacturing output figures for November, released today, were disappointing, showing no increase from October. Relative to its pre-recession peak, however, UK output is at a similar level to France and higher than in Germany, Japan and Italy – second chart. In other words, the smaller recent recovery in the UK partly reflects a less severe prior decline.