Balanced sustainable growth with low inflation requires the monetary authorities to maintain money and credit expansion at a moderate and steady pace. Policy-makers are apt to portray the financial / economic crisis of 2008 as a “black swan event” outside their control but its roots lie in their failure to prevent a monetary boom over 2005-07. In the UK, broad money M4 and M4 lending – both adjusted to exclude the activities of non-bank financial intermediaries – grew at annualised rates of 11.8% and 12.7% respectively in the three years to end-2007. In time-honoured fashion, monetary buoyancy encouraged excessive bank risk-taking while generating higher inflation, creating the conditions for an eventual bust.

Sir John Gieve, departing deputy governor of the Bank of England, recently defended the monetary policy committee’s failure to restrain credit expansion and asset prices, arguing that higher interest rates would have depressed economic growth and it lacked other policy tools. The former point is no doubt true but the MPC’s remit is to target inflation not activity – the CPI overshoots in 2007 and 2008 are prima facie evidence that rates were too low in 2005-06. Sir John is right to highlight the need for a broader range of policy tools – including the ability to vary banks’ capital requirements and “overfund” to curb monetary growth – but the committee could have requested the necessary actions by the Treasury and Financial Services Authority under tripartite arrangements yet it failed to do so.

While monetary policy errors mirror those made in prior boom / bust cycles, the current financial crisis has proved much more severe because banks have suffered significant damage to their regulatory capital early in the economic downturn. This reflects a combination of factors, including greater exposure to securitised assets and international rules requiring “mark-to-market” accounting and linking capital requirements to credit agency ratings. With banks forced to adjust to losses “up front” rather than over several years, as in previous cycles, monetary retrenchment has been accelerated – adjusted M4 rose by just 3.7% in the year to September, down from 11.5% in the prior 12 months.

In the same way that policy-makers should have acted to restrain excessive money and credit expansion over 2005-07, their focus now should be on keeping annual M4 growth above 5% – the minimum likely to be compatible with trend growth and 2% inflation over the medium term. A key aim should be to foster banking sector recuperation and discourage balance sheet contraction; this requires the authorities to offer generous liquidity support, tolerate temporarily lower capital ratios and allow banks to widen interest margins in order to boost retained earnings. Direct action to support money and credit growth should also be considered, such as “underfunding” the fiscal deficit, an extension of government loan guarantees and Bank of England purchases of private-sector assets.

Unfortunately, policy initiatives to date have reinforced rather than eased the pressure on banks to retrench. Capital requirements have been raised rather than temporarily lowered while liquidity support and recapitalisation funds have been provided on onerous terms, creating an incentive to husband resources in order to make early repayment. Banks have also been prevented from widening interest margins by government demands to “pass on” Bank rate cuts, despite a smaller decline in their funding costs. Meanwhile, the authorities have so far eschewed direct monetary intervention – in contrast to the US, where the Federal Reserve is now buying private-sector assets on a large scale.

Rather than tackle the problem of inadequate money and credit growth at source, policy-makers have sought to address the symptoms by slashing interest rates, expanding the fiscal deficit and encouraging a mega-devaluation of the exchange rate. Such measures, however, are unlikely to be effective while the banking system remains dysfunctional. Indeed, cutting rates to below the Eurozone level and fostering expectations of a bottomless decline in sterling could worsen the credit crunch by triggering an outflow of foreign capital: UK banks are reliant on overseas funding to bridge a large gap between their domestic sterling lending and deposits.

The above assessment warrants a grim view of economic prospects for the first half of 2009. Monetary trends lead activity by about six months so M4 weakness during the second half of 2008 suggests further declines in output through mid-2009. If GDP were to follow an average path based on the last three recessions – a reasonable base-case scenario consistent with current economic evidence – it would fall by 0.6% per quarter over Q4 2008-Q2 2009, matching the drop in Q3 2008 and implying a cumulative 2.4% decline from the Q2 2008 peak. The average path then entails several quarters of broadly flat output before a recovery begins from Q2 2010.

Contrary to much defeatist economic commentary, however, the outlook for the second half of the year has yet to crystallise and will depend critically on money and credit trends in early 2009. A further slide in adjusted M4 expansion would signal an ongoing contraction in activity while a stabilisation at current low levels would be consistent with stagnant or slightly rising output, as in the historical average GDP path. By contrast, if the authorities took technically-feasible action to boost annual M4 growth towards 10% in early 2009, the economic recovery forecast by the Treasury and Bank of England for the second half of the year would still be achievable.

The ability of policy-makers to influence monetary trends is illustrated by recent US developments. Following the failure of Lehman Brothers in September, the focus of Federal Reserve policy shifted from interest rate cuts to direct quantitative measures to support credit and money growth. The Fed has purchased over $300 billion of commercial paper since October and plans to buy up to $500 billion of mortgage-backed securities – the combined total of more than $800 billion represents 10% of the broad money supply M2. These initiatives have contributed to a pick-up in annual M2 growth from 5.3% in August to 9.6% by mid-December. This revival justifies optimism that the US economy will hit bottom by the spring and recover later in 2009, with positive global implications.

Based on November data for the US and Japan and October figures for other countries, G7 industrial output is about 7% below its peak reached in February 2008. This exceeds the decline during the 2000-01 recession and is almost as large as over 1980-82. The biggest post-war reduction occurred in 1974-75, when output plunged 12% from peak to trough – see chart.

Surveys signal a further decline by early 2009: for example, Japanese manufacturers plan to cut production by 8% in December and 2% in January, according to the Ministry of Economy, Trade and Industry. Reductions elsewhere should be considerably smaller but the cumulative fall in G7 output should soon approach 10%, making the current recession the second worst since the war.

As previously noted, the initial decline in output in the three prior recessions was over after a year, suggesting a trough by February 2009. Monetary trends are also consistent with a bottom in early 2009: annual G7 real M1 growth has been picking up since August and typically leads activity by about six months. 

The economy performed more poorly than previously thought in the third quarter, with GDP contracting by 0.6% (0.65% to two decimal places) versus an earlier estimate of 0.5%. The slide in activity was, however, temporarily arrested in October: a monthly GDP estimate based on data on services and industrial output rose 0.2% from September, to a level equal to the third-quarter average – see first chart. Significant weakness is likely in November and December but forecasts that GDP will decline by 1% or more in the fourth quarter now look too pessimistic.

Other highlights of the GDP release include:

• Growth in late 2007 and early 2008 was faster than previously thought – GDP rose by 1.7% in the year to the second quarter versus an earlier estimate of 1.5%. Third-quarter annual growth is unchanged at 0.3%.

• GDP is still estimated to have been slightly higher in the second quarter than the first, implying the recession started in the third quarter. This will be confirmed by a decline in fourth-quarter GDP, released in late January. Monthly figures suggest the economy peaked in April 2008 – first chart.

• If the current recession were to follow a path based on an average of the last three, GDP would fall by a further 1.8% between the third quarter and the second quarter of 2009, move broadly sideways over the subsequent year and recover by 2.5% in the year from the second quarter of 2010 – second chart. This would result in an annual average decline of 1.7% in 2009 followed by growth of 0.4% in 2010. Such a profile appears plausible based on current information – future monetary trends will determine whether the economy undershoots or recovers relative to the average path.

• Net exports lifted GDP by just 0.2% in the year to the third quarter despite a large fall in the exchange rate. A significant improvement in visible trade contributed 0.8% but was offset by a deterioration in net exports of services.

In a speech in October 1991 Chancellor Norman, now Lord, Lamont famously claimed that “the green shoots of economic spring are appearing once again” (sometimes misquoted as “the green shoots of recovery”). The statement is often cited as an example of a bad official forecast but this is unfair. The GDP low during the early 1990s recession was reached in the third quarter of 1991, just before Mr. Lamont’s remarks.

The problem with the statement was the implicit assumption that the end of the recession, or contraction in output, would coincide with the onset of “economic spring” or recovery. GDP was unchanged over the subsequent three quarters, returning to growth only in the third quarter of 1992. It was a further year before the economy was expanding at an above-trend pace.

The resuscitation period between the end of a recession and the start of a recovery is miserable, with a widening negative “output gap” reflected in rising unemployment and declines in capacity utilisation and profit margins. This “feel-bad factor” explains the exaggerated criticism of Mr. Lamont’s infelicitous statement.

As explained in a previous post, if the current recession were to follow a path based on an average of the last three GDP would hit bottom in the second quarter of 2009, move sideways over the following year and recover by 2.5% in the year from the second quarter of 2010. The end of the period of falling output would be foreshadowed by a significant improvement in leading indicators from spring 2009.

On this timetable, the equivalent month to October 1991 would be July 2009. Will Labour politicians next summer be tempted to “spin” less negative economic news as early signs of a recovery, perhaps in preparation for an autumn election? Mr. Lamont may have achieved notoriety for his premature optimism but his party went on to win at the polls just six months later.

Weekly US money supply numbers are volatile but the latest figures support claims of a significant acceleration. M2 – currency, checkable deposits, time deposits, savings deposits and money market mutual funds – grew by an annualised 22% in the 13 weeks to 8 December, similar to the peak reached briefly in the wake of the 911 terrorist attacks – see first chart.

The pick-up probably reflects the direct and indirect effects of the Fed’s recent shift to more aggressive forms of “quantitative easing”, involving the central bank supplying credit to households and firms as well as additional liquidity to banks.

The Fed has bought $319 billion of commercial paper since October but its plan to purchase $500 billion of agency-backed mortgage securities has yet to be implemented, suggesting a further boost to come. The latter initiative, however, has already contributed to the 30-year conventional mortgage rate plunging below its 2003 trough, resulting in a surge in refinancing applications that may partly explain the M2 pick-up (to the extent that borrowers take the opportunity to increase their loan balances). Interbank swap rates suggest a further fall in mortgage rates – second chart.

The Fed’s statements about quantitative easing have contained no reference to what level of monetary growth is deemed desirable under current conditions. Policy-makers are probably relying in on markets to signal that stimulus is working and may need to be reined back. However, the Fed’s recent actions may have killed off any remaining “bond vigilantes”, who might be expected to provide early warning of the inflationary implications of sustained rapid monetary expansion by pushing Treasury yields higher.

The 23% plunge in the effective exchange rate over the last 12 months is the largest annual fall since the pound was forced off the gold standard in 1931. The rate of decline is greater than during the 1976 IMF crisis and after sterling’s expulsion from the exchange rate mechanism in 1992 – see first chart.

Policy-makers and economists have cheered on the depreciation on the view that it will support activity at little inflation cost. This is based partly on the favourable aftermath of the ERM decline – growth rebounded in 1993 while inflation fell further. This recovery, however, reflected a revival in domestic demand in response to interest rate cuts – the monetary transmission mechanism was working – more than a boom in net exports. The economy was improving before exit from the ERM, having entered recession in 1990, and a huge negative “output gap” outweighed the inflationary impact of the lower exchange rate.

When the Thai baht collapsed in 1997, the boost to net exports was swamped by a contraction of money and credit as foreign capital fled the country. The UK is not Thailand but sterling’s plunge could accelerate a withdrawal of foreign funds from the banking system, exacerbating the credit crunch.

British banks’ net sterling borrowing from overseas stood at £113 billion in August 2007, just before the run on Northern Rock. Surprisingly, this increased over the subsequent 12 months, reaching £200 billion in August 2008 – so foreigners initially supplied more funds to struggling banks. The trend, however, may have turned: £37 billion was repaid in September and October combined and sterling’s plunge could accelerate withdrawals.

The consensus view that the lower currency carries little inflation risk may also be questioned. The second chart shows annual rates of change of manufactured import prices and the effective rate, the latter inverted. The relationship suggests import cost inflation will reach an annual 15-20% in early 2009. With manufactured imports accounting for 17% of domestic demand, this implies a 2.5-3.5% boost to economy-wide prices, excluding second-round effects. The “output gap” is widening rapidly but its impact should be smaller than in 1992-93 – it turned negative only in the third quarter, according to the OECD. Plunging commodity prices and the VAT cut will ensure significantly lower headline consumer price inflation in 2009 but the decline may fall short of MPC and consensus expectations.