The Federal Reserve yesterday gave markets a strong steer that official interest rates will remain at rock-bottom levels for a further two years. Despite the Governor downplaying the suggestion, the Monetary Policy Committee has delivered a similar message in the August Inflation Report.

A key summary measure of the MPC’s policy intentions is its mean forecast of inflation in two years’ time based on unchanged policy. In May, this stood at 2.54%, representing the largest positive deviation from the inflation target in the MPC’s history – see chart. This gave a strong signal that the Committee foresaw policy tightening on a one- to two-year horizon, despite divisions over the timing of the first move.

In the August Report, the mean two-year-ahead forecast has been slashed to an estimated 2.1%, based on chart 5.13 (p.46). This projection, moreover does not incorporate the risk of “an intensification of concerns about sovereign debt” in the euro area, which the MPC judges “almost impossible to calibrate”, but will take into account in setting policy. Since this risk merited a separate box in the Report (p.38), it is, presumably, regarded as significant. The implication is that, were a full risk-weighted computation possible, the mean forecast in two years’ would be below 2%.

This, in turn, supports the prediction of the “MPC-ometer” that the Committee shifted to an easing bias last week. The model forecasts an “average interest rate vote” of -7 basis points, the most negative reading since November 2009, consistent with the two rate-hike proponents backing down and one or more members of the middle group joining Adam Posen in voting for more QE – see previous post for more details.

The cut in the medium-term inflation projection since May looks out of proportion with a modest downgrade to growth, raising further doubts about the Bank’s forecasting credibility. The suspicion is that the Committee has shifted dovishly in response to recent market turbulence and the inflation projection has been adjusted to be consistent with the new stance, rather than the forecasting process itself driving policy.
 
Surprisingly, the shorter-term inflation forecast is little changed from May. With commodity prices softening, CPI inflation may peak below the 5.0% level predicted by the Bank and fall more quickly into early 2012 while remaining above target further out, partly reflecting further exchange rate weakness promoted by the MPC’s dovish stance.

The recent collapse in investor confidence threatens the forecast here of a revival in global economic momentum this autumn, based on faster real money supply growth since early 2011. The scenario is still tenable but requires an early stabilisation of markets – possible given oversold sentiment and renewed liquidity support from central banks.

G7 real narrow money has been a reliable predictor of economic fluctuations before and since the 2008-09 financial crisis, warning late last year of the current economic slowdown – see January post. The pick-up in real growth to an annualised 7% in the six months to June, therefore, should not be dismissed. The risk, however, is that the stimulative impact is neutralised by a fall in the velocity of circulation, reflecting weakened confidence.

To avoid this scenario, equities and other risk assets must stabilise. The MSCI World index in US dollar terms has given back most of its gain since the Fed signalled QE2 last summer and is in an important support zone:The Credit Suisse risk appetite measure fell into panic territory last week, a development normally signalling that equities are nearing a low (exception: September 2008):

Policy is shifting rapidly. Last week, the Bank of Japan expanded asset purchases by ¥5 trillion while the Swiss National Bank injected CHF50 billion of bank reserves, i.e. cumulative stimulus of about $130 billion. Today, the ECB seems to have bought Italian and Spanish bonds in size, judging from a large fall in yields. The intervention will be formally “sterilised” by issuing term deposits but banks are likely to regard these as a close substitute for reserves. Emerging-world central banks, meanwhile, are easing off on the brakes. The Chinese one-week repo rate is at a three-month low:
Until markets plunged, the forecast of a stabilisation of global economic momentum was on track. G7 real retail sales, for example, rebounded solidly in the three months to June, consistent with an imminent bottom in PMI new orders:
Emerging economies, meanwhile, looked poised to reaccelerate, with a growth leading indicator (based on a proprietary transformation of the OECD’s country indices) improving for the second consecutive month in June:

The recent plunge in equities has returned the Dow Industrials index to the “six-bear average” path last discussed in a post in June.

The six-bear average is based on previous recoveries after large bear markets involving a decline in the Dow of about 50%. The bear market trough was set to 100 in each case and the subsequent paths averaged. The starting level of the average was then aligned with the Dow's trough of 6,547 on 9 March 2009.

The six-bear average has proved a useful guide to the trend in the market since the 2009 low, with stocks fluctuating around the implied path – see chart, which also shows the six components of the average. (These refer to the recoveries from the bear market troughs in November 1903, November 1907, December 1914, August 1921, April 1942 and December 1974. The Dow fell by 45-52% into these lows versus a 54% decline between October 2007 and March 2009.)

The Dow closed at 11,384 on Thursday 4 August versus a six-bear average level of 11,357.

The bad news is that, although stocks are now close to the average, the average itself is declining, with a trough scheduled for late October. Of course, an undershoot – such as occurred last summer – is possible.

The good news is that, from the October trough, the average embarks on a sustained rise to a new peak in October 2012.

The suggestion that a buying opportunity is developing is supported by a reacceleration of global real money supply growth since early 2011 following weakness in late 2010. This pick-up, however, has been driven by strength in the US and Japan, with Eurozone real money contracting, contributing to sovereign debt woes. ECB policy easing to relieve the current liquidity squeeze may be required for stocks to resume an upward trend.

The hypothesis that the Monetary Policy Committee’s “reaction function” changed in 2010 is supported by the “MPC-ometer” forecasting model, which suggests that interest rates would have been raised several times last year and in early 2011 if the Committee had responded to incoming data in the same way as over 1997-2009. The model predicts that the MPC will shift to an easing bias this month because of recent financial market turbulence and more favourable inflation indicators.

Regular readers of these notes may remember previous discussion of an “MPC-ometer” model designed to forecast monthly interest rate decisions based on the latest economic indicators and financial market developments. This model performed well after its introduction in September 2006, correctly signalling the month and direction of 12 out of 13 Bank rate movements – two more than the mean forecast in the monthly Reuters poll of economists.

The MPC-ometer attempts to predict the average interest rate vote of the Committee’s members. For example, if five members recommend a quarter-point Bank rate increase while four prefer no change, the average interest rate vote is +14 basis points (i.e. five-ninths of +25 bp). If it is assumed that votes are either for no change or a move of 25 bp – reasonable under “normal” economic and financial conditions – then the model forecasts an actual rate change when the average prediction is greater than +12.5 or less than -12.5 bp.

The MPC-ometer’s 12 inputs were selected on the basis of statistical analysis and can be grouped into indicators of economic activity, inflation and financial market conditions. The inflation sub-set is largest, comprising the latest headline annual increases in consumer prices and average earnings as well as several measures of expectations. Activity indicators include GDP growth and business / consumer confidence while credit spreads and movements in share prices and the exchange rate are used to gauge financial conditions. Importantly, the model also includes the prior month’s average interest rate vote to capture any revealed bias.

The model was designed to predict the immediate interest rate decision but can also be used to forecast further ahead, based on assumptions about the input variables. In the latter mode, the model’s prediction for the average interest rate vote in a particular month feeds into the forecast for the subsequent month.

This latter approach was used to examine whether the MPC’s decisions since the start of 2010 have been consistent with its “reaction function” between 1997, when the current inflation-targeting regime was instituted, and 2009. Specifically, the MPC-ometer’s coefficients were estimated using data for 1997-2009 and the resulting model used to forecast the monthly interest rate vote based on actual economic and financial data and the previous month’s vote prediction.

This exercise suggests that the “old” MPC would have responded to a rising inflation overshoot and evidence of economic recovery by raising interest rates in four quarter-point stages over the last 18 months, implying a current level of Bank rate of 1.5%. The predicted increases occur in March, May and August 2010 and April 2011. The output of the model is shown in the first chart below – note the four peaks above the “unchanged policy range” since the start of 2010.

The suggestion that the monetary policy “goalposts” were shifted in early 2010 is not new and fits with MPC communications around that time. In particular, an important speech by the Bank’s Governor Mervyn King in January 2010 signalled that the Committee was willing to tolerate a substantial inflation overshoot caused by “temporary price level factors”, which Mr King defined broadly to include the exchange rate – traditionally regarded as a key element of the “transmission mechanism” of monetary policy. Some commentators have speculated that the Governor was preparing the ground for an informal pact with an incoming government, under which the Bank would agree to dilute inflation targeting and maintain super-low interest rates in return for a commitment to sustained fiscal contraction.

Does the divergence of actual from historical behaviour imply that the MPC-ometer should be cast on the statistical scrap heap? The answer is no, for two reasons. First, the model’s coefficients are reestimated every month so adjust – albeit slowly and incompletely – to changing policy priorities. Secondly, its inclusion of the prior month’s actual interest rate vote serves to adjust the current month forecast for any unusual behaviour.

The continued relevance of the MPC-ometer for current month forecasting is illustrated by the second chart, showing the fitted values of a model estimated on the full sample of data (i.e. extending up to July 2011) and incorporating the actual prior month vote. This version has continued to perform respectably over the last 18 months, with only one false tightening signal, in March / April 2011.

The MPC-ometer forecasts that the Committee will shift to an easing bias at this month’s meeting. In June, the predicted average interest rate vote was +7 basis points, consistent with two or three members favouring a quarter-point increase. The result that month was +3 bp, with hike votes by members Weale and Dale offset by Posen’s call for a £50 billion extension of QE (treated as equivalent to a quarter-point cut). The model shifted into neutral in July but the actual vote was unchanged at +3 bp. For August, the predicted average vote is -7 bp – the most negative reading since -13 bp in November 2009, when the MPC last increased QE (by £25 billion). This would be 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.

 
The significant swing in the model’s prediction between June and August has been driven by a combination of financial market turbulence – reflected in falling share prices and gilt yields – and declines in consumer confidence, actual inflation and CBI industrial firms’ price-raising plans.

It should be remembered that the MPC-ometer is designed to predict actual decisions rather than indicate the policy stance consistent with the inflation-targeting remit. The view of these notes remains that inflation is unlikely to return sustainably to the 2% target at current interest rates, partly because negative real rates are exerting strong upward pressure on monetary velocity. This view receives indirect support from the suggestion that Bank rate would now be at 1.5% had the MPC had reacted to events in 2010-11 in the same way as over 1997-2009, a period in which CPI inflation averaged 1.8%.

US national accounts revisions released on Friday show that, relative to their levels at the start of the recession, real GDP is lower and the price level higher than previously estimated. The less favourable output / inflation mix could be interpreted as negative news for equities.

The statisticians, however, simultaneously revised up corporate profits substantially, with a corresponding reduction in personal income. The level of “economic” profits in the first quarter of 2011 is 10% higher than previously estimated – see first chart. (Economic profits adjust for stock appreciation and are based on “true” rather than stated depreciation.)

A national accounts-based measure of the P/E on equities can be derived by dividing the market value of stocks by post-tax economic profits. This measure was previously above its long-run average at the end of the first quarter but is now exactly in line, reflecting the upward profits revision – second chart.

Equity market bears argue that the current level of profits is unsustainable because margins are unusually high and will revert to their long-run average. Historically, however, the initial decline in margins from a peak is usually associated with strong economic growth that boosts employment and labour incomes. Such a development now would probably be greeted with relief by investors fearful of another recession, suggesting an upward rerating of the P/E ratio that would outweigh any weakness in “E”.

Global manufacturing PMI surveys for July were – as expected – mixed, allowing optimists and pessimists to maintain their respective forecasts for second-half growth performance. The bias here remains with the optimists, based on faster G7 real narrow money expansion, which should continue to be supported by a slowdown in inflation due to recent commodity price stabilisation.

G7 weighted-average PMI new orders fell slightly further in July to just below the 50 break-even level. The weakness was within the tolerance of the monetary forecast, suggesting an improvement in momentum only from the late summer. The monthly decline reflected small further falls in the US, Euroland and UK offset by a sizeable gain in Japan.

Interestingly, Chinese new orders firmed for the third consecutive month (based on the more comprehensive Federation of Logistics and Purchasing survey, adjusting the raw number for seasonal factors). The Chinese series has led the G7 measure by one, four, three and three months respectively at the last four turning points since late 2008, suggesting that G7 orders will rise in August or September at the latest – first chart.

The fall in US PMI (ISM) new orders in July fits the responses on current flows in the five Federal Reserve regional manufacturing surveys – second chart. These surveys, however, indicated a small improvement in order expectations on average, consistent with the hypothesis that the ISM index is forming a bottom.