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The effective exchange rate has fallen by 25% since July 2007. This represents the largest depreciation over 17 months in the history of the index (going back to 1960).

At various stages of this plunge Bank of England Governor Mervyn King has spoken approvingly of a lower exchange rate. For example, in a speech in January he stated:

If we are to raise our national saving rate without overall demand, output and employment suffering in the medium term, we will need to export more and import less. Such a rebalancing is helped by the fall in sterling’s effective exchange rate. Sterling has fallen, against a trade-weighted basket of currencies by almost 10% since August. And financial markets are pricing in a significant probability of a further decline in the exchange rate during this year.

During the press conference to present the November Inflation Report, when asked whether the large decline in sterling worried him, Mr. King replied:

Well clearly if sterling falls far enough this will be a concern and it will have an impact on inflation. I think it is not surprising that it has fallen over the past year…And that can be a helpful part of the rebalancing provided it doesn’t threaten our ability to meet the inflation target.

Policy-makers’ comments arguably have little long-run impact on exchange rates. However, there is evidence that Mr. King’s remarks have had at least a short-term effect. The effective index has fallen by an average of 8 basis points a day since its peak in July 2007. Mr. King has given six speeches and presented at six Inflation Report press conferences over this period. The average daily change in the index following these 12 appearances was -50 bp. (This refers to the change on the day of his appearance when this occurred within trading hours or on the following day in the case of evening speeches.)

Mr. King’s view that a lower pound supports economic activity is questionable, particularly under current circumstances. British banks are dependent on overseas wholesale funding to bridge the gap between their UK-based deposits and lending. Net sterling borrowing from overseas stood at £162 billion in October, equivalent to 11% of GDP. Expectations of continuing sterling depreciation could lead to a withdrawal of this funding or an increase in its cost, thereby further tightening domestic credit conditions.

Markets are grappling with the issue of whether the bursting of the credit bubble will usher in sustained deflation, as occurred in the US in the 1930s and Japan in the 1990s. The answer will depend on monetary trends.

The onset of deflation in Japan was presaged by the annual rate of change of M2 turning negative in September 1992 – see first chart. M2 growth subsequently recovered but never rose above 5%.

When an economy enters deflation the demand for money rises, reflecting its appreciating purchasing power. To create “excess” money balances and reverse the falling trend in prices the authorities need to engineer a major acceleration in monetary growth. The Bank of Japan never achieved a boost on the required scale and the economy arguably never exited deflation.

In the interwar US, the annual rate of change of M2 was negative for almost five years between 1929 and 1934 – second chart. However, a major recovery ensued in 1935-36, with annual growth reaching a peak of nearly 13%. This succeeded in pulling the economy out of deflation temporarily before money trends slumped again in 1937-38.

US annual M2 growth was stable at about 6% between mid 2007 and mid 2008 and has recently moved above 7% – third chart. A broader liquidity aggregate including institutional money funds, large time deposits, commercial paper and Treasury bills is rising at a faster pace, of about 10%. The financial crisis has resulted in a rise in the precautionary demand for money but these growth rates appear incompatible with sustained deflation. (The latter should be distinguished from a temporary fall in consumer prices due to commodity price declines.)

Some commentators portray deflation as an inevitable consequence of the bursting of the bubble and monetary policy-makers as powerless bystanders. This is wrong. The Fed and other central banks are capable of expanding the money supply on whatever scale is necessary to prevent falling prices. The Fed has recently announced measures that will directly boost M2; the UK authorities must quickly embrace similar initiatives.

The ratio of household wealth to income is likely to have fallen by over 20% during 2008, reaching its lowest level for 10 years.

Net wealth – defined here as the value of houses and financial assets owned minus mortgage and other debt – amounted to £6.7 trillion at the end of 2007, or 7.6 times disposable income. Gross wealth was £8.2 trillion, of which housing contributed £4.1 trillion and direct and indirect equity holdings an estimated £1.8 trillion, while debt stood at £1.5 trillion.

An average of the Halifax and Nationwide house price indices fell by 15% between December 2007 and November 2008. Equity prices – as measured by the FT all-share index – were 35% lower at the end of November than at the close of 2007. These declines imply a loss of wealth of about £1.3 trillion.

Allowing for further growth in debt and a rise in income, the net wealth / income ratio is estimated to have fallen from 7.6 to 5.9 – a 22% decline. The largest previous annual drop was 21% in 1974.

The chart shows the ratio of net wealth to income along with gross wealth and debt separately. The recent loss is much greater than in the early 2000s, when housing resilience offset large equity price falls. The net wealth to income ratio hit consecutive record levels over 2004-07 but this year’s plunge has wiped out the entire rise since 2002.

Previous posts have argued that the UK authorities should “underfund” the public sector deficit to support broad money growth. Underfunding means borrowing from the banking system rather than selling debt to non-banks.

In the first seven months of 2008-09, the authorities have actually overfunded the deficit. According to the Bank of England, public sector sterling borrowing from banks, net of sterling deposits, fell by £17 billion over April-October – equivalent to 1.0% of broad money M4.

This overfunding reflects a decision to expand debt sales to cover the costs of the financial crisis. According to the Debt Management Office, various measures including transfer of the Northern Rock loan to the Treasury, bank recapitalisation and the Bradford & Bingley / Icesave rescues have added £81 billion to funding needs in 2008-09. These measures do not have a direct impact on the broad money supply but associated debt sales transfer funds from private deposits included in M4 to government deposits, resulting in a fall in the public sector’s net borrowing from banks.

Assuming the full £81 billion to cover financial support measures is raised from debt sales to non-banks, additional overfunding of £64 billion could occur between November and March – equivalent to over 3% of M4. Current funding policy therefore risks exacerbating liquidity pressures on firms and households, with negative economic implications.

Central banks, led by the Fed, are expanding their range of tools for supplying liquidity to markets and promoting financial stability.

Some of these interventions have no impact on either the monetary base – currency in circulation and bank reserves held at the central bank – or broad money supply measures. Actions that expand the base may be termed “quantitative easing”. The expression “printing money” should be reserved for interventions that directly boost the broad money supply. (These are my suggested definitions – economists often use the terms interchangeably.)

In theory, an increase in reserves held at the central bank encourages banks to expand their lending, thereby boosting broad money. In practice, however, many other factors also influence banks’ lending behaviour, resulting in large swings in the “money multiplier” – the ratio of broad money to the monetary base.

With banks currently under pressure to raise capital ratios, and able to obtain wholesale funding only on expensive terms, a rise in the monetary base is unlikely to feed through to an expansion of bank lending and broad money. “Quantitative easing” may therefore provide limited support to financial markets and the wider economy – “printing money” is required.

Various central bank actions are classified below according to their impact on monetary measures, with more radical interventions lower down the list.

The Fed employed sterilised lending (1) until Lehman’s failure in September but subsequently embarked on quantitative easing (2). Last week’s news that it would buy $600 billion of securities issued or guaranteed by government-sponsored enterprises implies printing money – either (3) or (4). If the full amount announced is bought from non-banks, money supply M2 would rise by 8%, other things being equal.

This shift was confirmed this week by Fed Chairman Bernanke’s suggestion that the central bank “could purchase longer-term Treasury or agency securities on the open market in substantial quantities”. If Fed buying of Treasuries substituted for debt sales to non-banks, this would amount to “underfunding” the budget deficit (5). Fed purchases used to finance an expanded deficit would be equivalent to Milton Friedman’s “helicopter drop” of money (6).

Japan’s policy of quantitative easing in 2001 targeted the monetary base but involved the Bank of Japan buying Japanese government bonds (JGBs) so it also resulted in an expansion of broad money – (4) below. In the year from March 2001 the BoJ bought ¥29 trillion of JGBs, equivalent to 4.5% of Japanese M2. (Some of these may have been purchased from banks, implying a smaller monetary impact.)

The ECB and Bank of England have engaged in quantitative easing since September – see chart – but neither central bank is yet printing money. The statement accompanying the MPC’s latest interest rate cut hinted at further market interventions but it is unclear whether the Bank is yet ready to copy the Fed’s recent initiatives.

1. Sterilised central bank lending to banking system
Example: Fed lends to commercial bank via discount window, simultaneously reduces conventional repo loans to banking system
Result: no impact on broad money or monetary base

2. Unsterilised central bank lending to banking system
Example: As above, no offsetting fall in repo loans
Result: bank reserves and monetary base expand – “quantitative easing”

3. Sterilised central bank purchase of securities from non-banks
Example: Fed buys mortgage-backed securities from insurance company, simultaneously reduces repo loans
Result: broad money expands – “printing money”

4. Unsterilised central bank purchase of securities from non-banks
Example: As above, no offsetting fall in repo loans
Result: broad money and monetary base expand – “printing money / quantitative easing”

5. Sterilised central bank lending to government to finance existing budget deficit
Example: Fed lends to Treasury, Treasury reduces debt sales to non-banks, Fed reduces repo loans
Result: broad money expands – “printing money / underfunding”

6. Unsterilised central bank lending to government to finance higher deficit
Example: Fed lends to Treasury, Treasury cuts taxes
Result: broad money, monetary base and incomes expand – “printing money / quantitative easing / helicopter drop”

With full data now available, both my MPC-ometer and ECB-ometer models suggest rate cuts tomorrow of 50 basis points, though with risks tilted towards more.

Models can break down under extreme conditions. Markets are priced for a full-point UK move and 75 bp from the ECB. It would take a brave central bank to disappoint expectations under current circumstances.

At least in the UK’s case, however, the model’s suggestion that a 50 bp cut is sufficient appears sensible given the 200 bp move in the prior two months, a 7% decline in the effective exchange rate since the November meeting and massive fiscal loosening announced in the Pre-Budget Report (with plans for later tightening predicated on a highly-optimistic economic forecast).

A headline-grabbing big cut in Bank rate may give the impression that the MPC is “doing something” but efforts would be better focused on direct actions to boost money and credit growth, including “underfunding” and Bank of England purchases of private paper. In the US, the Fed’s initiatives in this direction are bearing fruit, with narrow money M1 picking up and the three-month LIBOR / OIS spread of 180 bp well below the UK level of 250 bp.

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COMMENT:
AUTHOR: DavidP
EMAIL: david@pashley.org.uk
IP: 81.6.213.122
URL:
DATE: 12/04/2008 11:02:25 AM

Your final paragraph summarises the situation perfectly. If the BoE can’t find ways to reduce the LIBOR/OIS spread, a rate drop wont create the desired stimulus.

However the way your model is apparently strongly influenced by the exchange rate in predicting the size of cut seems flawed – especially in these abnormal circumstances. When the unexpected (and in my view late) 1.5% cut came, note that Sterling didn’t fall at all in immediate response, but instead devalued gradually over the subsequent weeks. The market is trying to predict the long term value of Sterling (i.e. demand) rather than being driven by base (or even interbank) rates. The falls over the last few days are more about publication of poor indicators than discounting today’s cut.

It would be better to have a 100 point cut now, so that the market is thinking about future increases, rather than going back to the usual dripfeed, which with the benefit of hindsight is always shown to have been too little too late.

Just some thoughts. Thanks for your excellent journal.

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COMMENT:
AUTHOR: Simon Ward
DATE: 12/04/2008 01:12:36 PM

Thanks for your comments. I hope you are right about a 100 bp cut offering support to sterling, given the vulnerability of the banking system to a withdrawal of overseas funds.

The MPC delivered the full-point cut expected by the market but the accompanying statement suggests its focus is shifting towards additional Fed-style interventions to improve money and credit flows. This would be a welcome if belated change and could imply Bank rate has reached a temporary floor at 2%.

With market conditions still “extremely difficult” despite the government’s financial support package, “the MPC noted that it was unlikely that a normal volume of lending would be restored without further measures”. Hopefully, this means the Bank of England emulating recent Fed actions designed to improve credit availability and boost the money supply rather than forcing banks to expand lending under threat of nationalisation.

The statement justified the rate cut with reference to the below-target inflation forecast in the November Inflation Report, weak activity data and further falls in commodity prices. The recent plunge in sterling was downplayed, as was the substantially weaker fiscal position revealed by the Pre-Budget Report. Indeed, the statement claims that “the new fiscal plans are unlikely to have a significant effect on inflation” over the longer term, despite the risk of an explosive rise in government debt.

Federal Reserve Bank credit – the Fed’s lending to banks, dealers, other central banks and AIG plus its holdings of securities – has soared by $850 billion, or over 90%, since 11 September, just before Lehman’s failure. Importantly, the Fed has chosen not to sterilise fully the impact of this expansion on banks’ reserves – their deposits held at the Fed. Reserves and currency in circulation constitute the monetary base. The average level of the base in the fortnight to 8 October was 17% higher than four weeks earlier.

Real monetary base expansion tends to lead economic activity so the recent pick-up could suggest improving growth prospects – see first chart. Historically, however, major swings in base money have been driven by the currency component rather than bank reserves. The hope is that banks holding excess cash in their accounts at the Fed will be more willing to lend to other banks and the wider economy but many commentators believe the Fed is “pushing on a string”.

The Fed is copying the Bank of Japan’s 2001 policy of “quantitative easing”, which involved the central bank buying government bonds in order to flood the banking system with liquidity. Real monetary base growth peaked at an annual 38% – see second chart. Commentators were similarly sceptical of any impact on financial behaviour or economic activity but growth recovered in 2002, while the rate of contraction of bank lending slowed, although these improvements may have reflected other factors.

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COMMENT:
AUTHOR: EQ
EMAIL: equityquant@gmail.com
IP: 76.181.239.178
URL:
DATE: 12/02/2008 11:55:00 PM

Do you know the parameters under which Thomson calculates "real" M1? Is it M1 in its entirety adjusted for inflation? The currency portion of M1 adjusted for inflation? I’m sort of curious. Thanks in advance.

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COMMENT:
AUTHOR: Simon Ward
DATE: 12/03/2008 10:34:19 AM

The inflation adjustment is made to M1 in aggregate, not just the currency component.

Reflecting fears of financial meltdown, UK savers withdrew cash from bank and building society accounts at a record pace in October. According to Bank of England data published today, households’ M4 money holdings fell by £5.2 billion, compared with an average rise of £5.6 billion over the prior 12 months. The cash withdrawn from banks appears to have been reinvested mainly in National Savings products and Treasury bills, which attracted £4.7 billion and £12.3 billion respectively – also records.

Other key features of the detailed monetary data for October include:

• M4 excluding money holdings of financial corporations slowed to an annual growth rate of 3.6% – the lowest since 1993.

• In addition to the decline in household deposits, M4 holdings of non-financial private corporations fell again, to stand 5.2% lower than a year before. This suggests ongoing severe pressure on profits – likely to be reflected in significant cuts in jobs and investment.

• Consistent with anecdotal evidence of a reduction in credit availability, bank borrowing by non-financial corporations grew at an annualised rate of just 2.4% in the three months to October, compared with a 10.7% rise in the prior year.

• Narrow money M1 – currency plus instant-access deposits – fell by 1.8% in the year to October, the largest annual decline since 1969. This compares unfavourably with recent trends in the US and Euroland, where M1 has been picking up.

• Banks replaced traditional interbank loans with purchases of bills issued by other banks and backed by the government under the Credit Guarantee Scheme. Market loans to other banks fell by £34.2 billion in October, while purchases of bank bills soared to £17.5 billion.

• The estimated spread between the average interest rate received on banks’ and building societies’ M4 lending and the rate paid on M4 deposit liabilities – a proxy for their net interest margin – fell slightly to a new low. Banks need a wider margin to enable them to rebuild capital to support higher lending.

The monetary data confirm a grim near-term economic outlook and warrant a further rate cut at this week’s MPC meeting. However, calls for Bank rate to fall quickly to 1% or even lower are questionable. Considerable stimulus is already in the pipeline in the form of the 2 percentage point reduction since September, a 17% fall in sterling’s effective rate over the last year and a projected rise in cyclically-adjusted public borrowing of 4.3% of GDP in 2008-09 and 2009-10 combined. The authorities’ efforts should now focus on improving the transmission mechanism and taking direct action to lift money and credit growth. Specifically, the Debt Management Office could fund the deficit partly by borrowing from banks, boosting M4, while the Bank of England could emulate the Fed by buying commercial paper and mortgage-backed securities, thereby easing credit supply.

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COMMENT:
AUTHOR: Simon Ward
DATE: 12/02/2008 11:39:54 AM

It doesn’t really drain funds from the system because if the government raises more through NSI it can issue fewer gilts. If the investors who would have bought the gilts hold their funds on deposit, there is no overall loss to the banking system, although particular banks could suffer an outflow.

MPC members have argued that Bank rate cuts and fiscal policy must bear more of the burden of supporting the economy because the “bank credit channel” of monetary policy is impaired. The logic is indisputable but the optimal solution is surely to take direct action to revive credit supply.

In the US, mortgage giants Fannie Mae and Freddie Mac, now under government control, are maintaining lending while the Fed has started to buy commercial paper and mortgage-backed securities on a large scale. The Fed’s recent actions have contributed to the three-month LIBOR / OIS spread falling to 1.8% – well below the UK level of 2.2% – while there are tentative signs of a pick-up in monetary growth.

In the UK, by contrast, state-run Northern Rock is on course to cut outstanding loans by £25-30 billion in 2009 while the Bank of England remains resolutely opposed to Fed-style direct lending to firms and households. Government plans to expand support for small firm credit and offer guarantees on mortgage securities backed by new loans are promising but cannot fully substitute for use of the central bank’s balance sheet.

The Bank’s intransigence is an extension of its refusal to offer lender-of-last-resort support to the banking system on other than penal terms – the special liquidity scheme is much more expensive to access than equivalent Fed or ECB facilities. The penal approach was also in evidence in Mervyn King’s recent suggestion that banks will be forced to raise still more capital if they refuse to expand their lending. The Bank’s October Financial Stability Report contained a detailed discussion of why the government’s £50 billion recapitalisation plan would be sufficient to cushion banks against losses over the next five years even in a severe macroeconomic scenario and assuming a low level of underlying future profits. Mr. King’s apparent U-turn is puzzling and threatens to undermine the confidence-building effects of the rescue package.