My ECB-ometer shifted from a tightening to an easing bias between late 2007 and early 2008, reflecting weaker economic news and financial market stresses. In early March, as the credit crisis moved towards a climax, it suggested a 40% chance of a rate cut at that month’s ECB meeting. The move has since reversed, however, as markets have normalised and inflation indicators have worsened.

Based on available data, the model suggests a 30% chance of a hike in official rates at next week’s ECB meeting – see chart. This compares with a small probability of a cut last month. The change is due to a combination of strong first-quarter GDP numbers, a further deterioration in both survey- and market-based measures of inflation expectations and a rebound in M3 growth. These developments have offset weakness in survey activity indicators.

It is too soon to expect a reappearance of “vigilance” but next week’s policy statement and press conference could signal a hawkish bias.

Market interest rate expectations have shifted dramatically as investors have reassessed near-term inflation prospects (discussed here). As recently as mid April, the gilt repo curve discounted a further fall in Bank rate to 4.0% by the end of 2008. By the time the Inflation Report was prepared in early May, the implied year-end level had risen to 4.6%. Poor April inflation data and the hawkish tone of the Report extinguished remaining hopes of reductions and the repo curve currently suggests a greater-than-50% probability of a quarter-point hike by December.

Market rates are now starkly at odds with economists’ forecasts, which have adjusted much less to recent news. In a Reuters poll conducted in mid April, 53 out of 56 respondents projected a further fall in Bank rate by the end of 2008, with a mean forecast of 4.43%. By mid May, the number expecting a decline had fallen to 45 out of 53, with the mean rising to 4.61% – still consistent with at least one quarter-point reduction. Strikingly, higher near-term expectations have been balanced by a lowering of projections further ahead – the mean forecast for the third quarter of 2009 fell from 4.37% to 4.33% between the April and May surveys.

So who is right – the market or economists? One way of approaching this question is to use the “MPC-ometer” model described in earlier posts to forecast Bank rate decisions over the remainder of 2008 assuming the economy performs in line with the MPC’s expectations. Specifically, suppose 1) GDP growth and CPI inflation follow the paths shown in the unchanged rates scenario in the May Inflation Report, 2) business and consumer confidence fall to levels consistent with the growth projection and 3) all other components of the MPC-ometer – including inflation expectations, earnings growth, equity prices and the effective exchange rate – remain at current levels. On this basis, the model indicates a 65% probability of rates remaining at 5.0% until the end of 2008, with a 35% chance of a quarter-point cut.

Put another way, economists’ expectations of one or two more quarter-point reductions before the end of 2008 depend on either growth and / or inflation undershooting the MPC’s forecasts or other components of the model shifting in a favourable direction. Neither seems particularly likely. The MPC’s growth projections are already downbeat, with GDP forecast to rise by just 0.9% in the year to the first quarter of 2009, while its expectation of a 3.7% peak in annual CPI inflation looks conservative. (This assumes a further 15% rise in retail electricity and gas costs but current wholesale energy prices suggest a larger increase.) Of the other model components, consumer inflation expectations and earnings growth are unlikely to fall back while the headline CPI rate is climbing, although a weaker economy may temper business price-raising plans. Lower equity prices and / or a rally in the exchange rate could boost easing hopes but neither carries strong weight in the MPC’s decisions, according to the model.

Monetary trends are also important for judging prospects for further rate cuts. Broad money M4 has continued to grow rapidly in recent months but appears to have been distorted by the credit crisis. Concerned about counterparty risk, banks have reduced traditional unsecured interbank lending in favour of secured loans, particularly gilt reverse repos. Unsecured lending is excluded from M4 but increasing repo activity may have boosted the aggregate because it is intermediated by the London Clearing House (LCH), which is classified as part of the non-bank private sector. The Bank of England has constructed a modified M4 measure excluding money holdings of the LCH and other financial corporations used to conduct interbank business (see p.18 of the May Inflation Report). This rose by 9.0% in the year to March and by 6.1% annualised in the latest six months (see chart) versus comparable growth rates of 11.9% and 9.6% for total M4. The gap between the two measures is likely to widen as a result of Special Liquidity Scheme (SLS) introduced in late April, which should significantly boost interbank repo transactions. It will therefore be important to focus on the adjusted measure rather than headline M4 to assess monetary conditions over coming months. (Unfortunately, the new measure is available only on a quarterly basis, with the next reading for June due in early August.)

Summing up, the MPC-ometer analysis supports market scepticism about economists’ forecasts of further Bank rate cuts later in 2008 but suggests a reduction is more likely than a rise. On this basis, current longer-term money market rates offer value – particularly unsecured rates, since credit / liquidity spreads should be capped by the SLS. Monetary trends are also consistent with a stable policy stance but a further slowdown in adjusted M4 would suggest improving medium-term inflation prospects, warranting consideration of a rate cut in late 2008 or early 2009.

Discussions about how far house prices could fall often confuse two issues – the extent of current overvaluation and the possibility that a serious economic downturn will result in prices undershooting “fair value”. This post focuses on the former.

According to widely-quoted IMF research (here, p.11), UK prices rose by nearly 30% more than justified by “fundamentals” between 1997 and 2007. Some commentators – including the MPC’s David Blanchflower (here, p.5) – have used this 30% figure as a measure of current overvaluation. As David Smith of the Sunday Times pointed out in a recent column, this is incorrect because the reference is the level of prices in 1997, not “fair value” at present. Adjusting for price growth since 1997, the IMF calculations imply 15% overvaluation currently.

The IMF approach may be questioned. The definition of “fundamentals” includes affordability, income growth, interest rates, credit growth, equity prices and population trends. The relevance of credit expansion and equity prices for sustainable valuation is debatable. In addition, no allowance is made for constraints on the supply of housing – likely to have been a more significant factor in the UK than in other countries recently experiencing house price booms.

Popular comparisons of the house price to earnings ratio with its long-run average significantly overstate current overvaluation. The first chart shows one such measure – the value of the housing stock divided by household disposable income. The ratio clearly trends higher over time, reflecting factors such as improving quality, the pressure of an expanding population on constrained supply and a high income elasticity of demand for housing.

Rather than its long-run average, the log-linear trend of the ratio is probably a better guide to current “fair value”. On this basis, prices were 10% overvalued at the end of last year versus an 85% deviation relative to the average.

An alternative and superior approach is to use rents rather than earnings as the basis of comparison. Rents already embody fundamental influences on housing demand and supply. Moreover, a potential homebuyer does not face a choice between consuming housing services or retaining earnings for other purposes – the decision is rather whether buying is financially preferable to renting.

The second chart shows a measure of the rental yield on housing derived from the national accounts – actual and imputed owner-occupied rents as a percentage of the value of the housing stock. The yield stood at 3.0% at the end of 2007 against a long-run average of 3.6%, suggesting price overvaluation of 20%.

However, this figure overstates the need for prices to fall to restore value, for two reasons. First, rents are growing solidly – by 7.7% on the national accounts measure in the year to the fourth quarter. The trend seems likely to persist, with the latest RICS letting agents’ survey reporting strong tenant demand and expectations for rents – see third chart. Secondly, low real yields on competing assets – particularly government bonds – may mean the “equilibrium” rental yield is below its long-run average.

Based on the above, a house price decline of 10% by 2009 could be sufficient to restore valuations to a sustainable level. This is consistent with modelling work by academics John Muellbauer and Anthony Murphy, reported in Thursday’s Financial Times.

A larger fall is certainly possible – based on the rental yield, prices have typically undershot their sustainable level by 10-20% during serious economic downturns. However, any such decline would create another attractive entry point for longer-term investors.

A post in March gave a list of reasons for expecting stock markets to rally. (A modified version of this piece appeared on the Telegraph website and elicited a torrent of hostile comment from enraged bears.) The MSCI World index (in dollars) has since risen by 10% and the FTSE 100 by 14% (to yesterday’s close). Is optimism still warranted?

One of the reasons for expecting a rally was that equities were then discounting an enormous amount of bad news. The first chart below updates an earlier comparison of the performance of world stocks in the current cycle with historical “soft” and “hard” landings – see here. At their March lows markets were fully priced for a hard landing scenario.

Following the rally, investors appear to be assigning roughly equal weight to the soft and hard landing scenarios. I still think a hard landing will be avoided, at least in 2008, but market levels are no longer hugely misaligned with economic fundamentals.

Another bullish argument was that plentiful global liquidity would be redeployed in equity markets as investors’ fears of financial meltdown abated. The second chart updates measures of G7 liquidity and risk aversion, last discussed here.

Liquidity remains ample although the indicator may be overstating the position because money supply figures have been distorted by the credit crisis. As expected, risk aversion has fallen and should continue to move lower barring further financial accidents. So the liquidity / risk backdrop still looks supportive.

The recent rally has been led by the energy and materials sectors but this pattern may be unsustainable, since further commodity price gains would threaten global growth prospects. A continuation of the uptrend in markets may therefore require a rotation of strength into other sectors, particularly beaten-up financials.

The third chart updates the comparison of the performance of US financial stocks during the current subprime crisis with the savings and loan crisis of the late 1980s, last discussed here. If the similarity persists – a big if – financials should soon embark on a strong recovery, which could sustain the uptrend in market indices.

Summing up, there are reasons to remain constructive on equities but some caution is warranted after the recent strong rally. Continuation of the uptrend is likely to require a stabilisation or modest setback in commodity prices along with a better performance of financial stocks.

At some point this summer, Mervyn King, the Bank of England governor, faces an unenviable task. For the second time in his tenure, he will have to write an open letter to the chancellor explaining why inflation has risen more than one percentage point above the 2% target and describing what the Bank’s Monetary Policy Committee plans to do about it.

Why have the institutional arrangements designed to anchor UK inflation failed for a second time?

In an accounting sense, the increase in Consumer Prices Index inflation since mid 2007 can be largely explained by rising global prices of food and energy. The deeper question, however, is why these higher prices have not been offset by slower rises or falls in prices for other products and services, as would be expected if monetary policy had been correctly calibrated to meet the inflation target.

Regrettably for its reputation, it is clear the MPC allowed excessively loose monetary conditions to develop between 2005 and 2007. Bank rate was cut inappropriately in 2005 and maintained below its neutral level until 2007. During this period, investors’ risk appetites significantly increased. The result was a prolonged period of buoyant money and credit expansion.

In the three years to December 2007, the ratio of the broad money supply, M4, to nominal gross domestic product (GDP) rose by 22 per cent. A comparable increase has occurred only twice since 1945 – the early 1970s and late 1980s. Both episodes were characterised by rampant demand and output growth, a widening current account deficit and a subsequent large rise in inflation. These “Barber” and “Lawson” monetary booms – named after the chancellor of the day – were followed by damaging recessions. The UK has now had an “MPC boom”, again with painful consequences

The MPC discussed rapid money and credit growth at its meetings in 2006 and 2007 but played down the dangers . Members argued that the build-up in money balances was concentrated in the financial sector so would not result in a significant boost to demand for goods and services.

While economic growth has been strong, it has been lower than in the early 1970s and late 1980s, implying less pressure on supply capacity. The MPC view, however, neglected the possibility that “excess” money would flow across the foreign exchanges, leading to a sharp decline in sterling, thereby exacerbating upward pressure on import costs. The concentration of liquidity in the financial sector, accompanied by a large rise in overseas sterling deposits, increased this risk. The effective rate has fallen by 13% since July 2007 – similar to the “pound in your pocket” devaluation of 1967. In addition, monetary buoyancy may have contributed directly to rising inflationary expectations.

The upshot is that official neglect of monetary warning signals has once again been followed by an unexpectedly large rise in inflation although details of the transmission mechanism differ from earlier episodes. In effect, loose domestic monetary conditions have accommodated or even supplemented the inflationary impact of rising global costs.

How should policy now respond? Some commentators have urged the MPC to “look through” the current overshoot on the grounds that a weakening economy will return inflation to target in two years’ time. Even if this were assured, the argument neglects the MPC’s requirement to meet the target “at all times”. While policy actions have their greatest impact at longer horizons, they also affect shorter-term prospects so it is wrong to focus solely on where inflation may be two years ahead.

The recent painful tightening in credit market conditions should, in time, contribute to much slower monetary growth. The headline CPI rate, however, is set to rise significantly further and firms and employees may build a higher trend level of inflation into their price- and wage-setting behaviour.

The danger of inflationary expectations becoming dislodged from the 2% target is greater now than in April 2007 when Mervyn King wrote his last exculpatory letter. In 2007, CPI inflation returned to target four months after reaching the 3.1% threshold. Now, it is likely to remain above 2% until late 2009, barring a significant decline in commodity prices.

This means that interest rate doves who think there is scope for further monetary loosening currently are misguided if they wish the Bank to restore its anti-inflation credentials. Any future reduction must be conditional on evidence of a moderation in monetary expansion and inflation expectations. The short-term economic pain implied by such a policy is outweighed by the potential costs of failing to return inflation sustainably to the 2% target over the medium term.

An edited version of this article appears in today's Financial Times.

 

The May Inflation Report is markedly more pessimistic about both inflation and growth than in February and confirms that early further interest rate cuts are off the MPC’s agenda:

1. The central projection based on unchanged rates shows CPI inflation at or above 3% for a year, peaking at 3.7% in the fourth quarter. The fan chart suggests a 30% probability of a peak at or above 4%.

2. The central forecast is on target at the two year horizon assuming unchanged rates, having been significantly below (1.77%) in the February Report. Moreover, risks to this forecast are judged to lie on the upside, having been viewed as balanced in February.

3. Annual GDP growth now troughs at 0.9% in the first quarter of 2009 in the central forecast on unchanged rates, compared with a February low of 1.4%. However, a significant rebound is still projected by 2010 – it is unclear why given reduced prospects of interest rate cuts.

4. The GDP fan chart suggests a 15% chance of an annual contraction in the first quarter of 2009. This implies a significant probability of two negative GDP quarters over the next year – perhaps around 30%.

The one silver lining in the Report is that its forecasts are sufficiently pessimistic to create the possibility of favourable economic surprises over coming months.