Simon Ward - Money Moves Markets

UK GDP stabilising after Q1 shocker

Simon Ward — Fri, 03 Jul 2009 10:00:25 +0000

The Office for National Statistics this week revised the fall in UK GDP in the first quarter from 1.9% to 2.4% but monthly figures on output in the services and production sectors – which account for 93% of GDP – indicate that the pace of contraction slowed during the quarter and the economy may have stabilised in April.

The chart shows official quarterly GDP, rebased to the peak level in the first quarter of 2008, together with a monthly proxy based on the services and industrial output data. The proxy was unchanged in April – the first month not to register a decline since September. The monthly numbers are subject to revision but the April reading is consistent with better purchasing managers' survey results, which improved further in May and June.

The monthly proxy was 0.3% below its first-quarter average in April so the preliminary second-quarter GDP estimate released on 24 July is likely to show a further fall. This should, however, be the smallest since a 0.1% drop in the second quarter of 2008.

More hopeful signs from latest UK credit survey

Simon Ward — Thu, 02 Jul 2009 13:17:04 +0000

Today's Financial Times contains another downbeat article about the UK's QE. One fund manager quoted is disappointed that no effect on RPI trends is yet apparent. Since the latest RPI number refers to a period only two months after QE started, while monetary changes typically take two years to have their full impact on prices, this might be considered unsurprising.

Another interviewee correctly links an assessment of the success of QE with money supply figures. Unfortunately, he proceeds to ignore the recent broad money pick-up, referring instead to weakness in bank lending to non-financial corporations. Money and credit are routinely confused in discussions of QE, with few commentators aware that money leads the economy while credit lags.

Contributors to the FT article may not have read the Bank of England's excellent explanation of the aims and mechanics of QE, available on its website. As well as expanding QE to £150 billion at next week's meeting, the MPC might consider stepping up its education programme.

Further evidence that QE is beginning to work is provided by the Bank's second-quarter Credit Conditions Survey released today, showing that a majority of banks made more credit available to mortgage borrowers and companies over the last three months, with a further improvement expected this quarter.

The results of similar surveys in other major economies are usually expressed in terms of the net percentage of banks tightening rather than loosening credit. When the Bank's survey is converted to the same format, the UK results compare favourably – see chart for corporate lending responses. This reflects the combined impact of QE and lending commitments made by the Lloyds Banking Group and the Royal Bank of Scotland as a condition of their participation in the Asset Protection Scheme. (The UK is the first country to publish a second-quarter survey.)

RPI inflation to rebound sharply in 2010

Simon Ward — Thu, 02 Jul 2009 08:31:04 +0000

This note examines the outlook for consumer and retail price inflation in 2010-11 from a "monetarist" perspective. The approach is to build up a forecast by considering in turn "core" inflation, VAT effects, food and energy prices and owner-occupied housing costs (relevant for the RPI).

The conventional "Keynesian" approach is to model core inflation as a function of the "output gap" with some allowance for the effect of exchange rate movements on import prices. The trouble with this is that the output gap is difficult to measure, particularly in real time, while currency movements are largely unpredictable. The consensus view, embodied in the MPC's Inflation Report forecast, is that a large negative gap has opened up and will persist in 2010-11, exerting sustained downward pressure on core inflation. Yet the financial crisis may have damaged supply capacity by more than the consensus assumes, by raising the cost of capital, disrupting its efficient allocation and reducing the sustainable size of the financial sector – the Treasury has cited estimates of a negative effect on potential GDP of up to 6%. History suggests that caution is warranted: an overestimate by policy-makers of the degree of economic slack contributed to the inflationary upsurge in the 1970s.

An alternative approach is to base a forecast for core inflation on the simplistic monetarist rule-of-thumb that the money supply leads prices with a variable lag averaging about two years. The monetarist rule has arguably performed much better than output gapology in recent years: a large fall in core inflation in the late 1990s was preceded by a major monetary slowdown, while faster money growth forewarned of the inflationary overshoot of 2007-08. The late 1990s disinflationary episode can be used to calibrate the possible impact of recent monetary weakness on core inflation. Annual growth in broad money M4 fell from 11.9% to 2.8% between Q4 1997 and Q3 1999 – a 9.1 percentage point drop. Annual core inflation – as measured by the CPI excluding unprocessed food and energy – subsequently declined by 1.9 percentage points to a low of just 0.1% in July 2000. So the "elasticity" of inflation to monetary growth was 0.21 (i.e. 1.9 divided by 9.1). Recent monetary trends are best measured by the Bank of England's adjusted M4 measure, excluding money holdings of financial intermediaries. Its annual growth rate fell from 11.6% in Q3 2006 to 3.6% in Q4 2008, rebounding to 4.2% in Q1 2009. Assuming that Q4 2008 was the low – reasonable given the positive impact of Bank of England gilt purchases in Q2 and Q3 2009 – the monetary slowdown suggests an eventual fall in annual core inflation of 1.7 percentage points (i.e. multiplying the money growth decline of 8.0 percentage points by the inflation elasticity of 0.21).

A major difference, however, between the late 1990s and now is a higher starting level of core inflation. The CPI excluding unprocessed food and energy rose by an annual 2.1% in May compared with 2.0% in February 1998, when the prior big slowdown began. However, recent numbers have been flattered by the temporary cut in the main rate of VAT from 17.5% to 15% last December. Assuming average pass-through of 60%, the core CPI measure would have risen by an annual 2.9% in May in the absence of the VAT change, down from a peak of 3.0% in February. (The 60% assumption may be conservative – the Office for National Statistics has estimated that 70% of prices collected from shops had been reduced to reflect the lower VAT rate in January.) Applying the predicted 1.7 percentage point fall in annual core inflation to the 3.0% February peak, the monetarist approach suggests an eventual trough of 1.3% – well above the 0.1% low reached in 2000. Assuming a two-year lead of money on prices, this trough could be reached around the end of 2010, with the recent recovery in monetary growth reflected in higher core inflation in 2011.

The outlook for headline CPI and RPI inflation will also depend on future VAT effects, food and energy prices and housing costs. The forecasts below assume that the planned return in the main VAT rate to 17.5% from January 2010 goes ahead, again with average pass-through of 60%. A further 1 percentage point increase is pencilled in for January 2011, on the basis that higher VAT will bear some of the burden of future fiscal consolidation. Unprocessed food inflation – still running at an annual 9.3% in May – is assumed to fall significantly by the end of 2009 but to remain positive, reflecting a judgement that the large increase in prices over 2007-09 reflected a "structural" shift. Following a modest further cut in retail tariffs later this year, energy prices are similarly projected to trend gradually higher. For the RPI forecast, the components linked to house prices are assumed to stabilise from late 2009 after a 20% drop from the peak. Finally, the average mortgage interest rate – currently 3.6% – is projected to fall slightly further over the remainder of 2009 before recovering by about 1 percentage point during 2010, reflecting an assumed rise in Bank rate from 0.5% to 2.5% next year.

The results of this exercise are shown in the chart. Annual CPI inflation falls from its current 2.2% towards 1% by autumn 2009, reflecting favourable food and energy price effects, but rebounds to about 3% in early 2010 as VAT is hiked. Slower core trends gradually reverse this increase and inflation moves temporarily below 2% again in early 2011 as a result of VAT effects (i.e. a smaller rise in 2011 than 2010), before drifting higher later in the year in lagged response to the current pick-up in monetary growth. Mirroring the CPI profile, the annual RPI change moves deeper into negative territory into the autumn but increases much more sharply in 2010, with the VAT increase compounded by a big turnaround in the housing costs component, reflecting both unfavourable base effects and higher mortgage rates. Annual RPI inflation peaks at about 3.5% in late 2010, slowing temporarily during the first half of 2011 as housing effects wane.

Two features of this forecast are worth emphasising. First, the CPI profile is significantly higher than the central projection in the May Inflation Report, which shows average inflation of 1.5% this year, 0.9% in 2010 and 1.3% in 2011. The difference mainly reflects the sustained disinflationary influence of a negative output gap in the Bank of England's forecasting model, although assumptions about VAT and commodity prices may also contribute. The MPC's recent forecasting record warrants some scepticism about its current prognosis: the central projection for annual CPI inflation one year ahead has been too low in 15 out of 17 Inflation Reports between February 2004 (after the inflation target was switched to the CPI from RPIX) and February 2008, with a mean forecast error of 0.7 percentage points.

Secondly, the swing in RPI inflation between 2009 and 2010 is unusually large and may have negative economic implications. Wage growth has slowed sharply since the onset of the recession in spring 2008 but it is unclear whether this reflects labour market flexibility or is simply a response to annual RPI falls. A pick-up in wage settlements as RPI inflation rebounds in 2010 would cast doubt on the MPC's view that economic slack will drive core price trends significantly lower. On the other hand, continued weak wage growth would imply a squeeze on real disposable incomes, potentially undermining prospects for consumer spending and an economic recovery.

Eurozone M3 contracting despite ECB injections

Simon Ward — Tue, 30 Jun 2009 11:35:28 +0000

The Wall Street Journal argues that the ECB's alternative to QE – supplying banks with unlimited funds on favourable terms – is superior to the Fed's and Bank of England's asset purchases on the basis that the effects are similar and the ECB will be able to exit the strategy without causing market disruption.

With due respect, the effects are not similar: the ECB's banking system loans have no direct impact on the broad money supply and may not even inflate the monetary base. The difference is highlighted by May monetary statistics. While UK broad money has risen at a 6.7% annualised rate so far this year – see yesterday's post – Eurozone M3 has contracted by 0.8% annualised.

Credit trends are weak in both economies: Eurozone bank lending to the private sector has risen by just 0.4% annualised so far in 2009. In the UK, however, QE has resulted in a large "public sector contribution" to monetary growth – equivalent to 4.9% of the broad money supply in the first five months. With the ECB relying on banks using cheap liquidity to buy government securities, the public sector contribution has been much smaller in Euroland – 0.9% of M3.

Eurozone M3 has also been depressed by a shift of funds into longer-maturity financial instruments to take advantage of the steep yield curve.

Current monetary trends suggest that the UK economy will recover from late 2009 while Euroland continues to flounder.

QE expansion likely pending corporate M4 pick-up

Simon Ward — Mon, 29 Jun 2009 12:09:06 +0000

Bank of England gilt purchases have contributed to a significant pick-up in broad money growth but this has yet to be reflected in higher cash balances of non-financial corporations, according to May monetary statistics released today. However, corporate liquidity should improve as companies continue to take advantage of more favourable market conditions to issue new shares and bonds.

The Bank of England's monthly proxy for its favoured broad money measure – M4 excluding money holdings of financial intermediaries – rose by 0.2% in May after a 1.1% gain in April. Chain-linking the monthly proxy to "official" data showing a 1.5% rise in the first quarter, broad money has risen at a healthy 6.7% annualised rate so far in 2009.

Moreover, this understates liquidity growth because households and companies have increased their holdings of Treasury bills by £18 billion so far this year – equivalent to 1.2% of the Bank's broad money measure. In other words, a wider aggregate including Treasury bills has risen by over 9% annualised in the first five months.

As expected, the Bank's gilt purchases have been reflected initially in higher cash balances of financial institutions (i.e. excluding intermediaries). M4 holdings of households and private non-financial companies have risen at an annualised rate of 3.2% so far in 2009, well below the 6.7% increase in overall broad money. (Again, this understates liquidity growth because households and non-financial companies are likely to account for a significant portion of the rise in Treasury bills outstanding.)

Non-financial corporate M4 holdings have risen by just £1 billion, or 0.8% annualised, so far this year, despite sterling capital market issuance of £18 billion. This partly reflects a large-scale repayment of foreign currency borrowing in recent months. Assuming that this slows, corporate liquidity should improve as high financial sector cash balances facilitate further significant issuance. (The Bank's numbers imply that financial companies' M4 holdings – excluding intermediaries – have risen by about £25 billion so far in 2009, equivalent to annualised growth of more than 20%.)

The fall in monthly broad money growth from 1.1% in April to 0.2% in May is partly explained by a smaller boost from QE last month, with banks and building societies accounting for £8 billion of the £27 billion of gilts acquired by the Bank of England – see table. Bank purchases from the banking system have no impact on broad money unless banks use the cash released to increase private sector lending.

This QE "leakage", coupled with the lack of a recovery to date in non-financial companies' money balances, suggests that the Monetary Policy Committee will expand asset purchases by a further £25 billion to the £150 billion current maximum at its meeting next week, while simultaneously requesting Treasury authority for a higher limit.

Change in gilt holdings £ billion

	Jan-09	Feb-09	Mar-09	Apr-09	May-09

Non-bank private sector	4.2	0.7	-5.9	-2.9	-6.2
Overseas	-1.3	14.2	-7.0	-10.9	-1.0
Banks	13.1	2.5	-2.0	2.0	-8.6
Building societies	0.0	0.7	0.2	1.0	0.7
Bank of England	0.7	0.5	15.3	28.8	26.8
Total	16.7	18.5	0.7	17.9	11.7

DMO sales	16.8	18.7	17.6	18.2	15.4
Redemptions	0.0	0.0	17.2	0.0	3.8
Sales net of redemptions	16.8	18.7	0.4	18.2	11.7

More on money leading credit

Simon Ward — Fri, 26 Jun 2009 15:00:50 +0000

The table below provides further evidence that money leads credit around the trough of the economic cycle.

The table dates the lows in the six-month rates of change of UK M4 and M4 lending around the recession troughs in the mid 1970s, early 1980s and early 1990s. Money bottomed about a year before credit in all three cases.

Six-month M4 growth – on the Bank of England's adjusted measure – appears to have troughed in the fourth quarter of 2008. Based on the historical lead, bank lending could remain weak until late 2009 / early 2010.

Providing recent faster money growth is sustained, an economic recovery can coexist with ongoing lacklustre credit trends. Lending constraints could become an issue as the upswing develops but by that stage banks' balance sheets and risk appetite may have improved significantly.

Date of trough in six-month growth	M4	M4 lending	Lag

Mid 1970s	Q3 1974	Q3 1975	4Q
Early 1980s	Q1 1982	Q2 1983	5Q
Early 1990s	Q1 1993	Q1 1994	4Q
Current	Q4 2008*

* M4 excluding intermediate OFCs

Money growth & equity market performance

Simon Ward — Thu, 25 Jun 2009 13:20:55 +0000

A simplistic monetarist view is that countries with higher rates of inflation-adjusted money supply growth should experience stronger economic and equity market performance.

The first chart shows six-month changes in real broad money across the major developed economies. At the start of 2009, real money trends were much stronger in the US, Canada and Australia than in Japan and Europe.

The second chart shows year-to-date equity market performance for the same group of countries, including the impact of currency fluctuations and expressed relative to the World index. As suggested by money supply growth, Canada and Australia have outperformed significantly, while Japan and Europe ex. the UK have lagged the global average.

China is not included in the charts. Its monetary growth and equity market performance have been stronger than in any of the developed countries shown.

The main deviation from the monetarist relationship so far this year has been the relative weakness of the US stock market, despite monetary strength in late 2008 / early 2009. This may partly reflect a drag from much heavier equity issuance than in other markets. US relative performance could improve as issuance abates, although the monetary backdrop is less favourable than at the start of 2009 – see earlier post.

Real money growth has accelerated in the UK and to a lesser extent Japan since early 2009 while slowing in the Eurozone – first chart. Since the start of the second quarter, UK equities have outperformed the other markets with the exception of Canada. Assuming that monetary trends continue to benefit from QE, UK relative gains could be sustained during the second half.

"Creditist" QE concerns misplaced

Simon Ward — Wed, 24 Jun 2009 13:45:53 +0000

As reported in today’s FT, British Bankers’ Association (BBA) figures for May show a £200 million fall in sterling lending to private non-financial companies. The report states that “a key objective of the Bank of England’s “quantitative easing” programme ... is to encourage more private sector lending”, suggesting that the Bank will be disappointed by the BBA news.

Three points are worth noting. First, a £200 million decline is insignificant, amounting to 0.07% of outstanding BBA member lending to private non-financial companies. Moreover, the BBA statistics cover only 65% of total loans by UK-based banks to non-financial firms, according to Bank of England data. The flow of total lending exceeded the BBA flow by an average of £500 million per month over the six months to April. (The Bank will publish its May data on 29 June.)

Secondly, the key objective of QE is to boost the money supply not lending, although credit trends should revive if the policy succeeds in generating an economic recovery. The Bank of England’s website explanation of QE places money rather than credit at the centre of the transmission mechanism:

Asset purchases increase the supply of money directly into the wider economy which should boost spending. ... The seller of an asset to the Bank can spend the new money it receives on goods and services which directly adds to overall spending or it can purchase other assets which will tend to boost asset prices more broadly and provide an indirect spur to spending.

Thirdly, to monitor the impact of QE, the MPC has stated that it will pay close attention to “the growth rate of broad money, the cost and availability of corporate borrowing, measures of inflation and inflation expectations, and developments in nominal spending growth”. The list does not include the volume of bank lending to companies, because the MPC recognises that lending weakness may reflect demand factors rather than supply constraints – including firms choosing to raise funds from markets rather than the banks.

The MPC will be encouraged by recent faster money growth, higher corporate equity and bond issuance and signs of a stabilisation in inflation expectations and nominal spending. In assessing the extent of improvement in the “cost and availability of corporate borrowing”, the Committee is likely to place high weight on its second-quarter Credit Conditions Survey, released on 2 July.

Why are UK & US money trends diverging?

Simon Ward — Mon, 22 Jun 2009 14:25:20 +0000

Bank of England gilt purchases have contributed to a pick-up in UK broad money growth. In the US, however, M2 expansion has slowed since early 2009, despite ongoing large-scale bond-buying by the Federal Reserve – see first chart. What explains this divergence?

Central bank lending or asset buying has a direct positive impact on the broad money supply only when transactions are conducted with domestic non-banks. One possible explanation for the UK / US monetary divergence is that the Bank of England has been buying securities from non-banks while the Fed has been buying from banks.

Available evidence, however, does not support this interpretation. For example, US flow of funds accounts for the first quarter show that Fed purchases of agency and mortgage-backed securities were more than accounted for by sales by the household sector (which includes domestic hedge funds). Commercial banks' holdings of such securities were little changed last quarter.

Rather than ineffective bond purchases, the US M2 slowdown appears to reflect two other factors absent in the UK. First, commercial bank credit has contracted by 3% (not annualised) since December 2008. By contrast, UK M4 lending rose by about 2% between December and May (based on the Bank of England's adjusted measure excluding transactions with financial intermediaries).

Secondly, the monetary impact of the Fed's bond-buying has been offset by a contraction of its liquidity swap lending to other central banks. Swaps ballooned in late 2008 as policy-makers sought to alleviate an international shortage of dollars. Some of the cash is likely to have flowed back to the US, contributing to faster M2 growth late last year. This process has reversed in 2009: liquidity swap lending has contracted by $405 billion since the start of the year – almost as large as the Fed's $487 billion combined purchases of Treasuries, agencies, mortgage-backed securities and commercial paper.

As well as contributing to the slowdown in broad money M2, the fall in swap lending has neutralised the impact of the Fed's bond purchases on the monetary base M0 (i.e. currency plus bank reserves), which has been static since the start of the year. In the UK, however, M0 has surged since the Bank of England embarked on QE, with annual growth recently overtaking the US – second chart.

Slower M2 growth, should it persist, is a threat to US economic prospects but there are grounds for expecting an improvement. Recent credit weakness partly reflects heavy destocking, which is now coming to an end. Similarly, the contraction in the Fed's swap lending is probably largely complete – the amount outstanding is down to $149 billion from a December peak of $583 billion. As these drags abate, monetary trends should be dominated by the positive impact of ongoing Fed securities purchases.

More evidence of QE working

Simon Ward — Thu, 18 Jun 2009 10:44:31 +0000

Monetary and financial statistics for May released today are encouraging in three respects.

First, the Bank of England's proxy measure for M4 excluding money holdings of financial intermediaries probably grew respectably, following a hefty 1.0% gain in April. The Bank currently has insufficient information to produce a firm estimate but headline M4 rose by 0.2% in May and was again depressed by intra-banking-group transactions – excluded from the proxy measure. Based on available evidence, the proxy may have risen by 0.5% or more last month.

Secondly, M4 lending – excluding the effects of securitisations and loan transfers – bounced back to show 0.9% growth in May after a rare 0.3% decline in April. As with M4, the rise would have been larger but for a decline in intra-group business. At the margin, this should lessen MPC concerns that lending constraints will be a major impediment to an economic recovery. (The Bank's latest Trends in Lending survey, also released today, is gloomy but Lending Panel banks report an ongoing modest recovery in mortgage approvals and a small net rise in corporate loan facilities in May.)

Thirdly, consistent with quantitative easing improving companies' access to non-bank finance, private non-financial firms raised a net £4.1 billion from issues of bonds, shares and commercial paper in May, up from £3.1 billion in April and well above the monthly average of just £400 million over 2003-08 – see chart. Companies have raised a net £13.6 billion in these markets so far in 2009, equivalent to 2.7% of outstanding sterling bank borrowing at the end of 2008.