Today’s National Statistics decision on the retail prices index (RPI) has provoked outrage from statistical purists but represents a sensible, if untidy, compromise.

Against forecasts, the National Statistician has addressed criticism of the calculation method used for the RPI by introducing a new measure, RPIJ, that employs superior methodology, rather than changing the RPI itself. The creation of an additional inflation measure risks causing confusion but avoids the windfall gains / losses entailed by reengineering the RPI. (The change would have lowered RPI inflation, benefiting the government and some pension scheme sponsors at the expense of holders of existing index-linked debt and recipients of RPI-linked pensions.)

The economic importance of the RPI has waned in recent years because of government decisions to switch to the CPI for uprating benefits and taxes. The introduction of RPIJ will continue this trend, as will the inclusion of owner occupiers’ housing costs in a new CPI measure, CPIH, to be released in March. CPIH may assume eventual dominance, having similar broad coverage to RPIJ but a superior weighting structure, reflecting the spending patterns of all UK households plus foreign visitors, whereas the RPI / RPIJ excludes the highest earners and some pensioners.

The Treasury has announced that it will continue to issue new index-linked gilts based on the RPI. There would be no benefit from switching to RPIJ / CPI / CPIH since investors would demand a higher initial real yield to compensate for lower future inflation compensation payments.

Bank of England research suggests that QE of £375 billion has boosted the broad money supply by about £220 billion, or 15%, and that this in turn has lifted nominal GDP by nearly 6%. The analysis below, however, argues that the Bank has significantly overestimated QE “pass-through” – the monetary impact, relative to a no QE counterfactual, may have been as low as £80 billion, or 5%. Using the Bank’s sensitivities, this would imply a boost to nominal GDP of only 2%, split roughly equally between output and prices.

An excellent article* in the latest Bank of England Quarterly Bulletin (BEQB) considers the impact of QE1 (£200 billion between March 2009 and January 2010) and QE2 (£125 billion between October 2011 and May 2012) on the broad money supply. The researchers conclude that pass-through was similar for the two episodes, at 61% and 56% respectively, or an average 59%. Assuming that the latter figure also applied to QE3 (£50 billion between July 2012 and October 2012), the cumulative QE impact on broad money has been £222 billion.

The Bank estimates of offsets to the direct monetary impact of QE are plausible except in one important respect: they assume that commercial banks’ holdings of government securities would have been static if no QE had been conducted. Banks, however, were under strong regulatory pressure to boost their holdings of high-quality liquid assets following the financial crisis. QE, in effect, did the job for them by expanding their Bank of England reserves. In its absence, they would probably have bought many more Treasury bills and gilts. These purchases would have had a similar monetary impact to QE.

The blue line in the chart shows the ratio of banks’ high-quality sterling liquid assets – defined as physical cash, Bank of England reserves, Treasury bills and gilts – to their sterling assets; the red line separates out the contribution of T bills and gilts. Note that the rate of increase of the latter slowed sharply when the Bank embarked on QE1 and the contribution actually fell during QE2 and QE3. This supports the view that the reserves boost supplied by QE substituted for purchases of government securities that banks would otherwise have made in order to achieve their liquidity targets.

How much more would they have bought in the absence of QE? One approach is to base an estimate on the pace of purchases during the 20-month interval between QE1 and QE2, when reserves stopped increasing**. The red dashed line in the chart assumes that the rate of increase of the ratio of T bills / gilts to sterling assets during this interval*** would have applied for the whole period from March 2009, when QE1 started, to the present. This is arguably conservative, since it implies an aggregate liquidity ratio now of 7.9% compared with an actual 10.7%, assuming no change in the cash / reserves portion since February 2009.

This approach implies that, without QE, the ratio of T bills / gilts to sterling assets would now be 6.7% rather than 2.8%, consistent with additional bank buying of £144 billion. This sum needs to be subtracted from the £222 billion estimate of the broad money impact of QE derived from the Bank’s research. The suggestion is that £375 billion of QE delivered a monetary boost of only £78 billion – pass-through, in other words, was 21% rather than 59%.

The BEQB article claims that QE1 and QE2 lifted broad money by £192 billion and that this resulted in nominal GDP being about 5% higher than otherwise by mid-2012. The lower estimate here of a £78 billion impact of total QE (i.e. including QE3) suggests a nominal GDP boost of only about 2%, of which slightly less than half will reflect higher prices, based on the Bank’s research.

These results, if accepted, raise doubts about the wisdom of QE: the boost to output of little more than 1% needs to be set against the damage to the Bank’s credibility from pursuing the policy despite above-target inflation and inviting a charge of printing money to suppress government borrowing costs****. There is, however, one positive implication: unwinding QE may have a surprisingly small negative impact on the money supply and economy as banks step up their purchases of government securities to offset the drag of falling reserves on their liquidity ratios.

*Butt, Domit, McLeay and Thomas, “What can the money data tell us about the impact of QE?”, Bank of England Quarterly Bulletin, Vol. 52, No. 4.
**Reserves, in fact, fell between QE1 and QE2 as banks repaid Bank of England loans.
***Specifically, between the two dates highlighted by boxes on the red line.
****Assuming identical DMO issuance, the yield curve would probably have been modestly higher and steeper in the absence of QE because aggregate Bank of England / commercial bank purchases would have been lower and of shorter duration, owing to banks’ preference for shorter-dated securities.

The expectation here of a significant pick-up in UK growth in 2013  – based partly on a simple money supply / share price forecasting rule – is supported by the fourth-quarter British Chambers of Commerce survey released today. A weighted average of home and export orders in the manufacturing and services sectors, seasonally adjusted, rose to its highest level since the fourth quarter of 2007 – see first chart.

Other aspects of the survey were positive: confidence in turnover and profitability as well employment expectations similarly reached new post-recession highs – second chart.

The manufacturing optimism revealed by the survey accords with recent PMI and CBI results but upbeat services responses are a surprise given a weak December PMI services poll released last week (although the PMI is an overrated indicator and often gives false signals).

In other news today, the EU Commission consumer confidence measure fell back in December but remains above the averages for 2012 and 2011. The slippage was probably related to a pick-up in inflation expectations: the sum of the balances reporting higher prices over the last 12 months and predicting a faster increase over the coming year rose to its highest level since May – third chart. Consumers have correctly anticipated inflation swings in recent years and their increased pessimism is consistent with the forecast here that CPI inflation will move back above 3% in early 2013.

UK money supply trends continue to suggest an improving economy and no case for more QE.

Annual growth of non-financial M4 (i.e. broad money held by households and non-financial companies) rose to 5.0% in November, the highest since August 2008. The pick-up has been concentrated in liquid forms of money more likely to be associated with future transactions: non-financial M1 grew by an annual 5.8% in November and Divisia by 7.0%*– see chart.

5% broad money expansion is probably too high to be compatible with the 2% inflation target over the medium term, at least on current policy settings. Negative real interest rates on bank deposits depress the demand to hold money and boost the velocity of circulation (i.e. the ratio of nominal GDP to the money stock). Broad money velocity has risen by an average 1.2% per annum from a trough reached in the second quarter of 2009. Extrapolating this trend, 5% money growth, if sustained, suggests nominal GDP expansion of more than 6%. Even assuming, optimistically, that output could rise by 3% per annum, this would entail inflation of 3% plus.

The suspension of QE may cause money growth to moderate but a major slowdown is not expected here – earlier stimulus should have positive lagged effects while the funding for lending scheme should partially substitute for QE by lowering lending rates and stimulating credit demand, and encouraging banks to reduce their non-deposit funding.

*M1 comprises physical cash and sight deposits while Divisia combines broad money components using liquidity weights based on interest rates.

Eurozone monetary trends continue to signal a recovery in regional economic activity in early 2013. Six-month real M1 growth eased in November but remains robust at 3.7% (not annualised)* – see first chart. The November slowdown is attributable to a large rise in May dropping out of the six-month window. M1 grew by a respectable 0.4% in November alone.

Broad money M3 was unchanged in November, with a rise in deposits offset by an outflow from bank securities and money market funds. Holders of the latter may have switched into markets on perceptions of improving prospects. The statistics are consistent with banks accommodating such demand – they ran down their own securities holdings in November. The flat M3 result, in other words, may reflect disintermediation rather than signalling any cause for concern.

The sectoral breakdown of November deposit growth is favourable, showing further solid rises for households and non-financial corporations offset by a fall in financial sector holdings.

Pessimists will highlight continued private sector loan weakness but credit is a coincident rather than leading indicator of the economy – this weakness, in other words, simply confirms other evidence that activity contracted in the fourth quarter. Divergent deposit and loan movements resulted in another large rise in the corporate liquidity ratio in November; a similar surge in 2009 preceded economic recovery – second chart.

While these developments are promising, the “crisis” cannot be deemed to be over until monetary expansion resumes in the periphery. Real M1 deposits rose in November but were still down 1.2% from six months earlier – third chart. This, however, is the smallest decline since June 2010. A further return of flight capital could result in the six-month change turning positive in early 2013. Caution remains warranted until this signal is given.

Country figures reveal interesting divergences. Within the periphery, Italy’s six-month real M1 deposit change joined Ireland’s in positive territory in November – fourth chart. By contrast, French real M1 deposits have slumped since M. Hollande assumed the presidency in May: the six-month decline of 3.1% in November is the weakest result since August 2008** – fifth chart. Italian / French yield spreads may continue to narrow.

*The monetary aggregates were artificially inflated by the initial capital subscriptions, totalling €32 billion, paid by governments to the European Stability Mechanism (ESM) in October. This transfer boosted M1 by 0.7%, i.e. real six-month growth would be 3.0% in its absence.

**There have been strong inflows to tax-free Livret A savings accounts following a recent lifting of the investment ceiling. However, the bulk of such inflows probably reflects transfers from other savings accounts rather than M1 (i.e. overnight) deposits.

UK household debt as percentage of disposable income fell further to 144.3% in the third quarter of 2012, down from a peak of 174.7% in the first quarter of 2008 and the lowest since 2004. With the average interest rate on outstanding debt also declining, the interest service burden dropped to a new low of 5.7% of income, in data extending back to 1987 – see first chart.

Commentators often claim that consumer spending will remain weak until deleveraging ends. The level of spending, however, is related not to the level of the debt to income ratio but rather its rate of change. A slower fall in debt/income, other things being equal, will be associated with a decline in the saving ratio and higher consumption. So spending could strengthen in 2013 even while deleveraging continues (without assuming a rise in real income).

A pessimistic view is that the debt to income ratio must return to the 100-112% range in operation between the late 1980s and early noughties, before the recent credit bubble. The current ratio remains far above this range, suggesting no slowdown in the pace of decline.

The “equilibrium” level of the ratio, however, cannot be judged simply by reference to history but depends on factors such as the interest service burden, wealth and credit supply.  As noted, the former does not suggest that current debt is “too high”. Nor does wealth: debt as a percentage of the value of housing and financial assets is estimated to have ended 2012 at 18.0%, the lowest since 2002 and close to the average since 1987 – second chart. Credit supply has been pushing down on the debt to income ratio but may improve at the margin in 2013, partly in response to the funding for lending scheme.

The expectation here is that consumption expansion in 2013 will be the fastest since 2007 (i.e. above the 1.3% rise in 2010), reflecting slower deleveraging and a pick-up in real income due to higher employment and a narrower inflation-earnings growth gap.