An indicator designed to estimate the probability of a UK recession – defined here as an annual fall in GDP – three quarters in advance has fallen from a peak of 48% in December 2011 to below 1% in October 2012, reaching its lowest level since 2003. The indicator suggests that the economy is starting to regain momentum and will be growing respectably by mid 2013, barring external “shocks”.

The indicator estimates the probability of a recession based on a range of monetary and financial variables including short-term interest rates, real narrow and broad money supply measures, the effective exchange rate, credit spreads and share prices. The variable weights were derived from statistical analysis of historical data extending back to 1967 (i.e. 45 years). The indicator rose well above 50% before the four recessions over this period – see first chart. The indicator peak of 48% in December 2011 fell just short of signalling a recession in 2012, in the sense of an annual fall in GDP. The Office for National Statistics (ONS) currently estimates that the annual change in GDP fell to a low of -0.5% in the second quarter of 2012 before recovering to -0.1% in the third quarter. Excluding oil and gas production*, however, the second-quarter annual loss was 0.2% while the third quarter registered a gain of 0.2%. Second-quarter weakness may have partly reflected special factors, such as a larger negative impact on activity from the extra spring bank holiday in 2012 compared with 2011. There is a significant probability that current GDP estimates will be raised based on past ONS revisions behaviour and a marked contrast with resilient labour market data.

The indicator’s suggestion of a much-improved economic outlook rests importantly on recent stronger monetary trends, confirmed by October data released today. Non-financial M4 (i.e. broad money holdings of households and private non-financial companies) rose by 2.8%, or 5.7% annualised, in the six months to October – the fastest growth rate since May 2008. Narrow money M1 is also expanding solidly – second chart. Economic prospects, however, are related to real monetary developments – there is a danger that the recent nominal money supply pick-up will be offset by a further rise in inflation, resulting in slower real growth. A rise in the exchange rate would be welcome to cap import price pressures and reduce this risk.

The upbeat message of the indicator suggests that incoming Bank of England Governor Mark Carney, far from accepting a poisoned chalice, has made another excellent career choice by moving to the UK just as economic prospects are brightening, especially given indications that the Canadian housing market bubble over which he has presided may be unravelling.

*Gross value added excluding oil and gas.

Solid Eurozone October money numbers support the view here that the economy will outperform gloomy consensus expectations next year – GDP could grow by 1% plus rather than contract by 0.1%, as forecast yesterday by the OECD. Monetary strength, however, remains focused on Germany and its satellites, with trends still weak in Spain and Italy.

Both broad and narrow money surged in October – M3 and M1 rose by 1.2% and 1.3% respectively on the month*. Real (i.e. CPI-adjusted) M1 is the best monetary leading indicator of the economy, outperforming real M3 and private sector credit, both of which failed to predict the 2008-09 recession. The six-month change in real M1 was negative as recently as April but rose to 4.6% (i.e. 9.5% annualised) in October in lagged response to the massive policy easing engineered by ECB President Draghi since late 2011 in the teeth of Bundesbank opposition. This is the fastest since December 2009 and a level historically associated with solid subsequent economic expansion – see first chart.

Consensus commentary is likely to ignore the upbeat message from M1, focusing instead on stagnant private sector bank loans. It is, however, normal for M1 / M3 to diverge positively from lending in the early stages of economic upswings – money leads the cycle whereas credit is, at best, a coincident indicator. The strong M3 rise in October, despite flat private sector lending, reflected a combination of an overseas inflow, central governments running down their cash holdings and a switch out of longer-term bank liabilities (e.g. bank bonds) into M3 deposits. Faster recent growth of M1 than M3 is interpreted here as signalling that households and firms are increasing holdings of “transactions money” ahead of a rise in spending.

Eurozone-wide real M1 predicted the recent recession but the country detail** also correctly signalled a wide divergence in economic performance between the core and periphery. The news here is less encouraging: the recent pick-up in real M1 deposits has been focused on the narrow core (i.e. Germany, Benelux and Austria), with France stagnant and contraction continuing in Spain and Italy – second chart. The suggestion is that the coming Eurozone recovery will be unbalanced, with “too much” growth in a resurgent Germany but too little in the other “big four” economies. There is, however, a glimmer of hope for two of the bailout countries: Portugal joined Ireland in recording a six-month rise in real M1 deposits in October – third chart.

*The rises in M3 and M1 may have been artificially inflated by the initial capital subscriptions, totalling €32 billion, paid by governments to the European Stability Mechanism (ESM). This would be the case if the ESM has been classified as part of the non-MFI, non-central government sector – the ECB’s “monetary developments” press release provides no guidance on this issue. If so, “underlying” increases in M3 and M1 in October will have been 0.8% and 0.7% respectively, i.e. still healthy.

**M1 comprises physical cash and overnight deposits. A country breakdown is available for deposits but not cash.

The basics of inflation-targeting are similar in Canada and the UK – the Bank of Canada aims to keep annual consumer price inflation at the 2% mid-point of a 1-3% target range. The Canadian approach, however, differs in two important respects, which the Bank of England’s new Governor Mark Carney may wish to import to the UK.

First, while the inflation target is expressed in terms of the total consumer price index (CPI), the Bank of Canada monitors several measures of “core” inflation as an “operational guide” to policy – in particular, “CPIX”, which excludes eight of the most volatile components (fruit, vegetables, gasoline, fuel oil, natural gas, mortgage interest, inter-city transportation and tobacco products) as well as the effect of changes in indirect taxes.

Previous posts (e.g. here) argued that the Bank of England effectively switched to a core inflation target in 2010, when the present Governor signalled that the MPC would ignore higher inflation caused by “temporary price level factors” – generously defined to include a weaker exchange rate – when setting policy. The Bank, however, has not formalised this shift by adopting a particular core inflation measure as an operational guide – Governor Carney may wish to do so.

A UK measure similar to Canadian CPIX is the CPI excluding energy and unprocessed food and the impact of VAT changes*. Annual inflation on this measure is estimated here to have averaged 2.4% over the past five years – see chart. The Bank of England, in other words, has failed to achieve 2% inflation even on a looser “core” interpretation. (Total inflation averaged 3.3%.) Governor Carney may well judge that policy has been excessively accommodative over this period.

A second difference is that the Canadian approach allows, in exceptional circumstances, for monetary policy to be used to support financial stability, implying temporarily deemphasising the inflation target. In a recent speech, for example, Dr Carney raised the possibility of the Bank of Canada “leaning against emerging imbalances in household debt” while allowing a longer (negative) deviation of inflation from target.

The recognition that monetary policy has a role in promoting financial stability is at odds with the Bank of England’s claimed impotence to prevent the recent credit bubble / bust. It suggests that Governor Carney will be unsympathetic to the UK division of responsibilities between the Monetary and Financial Policy Committees and will seek to coordinate their decision-making to the maximum extent.

*The calculation requires an assumption about VAT pass-through.

The fourth-quarter CBI services sector survey released today was markedly more upbeat, supporting the view here that the UK economy is regaining momentum in lagged response to faster real money supply expansion since late 2011. The net percentage of firms expecting higher business volumes surged to its highest seasonally-adjusted level since the fourth quarter of 2007, reflecting strength in professional and business services, although consumer services also improved. The CBI results suggest that the November PMI services survey, released on 5 December, will surprise positively – see chart.

Eurozone business surveys remain weak but have improved at the margin, consistent with the view here that activity is bottoming in late 2012 and will revive in 2013 led by Germany and other core economies – see, for example, posts from September and August. This forecast depends on the signal from real narrow money remaining positive – October monetary statistics are released next Wednesday.

Eurozone “flash” PMI results for November were a mixed bag but a key forward-looking indicator – manufacturing new orders – recovered to its highest level since March. The index, admittedly, continues to suggest falling output but a further rise towards the break-even 50 level is likely in December judging from the relationship with real money growth and improving global conditions, evidenced by recent stronger US / Chinese orders – see first and second charts.

The German Ifo business climate index, meanwhile, registered the largest monthly rise since July 2010 in November, driven by the leading expectations component – third chart. Manufacturers were positive about export prospects for the first time since July but expectations also improved sharply in wholesaling and retailing, consistent with real money strength since the spring starting to filter through to firmer domestic demand.

Several posts last year and early this (e.g. here) argued that the Treasury should book the net interest income of the Bank of England’s asset purchase facility (APF) as a receipt when calculating the targeted measure of the fiscal deficit. The rationale was that this would accord with international practice (i.e. failing to recognise the income risked creating an unduly pessimistic impression of the UK’s relative fiscal position) and could provide scope for modest stimulus measures (i.e. tax cuts or investment initiatives) within existing consolidation plans.

The Treasury announced on 9 November that excess cash held at the APF, mostly due to its net interest income, will henceforth be transferred to the Exchequer. The Office for National Statistics (ONS) has yet to determine whether these transfers will reduce the targeted borrowing and debt measures (i.e. public sector net borrowing and net debt excluding the temporary effects of financial interventions) but the Office for Budget Responsibility (OBR) forecasts that both will be lowered*. The Treasury could legitimately bypass the ONS determination by redefining the measures subject to the government’s fiscal mandate and supplementary debt target to include the APF’s net income / cash. (The total net borrowing definition used historically in fiscal planning includes the APF surplus.)

The Treasury’s move has attracted widespread criticism. One line of argument is that the APF is likely ultimately to be loss-making – net interest income will turn negative if Bank rate rises above about 4% and may cumulatively fall short of capital depreciation caused by a combination of some gilts being sold in less favourable market conditions when the MPC decides to unwind QE and others being held to maturity but having a redemption value below their purchase price. The cash surplus, on this view, should be retained as a provision against these future losses.

Such a practice, however, would be out-of-line with the treatment of other future government liabilities**, some of which are likely to dwarf any APF loss (e.g. public sector pensions, PFI commitments, nuclear decommissioning costs). Would critics of the APF transfer advocate that these liabilities should be similarly pre-funded by issuing additional debt in order to accumulate a cash provision?

More pragmatically, any APF loss will depend on a future rise in Bank rate but a large increase is likely to occur only in a scenario involving significantly stronger economic growth, in which case the value of the government’s stakes in the Royal Bank of Scotland and Lloyds Banking Group could appreciate substantially. “Financial interventions”, therefore, could break even or turn a profit even if the APF is ultimately loss-making.

Critics also claim that the Treasury’s manoeuvre represents an attack on the Bank of England’s monetary policy independence, since the transfer of APF cash has similar monetary effects to more QE. The Treasury, however, already has a significant impact on monetary conditions via its debt management policies – in particular, the decision about whether to issue short- or long-term securities to meet financing needs. Treasury bill issuance, for example, amounts to quasi QE, since bills are likely to be purchased by banks – resulting in a direct boost to the money supply – or else held by non-banks as a money substitute. The MPC should take account of such effects when calibrating its policy stance; the APF transfer raises no new issue of principle.

The Bank of England’s credibility and independence are under threat not from Treasury actions affecting monetary conditions but rather its serial failure to adhere to its inflation-targeting remit, defended on the invalid grounds that to have done so would have inflicted unacceptable economic pain***. The Governor will have been relieved that journalists used last week’s Inflation Report press conference to tackle him on the APF transfer non-issue rather than the inadequacies exposed by the recent reviews of the Bank’s performance and another big upward revision to its inflation forecasts.

*The OBR expects future APF net interest income to reduce both borrowing and debt but that only debt will be lowered by the transfer of cash accumulated to date.

 **The transfer of the Royal Mail pension plan to the government in April 2012 similarly lowered borrowing and debt while creating a future liability.

***The defence is invalid because the claim is unproven and the Bank is not at liberty to ignore the remit.