Bank of England Governor Mark Carney last week suggested that the MPC will consider a rise in Bank rate “around the turn of this year” and that increases will “proceed slowly ... to a level in the medium term that is perhaps about half as high as historical averages". Mr Carney claimed that the pre-crisis average level of rates when inflation was at target was around 4.5%, so "half as high" implies a "new normal" of about 2.25%. Even if he is correct, however, the tendency of rates to cycle around their normal level suggests a future peak significantly above 2.25%. The latter level, moreover, seems implausibly low.

Mr Carney’s remarks have been widely interpreted as signalling a peak level of rates no higher than 2.25%. This assumes that the MPC will be able to calibrate the timing and extent of policy tightening in order to keep actual rates in line with their recovering normal level, consistent with achieving the inflation target. Such a perfect glide path is highly unlikely to be achieved given uncertainty about the correct inflation “model”, imperfect information about the current state of the economy and “shocks”. Historically, rates have rarely, if ever, increased slowly to an extended plateau. They have, instead, tended to rise abruptly to a short-lived peak. The process of reaching the normal or equilibrium level, in other words, has involved an overshoot and correction.

There were five rate rise episodes between the start of inflation targeting in October 1992 and the onset of the financial crisis in late 2007. Bank rate peaked at 6.625%, 7.5%, 6.0%, 4.75% and 5.75%. The mean deviation from Mr Carney’s estimate of a pre-crisis equilibrium rate of 4.5% was 1.625 percentage points (pp). If the “new normal” is 2.25%, therefore, it would be reasonable to expect rates to overshoot temporarily to 3.75-4.0%.

The minimum deviation from Mr Carney’s “old normal” was 0.25 pp in 2004 but rates were subsequently reduced by only 0.25 pp before embarking on another sustained rise to 5.75%. Even in the one case when rate rises stopped around the supposed equilibrium level, therefore, a substantial further increase ensued.

Mr Carney’s estimates of old and new normals of 4.5% and 2.25% respectively, meanwhile, seem low. He claims that 4.5% was the average level of rates during the pre-crisis period when inflation was at target. In fact, inflation was exactly equal to the central objective between the start of targeting and the onset of the financial crisis, while Bank rate averaged 5.4%, not 4.5%, over this period*.

Why should the new normal be 2.25 pp below the old? Mr Carney mentions headwinds to growth and inflation from global economic weakness, sterling appreciation and fiscal tightening. Such restraints, however, are temporary – they warrant proceeding slowly with rises but do not imply that the long-run equilibrium level of rates will be lower than in the past.

The main reason for believing that the new normal is significantly lower, unmentioned by Mr Carney, is a changed relationship between bank interest rates and Bank rate since the crisis. For example, the average bank interest rate vis-à-vis households** is now 2.0 pp above Bank rate versus an average premium of only 0.3 pp in the nine years to end-2007 – see chart. This suggests that a given Bank rate now has the same impact on household economic behaviour as a level 1.7 pp higher before the crisis.

Assuming that the spread between bank interest rates and Bank rate remains at its current level, an old normal of 4.5% may, therefore, imply a new normal of about 2.75% rather than Mr Carney’s 2.25%. If the old normal was 5.4%, however, the suggested new equilibrium is about 3.75%. These estimates, of course, will increase if the spread between bank interest rates and Bank rate continues to trend lower.

*The target was initially expressed in terms of RPIX inflation, with a central objective of 2.5%, but was switched to CPI inflation at end-2003, with a 2% goal. RPIX inflation averaged 2.5% over 1994-2003 while CPI inflation averaged 2.0% over 2004-07.
**Average of lending and deposit rates.

Global equities and bank reserves held at the Fed, Bank of Japan (BOJ) and ECB have trended higher since the 2008-09 crisis / recession – see first chart. This has prompted claims that central bank liquidity creation has been the key driver of markets.

The view here is that the twin upward trends are largely coincidental. There was no correlation between equities and reserves before the crisis. Liquidity availability for markets depends on the relative growth rates of the real (inflation-adjusted) money stock and output. Global real narrow money has mostly risen faster than industrial output since 2008, explaining equity gains. The relative strength of real money growth, of course, partly reflects central bank policies but is only loosely related to rising reserves.

The largest fall in equities since 2009 occurred in 2011: the MSCI All-Country World Index in US dollars suffered a 23.9% peak-to-trough decline over May-October. This followed a period in 2010 when annual growth of G7 real narrow money was beneath that of industrial output – second chart. By contrast, G3 bank reserves were rising strongly before the 2011 correction.

The G7 real money / output growth gap remains significantly positive and is unlikely to close before end-2015. G3 reserves, meanwhile, will continue to trend higher as the BOJ and ECB proceed with QE programmes – third chart. Both indicators, therefore, suggest further near-term upside for equities but “excess” money growth is more likely to warn of the next bout of weakness.

Chinese economic growth has revived modestly in line with an earlier recovery in real money expansion. The latest monetary statistics suggest further improvement, although additional June details are needed to confirm this assessment.

GDP is officially estimated to have risen by 1.7% in the second quarter, up from 1.4% in the first. Annual growth was unchanged at 7.0%, implying that the government remains exactly on track to meet its full-year forecast of about 7%.

The monthly industrial output numbers* are regarded here as a more accurate reflection of economic reality. Six-month output growth reached a six-year low of 1.8% in March but has recovered to 2.6% in June (5.3% annualised). This is still well below an average of 4.4% (9.1% annualised) over 2012-14 – see first chart.

Economic weakness in early 2015 was signalled by a contraction of real narrow money during the second half of 2014. As previously explained, narrow money is best measured by “true” M1, which adds household demand deposits to the official M1 measure. The six-month change in real true M1 bottomed in December, recovering modestly in early 2015, consistent with a revival in economic momentum around mid-year.

Headline money numbers for June suggest that the economic pick-up will be sustained, with six-month real growth of official M1 and the broader M2 measure rising further. The assessment here, however, will rely on true M1, a June reading for which is not yet available**.

Another notable feature of today’s batch of activity data was a further recovery in housing sales, which, if sustained, should lift prices and housebuilding activity during the second half, with positive implications for industrial output – second chart.

*World Bank seasonally adjusted level series.
**Household deposit data are typically released one week after the headline money numbers.

The MSCI All-Country World Index in US dollars was down by 6.5% from its 21 May all-time peak as of Wednesday, the recent low. The modest response to “Grexit” risk and Chinese stock market chaos is consistent with the assessment here of a supportive global economic / liquidity backdrop.

A post in February suggested that global economic growth would pull back into mid-2015 before strengthening in the second half of the year. The pull-back has been sharper than expected: six-month growth of industrial output in the G7 developed economies and seven large emerging economies (the “E7”) fell to zero in May – see chart.

The real or inflation-adjusted money stock leads the economy, typically by about nine months. The recent economic slowdown was signalled by a decline in six-month growth of G7 plus E7 real narrow money in the third quarter of 2014. Real money growth, however, rebounded in late 2014 / early 2015, suggesting stronger economic performance during the second half.

Other leading indicators have improved: a composite G7 plus E7 measure derived from the OECD’s country leading indicator indices recovered significantly in May (new OECD data were released this week). The lower oil price, meanwhile, may start to have a positive economic impact during the second half. An earlier post examined changes in global economic growth after five previous large oil price falls: there was no clear pattern after six months but growth was consistently higher a year later.

An important gauge of liquidity availability for markets is the gap between the growth rates of real money and industrial output. An investment strategy of buying world equities after this gap turns positive but moving to cash when it falls sharply or becomes negative would have outperformed buy and hold by 2.7% per annum over the last 45 years. Real money growth has moderated since February but a simultaneous economic slowdown has maintained a substantial “excess liquidity” cushion.

The big story of the Budget is a dramatic reduction in the squeeze on departmental spending. The Chancellor made room for less spending restraint by cutting deep into the welfare budget and raising taxes significantly. He also allowed his borrowing targets to slip again.

The fiscal stance over the next two years is less restrictive than projected in March. Cyclically-adjusted net borrowing falls by 2.1 percentage points (pp) of GDP between 2015-16 and 2017-18, down from 3.1 pp in March.

The Chancellor attempted to soften the welfare cuts by raising the personal allowance and introducing a compulsory “national living wage” for over 25s, targeted to reach £9.00 per hour by 2020 versus the current minimum wage of £6.50. The OBR expects little inflationary impact from this measure but admits to significant uncertainty.

The living wage announcement represents an attempt to shift some of the burden of welfare cuts onto the corporate sector. The OBR estimates a direct impact on corporate profits of almost £4 billion by 2020, which would outweigh the benefit of a lower corporation tax rate and other business “giveaways”. Firms also suffer a big hit over 2017-19 from an accelerated payment schedule.

Households are significant net losers too, with higher taxes on dividends, buy-to-let investors, pension contributions, insurance premiums and cars swamping the cost of increases in personal / inheritance tax allowances and a raised higher rate threshold.

Higher borrowing and the living wage may incline the MPC towards an earlier rate hike. With the burden on business rising, neither equities nor gilts have much to cheer.

• The comfortable “no” majority – the opposite result to that predicted by betting markets – will, at least, serve to accelerate the conclusion of the crisis.

• The priority of the Eurozone authorities will shift from securing a deal with Greece to protecting other EMU members from financial contagion. This could involve an expansion of QE, a political commitment by leaders to implement the recommendations of the recent “five presidents’” report on strengthening monetary union, and financial guarantees against any ECB losses on its Greek exposure. Such measures would support markets.

• The Eurozone authorities are very unlikely to agree a softer bail-out deal with up-front debt relief, as promised by PM Tsipras to his electorate. Without a deal, the ECB will be unable to maintain its current level of liquidity support to Greece without Eurozone guarantees against losses, let alone increase it. Banks will run out of cash in days, further increasing economic hardship. The government’s popularity may unravel swiftly, leading to new elections, perhaps triggered by the resignation of the president.

• The liquidity crunch is likely to force the government to pay bills with scrip / IOUs, possibly as early as 12 July when public sector wages are due. These would trade at a large discount and their introduction could further undermine government popularity by raising fears of Grexit. Despite the “no” majority, polls indicate that support for the euro is at a record high.

• The choice facing Mr Tsipras, therefore, is to accept a deal similar to the one he rejected 10 days ago or risk his popularity imploding along with the economy. Events are moving fast and a prolonged “Grimbo” – Greece remaining in the euro but with the banking system and economy in lockdown – is unlikely.

• The suggestion here remains that wider market implications of the Greek crisis will be limited by a supportive global economic / liquidity backdrop and the determination of the Eurozone authorities to prevent contagion.