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All measures of the US money supply have risen strongly over the last three months – see chart and text below for definitions. On the traditional monetarist view that money leads the economic cycle by about six months, this suggests US activity will stabilise and begin to recover from the second quarter.

The Federal Reserve embarked on “quantitative easing” – i.e. monetary base expansion – in September. However, the broadest money measure M2+ began to accelerate only after the Fed began to buy commercial paper in late October. In contrast to its prior operations, which relied on banks transmitting additional liquidity to the wider economy, this initiative injected cash directly into corporate bank accounts.

Commercial paper purchases have slowed recently but the Fed has started to implement a previously-announced plan to buy up to $500 billion of agency mortgage-backed securities (MBS). External investment managers acting for the Fed had acquired $53 billion of MBS by last Wednesday. To the extent that purchases are from non-bank investors, this operation will also have a direct positive impact on broad money. The Fed is likely to discuss further initiatives, such as purchases of Treasuries, at this week’s policy meeting.

Sceptics argue that monetarist optimism is misplaced because faster money growth is being offset by a decline in the velocity of circulation. Clearly, recorded velocity is falling but this reflects the lag between money supply changes and their impact on activity and prices and is not evidence that the Fed’s new policy will be unsuccessful. Monetary trends are a leading indicator of nominal GDP whereas velocity is, at best, coincident.

Definitions:
M1 = currency and checkable deposits
M2 = M1 plus savings deposits, small time deposits and retail money funds
MZM = money of zero maturity = M1 plus savings deposits and all money funds
M2+ = M2 plus large time deposits at banks and institutional money funds (my definition and calculation)
Note: M3 = M2+ plus repurchase agreements and Eurodollar deposits (no longer published)

The most important parts of today’s package of financial support measures are the new Bank of England asset purchase facility and the commitments by Northern Rock and RBS to expand lending relative to previous plans. These have the potential to have an immediate impact on credit supply and monetary growth.

The asset purchase facility is significantly smaller than equivalent Federal Reserve initiatives but can be expanded at the request of the Monetary Policy Committee. The Fed has bought $335 billion of commercial paper and plans to purchase up to $500 billion of mortgage-backed securities – the $835 billion total is the equivalent of 10% of the broad money supply M2. The Bank’s asset purchase facility has been set initially at £50 billion, equivalent to 2.6% of broad money M4 (a wider definition than US M2).

The monetary impact of this programme will be supplemented by a slowdown in the rate of contraction of Northern Rock’s mortgage book and the commitment by RBS to maintain credit availability to large corporations as well as homeowners and small businesses and increase lending by a further £6 billion over the next 12 months. Rock’s previous business plan implied a further £20-25 billion reduction in its mortgage lending in 2009. If its mortgage book is now stabilised, the Rock / RBS initiatives together could add £30 billion to credit supply in 2009 – equivalent to a further 1.6% of M4.

The initial £50 billion purchase under the Bank of England asset purchase scheme will be financed by issuing Treasury bills, implying no impact on the monetary base – so it does not amount to “quantitative easing”. However, growth in the base has already picked up as a result of the Bank’s expanded lending to the banking system and the priority now is to boost broad money M4. The scheme will achieve this providing 1) the Bank buys assets from UK companies and non-bank financial institutions and 2) new Treasury bills are bought mainly by banks, as is likely. In other words, if successful, the scheme will amount to “printing money” to buy private-sector assets. (In theory, the MPC could request that the monetary base impact of a future expansion of the programme is not sterilised by issuing more Treasury bills, implying “quantitative easing”.)

The other parts of today’s package – in particular, the asset protection scheme and the guarantee scheme for asset-backed securities – have the potential to boost credit supply and monetary growth over the medium term but only if fees are set at non-penal levels. Prior UK financial support measures have been more expensive than equivalent schemes in other countries, reducing their effectiveness.

While welcome, today’s package is not all that might have been desired. In particular, the authorities continue to resist pressure to “underfund” the budget deficit in order to boost M4. This could have an immediate and significant impact in relieving the current corporate liquidity squeeze and would complement efforts to improve credit availability.

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COMMENT:
AUTHOR: Jonathan Purle
EMAIL: jp@intethic.com
IP: 81.148.166.47
URL: www.intethic.com
DATE: 01/21/2009 11:10:47 AM

I think this is semantics to argue that this is not quantitative easing. Ok, I take your point that its not expanding the monetary base in the way the Fed is.

But as you note yourself, financing purchase of longer-term assets using T-Bills is still ‘printing money’ via the fractional-reserve banking system.

I think you are still committing this Friedman/Schwartz error of believing that a monetary contraction is the cause of the difficulty – some sort of exogenous shock such that all you have to do is reverse this – rather than a symptom.

This is economics without a capital theory.

True, there are some profitable activities out there who are suffering from the secondary effects as the over-inflated value of collateral collapses and bank credit contracts.

But printing more money is as likely to prevent the correction in asset-values and the liquidation of malinvestments as it is to relieve the secondary effects.

The UK is at risk of following Japan’s path of a lost decade as a result of all these stimulas ideas – more so the monetary ones that actually have a short-term influence unlike cutting VAT!!

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COMMENT:
AUTHOR: Simon Ward
DATE: 01/21/2009 03:57:50 PM

Targeting a moderate, stable rate of monetary growth would have tempered the excesses of the boom and would now help to avoid unnecessary collateral damage from the economy’s inevitable adjustment.

There is a difference between quantitative action to prevent a monetary contraction and printing money on whatever scale is necessary to support the current level of asset prices.

Japan’s lost decade does not demonstrate the futility of monetary stimulus measures. The authorities never focused on boosting broad money and annual M2 growth remained below 5% throughout the 1990s – insufficient to create "excess" liquidity given a rising demand for money due to falling prices.

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COMMENT:
AUTHOR: Jonathan Purle
EMAIL: jp@intethic.com
IP: 86.160.33.216
URL: www.intethic.com
DATE: 01/22/2009 09:00:14 PM

In fact the Japanese figures for Broad money growth are even tighter than you mention – as you get into the period of BoJ’s attempts at quantitative easing: the growth in M2 plus certificates of deposits fell from 3.6% to 1.7% in the 5 years to 2003 inc. I’ll come back to that…

If "quantitative action to prevent a monetary contraction" does not "support the current level of asset prices", what would be the point in doing it? (Assuming, of course, this is possible with broad money).

I mean, what is the transmission mechanism by which the increased money supply impacts ‘demand’ in the monetarist models? Surely, this is primarily 2-fold as per Congdon: (1) a wealth effect from the new money being used in the first instance to purchase existing (inelastic) assets and so increasing their prices, and so funding "mortgage equity withdrawal" etc; and/or (2) more money going into bonds so as to lower market interest-rates and hence the ‘cost of capital’ (by increasing bond prices).

Or are you working off a Pantinkin style ‘real balance effect’ with seemingly no assets? Or simply relying on what Gov. Benanke referred to as a ‘black box’ transmission mechanism?

If asset prices are allowed to continue correcting themselves, the result is continued deleveraging and contraction in bank credit as losses mount and the value of collateral declines i.e. broad money contracts as a symptom of the correction rather than as a cause of the recession.

Returning to Japan, this is precisely what happened and can explain M2+CDs – the loan books of commercial banks contracted from 476trillion yen to 407 between 97-03 while land prices (collateral) continued to fall in value.

In other words, for an increase in the money supply to take the edge off the recession, it must surely do so by continuing to distort the structure of relative prices and asset prices generally? If attempts at monetary stimulus do not do this, then you will be pushing on a piece of string while broad money contracts…

On a lighter note, perhaps this is indeed the 3rd (or 4th?) case in my lifetime of the Treasury/BoE not understanding that ignoring the supply of money and credit so as to focus on other things (the exchange rate, CPI-targets) is a recipe for boom-bust. But is this an argument for monetary targeting? Or for binning the fractional reserve banking system and this misplaced belief in the ability of central banks and the State to centrally plan the money supply?

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COMMENT:
AUTHOR: Simon Ward
DATE: 01/23/2009 03:02:48 PM

There is absolutely no difficulty in boosting broad money. The government simply finances the budget deficit by borrowing from the central bank instead of selling gilts to non-banks. If it wishes, the central bank can sterilise the impact on the monetary base by reducing its normal lending to the banking system – this aspect is of secondary importance. Whether it does or not, broad money is higher (base expansion could magnify the impact but that depends on banks lending out additional reserves).

The supply of money has now expanded relative to the demand for money based on existing levels of income, wealth, interest rates etc. Except in the extreme case of a liquidity trap – an intellectual curiosity – this will lead to an increase in spending on goods and services and / or investment in financial or real assets as individual firms and households attempt to rebalance their portfolios. If spending on goods and services rises there is a direct impact on the economy unrelated to any asset price effect.

Efforts by individuals to restore equilibrium in their portfolios result in money being transferred to other agents, who will then undertake similar reallocations. The process continues until aggregate income, wealth etc. have adjusted sufficiently to balance economy-wide money demand with the increased supply. Asset prices have risen but this is a side-effect rather than the essence of the transmission mechanism. (This is all standard Congdon.)

The shocking 1.5% GDP fall in the fourth quarter reflects a collapse in output in November and December. The chart shows quarterly GDP rebased to the peak in the second quarter of 2008 together with a monthly estimate derived from data on industrial and services production. Monthly GDP was little changed between September and October but plunged 1.7% in November and a further 0.7% in December. (The Office for National Statistics currently has little information on activity in December so the latter figure could be revised significantly.) The December reading was 1.0% below the fourth-quarter average, implying a large negative carry-over into the first quarter. Monthly GDP has fallen 3.6% from a peak reached in April last year.

Retail sales figures also released today show a 0.6% rise between the third and fourth quarters. With retail spending accounting for about 20% of GDP, this suggests that other components of demand – non-retail consumer spending, government consumption, investment, stockbuilding and net exports – subtracted 1.6 percentage points from economy-wide output in the fourth quarter. In other words, GDP excluding high-street spending fell about 2%.

The severe corporate liquidity squeeze is likely to have resulted in a major decline in business investment and stockbuilding. Housing investment and consumer spending on cars should also have made significant negative contributions while even government expenditure may have fallen – output of “government and other services” was down 0.5% from the third quarter. Trade figures for October and November suggest net exports of goods had little impact, despite sterling’s plunge.

As previously noted, monetary weakness in late 2008 implies continuing economic contraction during the first half but prospects for later in the year will depend on money and credit trends in early 2009. Fed-style operations to bypass the banking system and supply cash and credit directly to companies, financial institutions and households offer the best hope of avoiding a prolonged recession. The new Bank of England asset purchase facility is a promising first step – the MPC should push for rapid implementation and expansion of the programme.

When the Bank of England buys securities from an insurance company or pension fund, the initial effect is to boost the institution’s deposit with its commercial bank, while the bank receives a credit in its reserves account at the Bank of England. The rise in institutional deposits constitutes an increase in the broad money supply M4, while the injection of reserves inflates the monetary base M0.

The Bank of England can “sterilise” the reserves impact of this transaction, for example by reducing its repo lending to the banking system or selling bills. However, providing any such operation is conducted with the banking system, there is no reversal of the initial rise in bank deposits and broad money M4.

For this reason, the Bank’s new asset purchase facility is likely to boost M4, even though additional Treasury bills will be sold to finance the scheme. M4 will rise providing 1) the Bank purchases securities from the non-bank private sector and 2) the additional bills are bought by the banking system.

In a speech last night, Bank of England Governor Mervyn King stated that “unconventional” monetary policy measures the MPC might use “would take the form of purchases by the Bank of England of a range of financial assets in order to expand the amount of reserves held by commercial banks and to increase the availability of credit to companies … Provided the additional reserves are not simply hoarded by banks … such asset purchases can increase the supply of broad money and credit”.

Mr. King is wrong. A positive impact on broad money does not depend on banks’ lending out additional reserves or even on the creation of new reserves. All that is required is that the Bank buys securities from non-banks and that any operation to sterilise the associated increase in reserves is conducted with banks.

This is not a technical point. A key reason for recommending quantitative action is to offset the drag on M4 from weak commercial bank lending. The attraction of the option is that it allows the authorities to influence directly the supply of money and credit, without relying on banks to transmit additional liquidity to the wider economy. Yet Mr. King appears to believe that any positive impact will occur only if “additional reserves are not simply hoarded by banks”.

As documented in a previous post, Mr. King’s speeches tend to be associated with a significant one-day decline in sterling. The effective index was 1.6% below last night’s close at midday.

CPI figures for December showed a much smaller decline than expected, probably reflecting sterling’s plunge during 2008 and an associated surge in manufactured import prices – up 14% in the year to November.

Annual CPI inflation fell to 3.1% from 4.1% in December but would have risen but for the VAT cut and lower energy costs. The Office for National Statistics estimates that the Pre-Budget Report tax changes would have subtracted 1.3 percentage points from the annual rate if passed on in full. It also reports that around two-thirds of prices collected in shops had been reduced, either at the shelf or the till, to reflect the lower VAT rate in December. This suggests that annual CPI inflation was depressed by 0.8-0.9 pp (two-thirds of 1.3).

A further negative impact, of 0.3 pp, came from lower energy prices. So annual CPI inflation would probably have risen from 4.1% to 4.2-4.3% without the VAT cut and a slump in world energy costs.

The VAT cut also accounts for the fall in annual “core” inflation – excluding energy, food, alcohol and tobacco – from 2.0% to 1.1%. The ONS estimate of the full CPI effect implies a reduction of 1.7 pp in the annual core rate in the event of full pass-through, or 1.1 pp with a two-thirds adjustment. This suggests annual core inflation would have risen from 2.0% to 2.2% – the highest since September – in the absence of the VAT cut.

Banks and building societies operating in the UK suffered an aggregate net loss after tax and provisions of £5.8 billion in the first three quarters of 2008, according to data obtained from the Bank of England under a freedom of information request. This compares with a net profit for banks alone of £29.0 billion in all of 2007. (The statistics include building societies from the start of 2008.)

The loss over Q1-Q3 2008 was due to a negative contribution of £18.9 billion from dealing activities – probably reflecting write-downs on securitised assets – and provisions of £12.8 billion for bad and doubtful debts. Pre-tax profits excluding dealing and provisions were £26.6 billion versus £40.5 billion for banks alone in all of 2007 – see chart.

Despite the £5.8 billion loss, banks and building societies paid out dividends of £17.9 billion over Q1-Q3 2008. Consequently, their stock of retained earnings fell by £23.6 billion – more than cumulative retentions by banks alone over the previous three years.

Even allowing for a further retained earnings loss in the fourth quarter, the erosion of internal capital last year will have been comfortably exceeded by new capital-raising of more than £70 billion, with the government contributing £37 billion. In other words, despite staggering write-downs and provisions, banks’ and building societies’ aggregate capital ended 2008 significantly higher than a year before.

Insurance companies and pension funds increased their liquid assets – currency, bank deposits and short-term money market paper – by £28 billion, or 18%, in the year to September. With the value of their portfolios falling by 10% over the same period, the ratio of liquid to total assets rose to 9.1% – the highest since September 1990.

Even assuming no further addition to liquid assets in the fourth quarter, weakness in markets should have ensured a continued rise in the ratio. In other words, the liquidity ratio has probably now surpassed the 1990 peak and is at its highest level since 1974 – see first chart.

Institutions generally target a stable proportion of liquid assets in portfolios over the medium term. For insurance companies and pension funds in aggregate, the ratio has averaged 5.5% since 1964 and the chart shows evidence of mean reversion.

Suppose insurers and pension funds attempted to reduce the liquidity ratio to its long-run average of 5.5%. Based on the position in September, this would involve a first-round injection of £70 billion into markets. Institutions might take the opportunity to “rebalance” their portfolios towards assets that have underperformed recently, including UK equities and corporate bonds. (Overseas investments have benefited from the fall in sterling.)

The £70 billion of buying, however, would represent only the first stage of a multiplier process. An individual institution can reduce its liquidity ratio by buying assets but if the seller is also an insurer or pension fund the aggregate position is unchanged. Rather than being extinguished, “excess” liquidity is simply transferred to another institution, leading to a further round of buying.

Consider the extreme case of a fixed supply of assets entirely owned by insurance companies and pension funds. Liquidity would circulate between institutions, stimulating further buying, until asset prices rose sufficiently to bring the aggregate liquidity ratio down to its target value. In other words, asset prices would bear the entire burden of adjustment back to equilibrium.

In practice, the supply of assets available to insurers and pension funds is not fixed – higher asset prices will induce other holders (e.g. overseas investors) to sell and originators to issue more. However, the essential point remains – the attempt to restore liquidity equilibrium is likely to involve multiple rounds of buying and a significant impact on asset prices.

Consistent with this explanation, there is historical evidence of a positive relationship between the level of insurance companies and pension funds’ aggregate liquidity ratio and future UK inflation-adjusted equity returns – second chart. The line of best fit suggests each 1 percentage point rise in the ratio is associated with a 10% increase in the cumulative real return on equities over the subsequent five years.

One caveat to the above analysis is that institutions may wish to hold a higher proportion of short-term assets in their portfolios than in the past because they have entered into interest rate swap agreements involving payment of a floating rate in exchange for a fixed nominal or real income stream, intended to match future liabilities. This may have raised the “equilibrium” level of the liquidity ratio, although any increase is likely to have been much smaller than the recent actual rise, implying the latter still has positive implications for asset prices.

 

The Nationwide house price index for December was 18% below the peak reached in October 2007. The chart updates a comparison of the current decline with the house price busts in the early 1990s and mid 1970s. (The Halifax index does not extend back to the 1970s.)

The projections assume that 1) inflation-adjusted house prices follow the same path from their peak as in the 1990s or 1970s and 2) retail prices move in line with consensus expectations, derived from the Treasury’s monthly survey of forecasters. The last actual number in the chart is an estimate for the first quarter assuming a further 1% fall in prices from their December level.

The current decline continues to track the 1990s bust closely. An exact replication would involve a further 15% fall in prices from their December level to a trough in the first quarter of 2011. The slightly milder 1970s bust would imply an 11% decline to a low one quarter later.

Cuts in interest rates were constrained in the 1970s and 1990s by high inflation and ERM membership respectively. On the other hand, mortgage credit availability may have deteriorated to a greater extent in the current cycle – although inflation-adjusted mortgage lending contracted significantly in the 1970s. I intend to revisit a comparison of valuations in a future post.

The corporate liquidity ratio – companies’ holdings of short-term assets divided by their short-term borrowing – is a good leading indicator of the economic cycle. A falling ratio may indicate that corporate profits are weakening and / or companies are expanding their operations too rapidly. In either case, future retrenchment is more likely, involving cuts in investment and jobs.

In the UK, the ratio of private non-financial companies’ M4 money holdings to their bank borrowing – a proxy for the liquidity ratio – began to fall significantly as long ago as 2005. It has continued to decline in recent months, matching the low reached in the early 1990s recession. This signals ongoing business contraction at least through mid 2009.

Worryingly, a similar trend is now in place in the Eurozone. The chart shows the ratio of Eurozone companies’ M3 holdings to bank loans with an original maturity of up to five years. This began to decline significantly in early 2007 and is currently at its lowest since 2003.

The higher level of the Eurozone ratio compared with the UK is of limited comfort. Unlike their UK counterparts, Eurozone companies borrow significantly on a long-term basis from their banks – about half of outstanding loans have an original maturity of more than five years. Including these in the calculation would push the ratio well below the UK level.

As in the UK, the decline in the Eurozone ratio initially reflected rapid growth in borrowing but slowing monetary expansion has been the key driver more recently. The annual rate of change of non-financial companies’ M3 holdings fell from 13% in November 2007 to 3% a year later – the lowest on record since 2000.

The appropriate policy response to the corporate liquidity squeeze is Fed-style quantitative action to boost aggregate broad money supply growth. Such measures are required just as urgently in the Eurozone as the UK.

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COMMENT:
AUTHOR: Jonathan Purle
EMAIL: jp@intethic.com
IP: 81.148.166.47
URL:
DATE: 01/08/2009 11:22:49 AM

Simon, I have a recollection of you saying back in the Autumn (Sept 12th) that the recession wasn’t a done deal and the money supply was holding up. Obviously it wasn’t?

I sometimes wonder if quantitative easing is based on Friedman or Idi Amin – the latter having been told by God that if the country was poor, Uganda’s central bank needed to print more money.

It surely makes sense only if you subscribe to Friedman’s view that a declining quantity of money is the cause of a depression – rather than being a symptom of a much needed correction to previous monetary excesses.

Quantitative easing might well in the short-term ease the problem of a $trillion of EU corporate debt needing refinancing in 2009. Especially given a backdrop of world Government’s issuing $3trillion of sovereign bonds to fund balooning deficits, and even half-baked ideas to reflate mortgage lending by underwriting a £100bn of RMBS effectively at the expense of corporate paper. In oither words, it’ll give some of the industry’s funds a nice boost.

But it doesn’t alter the fundamental weaknesses of US or UK economies, where neither labour nor capital are homogenous in the way so many macroeconomists seem to assume. "Mr Keynes’ aggregates conceal the most fundamental mechanisms of change" – Hayek (1931).

Real Estate Agents will not be convinced to retrain. "Car" Companies who only sell cars when there’s plenty of credit around, and then only make a profit if they sell that credit themselves, will not be liquidated and replaced by more efficient outfits. Malinvestments made on the back of the previous monetary expansion will not be liquidated as quickly and over-inflated asset prices will take longer to fall back.

As I see it, there are 3 choices. Let things run their course, as painful as this may be, so we can then hasten a real recovery. Or short-term fiscal and monetary stimulas that drags out the pain for years (a la Japan). Or longer-term reflation giving us a mild hyper-inflation, putting off the worst of it until the cholera outbreak… Personally, the first one looks the least worse of the options to me…

My MPC-ometer model predicted large cuts in Bank rate in November and December but not on the scale delivered. There was a similar divergence in 2001, after the 11 September US terrorist attacks, when the MPC appeared to “bring forward” reductions ahead of an expected deterioration in economic data.

To capture this behaviour in 2001, I included a “dummy variable” in the model, which had the effect of lowering the predicted level of Bank rate in October and November 2001 and raising it over the subsequent four months. Using an identical timing shift variable starting in November 2008 improves the model’s recent forecasting performance.

The 2001 parallel suggests that, having cut rates by more than suggested by incoming data in November and December, the MPC will require compelling evidence of further economic deterioration and / or diminishing inflationary pressures to warrant continuing to ease aggressively in early 2009.

For January, the version of the model including the dummy variable predicts a 25 bp cut. After its late 2008 pyrotechnics the MPC is unlikely to move by as little as 25 bp so the choice is between no change and a 50 bp reduction. I favour the former, on the view that the Committee will regard falls in the exchange rate and interbank / policy rate spreads over the last month as substituting for a further official cut. (The sterling effective index on Friday was 8% below its level at the start of the December meeting, while the three-month LIBOR / overnight indexed swap rate spread was 80 bp lower at this morning’s fix.) An additional argument for delaying any further move until February is that fourth-quarter GDP figures and results of the Inflation Report forecast round will then be available.

Interestingly, the Sunday Times Shadow MPC, which often calls the decision correctly, voted 6-3 for no change at its latest meeting.

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COMMENT:
AUTHOR: David P
EMAIL: david@pashley.org.uk
IP: 81.6.213.122
URL:
DATE: 01/06/2009 01:17:36 PM

My inexpert opinion concurs with your forecast of no change.

In addition to the sound arguments you bring forward, retail stocks are rising today on some better-than-expected Q4 figures, even though previous base-rate cuts and fiscal measures did not really impact until Dec.

Interesting to hear the retailers tempering any optimism with talk of future price pressures caused by the devaluation of the pound. Can the BoE really want it to fall still lower?