Domestically-generated inflation has risen and is above 2%

Domestic inflation is key because it determines where CPI inflation will settle when the effects of commodity price weakness and sterling strength dissipate.

A national accounts-based measure of domestic inflation is the annual increase in the deflator for gross value added (GVA), which measures the prices of goods and services produced in the UK. This rose to 2.2% in the first quarter of 2015.

The GVA deflator, moreover, has been suppressed by the fall in price of North Sea oil production. The GVA deflator excluding oil and gas rose by 2.7% in the year to the first quarter – the largest annual gain since 2009.

As well as signalling a likely strong rebound in CPI inflation, the rise in domestic inflation casts doubt on the MPC’s judgement that there is still slack in the economy (of about ½% of GDP, according to the May Inflation Report). Inflation should trend lower while slack persists, according to conventional doctrine.

The GVA deflator can be viewed, from the income side, as the sum of two components – employee compensation per unit of output and “other income” per unit of output. The large annual rise in the GVA deflator excluding oil and gas is accounted for by strength in the latter component – see first chart. Above-trend economic growth, in other words, has been reflected in upward pressure on corporate profit margins and self-employment incomes.

The danger is that the employee compensation component now takes up the running as wages pick up in response to a tight labour market. The annual change in unit compensation rose to 1.7% last quarter, the highest since 2013.



Economic growth is likely to remain above trend

The rise in domestic inflation would be of less concern if the apparent economic slowdown in early 2015 were to be sustained. Monetary trends, however, suggest that GDP growth will remain at around its 2013-14 level, which was associated with steady elimination of economic slack.

The second chart compares rates of change of GDP excluding oil and gas and measures of inflation-adjusted broad money (M4), narrow money (M1) and corporate money (M4 holdings of private non-financial corporations). The real money measures have given advance warning of economic fluctuations in recent years and their current growth rates are similar to or higher than in 2013-14.



Bank interest rates have fallen, delivering an effective monetary loosening

The MPC cut Bank rate to a minimum in 2009 partly to counteract a sharp rise in the spread between commercial bank deposit / lending rates and Bank rate in the wake of the financial crisis. The spread, however, has narrowed since 2012 as funding conditions for banks have eased, resulting in a 0.5 percentage point fall in the average bank interest rate vis-à-vis households – third chart.

Monetary policy was sufficiently loose in 2012 to produce solid economic growth in 2013-14. By keeping Bank rate stable as bank interest rates have fallen, the MPC has allowed an unwarranted further easing of domestic monetary conditions.

A possible counter-argument is that the impact of lower bank interest rates on monetary conditions has been offset by exchange rate strength, with the sterling effective rate rising by 8% since end-2012. The risk, however, is that this strength unravels rapidly. Historically, UK monetary policy-makers have frequently delayed necessary tightening because of concern about a temporarily high exchange rate, with inflation and interest rates subsequently rising significantly.

Global monetary trends have been suggesting faster economic growth in the second half of 2015 – see previous post. May business surveys are consistent with this scenario: a weighted average of G7 manufacturing purchasing managers’ new orders indices rose significantly, with improvements in six of the seven countries (Germany being the exception) – see first chart.

The coming growth pick-up is at least partially discounted in markets, judging from recent divergent performance of global equities and government bonds, and relative strength of cyclical stocks. The key issues now are how long the upswing will last and whether it will give way to another slowdown in 2016.

Six-month growth of global real narrow money reached a peak in February – second chart. The lead time from real money to output has averaged eight months at the last three growth turning points, suggesting that economic momentum will top out around October.

Real money growth remained solid in April, consistent with little economic slowdown in late 2015. It is likely, however, to fall further as inflation continues to recover, assuming that commodity prices are stable at current levels – third chart.

A plausible scenario, therefore, is that strong second-half growth will give way to a loss of economic momentum in early 2016, following a real money slowdown this summer. The coming upswing, in other words, will prove to be another false down.

How could this be too pessimistic? One possibility is that nominal money growth will strengthen, offsetting the inflation drag on real money expansion. The most likely source of a rise in global money growth is China, where trends are showing signs of improvement and recent policy easing has yet to feed through – see previous post.

An alternative growth-bullish possibility is that money velocity will pick up, or at least fall at a slower rate. A rise in velocity has the same economic impact as an increase in real money. A measure of the velocity of G7 narrow money is far below its declining long-term trend, suggesting the potential for a rebound – fourth chart.

What could trigger such a turnaround? The surprising answer is a rise in US interest rates. Velocity has increased when the Fed has tightened historically – fifth chart. Correlation is not causation, but this suggests that Fed tightening initially results in a stronger economy as the velocity effect outweighs the (lagged) impact of higher rates. An early Fed move, perversely, may warrant greater near-term economic optimism.

UK monetary trends are stable and consistent with a near-term revival in economic growth after the recent mild slowdown.

The preferred narrow and broad aggregates here are M1 and M4 excluding money holdings of financial corporations*. Both measures rose by 0.5% in April, leaving six-month growth rates little changed at 3.1% and 2.1% respectively, or 6.3% and 4.2% annualised – see first chart.

Economic prospects are related to real rather than nominal money trends. Reflecting the impact of commodity price weakness and sterling strength on consumer prices, six-month growth of real non-financial M1 and M4 is higher than during the second half of 2014, supporting the expectation of faster economic expansion through late 2015 – second chart.

An inflation revival later in 2015 will squeeze real money growth unless nominal trends strengthen. The latter scenario, however, is plausible: deposit / lending rates have fallen further, “excess” liquidity in the Eurozone may be flowing into the UK and bank lending is firming. Foreign investors bought £26.8 billion of gilts over February-April following the ECB’s QE announcement in January, the largest three-month sum since December 2013. Six-month growth of bank lending to households and non-financial firms rose to 1.1% in April, or 2.2% annualised, the fastest since December 2008 – first chart.

*M1 comprises notes / coin and sight deposits, with M4 adding in other deposits, repos and short-maturity bank paper. Money holdings of financial corporations are volatile and less relevant for judging near-term economic prospects.

The new orders component of the Chinese official manufacturing purchasing managers’ survey edged higher in May, and by more when account is taken of residual seasonality in the published series. This is consistent with a recent improvement in equity analysts’ earnings revisions noted in a previous post and suggests a near-term recovery in industrial output growth – see first chart.

The input prices component of the survey, meanwhile, rose to its highest level since July 2014, signalling a slowdown in producer price deflation – second chart.

Narrow money trends have been predicting a modest economic growth revival: the average level of six-month expansion of real “true” M1* so far this year has been higher than in the second half of 2014, although monthly data have been volatile and the latest reading was still subdued – third chart and previous post. Real M1 needs to strengthen significantly further to suggest that recent policy stimulus has been sufficient to return economic growth to target. (May money numbers are expected to be released over 10-15 June.)

*True M1 includes household demand deposits, which are excluded from the official measure.