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The recent recession and current revival in world industrial output bear a close resemblance to the deep 1974-75 contraction and subsequent recovery. This comparison suggests an ongoing economic upswing during 2010 but with growth momentum slowing as the year progresses.

A weighted average of industrial output in the Group of Seven (G7) major economies and seven large emerging economies (the “E7”) fell by 14% between February 2008 and February 2009 but had recovered by 7% by September – see earlier post for more details. The decline is similar to a 12% drop in G7 industrial output between May 1974 and May 1975 – the previous biggest post-war recession. It is reasonable to use G7 output as a proxy for world industrial activity in the 1970s, when emerging economies were much less significant.

Seven months after the May 1975 trough G7 industrial output had recovered by 5% versus the 7% rise in G7 plus E7 production between February and September this year. The first chart overlays the 1970s G7 path on current G7 plus E7 data, aligning troughs and rebasing the G7 series to equal G7 plus E7 output at the start of 2003. The comparison suggests that the recovery will be sustained during 2010 but  momentum will slow progressively from the spring into 2011. Output could regain its February 2008 peak level in October next year.

The downshift in momentum is clearer in rate of change data shown in the second chart. The implied slowdown in annual growth from a high to be reached in February 2010 is consistent with a recent peak and likely deceleration in G7 annual real narrow money supply expansion, which leads output by about six months – see previous post. Stock markets and other “risky” assets would probably anticipate slower economic growth later in 2010, suggesting a set-back early next year, although possibly after a significant further near-term gain. As the prior post explained, the liquidity backdrop may also turn less favourable for markets in early 2010.

Industrial output in the Group of Seven (G7) major economies recovered by 5% between March and September but was still down by 10% from a year before. G7 real money supply expansion, meanwhile, on narrow and broad measures is running at an annual 9% and 4% respectively – see first chart. The large gap between the rates of change of real money and output is a measure of the “excess” liquidity that has been pushing up stock markets, commodities and other “risky” assets.

On a six-month rather than annual basis, G7 output expansion has crossed above real money supply growth, implying that “excess” liquidity is no longer being created – second chart. The monetary backdrop for markets, therefore, is less favourable than in the spring but the huge money / output divergence of the prior six months should continue to buoy asset prices into early 2010. In other words, a “sell” signal awaits convergence of annual rather than six-month growth rates. Such a signal – annual output expansion rising above real money growth – occurred in 1987 and 1994, for example, and was associated with stock and bond market weakness respectively.

Real money growth – particularly narrow money M1 – leads output expansion by about six months. The annual rate of change of G7 real M1 reached a trough in August 2008 while the annual fall in industrial output bottomed in March 2009. Real M1 growth is likely to have peaked in September 2009, with a rise in headline inflation due to commodity price effects contributing to a significant slowdown into early 2010. This suggests that annual output expansion will reach a high next spring and fall back later in 2010.

G7 real broad money contracted in the six months to October. Previous posts have argued that this is unlikely to signal economic weakness because the demand for broad money has fallen in response to low interest rates and rising risk appetite. Put differently, broad money velocity is picking up after a plunge in late 2008 and early 2009. Real narrow money is a better guide to economic prospects – growth is slowing but remains solid by past standards, consistent with a moderation of output momentum within an ongoing economic recovery rather than a return to contraction later in 2010.

A big decline in pay growth since early 2008 is often cited as a reason for expecting lower inflation. This fall, however, largely reflects cuts in bonuses and working time rather than a slowdown in hourly wages.

The official average earnings index measures pay per worker and is separable into regular and bonus elements. The chart shows annual growth in total and regular earnings together with an adjusted regular pay measure taking into account changes in average weekly hours.

Headline earnings growth has fallen from an annual 4.0% in the first quarter of 2008 to 1.2% in the third quarter of this year with the bulk of the decline due to a slowdown in regular pay expansion from 3.8% to 1.8%. This latter reduction, in turn, mainly reflects a cut in average working time from 32.2 to 31.5 hours per week since last year’s first quarter.

Regular hourly pay growth, by contrast, has slowed only marginally, from an annual 3.5% in the first quarter of 2008 to 3.4% by this year’s third quarter.

Firms may base pricing decisions on trends in hourly pay rather than earnings per worker. This is because reductions in bonuses and working hours are usually associated with lower output so do not result in a fall in unit labour costs.

The limited response of hourly pay growth to labour market weakness may partly explain recent core inflation resilience, although this mainly reflects the impact of sterling depreciation and pass-through of global commodity price rises.

The relationship between the US monetary base – currency in circulation plus bank reserves at the Fed – and the performance of stock markets, commodities and other “risky” assets remains intact. The new high reached by the Dow Industrials last week followed a 9% surge in the base between the end of September and early November – see first chart.

The base contracted in the week to last Wednesday but this is unlikely to mark a change in trend. The Fed is scheduled to buy $500 billion of mortgage-backed and other agency securities by the end of the first quarter. This cash injection will be offset by a further decline in various forms of “emergency” lending, including term auction credit, discount window loans, commercial paper holdings and liquidity swaps with other central banks. These four items, however, currently sum to $172 billion – even in the unlikely event of the total falling to zero, the effect on reserves would be swamped by securities purchases.

The Fed could, in theory, sterilise the impact of its buying on the monetary base by conducting reverse repurchase agreements (repos), involving banks lending excess cash back to the central bank in return for securities. (The Bank of England has effectively sterilised the base effects of its asset purchases since August by cutting its short-term lending to the banking system.) Such an initiative, however, is unlikely before early 2010 and should be signalled in advance to reduce the risk of a large negative market reaction.

Expectations that US liquidity supply will remain ample at least until year-end have been reflected in further capital outflows from the US to Asia in particular. Currency board arrangements in Hong Kong result in a direct impact on the monetary base, which has climbed by 16% since the end of September, providing strong support for the local stock market and Hong-Kong-listed Chinese “H” shares – second chart.

Global industrial output has already recovered half of its loss during the recession. If the rebound were to continue at its recent pace, output would regain its prior peak level by May 2010 – far earlier than expected by the consensus but consistent with the “Zarnowitz rule” that “deep recessions are almost always followed by steep recoveries”.

The top line in the first chart shows an index of combined industrial output in the Group of Seven (G7) major economies and seven large emerging economies (henceforth the “E7”) – Brazil, Russia, India and China plus Mexico, South Korea and Taiwan. A smoothed path is also plotted, based on fitting log-linear trends to the separate G7 and E7 data since 2000. This path implies a current trend growth rate of global output of 3.5% per annum.

The global output measure peaked in February 2008 and fell by 14% to a trough in February 2009. It had recovered by 7% by September 2009, equivalent to an annualised increase of 13%. If this growth rate were to be sustained, output would regain its 2008 peak level in May 2010 and cross above its trend path in June.

The lower lines show the contributions of G7 and E7 output to the global total, together with associated trends. The outsized impact of emerging economies on global trend growth is immediately apparent. The curvatures of the trends imply annualised output increases of 8.1% in the E7 but only 0.4% in the G7. Put differently, the E7 account for 3.2 percentage points of current global trend growth of 3.5% per annum. If the recent growth differential were to persist, E7 output would surpass that of the G7 by 2014.

In addition to dominating the longer-term trend, emerging economies have been responsible for 5 percentage points of the 7% recovery in global output since the February 2009 trough. E7 output has already moved ahead of its prior peak and is only marginally below its fast-rising trend. If growth were to continue at its recent pace – plausible given current policy settings and functioning banking systems – emerging economies would overheat in the second half of 2010 and 2011.

The recovery in G7 activity, while less dramatic, has still been significantly stronger than forecast by most economists in early 2009. Output fell by 20% between February 2008 and March 2009 but had recovered by 5% by September. Short-term leading indicators signal a further solid gain in late 2009 – second chart.

G7 central bankers argue that their super-loose monetary policies are warranted by domestic “output gaps” that will exert strong downward pressure on prices. These gaps, however, may be smaller and closing more rapidly than they think. The deviation of G7 industrial output from trend has already narrowed from 14% to 10%.

Policy-makers, moreover, are ignoring inflationary risks from emerging-world buoyancy. Continued above-trend E7 output growth is likely to result in further gains in global commodity prices – third chart. If emerging economies overheat, labour cost and margin elements of prices of exports to the G7 will also increase. If E7 central banks tighten to prevent overheating while G7 policies remain lax, currencies should appreciate, with the same result of higher G7 import prices.

This week’s UK Inflation Report contained no discussion of such possibilities. The Bank’s view – reflected in Governor King’s five explanatory letters over 2007-09 – seems to be that any inflation overshoot due to external factors represents an exogenous “shock” that should not affect policy settings based on “output gapology”. Given the above-described global trends, this stance implies that actual inflation is much more likely to exceed than fall below the target – as it has in all but three quarters over the last four years.

Global economic activity has rebounded more strongly than most commentators expected over the last six months. A post last week suggested that this recovery would soon be reflected in a significant improvement in labour market indicators.

The US Conference Board this week reported that its employment trends index – a composite of eight labour market leading indicators – rose for the second consecutive month in October. In the last five US recessions the index bottomed between one and four months before non-farm payroll employment. With its recent low reached in August, this suggests a trough in payrolls by December.

The first chart shows the three-month change in payrolls together with an alternative labour market gauge based on three indicators excluded from the Conference Board measure – the ISM manufacturing employment index, the monthly tally of job-cut announcements by Challenger, Gray and Christmas, and the NFIB small firm hiring plans index. This also suggests an imminent employment trough.

In the UK, promising indicators include the strong Markit / REC job placements index highlighted in last week’s post and a further reduction in the net percentage of households expecting higher unemployment in the EU Commission consumer survey – see second chart.

Improving labour market indicators will boost confidence in the sustainability of the economic recovery while calling into question current super-loose monetary policies. In other words, better news for Main Street in early 2010 will represent the first real test of the liquidity-driven rally in markets.

The central projection in the November Inflation Report implies that current monetary policy is the loosest – in terms of calibration to achieve the inflation target over the medium term – in the 12-year history of the Monetary Policy Committee. The forecast casts further doubt on last week’s decision to expand asset purchases by another £25 billion to £200 billion.

In the August Report, the MPC projected that inflation would be 2.17% and rising in two years’ time based on unchanged interest rates and £175 billion of asset-buying. A key issue in the run-up to last week’s meeting was how the Committee could justify further easing against the background of this forecast.

Today’s Report provides the answer: the forecast was ignored. The new two-year-ahead projection based on unchanged policy is about 2.3% (estimated from the fan chart). The increase from August is partly due to rolling the forecast forward one quarter but also reflects an upgrade to GDP prospects based on the lower level of the exchange rate and stronger global demand, as well as the further expansion of asset purchases.

At 30 basis points, the positive deviation of the two-year-ahead central forecast from the target is the most since the MPC’s inception in 1997 – see chart. The previous largest excess, of 27 basis points, occurred in the May 2004 Report. The MPC raised interest rates in May, June and August 2004.

The MPC’s remit is to set policy to achieve the inflation target “at all times”. It might be justified to ignore two-year-ahead prospects if inflation were forecast to be persistently below target before or after two years. This, however, is not the case: the central projection is above 2% during the first half of 2010, below 2% between mid 2010 and mid 2011, and above 2% from the second half of 2011.

Another possible defence of current policy settings is that inflation risks are weighted to the downside. The Report, however, states that risks are balanced at the two-year horizon and an inspection of the fan chart does not suggest a significant downward skew to shorter-term forecasts.

The inconsistency between its forecast and last week’s further easing poses a risk to the MPC’s credibility. Markets, for example, may worry that the Committee is retreating from a pure focus on the inflation target, or placing more weight on avoiding an undershoot than an overshoot, although this would be in conflict with its remit.

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COMMENT:
AUTHOR: Econoclast
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DATE: 11/12/2009 08:12:04 AM

I agree with your argument and also believe this could start to undermine the Bank’s credibility. But I think there are three explanations for what it’s doing:

1. Given the uncertainty about where we are and the forecasts for 2010, an additional chunk of QE is ‘insurance’ against downside risks that – if realized – would be more intractable than upside risks.

2. I don’t buy the ‘hyperinflation’ argument, but might the Bank be aiming to create a little unexpected inflation, which together with a weaker pound, will help to erode debt burdens?

3. Perhaps the Bank knows that there is one obvious downside risk to its forecasts that it can’t talk about – fiscal tightening. For monetary policymakers, it makes sense to anticipate this and we have to hope that fiscal policymakers get on with it before markets question their credibility more openly.

The monetary approach to economics argues that “excess”money – the difference between the supply of money and the demand to hold it – is a key influence on spending and financial investment decisions. Assuming that the (unobservable) demand for money is stable, shifts in “excess” money will reflect changes in money supply growth.

Money demand, however, has been unstable in 2008 and 2009. The financial crisis led to an increase in liquidity preference as investors scrambled to sell “risky” assets. More recently, desired cash levels have fallen in response to low interest rates and reviving markets. Strong inflows to US and UK equity and bond mutual funds are one sign of reduced money demand.

The chart shows six-month growth in US broad money M2 together with a six-month running total of flows into or out of US funds, expressed as a percentage of M2. A strong inverse relationship is apparent since the start of 2008. The recent monetary slowdown and pick-up in fund inflows is the mirror-image of late 2008, when a surge in M2 accompanied record outflows.

The implication is that buoyant M2 growth in late 2008 overstated support for the economy and markets from “excess” money because the demand for cash was temporarily elevated by a flight from “risky” assets. Conversely, recent M2 weakness may not imply “deficient” money because liquidity preference has fallen back.

Rather than M2 itself, the sum of money growth and mutual fund flows – the third line in the chart – may provide a better guide to shifts in “excess” money. This indicator has performed well recently: it weakened sharply from mid 2008, warning of a deepening recession, but recovered late last year and in early 2009, foreshadowing the revival in markets and the economy.

Some monetarist economists claim that recent M2 stagnation signals renewed economic weakness in 2010. The indicator incorporating mutual fund flows, however, remains at a healthy level, suggesting monetary underpinnings for an ongoing recovery. This message is supported by more upbeat narrow money trends – see previous post.

Producer price figures for October raise further concerns about inflation prospects. “Core” output prices – i.e. excluding food, beverages, petroleum and tobacco – rose by 0.3% on the month following a 0.5% September gain, pushing annual growth to a six-month high of 2.0%.

Recent solid monthly increases are unusual for this time of year. The chart shows annual growth together with a three-month rate of change based on an attempt to adjust the raw numbers for seasonal variation. This latter series has surged to an annualised 7% – the highest since July last year.

This pick-up conflicts with the official and consensus view that large-scale excess capacity will pull core inflation lower, offsetting upward pressure from the weak exchange rate, rising commodity input costs and supply-chain disruptions due to insufficient working capital. Companies may be attempting to push through faster price increases under cover of the further fall in the pound since the summer and the coming hike in VAT.

The Monetary Policy Committee has delivered a minimal further easing of policy by raising its gilt-buying programme by £25 billion to £200 billion. The additional purchases will be spread over three months, implying a slowdown to half the recent pace, and no additional authority beyond £200 billion has been requested. The message seems to be that this will be the final slug barring an economic shock. The statement contained no reference to any change in current arrangements for paying interest on bank reserves.

Today’s decision is questionable in two respects. First, an additional £25 billion of buying spread over three months will have minimal effects relative to a policy of suspending purchases now. If the MPC really believes that further stimulus is required, the debate should have been between £50 billion and £75 billion, as it was in August.

Secondly, the suggestion that additional buying is warranted by the MPC’s updated inflation projection lacks credibility. In August, it forecast that inflation would be above 2% and rising in two years’ time. Since then, inflation outturns have been higher than expected, sterling has weakened and commodity prices have strengthened. By lowering its projection, the MPC appears to be placing even more weight on a simplistic “output gap” inflation model, despite its recent forecasting failure.