Eurozone monetary statistics for March and the latest survey of bank loan officers suggest an urgent need for the ECB to embrace US / UK-style quantitative easing at its meeting next week.

Broad money M3 has contracted over the last three months, pulling annual growth down to a five-year low of 5.1% – see first chart. The liquidity squeeze remains focused on the corporate sector, with M3 deposits of non-financial companies 1.2% lower than a year ago.

In terms of the credit counterparts, M3 weakness reflects a recent fall in bank lending to the private sector – second chart. A similar decline in the US has been offset by the expansionary impact of the Fed’s securities purchases, so US M2 has continued to grow, albeit at a slower pace than in late 2008 – see last post.


The latest bank loan officer survey shows a fall in the net percentage tightening credit standards on corporate loans but the decline was much less than in the Bank of England survey released in early April – third chart. The equivalent US survey is due next week; the Fed’s statement yesterday referring to “some easing of financial conditions” hints at favourable results.

US money measures accelerated sharply when the Federal Reserve embarked on quantitative easing in late 2008, buying commercial paper and mortgage-backed securities. Three-month growth in the broader M2 aggregate reached an annualised 24% in December – see first chart. The monetary injection laid the foundations for the March / April rally in equities and recent improved economic news.

M2, however, began slowing in early 2009 and has actually fallen over the last four weeks, bringing the three-month rate of change down to 3%. Annual growth remains solid at 8% but has retreated from 10% in January.

Recent M2 weakness has not reflected any slowdown in Fed securities purchases. At its March meeting, the Fed announced a big expansion of its buying plans to a potential $2 trillion by the end of 2009 – second chart. This would imply $1.25 trillion of purchases over the remaining eight months of the year, or about $35 billion per week. Recent buying has been on roughly this scale.

Unlike the ECB and Bank of England, the Fed does not publish a “counterparts analysis” of the drivers of M2 growth but it appears that the expansionary impact of official securities purchases has been offset by a recent contraction in bank lending to the private sector. Commercial bank loans and leases outstanding have fallen at an annualised 5% rate over the last three months – third chart.

On further analysis, this contraction mainly reflects declines in commercial and industrial loans and advances under sale-and-repurchase agreements. Corporate lending has been depressed by recent heavy destocking while the fall in repo advances is consistent with other evidence of investor deleveraging. With the stocks cycle turning, and investor risk appetite beginning to revive, lending trends could improve going forward.

M2 trends are not yet ringing alarm bells but a further slowdown would question the sustainability of recent equity market gains and tentative economic improvement.

The Treasury’s medium-term fiscal forecasts appear to rest on optimistic assumptions about future borrowing costs. On reasonable alternative assumptions, public sector net interest payments could rise to 3.9% of GDP by 2013-14 versus an official projection of 3.0%.

The Treasury’s forecasts for debt interest have received limited scrutiny partly because they are buried within the detail of the Budget documents. Medium-term projections for public sector net interest as a percentage of GDP can be derived from Table C2 of the Financial Statement and Budget Report (FSBR) as the difference between public sector net borrowing and the “primary balance”. These forecasts can be converted into nominal terms using money GDP assumptions from Table C1.

To derive the Treasury’s unpublished assumptions about future borrowing costs, it is necessary to put these public sector net interest numbers onto a general government gross basis by adding back estimated interest receipts and adjusting for public corporations. The gross interest projections can then be compared with published numbers on gross government debt to derive an average interest yield.

According to the FSBR, public sector net interest will rise from 1.6% of GDP in 2009-10 to 2.6% in 2010-11 and 3.0% in 2011-12 – see first chart. A further small increase to 3.1% in 2012-13 is then reversed in 2013-14, when the proportion returns to 3.0%. This stabilisation raises suspicion, since general government gross debt is projected to rise by 17% in the two years to the end of 2013-14.

To generate this profile, the Treasury must be assuming a fall in the interest yield on government debt in 2012-13 and 2013-14. The FSBR projections are consistent with the yield averaging less than 4% in the three years to 2013-14, far below projected money GDP growth of more than 6% per annum over this period – second chart.

The bulk of outstanding debt consists of fixed-coupon gilts. The interest yield in a particular year is a weighted average of the rates on existing debt and new borrowing – not just to cover the budget deficit but also to finance gilt redemptions and roll over the stock of Treasury bills. For the average yield to fall after 2011-12, as implied by the FSBR forecasts, the interest rate on new borrowing in 2012-13 and 2013-14 would have to be well below 4% – a rough calculation suggests an average of about 3% over the two years.

The charts present an alternative scenario for the average yield and net interest as a percentage of GDP based on the assumption that the interest rate paid on new borrowing in 2011-12, 2012-13 and 2013-14 is equal to the projected rate of money GDP growth in each year (i.e. 6.0%, 6.2% and 6.1% respectively). This generates a gradual rise in the interest yield to 4.9% by 2013-14. While significantly higher than the 3.8% implied by the Treasury’s forecast, this is below the 5.2% average between 2004-05 and 2007-08 (when money GDP grew more slowly than projected for the three years to 2013-14).

On this alternative scenario for the average yield, net interest as percentage of GDP rises to 3.9% of GDP by 2013-14 against the Treasury’s projection of 3.0%. More pessimistic scenarios are clearly feasible, based on investor concerns about inflation and / or solvency pushing new borrowing costs above the rate of money GDP growth.

A higher interest bill would imply either a greater squeeze on non-interest spending or, more likely, further fiscal slippage. According to the Treasury’s forecasts, real current spending will rise by 0.7% per annum in the three years to 2013-14. Stripping out interest costs, however, the rate of growth is just 0.2% pa. On the alternative scenario presented here, real non-interest spending would need to fall by 0.7% pa over this period to make room for higher debt-servicing costs, assuming no further upward revision to plans.

The 1.9% fall in GDP in the first quarter represents the largest quarterly drop since a strike-related 2.4% plunge in the third quarter of 1979. GDP has now declined 4.1% from its peak in the first quarter of 2008, which compares with peak-to-trough falls of 2.5% in the 1990-91 recession, 3.3% over 1973-75 and 5.9% in the 1979-81 slump.

The chart shows the current fall in GDP together with Treasury and Bank of England forecasts and the 1979-81 decline, rebased to the peak in the first quarter of last year. The first-quarter result was 0.8% lower than implied by the central projection in the Bank’s February Inflation Report. The MPC judged that the latest indicators were broadly consistent with this forecast at its April meeting so today’s number could boost the chances of an expansion of QE.

The Treasury’s Budget forecast implied that GDP would fall by 2.2% between the fourth quarter of 2008 and the second half of 2009. This looked hopeful even before today's news of a 1.9% first-quarter loss. A monthly GDP estimate derived from data on industrial and services output was 0.4% below its first-quarter average in March, suggesting a further fall of at least this amount in the second quarter.

The Treasury projects a recovery in GDP of 2.9% per annum between the second halves of 2009 and 2011. While widely derided, this is lower than the 3.3% pa increase over the same period forecast in the Bank of England’s February Inflation Report. A key issue is whether the Bank will retain this steep recovery profile, albeit from a lower base, in its next Report, released on 13 May.

The 1.9% first-quarter decline is difficult to reconcile with available expenditure data. With retail sales rising by 1.0% in the first quarter, overall consumer spending seems unlikely to show a decline larger than the 1.0% recorded in the fourth quarter. Trade figures for January and February signal little impact from net exports. Meanwhile, output of “government and other services” rose in the first quarter, suggesting higher general government consumption. The implication is that GDP weakness was driven by investment and stocks.

Destocking already amounted to 1.3% of GDP in the fourth quarter, based on current data. This offers a glimmer of hope – a faster cut-back in the first quarter would imply a correspondingly larger future boost to GDP when stock levels stabilise.

The Budget "Red Book" paints a dire picture of the state of the public finances. It is tempting to suggest the Chancellor has exaggerated the gloom to create room for favourable “surprises” ahead of the election but the assumptions underlying the projections look, if anything, too optimistic.

• In the five months since the Pre-Budget Report, forecast net borrowing in 2010-11 has ballooned from £105 billion to £173 billion. Collapsing receipts account for £48 billion of this increase, with the remaining £20 billion due to higher expenditure.

• Receipts could yet undershoot even this revised forecast. The ratio of taxes to GDP is projected to bottom at 33.0% in 2009-10 before recovering but reached a low of 31.8% after the less-severe recession of the early 1990s.

• The Augustinian approach to spending discipline is maintained. Longer-term projections benefit from cuts to previous plans but the expenditure-GDP ratio surges to 48.1% in 2010-11 – the highest since 1982-83 and up from 41.0% as recently as 2007-08.

• After a 3.5% drop this year, GDP is forecast to grow by 1.25% in 2010, 3.5% in 2011 and 3.25% per annum in later years. While not unreasonable, this is clearly at the optimistic end of the range of possible scenarios.

• The Budget changes were modest in terms of sums dispensed. A net “injection” of £5.2 billion in 2009-10 is reversed in 2010-11 as the tax hike on higher-earners kicks in. The key measures this year are a temporary boost to capital allowances (costing £1.6 billion), phasing-in of the uprating of business rates (£700 million), employment initiatives (£890 million) and winter payments to pensioners (£600 million).

• The planned hike in the income tax rate on high-earners to 50% will tie the UK with Japan at the top of the G7 league table. This will create significant negative economic incentive effects and is unlikely to raise the amounts projected, especially if capital gains tax is kept at the current 18%.

• With the rise in net borrowing fully reflected in the “central government net cash requirement”, the Debt Management Office projects net gilt sales of £220 billion in 2009-10, up from £146.5 billion in 2008-09. The Bank of England, however, will absorb at least £55 billion – the gilt market's day of reckoning may be delayed until 2010-11, when a similar level of funding will need to be raised without Bank support

The macroeconomic judgement underlying the Chancellor's strategy is that higher borrowing will deliver an economic stimulus even though households and companies anticipate a significantly higher tax burden in years to come. This would be questionable in normal times but is even less likely given the unprecedented scale of necessary future fiscal adjustment bequeathed by Mr. Darling to his successor.

The plunge in sterling has pushed the gap between UK and Eurozone consumer price inflation to its highest level since 1992 – despite the UK number being artificially depressed by December’s VAT cut.

Slower food and energy price gains caused UK annual CPI inflation to ease from 3.2% in February to 2.9% in March but the equivalent Eurozone measure slumped from 1.2% to just 0.6%. The difference of 2.3 percentage points between the UK and Eurozone increases is the largest since a 2.8 point divergence in March 1992 – see chart.

The gap would be significantly larger but for the VAT cut. The CPI at constant tax rates (CPI-CT), which assumes that the reduction was passed on in full, rose by an annual 3.9% in March – one percentage point more than the headline measure. Some retailers have used the cut to boost margins: a conservative assumption that only half of the reduction has been transmitted to consumers would imply “true” CPI inflation of 3.4%, 2.8 percentage points above the Eurozone level.

The gap can be attributed roughly equally to differences in food and energy price trends and “core” inflation – both have been affected by the fall in sterling. The UK CPI excluding unprocessed food and energy – a measure of core prices – rose by an annual 2.3% in March, or 2.9% assuming 50% pass-through of the VAT cut, versus an increase of just 1.5% in the equivalent Eurozone index.