Blog

The recent slide in sterling began on the day the Bank of England announced a £50 billion expansion of its quantitative easing programme. The timing is unlikely to be coincidental. The Bank’s gilt-buying may be creating excess liquidity in the economy, helping to explain surging asset prices as well as the fall in the pound.

The suggestion that monetary conditions are over-expansionary is controversial since broad money supply trends remain sluggish, with the Bank’s favoured measure growing at an annualised rate of only 4% so far in 2009. The impact, however, of supply trends on markets and the wider economy depends on the velocity of circulation of money. Having plunged in 2008 and early 2009, velocity may now be recovering.

Velocity is inversely related to the demand to hold money. A flight from markets as the financial crisis snowballed from late 2007 led to a big increase in money demand but this move is reversing as confidence returns and investors become disenchanted with record-low deposit rates. Despite weak supply growth, therefore, households, firms and institutions may be holding more money than they desire. Their efforts to remove the excess involve an increase in investment in markets and spending in the economy.

The current monetary backdrop echoes conditions between late 2005 and mid 2007 but excess liquidity was then the result of buoyant money supply expansion rather than weak demand. Excess money magnified the credit bubble while causing strong economic growth and, later, a significant inflation overshoot.

This inflationary process, however, was short-circuited when the bubble burst in late 2007. With banks curtailing credit expansion, the money supply slowed sharply while money demand boomed as investors fled risk assets. Excess liquidity in early 2007 was replaced a year later by a deficiency of supply relative to demand. This shortage exacerbated market and economic weakness as households and firms sought to boost cash levels by liquidating investments and cutting spending.

Official support for the banking system and the Bank’s gilt-buying have succeeded in stabilising money supply growth this year while money demand has eased, initially in response to interest rate cuts and more recently as confidence and risk appetite have revived. Several recent developments support the view that excess liquidity is now present.

First, households and companies have been shifting funds out of savings accounts into currency and accounts used for transactions purposes – a typical precursor of increased financial investment or spending. A narrow money measure comprising notes and interest-free current accounts has surged at an annualised rate of 46% so far in 2009.

Another sign of reduced money demand is the strong pick-up in mutual fund inflows, with retail sales of unit trusts and OEICs on course to surpass the 2000 record this year. Institutions have also been putting cash to work, with purchases of securities back up to 2007 levels in the spring quarter.

The deployment of funds by investors has allowed non-financial companies to issue bonds and shares in record amounts, using the proceeds partly to pay down more expensive bank debt. Their liquidity ratio – UK bank deposits divided by loans – has recovered to pre-recession levels, supporting hopes of a revival in business spending.

Higher-than-anticipated cash levels may partly explain markedly more optimistic consumer and business surveys. Consumer confidence has risen by much more in the UK than other major economies, supporting a linkage with the Bank’s unusually aggressive easing.

Finally, while asset prices are influenced by other factors, the strength and breadth of gains are consistent with monetary laxity. In addition to the fall in the pound, recent outperformance of gilts and UK property suggests looser conditions than in other economies.

What are the policy implications? If excess liquidity is present the economy is likely to recover faster than the Bank expects while inflation may continue to overshoot its forecasts, partly owing to renewed sterling weakness. This argues strongly against further easing and suggests that some withdrawal of monetary stimulus may be needed early in 2010 to keep the Bank’s projection for inflation in two years’ time in line with the 2% target.

Calls for a further extension of gilt-buying in November based on weak broad money trends are misguided. It would be unfortunate if officials, having ignored the monetary dimension while the bubble inflated, now place overreliance on broad money numbers when a range of other evidence indicates loose policy. A further monetary boost would risk creating another boom-bust in asset prices and the economy. With sterling already on the ropes, it could also precipitate a full-scale currency crisis.

Purchasing managers’ surveys for September were encouraging, with further gains in services output and new business offsetting slippage in the corresponding manufacturing indices. A weighted average of services new business and manufacturing new orders is only slightly below its long-term average, supporting hopes of GDP growth of 2% annualised or more during the second half – see first chart. (The rise in the PMI indicator had been foreshadowed by recent better corporate earnings news – see previous post.)

The suggestion that the recovery is being led by services rather than manufacturing – in contrast to widespread expectations of “rebalancing” to be induced by a plunging exchange rate – is supported by the CBI’s quarterly surveys of financial services, business and consumer services and manufacturing. The balance of manufacturing firms expressing greater optimism has recovered to the middle of its historical range but the corresponding balances in the two services surveys are at multi-year highs – second chart.

The six biggest bear markets in the Dow Jones industrial average in the 100 years before the October 2007-March 2009 decline were 1973-74, 1937-42, 1929-32, 1919-21, 1909-14 and 1906-07. The 1929-32 fall was by far the largest at 89% while the other five ranged between 45% and 52%. The 2007-09 bear involved a 54% slump. (For reference, the Dow decline over 2000-03 was “only” 38%.)

The chart compares the 2007-09 decline and subsequent recovery with the four peacetime bears, i.e. excluding the 1909-14 and 1937-42 falls, which were influenced in their later stages by the world wars. The peak levels of the Dow were rebased to 100 and the earlier cycles aligned with the October 2007 top.

At the March 2009 low the Dow was much weaker than at the equivalent stage of the 1906-07, 1919-21 and 1973-74 bear markets and was tracking the 1929-32 decline. The recent recovery, however, has moved the index above the four prior cycles.

The 1906-07, 1919-21 and 1973-74 bears were comparable in terms of magnitude and duration and the subsequent recoveries were also broadly similar. A repeat performance in the current cycle would involve the Dow rising to within 5-15% of its October 2007 peak by the end of 2010, implying an index level of 12000-13500.

Some pessimistic commentators draw a comparison between the recent recovery and the failed rally of November 1929-April 1930 – see the rise in the bottom, black line between late 2007 and mid 2008. The Dow climbed 48% versus a recent trough-to-peak increase of 50% before embarking on a further devastating decline.

Even ignoring policy differences, the comparison is dubious because the 1929-30 failed rally began only two months into the bear market and three months into the recession, before the full consequences of the bursting of the prior credit bubble were apparent. The March 2009 bottom, by contrast, followed a long economic and market decline and was characterised by very weak investor expectations.

—–
COMMENT:
AUTHOR: kagiso
EMAIL:
IP: 94.196.245.152
URL:
DATE: 10/02/2009 11:14:45 PM

Mmmm, including the ’73 data without adjusting for inflation doesn’t meet your usual impeccable standards. Deflating puts the current peak at 2000 rather than 2007 and the ’73 peak was actually back in ’66. Although real prices in 1982 were above 1973 the real increase from ’73 to ’82 was derisory. This secular bear market is still very young.

Recent posts have argued that the consensus is misreading the monetary data and underestimating the degree of stimulus to asset markets and the wider economy from the current policy stance. News this week supports the view that economic performance and prospects are improving significantly.

First, a monthly GDP estimate based on services and industrial output data rose by 0.1% in July after a 0.3% June gain, to stand 0.2% above its second-quarter average – see first chart. With business surveys suggesting a further recovery and upward revisions possible, GDP may have grown by as much as 0.5% in the current quarter (preliminary figures will be released on 23 October).

Secondly, the EU Commission measure of consumer confidence vaulted higher in September and is now only marginally below its long-term average. UK confidence has recovered much more strongly than in other major economies – second chart. In addition to becoming more optimistic about the economy and their own finances, households are signalling reduced concern about labour market weakness, suggesting that unemployment could peak earlier than many expect.

Thirdly, the number of upgrades to company earnings forecasts by equity analysts is exceeding downgrades by a widening margin, which is usually a sign of rising economic momentum. The “revisions ratio” (i.e. net upgrades divided by the total number of earnings estimates) correlates with business surveys and suggests further improvement in forthcoming purchasing managers’ indices – third chart.

UK broad money growth remained sluggish in August but narrow money posted another strong gain, corporate liquidity continues to improve and mortgage lending is recovering. These developments suggest that the broad money numbers understate monetary support for the economy, i.e. the velocity of circulation may now be rising.

1. M4 excluding “intermediate other financial corporations” rose by 0.2% in August, down from 0.4% in July, with the decline probably due to smaller Bank of England gilt purchases (£12 billion versus £23 billion). Incorporating downward revisions to earlier numbers, broad money grew by 4.0% annualised in the first eight months of the year.

2. By contrast, “non-interest-bearing M1” – comprising cash and interest-free current accounts – rose by 1.8% in August, giving a year-to-date annualised gain of 46%. As discussed in recent posts, narrow money strength relative to broad money is often an indicator of a pick-up in velocity. (Note: non-interest-bearing M1 includes only current accounts with no advertised interest rate, i.e. it is not distorted by the rate on some accounts being cut to zero.)

3. Private non-financial corporations’ cash and deposits rose last month, with a small fall in their M4 holdings offset by a rise in foreign currency assets. With bank borrowing little changed, a foreign-currency-inclusive measure of the liquidity ratio rose further to its highest level since October 2007 – see first chart.

4. M4 lending excluding intermediate OFCs slumped by 0.5% last month but this was entirely due to financial corporations, whose borrowings are often volatile. Lending to households and private non-financial corporations rose by 0.1%.

5. Net mortgage lending recovered to £1.0 billion in August while the value of mortgage approvals for house purchase reached its highest level since April 2008. The number of approvals, however, was marginally lower than in July, indicating that the lending pick-up is weighted towards higher-value homes – second chart. Net lending remains on course to recover to about £2 billion over coming months – see earlier post.

While the primary cause appears to be relatively loose UK monetary conditions, sterling’s recent slide was given an additional fillip last week by comments by Bank of England Governor Mervyn King again welcoming a weaker pound. This extends a previously-documented pattern of the Governor’s public utterances coinciding with currency depreciation.

Since August 2008, Mr King has presented at five Inflation Report press conferences and given four set-piece speeches. A strategy of shorting the effective index at the close before each appearance and covering the position 24 hours later would have been profitable on all nine occasions. Assuming no gearing, the strategy would have returned a cumulative 11.9% over nine trading days – an annualised gain of more than 2000%.

The benefits of sterling depreciation were questioned in a post last December, which suggested that the inflation cost would be greater than assumed by the MPC and the consensus; this appears to have been borne out by disappointing CPI outturns this year. Official remarks are unlikely to have any lasting effect on currency movements but it is nonetheless surprising that Mr King continues to sing the praises of a slumping pound.

Further evidence of a fall in the demand to hold money is provided by Investment Management Association figures showing £2.2 billion of net retail sales of unit trusts and OEICs in August, a record for the month – see chart. Sales remain on course to reach £24 billion in 2009, above the 2000 peak of £18 billion and up from just £4 billion last year.

As previously explained, if this year’s increase is a reflection of reduced money demand, broad money numbers will understate the growth in cash available to support a recovery in the economy and markets by about £20 billion, equivalent to 1.3% of M4 excluding “intermediate other financial corporations”.

Sales of bond and equity funds were similar in August, at £742 million and £696 million respectively, while property inflows continued their recent revival, reaching £129 million – the highest since June 2007.

The April Budget signalled substantial fiscal tightening starting from next year, with cyclically-adjusted public sector net borrowing projected to fall from a peak of 9.8% of GDP in 2009-10 to 4.5% by 2013-14. The current political debate is less about the scale of adjustment required than how it will be achieved.

It is widely assumed that a deficit cut of this size will act as a major growth depressant. Comparable tightening in the mid 1990s, however, was associated with robust economic expansion. Cyclically-adjusted net borrowing fell from 5.4% of GDP in 1993-94 to 0.6% four years later, a decline only slightly smaller than the 5.3 percentage point projected reduction between 2009-10 and 2013-14. Yet GDP growth averaged 3.2% a year between 1994 and 1998 – see chart.

The lesson of the 1990s is that major fiscal tightening need not derail economic expansion providing it can be phased over several years. The risk is that markets will deny policy-makers the luxury of a slow pace of adjustment – a gilt-buyers’ strike could push yields sharply higher and force action to be accelerated, with larger negative economic consequences.

Such a scenario could develop but there is currently little sign of any funding constraint. The bond market vigilantes were run out of town years ago, to be replaced by pension fund actuaries and compliant central bankers.

—–
COMMENT:
AUTHOR: Neil Prothero
EMAIL:
IP: 194.129.61.10
URL:
DATE: 09/25/2009 11:03:54 AM

Excellent blog Simon.
You state that "Comparable tightening in the mid 1990s was associated with robust economic expansion". This was certainly true, but my concern with regard to the impact of major fiscal tigthening in the coming years is that current economic conditions are far different from those in the last decade, when strong export growth helped to offset weaker domestic demand. The world is now emerging — in a highly unconvincing manner, in my view — from a severe "global" recession with significantly impaired financial markets. Where is the external demand going to come from to offset the fragile growth conditions at home? The US? Euro area? This seems highly unlikely given the economic problems both face. Some support will obviously come from Asia, helped by weaker sterling, but this will hardly be sufficient on its own to drive a robust or sustainable economic expansion.

(Apologies for the delay in publishing this comment – Ed)

Sterling’s effective rate index reached a nine-month high on 5 August, the day before the Bank of England’s announcement of a £50 billion expansion of its quantitative easing programme. It had fallen by 6.9% by last night’s close, with a further move lower this morning. The timing is unlikely to be coincidental. The Bank’s gilt-buying may be creating excess liquidity in the economy, helping to explain surging equity and prime property prices as well as the fall in the pound.

The suggestion that monetary conditions are over-expansionary may appear strange given recent sluggish growth in the Bank’s favoured broad money measure – 5% annualised between January and July. However, the velocity of circulation of money is probably rising in response to record low interest rates and reviving risk appetite so the current rate of expansion may be more than sufficient to support an economic recovery, implying an excess available to push up asset values, including the sterling price of foreign currencies.

A recovery in velocity is suggested by a recent shift of funds out of savings accounts into cash and accounts used for transaction purposes: “non-interest-bearing M1” – comprising cash and interest-free current accounts – rose by 46% annualised between January and July. Strong retail buying of unit trusts and OEICs is also consistent with a reduced demand to hold money – see earlier post.

Though the figures relate to the second quarter, today’s National Statistics release on institutional investment flows provides evidence that some of the liquidity created by the Bank’s gilt-buying is flowing overseas. Insurance companies, pension funds and trusts bought £13 billion of foreign shares and bonds last quarter – the highest since the third quarter of 2007.

With the economy recovering and inflation continuing to overshoot the Bank’s forecasts by an embarrassingly large margin, the case for a further extension of QE was already looking weak. Sterling’s slump adds to the reasons for caution and – if sustained – could lead markets to bring forward expectations for monetary tightening.

G7 broad money has slowed significantly this year, with an estimated rise of only 2% annualised in the six months to August – see first chart. A theme of recent posts is that this weakness is not of undue concern because the velocity of circulation is likely to be rebounding after a plunge in 2008 and early 2009. Expressed differently, the demand to hold cash has fallen in response to record low interest rates and reviving markets so weak monetary growth does not signal insufficient liquidity to support an economic recovery.

Prior posts have also noted that a rise in broad money velocity is likely to be associated with a shift of funds out of savings accounts into cash and accounts used for transactions, implying a pick-up in narrow money relative to broad money. Continued solid growth in G7 M1 – an estimated 7% annualised in the six months to August – is therefore reassuring.

The relationship between velocity and the ratio of narrow to broad money is demonstrated for the US in the second chart. Velocity is normally calculated using nominal GDP and money supply data for the same period but this ignores lags in the transmission mechanism; the measure in the chart divides GDP by M2 six months earlier. For narrow money, “non-interest-bearing M1” is used, comprising currency, traveller’s cheques and “demand deposits” – interest-free accounts with a cheque facility.

There is a clear pattern of changes in the narrow to broad money ratio leading swings in velocity. The ratio is currently growing at an annual rate of 10%, which is the fastest since 1992-93, when M2 velocity rose by 4-5% per annum. A similar increase over the coming year would imply a strong rebound in nominal GDP – even if M2 shows little growth.