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The August minutes contained yet another surprise for MPC-watchers, with three members voting to expand asset purchases by £75 billion rather than the £50 billion favoured by the majority. The difference, however, should not be exaggerated: the Committee agreed that the new purchases should be spread over three months and the size of the programme is unlikely to be revisited before the November meeting, when the MPC will update its quarterly forecasts. If the economy evolves in line with the projections in the August Inflation Report, there will be no justification for continuing gilt-buying and by early 2010 the Committee will be under pressure to start withdrawing monetary stimulus.

A useful summary measure of the implications of the Inflation Report for future policy direction is the MPC’s mean forecast for inflation in two years’ time based on unchanged policies. This forecast fell to a record low of 0.38% in February, signalling that the Committee judged significant further easing to be necessary – the gilt purchase programme was announced the following month, along with a half-point cut in Bank rate. In the May Report, the two-year-ahead forecast was raised to 1.71% but the shortfall from the 2% target indicated that the MPC retained an easing bias. This residual bias partly explains the decision to expand asset purchases further in August.

The August Report, however, suggests that the £50 billion expansion was larger than strictly necessary because the two-year-ahead forecast is now above the target, at 2.17%. This is the first positive deviation since last August and the largest since August 2007 – the MPC last raised Bank rate in July 2007. The Committee’s decision to adopt a looser policy than warranted by its projections appears to reflect a judgement that the economic costs of inflation undershooting the target would exceed those of an overshoot. It has, in effect, taken out temporary insurance against worse-than-expected outcomes.

The emphasis, however, is on “temporary”, since such an approach risks damaging inflation-fighting credibility. Moreover, if the economy performs in line with the MPC’s mean expectations, the deviation between the current policy stance and one calibrated to achieve 2% inflation will widen. The August Report shows mean inflation climbing by 0.2 percentage points between the third quarter of 2011 and the first quarter of 2012 in the forecast based on market-implied interest rates; the increase would be greater if rates are unchanged. So the two-year-ahead projection based on unchanged policies could rise from 2.17% currently to about 2.5% by early next year. A 0.5 percentage point excess over the target would be at the top of the historical range.

Taken at face value, therefore, the August forecasts seem to lay the foundations for a withdrawal of monetary stimulus in early 2010. Of course, with economic recovery at an early stage and unemployment possibly still rising, any such action would be controversial. Moreover, some MPC members may argue for a delay to monitor the impact of the January VAT rise, although an assessment has already been built into the projections. The imminent general election may also affect the Committee’s willingness to follow the logic of its forecasts – political sensitivities may be heightened by the Conservative proposal to transfer responsibility for financial regulation from the Financial Services Authority to the Bank of England.

While the likelihood of policy tightening in early 2010 can be debated, the August Report appears to rule out further loosening unless growth and / or inflation fall significantly short of the MPC’s expectations. This seems unlikely. The GDP forecast based on unchanged policies shows a mean rise of only 1.1% in the year to the second quarter of 2010 but purchasing managers’ indices have recovered close to long-term averages, consistent with annualised growth of more than 2%, while an end to destocking alone will give an arithmetical boost of 1.4 percentage points.

The MPC has revised up its short-term inflation projections significantly since the May Report, now expecting an annual CPI gain of 1.3% in the third and fourth quarters, but this is possibly still too low in light of July’s higher-than-expected outcome of 1.8%. While food price trends are favourable, core inflation may remain disappointingly sticky, reflecting lagged currency effects and – perhaps – a smaller “output gap” and / or lower sensitivity to economic slack than widely assumed. Also worthy of note is a likely strong rebound in retail price inflation from late 2009, which may boost measures of household inflation expectations monitored by the MPC. (See previous post for more discussion of inflation prospects.)

An eventual withdrawal of monetary stimulus is likely to take the form of a rise in Bank rate rather than a reversal of quantitative easing. The Bank of England could drain banks’ excess cash reserves, by selling bills or reducing repo lending, but such action would probably have little economic impact. A run-down of the Bank’s gilt portfolio is unlikely to be possible next year given forecasts that fiscal funding needs will remain gargantuan – unless officials are prepared to risk triggering a major rise in yields. With “quantitative tightening” off the agenda, and given the historically low starting level, rises in Bank rate, when they begin, could be larger than in the initial stages of prior cycles.

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COMMENT:
AUTHOR: Stuart Henshall
EMAIL:
IP: 85.14.77.128
URL:
DATE: 09/07/2009 09:43:09 AM

‘The need for low rates and cash pushed in the economy from the Bank of England is cited as being necessary to counter expected higher taxes – which will put a lid on consumer demand.’

— Is the issue of higher taxes considered in this blog?

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COMMENT:
AUTHOR: Stephen Spurdon
EMAIL:
IP: 82.11.14.159
URL:
DATE: 09/07/2009 01:09:44 PM

Simon. BANG-ON yet again. The fact that the City Page comment took the OECD at face value makes me suspect most of them are asleep at the wheel … which would be a surprise (NOT).
The obvious (since you have pointed them out) deficiencies in OECD/IMF forecasting make it extremely perplexing that they are taken seriously – I suppose it is the case that they say what people want to hear???

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COMMENT:
AUTHOR: Simon Ward
DATE: 09/08/2009 07:33:23 AM

Higher taxes are taken into account but empirical evidence shows that monetary conditions are a more powerful influence on cyclical fluctuations.

The technical abilities of OECD and IMF economists are not in doubt but the institutional structure of the organisations militates against criticism of member countries’ policies. The OECD’s downbeat UK view helps the government to justify current extreme fiscal laxity.

The significance accorded by media commentators to OECD and IMF forecasts remains a mystery. Both were later even than the consensus of economists to recognise last year’s developing recession. Neither predicted the emerging strength of the current recovery, reflected in a V-shaped rebound in industrial output in emerging economies and this week’s upbeat G7 manufacturing surveys.

Both are political bodies and thereby constrained from issuing forecasts implying criticism of member governments’ policies. The IMF’s warnings of financial and economic doom since late 2008 have not been unrelated to its demands for additional funding.

Both organisations have been unaccountably, and so far wrongly, negative on the UK’s relative economic performance, predicting late last year that Britain would suffer the largest annual decline in GDP among the major economies in 2009. Even based on the OECD’s latest forecast that UK GDP will continue to contract during the second half while the US and Euroland recover, the calendar 2009 fall of 4.7% will be smaller than in Germany (4.8%), Italy (5.2%) and Japan (5.6%).

The projected further UK decline, however, is implausible. June data on services and industrial output already suggest a marginal GDP rise in the third quarter. Recent purchasing managers’ surveys are consistent with expansion and stronger than their Eurozone counterparts. Broad money trends are also more favourable in the UK: the 4.9% annualised rise in adjusted M4 between January and July compares with growth of just 0.3% in Eurozone M3.

The OECD bases its UK pessimism partly on the larger role of the financial sector in the economy. Yet the last CBI financial services survey signals that the big recovery in markets since the spring is already contributing to a revival in business volumes, suggesting a positive GDP impact going forward – see chart.

The GDP rises in Germany and France in the second quarter partly reflected temporary “cash for clunkers” effects and pay-back for earlier extreme German weakness. Germany may continue to outperform other EMU members as global trade revives but Euroland as a whole is likely to lag the UK in the coming recovery.

Purchasing managers’ new orders indices support hopes of a strong recovery in G7 industrial activity during the second half – see first chart. This pick-up, however, partly reflects temporary factors such as slower destocking and “cash for clunkers” schemes. Sustained growth will require companies to move out of retrenchment mode and in particular to resume hiring, thereby providing income support for increased consumer spending

Other components of the latest surveys indicate that companies are reacting cautiously to unexpected strength in incoming demand. For example, while the US Institute for Supply Management (ISM) new orders index reached a five-year high last month, employment, inventories and import indices remain below their historical average readings – second chart.

One scenario is that orders strength will fade rapidly, validating firms’ scepticism. This is unlikely: stocks cycle upswings typically last 12-18 months and the current boost should be unusually large given record destocking in late 2008 and early 2009.

Alternatively, firms may wait for higher orders to be sustained for a couple more months before shifting into expansionary mode. This is plausible and would be consistent with behaviour in previous cycles. However, companies may be more risk-averse given recent traumas while restricted credit availability may limit their ability to ramp up production and hiring.

This raises the possibility of a third scenario, in which order flows remain strong but the supply-side response is less dynamic than in prior upswings. As well as a less steep recovery trajectory, this would imply an earlier emergence of supply constraints and upward pressure on prices than suggested by consensus analysis based on highly-uncertain “output gap” estimates.

An indirect measure of US supply pressures is the ISM vendor deliveries index – higher values indicate more firms reporting delivery delays. Interestingly, this rose sharply in August to its highest level since May 2006. Historically, large increases have often preceded rises in US official interest rates, although the index would need to climb significantly further to reach its level before the Fed last began to tighten in June 2004 – third chart.

Weak second-quarter monetary data contributed to the MPC’s decision last month to embark on an additional £50 billion of gilt purchases. July statistics released today are more encouraging, supporting recovery hopes and reducing the chances of further QE expansion.

Key points:

1. The MPC’s favoured broad money measure – M4 excluding money holdings of “intermediate other financial corporations” – rose by a respectable 0.6% in July while first-half growth has been revised up from 3.5% annualised to 4.4%. Broad money increased by 4.9% annualised in the first seven months of 2009.

2. The Bank of England estimates that broad money rose by an annual 3.9% in July, which compares with a 1.2% gain in the retail prices index excluding mortgage interest costs. Implied real growth of an annual 2.6% contrasts with a contraction of 1.1% in Sepember last year and is higher than at the start of the economic recovery in the early 1990s.

3. M4 holdings of private non-financial corporations rose by 0.2% in the year to July – the first annual increase since March 2008. M4 lending to such corporations continued to contract in July, falling 2.9% from a year earlier. However, this partly reflects companies choosing to use the proceeds of recent capital issues to repay bank borrowing.

4. Historically, business spending has been positively correlated with the corporate “liquidity ratio” – M4 holdings divided by lending. Reflecting recent debt repayment, the ratio has recovered to its highest level since March last year. A wider definition including foreign currency deposits and loans has risen by more – see first chart.

5. Credit demand needs to revive to support M4 expansion when QE ends. Excluding remortgaging, mortgage approvals rose by 6% in July to stand 37% higher than a year earlier, suggesting a pick-up in mortgage lending later in 2009 – second chart.

Recent US monetary trends have been mixed, with the broader M2 measure slowing sharply but M1 continuing to grow strongly. The economy should recover solidly during the second half but momentum could falter in early 2010 unless M2 revives.

M1 comprises currency and checkable deposits, while M2 adds small time deposits, savings accounts and retail money funds. M2 has risen at a 2% annualised rate over the last six months versus 12% for M1. The M2 slowdown is partly pay-back for a surge in growth in late 2008 and early this year – see first chart.

M2 was weak earlier last year, contracting in inflation-adjusted terms in the six months to August, just before the financial crisis snowballed. The impact on the economy was compounded by a fall in the velocity of circulation, as households and firms hoarded cash in response to rising perceived risks.

One sign that velocity might be declining was that narrow money M1 was even weaker than M2. M1 is a better measure of transactions money while M2 contains a large savings element and is likely to be boosted disproportionately by an increase in precautionary balances.

Fast-forwarding to the present, the recent M2 slowdown is less worrying because it follows a period of unusual strength and has been accompanied by continued rapid growth in M1, suggesting that velocity is recovering as financial markets normalise and economic uncertainty abates.

M2 weakness will warrant greater concern the longer it persists. Slower destocking and some revival in housing market activity may support credit and money trends later in the year. The Federal Reserve’s securities purchase programme is scheduled to continue until the end of 2009, though its effects have recently been offset by other factors.

The mixed message from recent monetary data is echoed by the Fed’s latest senior loan officer survey. The net percentage of banks tightening credit standards on commercial and industrial loans fell further between April and July but is still far above a level consistent with sustained economic expansion – second chart.

In December last year the Council of Mortgage Lenders (CML) predicted that the percentage of mortgages more than three months in arrears would rise from 1.8% at the end of 2008 to 4.4% by end-2009. First-half performance has been much better than expected, with the arrears proportion standing at 2.4% at the end of June.

As well as undershooting forecasts, current arrears experience compares favourably with the recession and housing market downturn of the early 1990s. The CML’s series for three-month-plus arrears starts in 1995 but rough estimates for earlier years can be derived from data on six-month-plus cases. The current 2.4% arrears proportion compares with an estimated peak of about 6% in 1992 – see chart.

As pointed out on page 29 of the August Inflation Report, employment has fallen by less than at the comparable stage of the last downturn, partly reflecting cuts in real pay. Government schemes are also helping: 220,000 households were receiving income support mortgage interest payments in May (although such support was also available in the 1990s), while the Department of Communities and Local Government has estimated eventual take-up of the homeowners mortgage support scheme – which allows borrowers to defer interest payments for up to two years – at 42,000.

The key factor suppressing arrears, however, is a lower burden of interest service costs than in the early 1990s. Household interest payments peaked at 10.9% of disposable incomes in the fourth quarter of 2007 versus a high of 15.0% reached in the third quarter of 1990. One year into the 1990-91 recession, the interest burden was still 11.6% of income; the latest figure – for the first quarter of 2009 – is 8.7% and a further decline to 7-7.5% is likely, based on more recent Bank of England data on effective interest rates.

So the interest burden is now nearing the bottom of its historical range, despite a record level of debt. A bearish view is that mortgage defaults have simply been postponed because interest service will rise rapidly once official rates start to normalise. The impact of policy tightening, however, may be partly offset by a narrowing of current wide lending spreads. Moreover, MPC action will be conditional on a solid recovery, implying more favourable labour market conditions for borrowers.

(Please note: an earlier version of this post used a National Statistics series for household interest payments that nets off an estimate of consumption of financial intermediation services. The chart and text have been updated to include these payments in the analysis, as is appropriate. Thanks to an observant reader for spotting this omission.)

Professor Charles Goodhart has advocated charging banks for holding reserves at the Bank of England to encourage them to lend out the cash created by quantitative easing. He cites the example of Sweden, where the interest rate on the Riksbank’s deposit facility has been set at minus 0.25%.

Current Swedish monetary policy and money market arrangements, however, are not comparable with the UK’s. The Riksbank has cut its target interest rate, the repo rate, to 0.25% but has not engaged in quantitative easing, in the sense of asset purchases financed by creating new reserves. The deposit rate has fallen to -0.25% because it has recently been set 50 basis points below the repo rate.

Swedish banks make little use of the deposit facility because they are able to lend to the Riksbank in daily “fine-tuning” operations at the repo rate minus 10 basis points – i.e. 0.15% at present. The Riksbank’s weekly statement shows that these fine-tuning loans currently stand at SEK176 billion versus deposits of only SEK39 million. So the negative deposit rate has little practical relevance.

In the UK, a key objective of market operations is to maintain overnight interest rates in line with Bank rate. If the Bank of England stopped paying interest on reserves, banks would attempt to earn a return on their cash by lending it out short term in secured money markets; this increased supply would push overnight rates close to zero. In other words, the change would undermine the anchor role of Bank rate and, by extension, the MPC’s control over monetary conditions.

On the same logic, if the Bank charged banks for holding reserves, overnight rates would turn negative. Banks would then have an incentive to hold liquidity in the form of bank notes, which would at least maintain a fixed value, rather than deposits at the central bank or overnight loans. To prevent such behaviour, the Bank would have to place restrictions on banks’ ability to convert their reserve holdings into bank notes – another fundamental feature of current monetary arrangements.

Paradoxically, banks as a group would be unable to avoid charges even if they increased their lending as desired, since the aggregate amount of reserves would be unaffected. While an individual bank might succeed in reducing its deposits, other institutions would find themselves holding more cash. The aggregate level of reserves is effectively fixed by the Bank of England, assuming a stable demand for bank notes.

Recent lending stagnation has been partly due to a fall in credit demand. To the extent that supply of loans is constrained, this reflects banks’ efforts to conserve capital and reduce risk, rather than the competing attraction of earning 0.5% by holding cash at the Bank of England. Even if the technical obstacles could be overcome, a reserves-charging scheme would probably have little impact on lending behaviour.

As expected, food prices had a favourable impact on July consumer prices, cutting the annual increase by 0.14%. This effect, however, was offset by a pick-up in “core” inflation, resulting in the headline CPI rise remaining at 1.8%. This is well above the Inflation Report forecast of average inflation of about 1.25% in the third quarter and casts doubt on Bank of England Governor Mervyn King’s suggestion of a fall below 1% later in 2009.

The CPI excluding food, energy, alcohol and tobacco rose by an annual 1.8% in July, up from 1.6% in June and the highest since November. Based on recent National Statistics research, this measure of core inflation would probably stand at 2.4-2.5% in the absence of December’s VAT cut.

Stubborn core trends partly reflect the continuing impact of last year’s sterling depreciation but also call into question consensus and Bank of England estimates of the sensitivity of inflation to rising economic slack. An alternative forecasting approach based on monetary growth may be more consistent with recent numbers than “output gapology” – see previous post.

Retail prices were down by an annual 1.4% in July but this compares with a 1.6% June decline. Interestingly, the housing depreciation component of the RPI – linked to house prices – rose last month for the first time since June last year. As argued in the previous post, RPI inflation should rebound strongly and exceed CPI inflation in 2010 as housing and interest rate effects unwind.

Energy price falls in late 2008 and early 2009 helped to offset the impact of a decline in labour incomes on consumer spending power. Energy prices have started to firm again recently but household budgets have enjoyed relief from a new source – a decline in food bills.

A surge in consumer food prices during 2008 squeezed real incomes and contributed to a cut-back in household spending. Food commodity prices, however, weakened sharply late last year and this decline has been feeding through at the retail level recently, with food components of consumer price indices in the US, Japan and Euroland recording an unusual fall over the last six months – see chart.

Food commodity prices recovered during the first half of 2009 but the Economist food price index is currently still 26% below the peak reached in July last year in dollar terms. Despite a headline-grabbing spike in sugar prices, the index has retreated 5% from a recent high in early June. So food CPI trends may remain subdued during the second half.

UK food inflation peaked at a higher level and has been slower to subside, reflecting sterling’s big decline during 2008. With the pound recovering recently, however, this effect is reversing and food prices should suppress CPI numbers over coming months (producer prices suggest a favourable impact in the July report released tomorrow – see chart in previous post).

Major British banks (i.e. the high-street groups covered by British Bankers’ Association statistics) incurred impairment charges of £31 billion in the first half of 2009, up from £26 billion in the second half of 2008, according to recent interim statements. As explained below, a comparison with the bad debt cycles of the early 1980s and early 1990s suggests further provisions of £100-150 billion over the three and a half years to the end of 2012.

More optimistically, the same group of banks made pre-impairment operating profits of £26 billion during the first half. Providing this run-rate is maintained, cumulative profits between the second half of 2009 and 2012 should be sufficient both to cover future impairments and allow some addition to capital, implying no need for a further government “bail-out”.

Loss provisions by major banks totalled 9% of credit exposure over the five years from 1982 to 1986, following the 1979-81 recession, and 7% over 1989-93, encompassing the 1990-91 recession. The 1982-86 figure includes losses on sovereign loans, although these were not formally recognised until later in the 1980s. (See previous post for more details.)

A similar loss rate, i.e. between 7% and 9% over five years, is plausible in the current cycle. It is not clear that recent bank behaviour was any more reckless than in the rush to lend to developing countries in the late 1970s or the property lending boom of the late 1980s. Moreover, nominal and real interest rates are much lower than in the 1980s and 1990s, which should limit defaults.

Based on 2008 exposure, a 7-9% rate of attrition would imply credit losses of £190-240 billion over the five years 2008-12. Impairment charges totalled £64 billion in 2008 and the first half of 2009 so this suggests losses of £125-175 billion over the three and a half years to the end of 2012.

In addition to impairment charges, however, Lloyds, HBOS and RBS recorded a combined net trading loss of £23 billion in the 18 months to mid 2009, reflecting writedowns of securities. On the basis that banks held a much greater proportion of credit exposure in securitised form in the current cycle, such writedowns should be included in total losses recognised to date when comparing with the early 1980s and early 1990s.

A conservative approach is to incorporate only the net trading loss of these three banks, rather than aggregate trading writedowns. (Writedowns by other banks have been offset by income from other trading activities.) Assuming no further trading losses, this reduces the forecast range for provisions to £100-150 billion between the second half of 2009 and 2012.

The chart translates this range into a half-yearly profile, assuming that impairments decline steadily from a peak in the first half of 2009. The middle of the range implies annual totals of £57 billion, £40 billion, £23 billion and £6 billion over 2009-12.

Banks’ pre-impairment profits of £26 billion during the first half of 2009 incorporate £6 billion of trading gains by Barclays and RBS, offset by a further £3 billion loss by Lloyds / HBOS. Investment bank profits could be less favourable going forward but any decline should be offset by higher net interest income as average lending / deposit rate spreads recover from recent lows – see previous post on banks’ margins.

If pre-impairment profits are stable at £26 billion per half-year – arguably cautious – and impairment charges total £100-150 billion between the second half of 2009 and 2012, banks will earn cumulative post-provision profits of £30-80 billion by the end of 2012. This surplus will be available to boost capital levels, on top of any addition from further fund-raising in markets.