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In January, the IMF predicted that the UK would suffer the largest GDP decline of the Group of Seven (G7) economies in 2009. This forecast looked suspect at the time – see here – and is not supported by recent data.

UK GDP peaked in the first quarter of last year and had fallen by 2.2% by the fourth quarter. Over the same period, however, GDP dropped by 3.0% in Italy, 3.1% in Germany and a whopping 4.8% in Japan. Canada was the best performer among the G7, with a decline of just 0.5%.

According to figures released today, UK industrial output fell by a further 2.6% in January to stand 11.4% below its level last February, when G7 industrial activity began to contract. Germany, France, Italy and Japan have all registered larger declines, however, while UK performance is only slightly worse than the US – see first chart.

Forward-looking indicators are also no weaker than the average. The second chart shows a measure of new orders derived from purchasing managers’ surveys of manufacturing and services. The UK indicator has risen for three consecutive months and is slightly above its US counterpart and significantly higher than the Eurozone measure, which is still falling. Meanwhile, stock market earnings revisions have been less negative than elsewhere recently – third chart.

Countries that tackle the shortage of money and credit will be the first to emerge from recession. The MPC should have embarked on “quantitative easing” last autumn, at the same time as the US Federal Reserve. It has at least acted before the European Central Bank and Bank of Japan, suggesting the UK is well-placed to recover earlier than the Eurozone and Japan.

The terms agreed by Lloyds / HBOS for its participation in the asset protection scheme appear to represent a good deal for the bank but the attraction for private shareholders is significantly reduced by their enforced dilution due to upfront payment to the Treasury in new B shares.

Combined lending of Lloyds and HBOS in the form of loans and advances to customers and holdings of trading and investment securities amounted to £935 billion at the end of 2008. The £250 billion of assets to be covered by the insurance scheme represents 27% of this sum.

Lloyds will suffer a first loss of 10% on the covered assets and a 10% share of additional losses, for which it will pay a fee equivalent to 6.25%. So the total cost of participation will be:

10 + 6.25 + 0.1 * (L – 10) %

where L = the ultimate percentage loss on the covered assets.

To justify participation, Lloyds must believe that this cost is less than L itself, i.e.:

L > 10 + 6.25 + 0.1 * (L – 10)

Rearranging terms and simplifying, participation is worthwhile if the ultimate loss L is greater than 16.9%.

Now assume that Lloyds has dumped all of its suspect assets into the scheme and that losses will be negligible on the remaining 73% of its lending. The 16.9% breakeven loss on the covered assets then translates into a 4.5% loss on its total lending.

As explained in a previous post, British banks in aggregate suffered five-year credit losses of 8.9% and 7.1% of assets at risk following the recessions of the early 1980s and early 1990s respectively. Assuming that 1) current losses are on the same scale or larger, 2) the combined loan book of Lloyds and HBOS is of no better than average quality and 3) Lloyds has succeeded in placing its lowest-quality assets in the scheme, the fee charged looks inexpensive.

Yesterday’s Bank of England news release states that “the Committee will monitor the effectiveness of this purchase programme in boosting the supply of money and credit”. However, the MPC needs to clarify which monetary measures it is monitoring and how big a boost it is aiming to achieve.

Headline M4 and M4 lending numbers are unusable at present, having been inflated by an explosion in money holdings and bank borrowing of “intermediate other financial corporations”. This reflects the replacement of traditional unsecured interbank borrowing and lending by secured forms of lending channelled through off-balance-sheet entities and third parties such as the London Clearing House.

The MPC will probably focus on the Bank of England’s adjusted M4 and lending measures, which exclude these financial intermediaries. Annual growth rates are published quarterly in a chart in the Inflation Report, with underlying data provided in a spreadsheet. Adjusted M4 rose by an annual 3.8% in December versus 16.1% for headline M4; the corresponding numbers for adjusted and headline M4 lending were 3.8% and 15.9%. Bank statisticians also calculate monthly estimates for the MPC meetings but these are not currently published (I have submitted a request for access under freedom of information provisions).

While it is not possible to derive the Bank of England’s adjusted measures from published data, monthly figures can be calculated for M4 and lending excluding all financial corporations, i.e. covering only households and non-financial companies. The latest annual growth rates, for January, were 2.8% and 4.9% respectively. Asset purchases, however, will boost the money holdings of traditional financial institutions – insurance companies, pension funds, unit and investment trusts etc. – in the first instance so the omission of the financial sector is a major disadvantage for monitoring the progress of the scheme.

A previous post argued that the MPC should aim to deliver a five percentage point boost to the annual growth rate of adjusted M4, i.e. from 3.8% to about 9%. The announced programme looks consistent with this target but the MPC should be prepared to adjust operations – in either direction – in light of incoming monetary data.

In the same way that individuals and companies settle transactions using accounts at commercial banks, banks themselves have accounts at the central bank that they use for clearing purposes. Quantitative easing – or tightening – refers to central bank actions that expand or contract the supply of funds held in these reserve accounts.

In operating monetary policy, central banks can alter either the price of money – interest rates – or the quantity of reserves. In recent years interest rate changes have been the dominant tool but historically policy-makers also used quantitative actions to achieve their goals.

A cut in interest rates boosts the economy by stimulating spending and borrowing. Higher bank borrowing results in an expansion in the amount of money in individuals’ and firms’ bank accounts – the broad money supply. This monetary expansion leads to further increases in spending and economic activity.

With quantitative easing, the central bank buys securities from the private sector and pays for them by crediting banks’ reserve accounts – effectively creating new reserves by the click of a mouse. This can boost the economy in two ways. First, if the central bank buys from individuals or firms, the money in their accounts with commercial banks increases, matching the rise in the banks’ reserves with the central bank. This increase in the broad money supply then encourages higher spending.

Secondly, the higher level of reserves may encourage commercial banks to lend more. The higher lending may be associated with a rise in spending and results in a further expansion of the broad money supply, with additional stimulative effects.

Quantitative easing is appropriate currently because interest rates are already exceptionally low and cuts may fail to stimulate borrowing and spending because individuals and firms wish to reduce their debt. A clear sign that interest rates are providing insufficient stimulus is the low rate of growth of the broad money supply.

Quantitative easing is capable of directly boosting money supply growth to the level required to generate an economic recovery. To ensure the necessary impact, however, it is important that the central bank purchases securities from companies and families rather than banks. Buying from banks boosts the broad money supply only if the higher level of reserves causes them to expand their lending. In current circumstances, with banks constrained by lack of capital and potential borrowers reluctant to increase their debt, any such effect might be small.

The annual growth rate of the broad money supply, M4, adjusted for distortions caused by the financial crisis, is currently about 4%. A rise towards 10% is probably necessary to generate an economic recovery. To achieve a boost on this scale, the Bank of England may need to buy £125 billion or more of securities. In order to implement the scheme quickly while minimising distortions to market prices, the Bank should concentrate purchases in gilts rather than corporate bonds or other private sector paper. Statistical work suggests that a programme on this scale could boost gross domestic product (GDP) by more than 1% after a year.

Could quantitative easing lead to an upsurge in inflation? Not so long as policy-makers ensure that the monetary boost is temporary. Once recovery is established, broad money supply growth will need to be reined back to about 6-7% per annum to ensure consistency with the 2% inflation target over the medium term.

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COMMENT:
AUTHOR: Andrew
EMAIL:
IP: 82.109.140.145
URL: http://www.geophysicsanonymous.net
DATE: 03/05/2009 05:26:17 PM

The way you describe it makes it sound like quantitative easing is no different to the government supporting industries directly i.e., giving a bank several billion to improve their balance sheet in the hope of them lending more. Is that really true, or what you meant?

Taking this whole idea too far:
Presumably money created now by the central bank will be withdrawn from the economy at some future date (selling the bonds?). Doesn’t that make it even more like the loan above. What is the difference here?

The key elements of the announcements today were:

1. The existing asset purchase facility of up to £50 billion has been expanded to up to £150 billion, with gilt-edged securities added to the list of eligible assets, and purchases to be financed by the creation of central bank money rather than Treasury bill issuance.

2. The MPC has initially authorised purchases of £75 billion over three months. Gilts are likely to account for the majority of this amount. Purchases will be of medium- and long-maturity conventional (i.e. not index-linked) gilts.

3. The effectiveness of the programme will be judged by its impact on the supply of money and credit but the MPC has failed to specify any quantitative targets. The relevant monetary aggregate is presumably the broad money supply, M4, but this is not confirmed.

4. The MPC cut Bank rate by a further 0.5 percentage points despite possible “counter-productive effects on the operation of some financial markets and on the lending capacity of the banking system”. This suggests a split decision. The further cut is logically inconsistent with the reduction of only 0.5 percentage points last month – the MPC agreed that additional stimulus was required but judged that cutting below 1% might have no positive impact on the economy.

The welcome aspects of the announcements are that asset purchase plans are on the right scale – £150 billion is equivalent to 7.5% of M4 – and the focus on buying medium- and long-term gilts will maximise the monetary impact. (This is because longer-term gilts are held mostly outside the banking system so purchases will boost non-bank domestic investors’ bank deposits, included in M4.)

Less impressive is the MPC’s failure to specify a target impact on M4 and lending, or to make a commitment to reining back monetary growth once economic recovery is established to ensure there are no longer-term inflationary consequences. In addition, the Bank rate cut was not necessary to implement quantitative easing and is likely to put further pressure on banks’ interest margins, with negative implications for credit supply.

Amid current deep gloom, are there any signs that global economic clouds could lift later in 2009?

The most hopeful message continues to come from monetary trends. Annual growth in G7 real narrow and broad money has been picking up since August / September last year, rising further in January – see first chart. Money growth typically leads industrial output momentum by 6-12 months, suggesting a bottom in the latter by late summer at the latest.

One reservation is that the monetary acceleration has been heavily dependent on the US, reflecting Fed asset purchases. Similar action is needed in other G7 economies, though the Bank of England should step up to the plate this week. In addition, the Fed must sustain the pace of asset purchases to prevent a relapse in money growth – buying has slowed in recent weeks.

Another glimmer of hope is that output has been falling much faster than final demand, allowing inventories to decline. While G7 industrial output plunged by an estimated 14% in the year to January, retail sales volumes were “only” 5.5% lower – second and third charts. GDP reports show significant declines in inventories in the US, France and the UK in the fourth quarter (Japan was a notable exception). This supports expectations that the stocks cycle will act to support economic activity later in 2009 – a positive impact requires only a slowdown in the pace of destocking, not an actual rise in inventories.

Shorter-term indicators remain mostly grim and labour market news should be especially awful over the next few months. Nevertheless, this week’s purchasing managers surveys at least suggest some slowdown in the pace of industrial contraction – fourth chart.

The spread between UK banks’ average lending and deposit rates – a measure of their net interest margin – remained close to its historical low in January, according to estimates derived from Bank of England data published today. The spread stood at 2.08%, little changed from 2.09% in September before the MPC began slashing Bank rate and well below its average of 2.77% over 1999-2008 – see chart.

Some commentators accuse banks of widening margins by increasing the spread between lending rates and Bank rate, particularly for new and refinancing borrowers. The effect, however, has been offset by a rise in deposit rates relative to Bank rate. For example, the spread between Bank rate and the average rate paid on interest-bearing sight (i.e. instant access) deposits from households fell to just 0.47% in January versus an average of 2.20% over 1999-2008. In effect, banks have been forced to charge borrowers more in order to keep deposit rates high enough to retain funds.

The sight deposit rate stood at just 1.14% in January, a level that does not fully reflect the 0.5 percentage point reduction in Bank rate to 1.5% at the start of the month. The MPC cut by a further 0.5 pp in February and the consensus expects another 0.5 pp this week. If this is delivered, banks will face a choice between lowering sight deposit rates almost to zero, thereby risking a significant outflow of funds in favour of government-sponsored savings (National Savings / Northern Rock), or allowing a further narrowing of the Bank / deposit rate spread, with negative implications for profitability. Either way, their ability / willingness to lend may be impaired.

The MPC discussed possible adverse effects of a larger Bank rate cut at the February meeting. “There was a great deal of uncertainty about what would happen to banks’ and building societies’ willingness to lend at low levels of interest rates. It was possible that the negative impact on profitability could be significant for some banks as Bank rate fell further. Taking that into account, a majority of members concluded that a cut of 50 basis points was appropriate this month.”

If a sub-1% Bank rate was judged inappropriate last month, despite the MPC’s forecast of a significant inflation undershoot over the medium term, it would seem difficult to justify a further cut this week. Contrary to popular assertion, there is no technical requirement to reduce Bank rate towards zero before embarking on asset purchases designed to boost the money supply – see previous post for more discussion.

The Bank of England’s central forecast, based on an unchanged 1% Bank rate, implies a further decline in GDP of about 1.9% from the fourth quarter of 2008 to a bottom in the third quarter of 2009. It then embarks on a strong recovery, rising by 3.2% in the year to the third quarter of 2010. Risks to this forecast, however, are judged to be “weighted heavily to the downside”. Indeed, the Bank’s mean projection – which takes into account this skew – entails a further 2.7% fall by the third quarter of 2009, with slower growth of 1.9% in the subsequent year.

The Bank’s forecasts can be cross-checked against the monetary leading indicator model described in earlier posts. This predicts GDP three quarters in advance based on current and lagged values of interest rates (three-month LIBOR), real money supply growth (both narrow and broad measures), the corporate liquidity ratio (companies’ bank deposits divided by their bank borrowing), the yield spread between corporate bonds and gilts, the effective exchange rate and share prices. The model’s forecasts can be expressed either as a probability of the economy being in recession (defined as an annual fall in GDP) or a numerical growth prediction.

The model supports the Bank’s forecast that recessionary forces will abate in late 2009. Based on available first-quarter data, the recession probability estimate falls significantly between the third and fourth quarters of 2009 – see chart – while the numerical projections imply a small GDP rise in the final quarter. However, the model casts doubt on the Bank’s forecast of a subsequent solid recovery. On the assumption that the input variables remain at their current values over the remainder of 2009, GDP is projected to grow by only 1.2% in the year to the third quarter of 2010 – well below the Bank’s central and mean forecasts of 3.2% and 1.9% respectively.

With the scope for further interest rate stimulus exhausted, a revival in monetary growth represents the best hope of achieving an outcome more in line with the Bank’s projections. The model can be used to assess the possible impact of the MPC’s new initiative to boost the money supply by buying gilts and other securities, financing purchases by creating new bank reserves. Suppose the programme results in a five percentage point rise in the annual growth rates of both broad and narrow money by the end of the third quarter of 2009. With all other input variables unchanged, the model forecasts GDP growth in the subsequent year of 2.2% – 1.0 percentage points higher than in the “base case”. This understates the impact because the monetary acceleration would be likely to affect other model inputs favourably: the corporate liquidity ratio would probably rise, while credit spreads might narrow and share prices rally as investors with higher cash balances deployed funds.

How big would Bank asset purchases have to be to have a monetary impact of five percentage points? Excluding deposits of “intermediate other financial corporations”, the broad money supply M4 stood at £1.7 trillion at the end of December so a 5% boost implies an increase of £85 billion. The Bank’s buying, however, will have a direct impact on M4 only if securities are purchased from domestic non-bank investors – essentially, insurance companies and pension funds, non-financial companies and households. Purchases from banks will increase M4 only if their lending rises as a result – far from guaranteed given current capital constraints and risk aversion. Assuming that one-third of the securities bought by the Bank is acquired from banks or overseas investors, the programme might need to amount to at least £125 billion to have the desired monetary impact.

The upcoming MPC meeting is intriguing. Despite an Inflation Report forecast showing annual CPI inflation far below target in the medium term if Bank rate remains at 1%, only David Blanchflower voted for a reduction of more than 0.5 percentage points in February. This suggests other MPC members believe that cutting Bank rate below 1% would have a negligible or even negative impact on the economy. The Report explains that, in the event of a further cut, banks might fail to pass on the reduction; alternatively, their interest margins would be squeezed, damaging earnings and lending capacity. If most MPC members held this view in February, as the vote suggests, it would seem logically inconsistent for those individuals to support a cut at this month’s meeting.

Some commentators have suggested that an unchanged 1% Bank rate would conflict with the MPC’s plans to finance asset purchases by creating new bank reserves. They argue that an expansion of reserves will push very short-term interest rates towards zero, undermining the main objective of the Bank of England’s money market operations – “to implement monetary policy by maintaining overnight market interest rates in line with Bank rate”. This appears to be incorrect. Under current arrangements, banks choose the level of reserves they wish to hold on average each month and are remunerated at Bank rate on balances close to these targets. In theory, the Bank could coordinate with banks to raise targets progressively so that reserves created by asset purchases continue to earn interest at Bank rate. In addition, the Bank could limit any decline in market rates by allowing banks to make greater use of its operational standing deposit facility, which pays Bank rate minus 25 basis points; this level would then act as a floor for overnight rates. The facility is intended to accommodate unexpected “frictional” payments shocks rather than a structural excess of reserves but the scale of its usage recently suggests that the Bank has adopted a liberal interpretation of this requirement. (Deposits averaged £5 billion during the December maintenance period versus reserve balances of £45 billion.)

Revised figures show that GDP fell by 0.02% between the first and second quarters of 2008, having previously been estimated to have risen marginally. So the recession began in the second not third quarter of last year.

A monthly GDP estimate can be calculated using output data for industry and services, which together account for 93% of total activity. This peaked in April, implying that the recession began in May last year – see chart.

After a 1.6% plunge in November, monthly GDP fell by a further 0.4% in December, to a level 0.8% below the fourth-quarter average. In other words, GDP would decline by 0.8% in the first quarter even in the unlikely event of activity stabilising in early 2009. For comparison, the Bank of England’s central forecast implies a 1.1% first-quarter drop.

The expenditure breakdown is not particularly reliable at this stage but suggests that inventory liquidation accounted for much of the 1.5% fall in GDP in the fourth quarter. Domestic final demand contracted by a smaller-than-feared 0.5%, with a large – but presumably temporary – rise in government spending providing support.

The GDP price measures are also subject to significant revision but do not support deflation claims. The deflator for gross value added at basic prices – which corrects for the depressing effect of the VAT cut – rose by 1.2% on the quarter for a 3.6% annual gain. (See here for more on inflation.)

On the face of it, Northern Rock is suffering significantly higher delinquencies on its mortgage lending than the industry average. According to yesterday’s 2008 results preview, residential loans more than three months in arrears were 2.92% of the total number of loans at the end of December, which compares with an industry figure of 1.87% (reported by the Council of Mortgage Lenders last week).

The Northern Rock number, however, has been inflated by its policy of encouraging borrowers to refinance their loans with other lenders. The number of mortgages in the Granite pool fell by 30% during 2008, a figure likely to be representative of the bank as a whole. With other banks tightening lending criteria, only Rock’s more credit-worthy customers will have been able to refinance elsewhere and it is reasonable to assume that most of these borrowers have continued to service their loans.

Accordingly, when comparing Rock’s arrears performance with the industry average, it may be more appropriate to express the number of cases as a proportion of the total including those who have moved to other lenders, i.e. the number at the end of 2007 rather than 2008. Adjusting for a 30% fall, this reduces the three months plus arrears proportion at the end of December to 2.05% – only slightly higher than the industry figure.

One way of moving borrowers off arrears is to repossess their homes. Properties accounting for 0.66% of the loans in the Granite pool at the end of 2007 were repossessed during 2008, which compares with an industry repossession rate of 0.34% last year. Northern Rock has therefore contained the rise in its arrears proportion by a relatively aggressive repossessions policy but the effect has not been large.

Arrears nationally are likely to continue to rise rapidly during 2008 – see here – and it is possible that Northern Rock’s relative performance will deteriorate more significantly in the process. Its rapid expansion during the late stages of the boom and an above-average loan-to-value ratio are reasons for pessimism but Rock avoided subprime lending and – unlike Bradford & Bingley – has limited exposure to the buy-to-let sector, where arrears are rising more rapidly.

Earlier posts on Northern Rock can be found here and here.