Blog

For the last couple of months my ECB-ometer model has suggested a neutral policy stance was warranted by economic data and financial market developments (see here). The statement issued after last week’s ECB meeting retained a hawkish slant but, as the FT has reported, comments from officials this week have been more ambiguous and may indicate the balance of opinion on the Governing Council is shifting.

The ECB-ometer attempts to estimate the average interest rate recommendation of Governing Council members each month. A reading of above 12.5 basis points generates a forecast of a 25 bp rise in the ECB’s repo rate; below -12.5 bp predicts a quarter-point cut. The chart below shows the history of official interest rate changes and the model’s forecasts since the ECB’s inception .

Based on the latest information, the ECB-ometer’s forecast for the February ECB meeting is 0 bp, implying an exactly neutral policy stance. The ECB may be toning down its hawkishness but the model suggests economic news needs to change significantly to warrant hopes of a rate cut. As well as more evidence of a serious slowdown, Governing Council members are likely to require falls in money supply expansion and household inflation expectations before contemplating a dovish shift.

The recent small decline in the euro may indicate the market is sensing a turn in the Eurozone interest rate cycle but a sustained reversal against the dollar probably also requires investors to believe that the next cut in US official rates will be the last for some time.

Last August Jim Cramer of CNBC ranted that the Fed had "no idea" how bad markets and the economy were looking. The central bank duly obliged with a 50 bp cut in its discount rate. Sir Stuart Rose of M&S tried a similar trick yesterday when commenting on his company’s woeful Christmas trading results. Thankfully, the MPC held firm.

The economy has slowed significantly in recent months but it is not clear that growth is weaker than the MPC desired when they tightened policy last year. Household inflation expectations and business price-raising plans remain at or above levels that troubled Committee members then. Meanwhile, financial conditions have eased significantly over the last month as interbank lending rates have tumbled and sterling has weakened sharply.

A 25 bp cut remains likely in February but the MPC is right to be cautious given near-term inflation risks.

Today’s downbeat December sales figures from the British Retail Consortium confirm the slowdown in retail spending predicted by our leading indicator – see here. The indicator has weakened further over the last month, reflecting falls in mortgage approvals and consumer buying intentions.

Despite a gathering consumer slowdown, I still think the MPC should and probably will leave rates unchanged this Thursday. As recent US experience has demonstrated, easing policy before inflation expectations moderate is liable to boost price pressures while proving ineffective in stimulating the economy. Consumer inflation perceptions rose to a new post-MPC-inception high in December (before Npower’s recent announcement of 17% and 13% hikes in gas and electricity tariffs) – see chart. Statistical analysis confirms that the MPC takes consumer and business inflation expectations into account in setting rates and it would be a surprise if they ignored this deterioration.

Our MPC-ometer model forecasts a 5-4 vote for unchanged rates at this week’s meeting (four votes for a cut). This also appears to be the consensus view: 51 out of 63 economists polled by Reuters expect no change. By contrast, the respected Sunday Times Shadow MPC has voted 5-4 for a 25 bp cut. (Like the MPC-ometer, the Shadow MPC correctly forecast the December reduction.)

The key factors holding the model back from forecasting a January cut are high household and business inflation expectations and the recent sharp drop in the effective exchange rate. It also takes into account the tendency for the MPC to prefer to move in Inflation Report months. Weakness in activity indicators has not been sufficient to outweigh these factors.

Assuming a 5-4 unchanged vote this month, the model suggests a high probability of a cut in February. There is clearly a chance that the Committee will choose to act early, as it did in January last year. However, with LIBOR spreads and sterling falling, financial conditions have eased significantly since its last meeting, giving it scope to wait for further information before acting again. I think that would be the right decision given troubling near-term inflation prospects.

On the last reading my probability indicator suggested a 45% chance of a US recession (I shall provide an update soon). While below the “trigger” level, such a high reading clearly implies a weak economy, with GDP growing negligibly. The data this week have been consistent with this picture.

Take today’s employment report for December. I think the index of aggregate hours worked in the private sector is a better cyclical indicator than headline non-farm payrolls. As the first chart shows, this measure has shown little growth over the last three months but is not yet contracting – a necessary but not sufficient condition for a recession.

A similar message comes from another sensitive indicator – the new orders index from the ISM manufacturing report. This index plunged to 46 in December but has fallen to 43 or below in recessions historically – see second chart.

If the US economy does fall into recession the culprit will be not the “credit crunch” but soaring energy prices. At the risk of labouring the point, I think premature Fed easing has been a significant contributor to this surge.

My last post suggested the Fed’s “pre-emptive” rate cuts have been counterproductive. Yesterday’s market action illustrates the dilemma the central bank now faces. A shockingly weak ISM manufacturing report caused market players to discount greater future rate cuts, with some even speculating about a move before the next scheduled FOMC meeting on 30th/31st January. These expectations contributed to a sharp drop in the dollar and a surge in commodity prices, with oil and gold hitting new peaks. Yet higher commodity costs will further squeeze consumer budgets and corporate profit margins, offsetting any support to the economy from lower rates.

The way out of this unproductive cycle is for the Fed to make clear that its primary focus is inflation. Further rate cuts should be made conditional on a stabilisation of the dollar and softer commodity prices. Until inflation expectations moderate, policy easing will continue to have little traction on the real economy.

Available evidence suggests the US economy continued to expand in the fourth quarter (e.g. consumer spending rose at a 2.6% annualised rate in October and November). It looks as if the bears who forecast a US recession to start before the end of 2007 will have to roll their predictions into the new year (in some cases for the second year running).

Against this background the 100 bp reduction in the Fed funds rate delivered by the Bernanke Fed since August looks unusually aggressive, contrasting with the central bank’s behaviour in prior economic downswings. The Greenspan Fed started to cut rates only two months before the 2001 recession began. In the prior recession in 1990, the first cut coincided with the onset of the contraction.

The speedier response cannot be justified by a more restrictive starting level of rates than in earlier cycles. A reasonable summary measure of policy tightness is the differential between the Fed funds rate and annual growth in nominal GDP. This gap exceeded two percentage points at the time of the first rate cuts in 1990 and 2001 but was close to zero when the Fed eased in August.

Has the Fed’s action supported the economy? The principal effect has been to weaken the dollar and put renewed upward pressure on commodity prices, particularly oil. Reflecting surging food and energy costs, consumer prices rose at a 5.6% annualised rate in the three months to November, squeezing real incomes and depressing consumer confidence. So the Fed has contributed to a likely set-back for consumer spending in December.

Has the Fed taken a risk with inflation? The annual CPI increase hit 4.3% in November and even the ex. food and energy measure has firmed to 2.3% from a recent low of 2.1%. Medium-term consumer inflation expectations in the Michigan survey have returned to their 2007 high of 3.1%. The weaker dollar has contributed to a pick-up in manufactured import price inflation, to an annual 4.6% in November. Even imports from China are now rising in price (up 2.3% on the year).

I think the Fed should have waited for commodity prices and inflation expectations to soften before cutting rates significantly. Premature action has served to boost price risks with little or no benefit to economic activity. The Fed may now find itself constrained from easing further at a time when the economy is looking more vulnerable.

My MPC-ometer model correctly forecast the 25bp December rate cut but indicated a narrow 5-4 vote rather than the 9-0 revealed this morning. The four vote “miss” is the largest since March and compares with an average model error of just one vote since I began to use it to forecast in “real time” in October 2006.

The minutes suggest the Committee was particularly concerned by renewed widening in interbank / Bank rate spreads during November: three-month LIBOR stood at 6.6% at the time of the December meeting. According to analysis presented in the Bank’s Quarterly Bulletin, this increase reflected rising credit risk premia rather than a shortage of liquidity, which was the dominant factor during earlier spread widening in August / September.

The MPC-ometer assesses whether the prevailing level of Bank rate is appropriate given incoming economic and financial news. It implicitly assumes a normal relationship between Bank rate and interbank rates, which are the key driver of borrowing costs faced by households and companies. Under current unusual circumstances, there is a case for using the model to assess the need for a change relative to three-month LIBOR rather than Bank rate. If I rerun the December forecast using the prevailing three-month rate of 6.6% rather than the 5.75% Bank rate, the forecast changes from 5-4 for a cut to 9-0, as actually occurred.

This suggests the next cut could occur as soon as January if interbank rates fail to fall back significantly early in the New Year. Some decline is likely but three-month LIBOR probably needs to move below 6% to justify my current forecast that a move will be delayed until February.

As explained here, I think the economic outlook warrants policy being set to achieve three-month rates of about 5.5% in early 2008.

“Other assets” on the Bank of England’s balance sheet rose by £29.3 billion between 12th September – just before the authorities stepped in to support Northern Rock – and 12th December, the latest available date. Northern Rock itself has claimed to have borrowed a smaller amount from the Bank – the BBC’s Robert Peston quotes a current figure of £26 billion. The discrepancy has led to speculation that the Bank of England has been providing covert support to other distressed banks.

The latest Bank of England Quarterly Bulletin, published yesterday, suggests this is not the case. Table B on page 509 of the Bulletin (page 27 on PDF) gives further details of changes in the Bank’s balance sheet between 5th September and 7th November. “Foreign currency denominated assets” are reported to have risen by £5 billion between these two dates, an increase that will have contributed to growth in “other assets” on the weekly Bank return. There was an identical rise of £5 billion in “foreign currency denominated liabilities” over the same period; both changes may reflect the Bank’s normal provision of banking services to other central banks.

Assuming “other assets” continue to be inflated by about £5 billion by foreign currency transactions undertaken since early September, the weekly Bank return suggests current lending to Northern Rock of about £24 billion (£29.3 billion minus £5 billion), close to estimates emanating from the troubled bank.

Prospects for UK official interest rates in 2008 will depend as much on developments in money markets as the wider economy. I expect a further quarter-point cut in early 2008 followed by a period of stability. However, risks to this forecast lie on the downside.

Economic growth is clearly slowing in response to earlier rate rises and tighter credit conditions but the risk of a recession in 2008 is still small, according to my indicator  – see chart. A key supportive factor is the strength of corporate finances, with retained earnings more than sufficient to finance capital spending. This surplus provides insulation from the credit “crunch” and suggests companies are unlikely to cut investment and jobs on a significant scale. Stable labour market conditions would in turn boost the chances of a “soft landing” for the housing market and consumer spending.

Inflationary pressures may prove stubborn despite a slowing economy. Business surveys show firms are planning price rises in early 2008, while a recent pick-up in household inflation expectations and fall in unemployment may lead to higher pay demands. These pressures reflect earlier monetary buoyancy – broad money supply grew by 13% pa between mid 2005 and mid 2007. Significant inflation relief could be delayed until 2009.

The prospect of a moderate economic slowdown with little change in inflation does not argue for dramatic monetary easing. I think policy-makers need to achieve a fall in the key three-month interbank rate to about 5.5% in early 2008. Assuming money markets normalise, this would be consistent with an official Bank rate of 5.25%, implying a quarter-point reduction from the current level. However, the risks lie firmly on the side of a larger cut, either because the interbank lending market remains dislocated or global economic weakness leads to a sharper slowdown in domestic activity.