According to the Financial Times, the Office for Budget Responsibility (OBR) now expects the structural (i.e. cyclically-adjusted) current budget deficit to be eliminated in 2016-17 on announced policies – two years later than at the time of the Budget. This slippage, however, reflects a downward reassessment by the OBR of the UK economy’s supply-side capacity rather than worse-than-expected recent borrowing outturns.

Running the raw borrowing numbers through Datastream’s seasonal adjustment programme, the actual current deficit was an annualised £91 billion in the first seven months of 2011-12 – on track for the OBR’s previous full-year forecast of £90 billion. Overall public sector net borrowing was £124 billion versus a £122 billion full-year projection.

This year’s fiscal performance, in other words, has been surprisingly good against the background of weaker-than-expected economic growth.

The fiscal position, moreover, is better than implied by the targeted measures, which exclude income arising from the financial interventions of recent years – see previous post. In particular, the Bank of England is currently earning about £10 billion per annum on its QE operation (by paying Bank Rate on reserve money created to finance a higher-yielding gilt portfolio).

It is bizarre that the government is under pressure to implement additional fiscal tightening because OBR economists have changed their guess about supply capacity and despite respectable progress to date in reducing the deficit.

Equity earnings revisions ratios for November offer further evidence of a tentative recovery in global economic momentum, albeit one at significant risk from the escalating Eurozone crisis and premature US fiscal tightening – the failure to agree a longer-term deficit reduction plan has lowered the probability of payroll tax cuts and jobless benefits being extended beyond end-2011.

The revisions ratio expresses the net number of upgrades to company earnings forecasts as a proportion of the total number of analyst estimates. It correlates closely with business survey information – in particular, the new orders component of the manufacturing purchasing managers’ survey – but is available earlier and at higher frequency (i.e. weekly as well as monthly).

The world revisions ratio remained negative in November (i.e. more downgrades than upgrades) but rebounded from a depressed October reading, reaching its highest level since July. This confirms a small rise in the G7 PMI new orders index in October and suggests a further increase to above the break-even 50 level this month.

The regional breakdown shows, unsurprisingly, relative weakness in the Eurozone and strength in the US, where the revisions ratio turned positive for the first time since May – consistent with recent better-than-expected US economic data discussed in yesterday’s post. Even the Eurozone ratio recovered significantly, however, suggesting a less downbeat new orders reading in tomorrow’s “flash” PMI report for November.

Amid the gloom in markets, it is worth noting that recent US economic news has been mostly encouraging, consistent with earlier monetary strength. In particular, retail sales recorded another solid gain in October while Philadelphia manufacturers were much more upbeat about order prospects in early November. Both suggest a further gain in the key ISM manufacturing new orders index in November.



The issue, of course, is whether financial and economic weakness spreading from Europe will abort an incipient upswing in US momentum. Historically, the US ISM new orders index has led the corresponding Eurozone purchasing managers’ survey measure rather than vice versa. Is this changing or will the Eurozone “flash” PMI for November released this week show some recovery from a very weak October reading?


The euro weakened last week but many commentators have been surprised at its resilience in the face of escalating sovereign debt woes. September Eurozone balance of payments released today help to explain the puzzle: foreign portfolio investors, unsurprisingly, withdrew funds from the region in the latest three months but this outflow was more than offset by a repatriation of foreign assets by Eurozone residents. This may reflect Eurozone financial institutions being forced to liquidate foreign investments and convert the proceeds into euros because of the seizure of domestic funding markets.

David Smith wrote bearishly about the UK labour market in his Sunday Times column, highlighting a 305,000 drop in the labour force survey (LFS) measure of employees in the latest three months. This fall, however, is partly payback for a similarly odd-looking rise of 161,000 in the prior six months – the exaggerated fluctuations may reflect a sampling error. Vacancies are a smoother measure of labour market demand and lead the LFS measure – they have been moving sideways recently, consistent with stagnant conditions rather than major weakness.

The Eurosystem’s lending to euro area banks related to monetary policy operations (i.e. via repos and the “marginal lending facility”) has risen from €408 billion in April to €589 billion as of last week but remains well below a June 2010 peak of €870 billion. This lending, however, has been supplemented by an expansion of other forms of support – “emergency liquidity assistance” operations, other lending to banks and sovereign bond purchases under the securities markets programme (SMP). Total support is now back at the previous high and should continue to expand over coming weeks.

The following changes to the Eurosystem’s balance sheet have occurred since June 2010:

• Lending related to monetary policy operations has fallen by €281 billion.

• Ireland and Greece (at least) have instituted “emergency liquidity assistance” programmes, under which local banks borrow against inferior collateral at a penal rate. These programmes have been recorded under “other assets” on the respective central bank balance sheets. Eurosystem-wide “other assets” have expanded by €93 billion since June 2010.

• “Other claims on euro area credit institutions denominated in euro” have risen by €47 billion. The form and purpose of this lending is not disclosed but it could reflect “covert” support – an increase on the recent scale last occurred in September 2008 following Lehman’s collapse.

• The ECB has expanded its SMP sovereign bond holdings by €132 billion, with securities probably mostly purchased from banks. It has also recently embarked on a second covered bond purchase programme (CBPP2), intended to reach €40 billion by October 2012.

Aggregating the above categories gives a proxy for total support – this has risen from €886 billion in April to €1265 billion as of last week, close to a €1275 billion June 2010 record. A further significant expansion is likely, reflecting ongoing sovereign and covered bond purchases and likely strong demand for funds at the 13-month repo operation scheduled for 21 December.

The average 7-10 year Eurozone government bond yield – derived from country yields using debt weights – has risen by 90 basis points since early October, returning to the post-2008 peak reached in July. (The average yield is calculated by Thomson Reuters Datastream from data on 12 markets including the three bail-out countries.)

The increase reflects contagion into the core together with stability in German yields, a fall in which had previously provided an offset to rises elsewhere – capital fleeing other markets may now be leaving the euro area rather than seeking a “safe haven” in Bunds.

The yield rise threatens an inappropriate tightening of monetary conditions and warrants offsetting ECB action in the form of further rate cuts and an expansion of bond buying, though spread across national markets in proportion to GDP rather than focused on Italy and Spain. Such a country-neutral strategy would insulate the ECB from German criticism of launching a backdoor fiscal bail-out for peripheral miscreants.

The November Inflation Report is super-dovish and signals early further policy easing, confirming the message of the “MPC-ometer” model, which suggested that the MPC would either cut Bank Rate or boost the QE2 programme at its November meeting.

A key summary measure of the Committee’s bias is the two-year-ahead mean forecast for CPI inflation based on unchanged policy. This was 2.08% in the August Inflation Report but has been slashed to an estimated 1.25% this quarter – the lowest since the depths of the financial crisis in February 2009. (The projection, moreover, contains an upward bias because it excludes “the most extreme outcomes in the euro area”.)

The implied policy adjustment necessary to move the two-year-ahead forecast back to the 2% target can be estimated from “ready reckoner” sensitivities provided in an article assessing QE1 published in the last Bank of England Quarterly Bulletin. According to the article, “a 100 basis point cut in Bank Rate increases CPI inflation by about ½ percentage point after 18 to 24 months” while the effect of the £200 billion QE1 programme “was equivalent to a 150 to 300 basis point cut in Bank Rate”. These numbers imply that the ¾ point boost to inflation necessary to hit the 2% target in two years’ time would require either an impossible 150 basis point cut in Bank Rate or between £100 billion and £200 billion of additional gilt purchases.

At a minimum, therefore, the Inflation Report suggests that the MPC will either expand QE2 by £100 billion, or else combine a £75 billion increase with a quarter-point cut in Bank Rate to 0.25%. Further action is likely to be announced at the December meeting, barring surprise positive developments in the Eurozone.