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While the fall in GDP in the fourth quarter has been revised from 1.5% to 1.6%, the expenditure breakdown is less negative than last month. On the new figures, the stocks cycle accounts for the entire decline in GDP last quarter. GDP excluding stocks actually rose by 0.1%, with falls in consumer spending and investment offset by higher government consumption and stronger net exports.

The big drag from stocks suggests the decline in GDP peaked last quarter. Destocking amounted to 1.3% of constant-price GDP – the largest since the fourth quarter of 1990. This was two quarters into the last recession, when GDP was 70% through its peak-to-trough decline. GDP weakness over coming quarters will be driven by investment and consumer spending.

Other notable features of the data released today include:

• GDP fell by 2.0% in the year to the fourth quarter but gross national income (GNI), which includes net income from abroad, plunged by an estimated 4.0% – the biggest annual fall since 1980. (Constant-price GNI is calculated by deflating current-price GNI using the GDP deflator.)

• The household saving ratio surged to 4.8% in the fourth quarter, the highest since the first quarter of 2006 and up from a low of -1.2% in the first quarter of last year. The ratio is likely to rise further – it has averaged 6.8% since 1985 – but the significant adjustment to date reduces downside risks to consumer spending.

• The figures do not support deflation claims. The price deflator for gross value added – which excludes the impact of the VAT cut – rose by 1.2% from the third quarter to stand 3.3% higher than a year before.

• Private financial corporations’ operating surplus surged 36%, or £5.1 billion, last quarter, apparently reflecting a rise in banks’ net interest receipts. As explained in a previous post, the operating profits – not reported earnings – of the Lloyds Banking Group and the Royal Bank of Scotland will be counted as public sector income from October last year, reducing public net borrowing. (The reclassification has yet to be reflected in public finances data.)

• The current account deficit was just 1.7% of GDP in 2008 – inconsistent with claims that sterling was “grossly overvalued” before its recent plunge.

Recent talk of imminent deflation has been highly misleading. Headline CPI and RPI inflation have been artificially depressed by the December VAT cut, falling world energy prices and interest rate reductions. Underlying inflation has been picking up in response to the plunge in the exchange rate. February numbers released today confirm the trend and cast doubt on the MPC’s forecast of a big decline in the headline CPI rate later in 2009.

Despite a favourable impact from lower energy costs, annual CPI inflation rose from 3.0% in January to 3.2% in February. This was well above both the consensus expectation of 2.6% and a February Inflation Report projection of 2.7% for the first quarter. Inflation would be significantly higher but for December’s VAT cut: the CPI at constant tax rates rose an annual 4.2% in February.

Underlying inflation is often measured by the CPI excluding unprocessed food and energy. The annual rate of change of this index rose from 1.9% to 2.3% between January and February. Without the VAT cut, the February figure would have been over 3% – above the peak of 2.8% in August / September last year.

The culprit is the plunge in sterling and a resulting surge in non-energy import costs – manufactured import prices rose an annual 14% in January. In his latest explanatory letter, Bank of England Governor Mervyn King notes that “much of the strength of the outturn appears to be concentrated in components where a large share of goods is imported”.

In his last letter, in December, Mr. King suggested that he would next have to write when annual CPI inflation fell below 1% later in 2009. The MPC, like the consensus, has underestimated the inflationary impact of sterling’s slump. Recent cuts in energy tariffs and rising economic slack will pull inflation lower but sub-1% readings are unlikely barring a significant exchange rate recovery. Headline inflation will rebound sharply in early 2010 as VAT and energy benefits reverse.

Martin Wolf of the Financial Times has argued that the UK’s real exchange rate was “grossly overvalued” before the recent plunge, which represents a “move towards equilibrium” (see comments to previous post). The evidence presented below suggests the degree of overvaluation was modest and sterling is now “grossly undervalued”, with unfavourable implications for future UK relative inflation performance.

The first chart shows J P Morgan’s real broad trade-weighted exchange rate index, based on a common-currency comparison of UK manufacturing prices (ex. food and energy) with prices in 46 developed and emerging economies. The index was 14% above its 1970-2006 average at sterling’s peak in January 2007. This average, however, is biased downwards by a very low real exchange rate in the 1970s, when UK trade performance was damaged by non-price factors such as poor quality and supply unreliability. Relative to an average calculated over 1985-2006, the deviation was 7% in January 2007. The subsequent fall has pushed the index 19% below this average to the lowest level since 1978.

Exchange rate overvaluation should be reflected in a worsening trade balance. The second chart shows the goods and services balance excluding oil expressed as a percentage of current-price GDP. The trade position deteriorated significantly over 1997-2001 following a large rise in the exchange rate between 1996 and 1998. Once sterling stabilised, however, so did the trade deficit, suggesting that, after an initial negative impact, UK suppliers adjusted to the higher currency. If the pound had been “grossly overvalued”, UK firms would have continued to lose market share, implying further deficit widening.

The third chart shows the percentage of CBI manufacturing companies citing price competitiveness as a constraint on exports. Firms may interpret the survey question as asking whether they are able to win orders at the current level of the exchange rate, in which case responses will also reflect non-price influences on competitiveness. Consistent with this, the CBI measure suggests a smaller degree of undervaluation in the 1970s than the J P Morgan real exchange rate index. It also supports the view that UK manufacturers adjusted successfully to the 1996-98 appreciation, with an initial rise in the measure reversed over 2000-03. In contrast to the J P Morgan index, the CBI series was close to its 1972-2006 average in January 2007. It is currently at its lowest level since 1974.

Previous posts have argued that sterling’s plunge may deliver little net stimulus to the economy, partly reflecting adverse effects on banks’ capital and funding. Unless reversed, it will also result in higher UK inflation than elsewhere. The real exchange rate is unlikely to remain at its current very depressed level over the longer term. A recovery can occur either via nominal appreciation or higher relative inflation. A return of the J P Morgan index to its 1985-2006 average over 10 years, coupled with a stable nominal exchange rate, would imply UK manufacturing prices rising 2.2% per annum faster than in competitor countries.

Postscript: The previously-documented pattern of sterling weakening when Bank of England Governor Mervyn King gives a speech was repeated last week. Mr. King spoke on Tuesday evening; the effective index fell by 1.4% between the closes on Monday and Wednesday.

As argued in previous posts, current exceptional circumstances justify action by central banks to boost broad money supply growth to 10% or so temporarily in order to support an economic recovery. For this reason, the asset purchase schemes introduced by the Federal Reserve last autumn and the Bank of England this month are welcome.

The scale of the expansion of the Fed’s buying programme announced yesterday, however, threatens to push money growth well above 10% for a sustained period. While US recovery prospects are further enhanced, so is the medium-term risk of higher inflation and market disruption as the Fed is forced to withdraw unprecedented liquidity support at short notice.

Since last autumn the Fed has bought $241 billion of commercial paper, $44 billion of agency securities (i.e. issued by Fannie Mae, Freddie Mac and the Federal Home Loan Banks) and $217 billion of agency mortgage-backed securities (MBS). The total of $502 billion amounts to 6.1% of the M2 money supply and 4.4% of the broader money measure discussed in an earlier post.

The Fed had scope to buy a further $339 billion of agency debt / MBS under previous plans. It has now expanded the buying programme by up to a further $1.15 trillion, comprising $100 billion of agency securities, $750 billion of MBS and $300 billion of Treasuries. Future purchases could therefore total $1.489 trillion – 18.0% of M2 or 13.0% of broad money.

M2 grew by 9.8% in the year to February, while the broad money measure rose by 6.5% during 2008. The Fed may not utilise its full buying potential but if it did annual M2 / broad money growth could rise to 15-25%. Such rapid expansion is neither necessary for an economic recovery nor desirable for medium-term inflation and market stability.

Trade figures for January released today show little evidence of the economic benefits promised by the many advocates of exchange rate devaluation.

Contrary to the script, net exports appear to be exerting a drag on the economy in early 2009. Excluding oil and erratic items, export volumes in January were 8% below their fourth-quarter level versus a 5% decline in imports.

Meanwhile, manufactured import prices climbed a further 1% in January to stand 14% higher than a year before. Ongoing sterling weakness suggests the annual rate of change will remain in double-digits – see chart. As argued previously, the import price surge has lifted underlying inflation, thereby partly offsetting the boost to real incomes from lower energy prices and the VAT cut.

The weaker exchange rate may also have worsened the credit crunch by encouraging foreigners to reduce their sterling bank deposits and eroding banks’ capital ratios by inflating the sterling value of their foreign currency assets. Foreign net lending in sterling to UK-based banks fell by £63 billion between August and January. Credit constraints may have prevented some exporters from taking full advantage of the falling currency.

Sterling has weakened again following last week’s MPC decision to embark on “quantitative easing”. While this policy change is warranted, it carries inflationary risks from a possible further large fall in the exchange rate. These risks would have been reduced by smaller interest rate cuts, greater fiscal discipline and less “talking down” of the currency by policy-makers.

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COMMENT:
AUTHOR: Martin Wolf
EMAIL: webrequests@newstaram.com
IP: 217.196.237.120
URL:
DATE: 03/18/2009 02:46:32 PM

Did anybody say it was a panacea? This is surely a straw man. It is better than the alternative.

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COMMENT:
AUTHOR: Simon Ward
DATE: 03/18/2009 03:17:58 PM

I disagree that it is better than the alternative. By reducing domestic purchasing power and exacerbating the banking crisis, the fall in sterling has been negative for the economy.

Official encouragement of currency depreciation has been reminiscent of Japan’s attempt to reflate its economy via a lower exchange rate in the late 1990s. This worsened a credit crunch by forcing capital-constrained banks to cut back domestic lending to compensate for a higher yen value of their foreign assets.

The policy even failed to stimulate trade – the yen’s depreciation helped to topple other Asian currencies and resulting deep recessions damaged Japanese exports. Similarly, sterling’s plunge may have contributed to the Eastern European currency crisis and pressure for devaluation elsewhere.

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COMMENT:
AUTHOR: Martin Wolf
EMAIL: webrequests@newstaram.com
IP: 217.196.237.120
URL:
DATE: 03/18/2009 03:22:47 PM

I don’t see any deliberate sterling policy. The currency does what it does. When I talk about the costs of the alternative, I include, of course, the costs of trying, vainly, to stop it falling. That would presumably include higher interest rates.

In the longer run, the recovery of the UK must include a substantial rise in net exports. That certainly required a fall in what I have long considered a grossly overvalued real exchange rate. So this is, beyond doubt, a move towards equilibrium. Obviously, its effects will take time to work through.

I do not think it is the responsibility of the UK to consider the impact on the central and eastern European countries that have made absolutely classic macroeconomic policy errors, particularly encouraging very large-scale foreign currency borrowing.

The 138,000 jump in claimant-count unemployment in February appears to represent pay-back for surprisingly modest increases in earlier months.

The rise brings the cumulative increase since the low in January 2008 to 596,000. This is larger than at the equivalent stage of the 1970s labour market recession but below the rises in the early 1980s and early 1990s – see first chart.

A similar analysis for job vacancies gives a slightly different message: the decline from the peak in March 2008 is greater than in the early 1990s recession but is trailing the falls in the 1970s and 1980s – second chart.

These earlier episodes indicate that vacancies are unlikely to bottom before October 2009 at the earliest, while unemployment may continue to rise well into 2010.

Fourth-quarter US flow of funds accounts, released last week, confirm that broad money is growing at a respectable pace and has picked up in inflation-adjusted terms. Corporate monetary trends are healthier than in the UK and Eurozone, suggesting less pressure for business retrenchment.

The flow of funds accounts permit a more thorough analysis of broad money trends than is possible from weekly and monthly money supply releases. First, the accounts provide information on all the components of the old M3 – discontinued in 2006. Secondly, an adjusted M3-type measure can be calculated excluding money holdings of quasi-banks, which have been boosted by the financial crisis. Thirdly, this adjusted broad money measure can be broken down between households, non-financial business and financial institutions such as insurance companies and pension funds.*

Annual growth in adjusted broad money stood at 6.5% at the end of 2008, below a 9.9% December rise in the narrower M2 aggregate but above a 3.8% rate of increase of the equivalent UK measure (adjusted M4) – first chart. The 6.5% expansion was down from 7.6% at the end of the third quarter but a sharp fall in consumer price inflation resulted in real growth accelerating from 2.5% to 6.4%, implying greater monetary support for the economy in 2009 – second chart.

The 6.5% aggregate increase breaks down into growth of 5.3% for households, 6.2% for non-financial business and 13.9% for financial institutions – third chart. This suggests less pressure on non-financial business liquidity than in the UK and Eurozone: UK M4 holdings of private non-financial corporations fell by 4.7% in the year to January, while Eurozone non-financial corporate M3 rose by just 1.8% – fourth chart.

* Definitions:
M2 = currency, checkable deposits, savings deposits, small time deposits and retail money funds, other than held by government, monetary authority, depository institutions and foreign banks / official institutions
M3 = M2 plus large time deposits, institutional money funds, repurchase agreements and Eurodollar deposits, other than held by government, monetary authority, depository institutions, money funds and foreign banks / official institutions (discontinued)
Flow of funds adjusted broad money = checkable deposits and currency, time and savings deposits, money funds, repurchase agreements and foreign deposits, other than held by government, monetary authority, commercial banks, savings institutions, credit unions, money funds, “funding corporations” (= quasi-banks) and rest of world

The reclassification by the Office for National Statistics (ONS) of the Royal Bank of Scotland and Lloyds Banking Group as public corporations will be a big help to the efforts of the chancellor, Alistair Darling, to limit fiscal red ink. The banks’ underlying profits will be booked as public sector income, significantly reducing net borrowing.

At first sight this looks odd since the banks suffered a combined operating loss before tax of £49.0 billion in 2008 and may remain in the red in 2009. ONS guidance, however, indicates that the profits definition to be used will exclude dealing/investment losses, credit impairments and goodwill write-downs. Profits before these deductions were a combined £27.7 billion in 2008. (The ONS figure could be lower because of other adjustments, e.g. excluding undistributed income of foreign subsidiaries.) RBS and Lloyds are to be included in the public sector from 13 October 2008.

The chancellor is widely expected to announce a large upward revision to his public sector net borrowing forecast of £118 billion in 2009-10 in next month’s Budget, reflecting a much deeper recession than projected by the Treasury last November. The average independent projection is £128 billion, according to the Treasury’s monthly survey of forecasters. The inclusion of the banks’ profits, however, implies that Darling could announce little or no increase.

The effect, of course, is entirely artificial: although not included in public borrowing, the losses suffered by the banks are real and have been reflected in the value of the government’s shareholdings. With no improvement in the public sector’s true financial position, the classification change does not create additional fiscal “room for manoeuvre”.

The ONS previously announced that the reclassification of the banks would boost public net debt by between 70 and 100 percentage points of gross domestic product from 47.8% currently.

The sharp falls in many financial markets in late 2008 partly reflected forced position-closing by leveraged investors. Leverage levels now appear to be low by the standards of recent years, suggesting that future market moves will be driven more by “fundamentals”.

A measure of equity market leverage is margin debt outstanding on the New York Stock Exchange. This has fallen by 54% from a peak in July 2007, reaching its lowest level since August 2004 – see first chart below.

In the corporate bond market, deleveraging by market-makers with excessive inventory contributed to rapid price declines in late 2008. US primary dealers’ net long position in corporate securities is now the lowest since August 2003 – second chart.

Hedge fund leverage is difficult to measure directly but can be proxied by the sensitivity of their returns to market movements. The 30-day trailing betas of the FTSE “all strategies” and “directional equity” hedge fund indices to the FTSE World equity index are close to zero, suggesting little net market exposure – third chart.

As investors scrambled to close positions in late 2008, the Chicago Board Options Exchange implied volatility (VIX) index spiked to its highest level since the October 1987 stock market crash. Recent further equity declines were associated with a lower peak in volatility – fourth chart. A similar “non-confirmation” occurred at the October 2002 US stock market low, retested in March 2003.