Entries from August 1, 2011 - August 31, 2011
Is the US economy in a "liquidity trap"?
A key tenet of this journal is that economic and market cycles are driven by deviations between the supply of money and the demand to hold it. When supply outpaces demand, there is “excess” money available for spending on goods and services or investment in financial assets.
The supply of money can be measured but demand, of course, is unobservable. Monetarists, however, assume that demand is relatively stable so that supply swings are the key determinant of whether there is “excess” or “deficient” money. This assumption is reasonable under normal economic conditions but can break down under extreme circumstances, as currently.
Recent posts have drawn attention to a surge in US money supply measures, suggesting an improving monetary backdrop for the economy, allowing for the normal lag of about six months. Some commentators, however, suggest that this surge has been matched or exceeded by a rise in the demand to hold US bank deposits, reflecting increased risk aversion. The economy, on this view, is in a “liquidity trap”.
Scott Grannis, for example, argues that US money demand has been boosted by massive capital flight from the Eurozone as investors anticipate a break-up of the single currency. The US money supply gain, however, has not, to date, been fully offset by Eurozone weakness – G7 monetary growth, therefore, has risen. Eurozone figures for July, released next week, could conceivably change the story but would need to show a large decline to offset US strength.
The Grannis theory of a huge capital inflow to the US from Europe, in any case, is inconsistent with the stability of the euro / dollar exchange rate in recent weeks.
Other commentators have suggested that the rise in US M2 reflects a transfer of cash from money substitutes into bank deposits, partly reflecting perceived risks surrounding the substitutes (e.g. institutional money funds with exposure to European banks). On this view, a broad liquidity aggregate including such substitutes would look much weaker than the conventional measures.
Again, however, the theory runs aground against the facts. The chart shows six-month growth in M2 and two broader measures – “M2+” including large time deposits and institutional money funds and a wider liquidity aggregate additionally incorporating commercial paper and Treasury bills. These alternative measures are less strong than M2 but have still accelerated significantly in recent months.
It is impossible to be sure but recent US money supply strength is unlikely to have been fully offset by a rise in liquidity preference due to the current crisis, so monetary support for the economy and markets should be increasing, though will operate with a lag. Liquidity preference, of course, would fall back in the event of confidence-building policy measures – admittedly difficult to imagine given recent abject performance but not impossible.
UK inflation: lower peak, faster fall
Numerous posts here over the last three years predicted that UK inflation would overshoot Bank of England and consensus forecasts. Since the spring, however, it has been suggested that CPI inflation would peak at a lower level and fall faster than generally expected, while remaining above the 2% target over the medium term.
The chart below shows updated profiles for CPI and RPIX inflation taking into account July outturns, which were broadly in line with expectations at the headline level but with some differences within the detail. CPI inflation is forecast to rise from 4.4% in July to a peak of 4.8% in September / October before falling sharply to 2.5% in April 2012.
RPIX inflation may already have peaked at 5.5% in February, though is projected to return to this level in October (from July’s 5.0%), before falling to 3.4% next April.
For comparison, the Bank of England expects CPI inflation to reach a quarterly-average peak of 5.0% in the fourth quarter of 2011, falling to 3.3% in the second quarter of 2012. The latter figure is 0.5 percentage points higher than implied by the forecast here.
The profiles in the chart are based on “core” prices rising at their recent rate (allowing for seasonal movements), with the projected sharp decline in late 2011 / early 2012 mainly driven by the VAT effect and falls in petrol and food inflation in lagged response to recent commodity price stabilisation. The forecasts assume a stable exchange rate – an important proviso.
The prospect of a larger drop over the next 12 months does not, of course, vindicate the MPC’s inaction in the face of the prior surge. On the forecast here, CPI inflation will remain above the 2% target through the end of 2012 and probably beyond. The index, moreover, is currently 5.5% above the level implied if the target had been met since the CPI was adopted as the reference measure in 2003. This overshoot implies a probably-permanent loss of purchasing power for savers who mistakenly based their investment decisions on an assumption that the MPC would fulfil its remit.
"MPC-ometer" suggests further dovish shift
The August MPC minutes confirm that the Committee has shifted to an easing bias, as predicted by the “MPC-ometer” and signalled by last week’s Inflation Report.
A post two weeks ago noted that the MPC-ometer forecast was “consistent with Weale / Dale retracting their tightening votes and one or two members of the middle grouping moving into Posen’s camp. In reality, any shift is likely to be smaller, partly reflecting the difficulty of changing entrenched positions.”
While Posen remained formally isolated, some other members considered voting for more QE but concluded that the “case was not yet strong enough”, partly because market interest rate expectations had fallen, providing indirect stimulus.
The MPC-ometer prediction for September will not be finalised until the start of the month but the current indication is for a further dovish shift, based on information on about half of the inputs and an assumption that the others remain unchanged. The forecast “average interest rate vote” is -11 basis points, close to the -12.5 bp trigger for easing action – see chart. Assuming equivalence between a £50 billion QE expansion and a quarter-point rate cut, this is consistent with three other members voting with Posen next month.
The further move in the model mainly reflects deteriorating financial market conditions, with inflation indicators little changed. The final reading will depend importantly on forthcoming activity data, including the second-quarter GDP revision, August EU Commission consumer survey and August PMIs for manufacturing and services.
Global monetary divergence widens further
The following two charts highlight the monetary tensions in the global economic outlook.
The first chart shows that six-month growth in G7 real narrow money (i.e. an M1-type measure comprising cash and current accounts) rose to its highest level since May 2009 last month, based on preliminary data. Allowing for the normal lead of about six months, this is a positive signal for the global economy in late 2011 and early 2012.
Underlying this improvement, however, is a very unusual divergence between monetary strength in the US and Japan and weakness in the Euro area, as shown by the second chart. Viewing the Eurozone in isolation, falls in real narrow money on the current scale have only ever been observed before recessions.
The risk, therefore, to the hopeful global view expressed in these notes is that a downward economic spiral in the Eurozone, via direct and financial spill-over effects, neutralises or outweighs the impact of monetary stimulus elsewhere.
If the global economic upswing expires, the ECB’s finger-prints will be all over the murder weapon. The decision this year to increase interest rates despite a contracting real money supply ranks among the most egregious monetary policy blunders of recent decades, on a par with the Bundesbank undermining the Louvre accord to stabilise the dollar by hiking rates in 1987, thereby triggering the October stock market crash. ECB loosening – rather than an expansion of the EFSF, further fiscal retrenchment, structural reforms etc – is the key requirement for ending the Eurozone crisis.
Hopeful liquidity indicators
G3 bank reserves have risen to a new record, reflecting Japanese foreign exchange intervention and an increase in the ECB’s repo lending:
The ECB’s bond purchases have contributed to a debt-weighted average of Eurozone 7-10 year government yields falling to its lowest level since November:
US money measures have picked up further, implying ample “sideline” cash available to flow into the economy and markets when risk aversion abates:
ECB policy ease key to global revival
Eurozone monetary weakness, in the view of the author of these notes, has been the key driver of the recent deterioration in global economic and financial conditions. Various posts over the last year drew attention to a contraction of the real narrow money supply, M1, initially in the periphery but spreading to the core in early 2011.
By February 2011, Eurozone-wide real M1 was 2.1% lower than six months before (not annualised). The six-month change has turned negative on seven previous occasions over the last 40 years, in five cases signalling an oncoming full-scale recession and the other two instances a significant contraction in industrial output – see first chart below.
Against this backdrop, it was astonishing that the European Central Bank, which trumpets its adherence to monetary analysis as a distinguishing feature of its modus operandi, chose to rein back its longer-term repo lending in late 2010 and raise official interest rates in two quarter-point moves in April and July. This was a repeat of its error of 2008, when it hiked by a quarter-point in July despite a fall in real M1 – the economy, in fact, had already entered a recession in the second quarter.
Real M1 contraction, predictably, has fed through to economic weakness and heightened risk aversion, reflected in ongoing sovereign debt woes and increased banking system stress. Conventional economic leading indicators are now confirming the recessionary signal from monetary trends. Our proprietary transformation of the OECD’s leading index for the Eurozone, for example, is at a level only previously reached before major downturns – second chart.
The hope was that Euroland’s economic relapse would be tempered and offset globally by favourable monetary trends elsewhere – particularly the US and Japan, where real M1 rose by 4.5% and 3.4% respectively in the six months to June. As previously noted, G7 real money expansion has revived since early 2011. The global loss of confidence stemming from the Eurozone’s unravelling, however, threatens to “freeze” these cash balances – the monetary pick-up, in other words, could be neutralised or outweighed by a fall in the velocity of circulation.
On this diagnosis, a reversal of current negative drift requires the ECB to admit its mistake and embark on a major loosening of policy, cutting the repo rate and stepping up government bond purchases to inject cash directly into the economy. These purchases should be spread across national bond markets rather than focused on Italy / Spain – it is not the ECB’s role to engage in quasi-fiscal transfers. The aim, in other words, should be to reduce peripheral yields by driving core rates towards zero rather than targeting spreads.
ECB “QE” would be much more effective than Fed easing, partly because it addresses the fundamental cause of current global difficulties and partly because a further injection of US cash would risk tanking the dollar and renewing upward pressure on commodity prices, thereby reversing the recent welcome relief to G7 real incomes from slowing inflation. Unilateral ECB loosening would allow the overvalued euro to depreciate – another necessary escape-route for struggling peripheral economies.
The consensus is that any such action would be vetoed by the Bundesbankers and their allies, although recession looms even for Germany. Incoming ECB President Draghi, however, has every incentive to be bold. A majority of the Governing Council would probably support large-scale policy easing. If EMU is to break up, let it be through the voluntary withdrawal of Germany rather than the forced exit of peripheral economies pushed into a depression by hardliners masquerading as monetarists.