Entries from June 5, 2011 - June 11, 2011
UK "output gap" estimates still too high
A post in January 2010 suggested that the UK "output gap" (i.e. the shortfall of GDP relative to normal supply capacity) was about 2% rather than 5-7%, as estimated by various official forecasting bodies (i.e. the OECD, IMF and Treasury). The Bank of England seemed to share the official assessment, judging from MPC communications. (The Bank refuses to disclose its own estimate, believing the information too hot for markets to handle.) The post argued that overstatement of the gap had contributed to the Bank's big inflation forecasting miss.
The official bodies have since significantly reduced their output gap estimates. The OECD now believes that the GDP shortfall was 4.6% in 2009, rather than 6.4% as indicated a year ago, and will average 3.1% in 2011, despite forecast sluggish growth. Similarly, the IMF's 2011 projection is 2.6% while the Office for Budget Responsibility has estimated that the gap was about 3% in the third quarter of 2010. The Bank, of course, never admits that it was wrong but a comparable reassessment is implied by a sizeable upward revision to its medium-term inflation forecast.
The methods used to generate a 2% estimate in early 2010, however, now suggest a smaller or even closed gap. The first method utilises the "Okun's law" relationship between the GDP gap and the deviation of unemployment from its non-accelerating-inflation rate (the NAIRU). An analysis of UK data since the early 1970s indicates that each 1 percentage point rise in the unemployment rate has been associated, on average, with a 1.56% fall in GDP relative to trend. The unemployment rate has risen by 2.4 percentage points since the first quarter of 2008, suggesting a 3.8% decline in output relative to trend (1.56 multiplied by 2.4). The OECD's revised figures imply that GDP was 2.7% above trend in early 2008. Using this as a starting point, the implied shortfall currently is only 1.1%. (This assumes an unchanged NAIRU; the estimate would be smaller if this has risen.)
The second approach uses business survey information on capacity constraints to gauge the position of GDP relative to trend. The percentages of CBI manufacturing firms reporting shortages of plant capacity and skilled labour were summed and the resulting series rescaled to match OECD output gap data since the early 1970s. This approach suggests that GDP moved above potential this spring, despite still being far below its pre-recession peak (by 4.1% as of the first quarter). If correct, this would be profoundly depressing, implying that the NAIRU has risen above the current unemployment rate of 7.7%. The survey-based measure, however, may be less reliable than the Okun's law estimate because of the recent relative strength of manufacturing and its focus on short-run production constraints, as well as CBI data volatility.
Improving monetary backdrop suggests shallow equity correction
A post in late March suggested that equities and other risk assets faced increasing monetary headwinds:
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A slowdown in G7 real narrow money in late 2010 signalled an imminent loss of economic momentum.
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Six-month growth in G7 real money had fallen below that of industrial output – often a warning signal for equities.
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A surge in bank reserves at central banks seemed to be ending, with a further injection by the Federal Reserve likely to be offset by the Bank of Japan withdrawing liquidity added after the 11 March earthquake and tsunami.
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The US Dow Industrials Index was higher than at the equivalent stage of five out of six prior recoveries that followed a decline of about 50%, suggesting a correction.
The Dow continued higher until late April but the recent set-back has taken it below the level in late March. The correction may have further to run but monetary indicators have improved since the earlier post:
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Six-month G7 real narrow money expansion has revived from a low in February, hinting at a recovery in economic momentum later in 2011 – see Monday's post.
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The real money / output growth gap has turned positive again, partly as a result of Japan-related production weakness.
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Central bank reserves have edged up, reflecting the final tranches of US QE2 and a stabilisation in Japan – see first chart.
The Dow, however, is still 6% above the "six-bear average" of the prior recovery paths, as of yesterday's close – second chart. The average, moreover, falls over the summer, bottoming in late October. While monetary factors are improving, equities may need an extended period of consolidation before embarking on another upward push.
Global growth slowing but G7 monetary trends reassuring
Markets have suddenly woken up to a slowdown in global industrial activity that has been under way for several months. The downturn, as usual, was signalled by monetary trends. Six-month growth in G7 real narrow money peaked in July 2010 at 3.3% (not annualised) and fell to 1.4% by February. The Friedmanite rule is that monetary changes lead output by about six months and prices by about two years. Accordingly, six-month G7 industrial output expansion reached a high of 2.6% in December and fell to zero by March (the latest available month). A slump in purchasing managers’ surveys in May indicates further weakness over the summer, consistent with the monetary rule*.
While the usual cast of bears is talking up a “double dip”, however, monetary trends have recently taken a turn for the better, with six-month G7 real narrow money growth recovering to 2.1% by April – see chart. Real money, therefore, has not contracted as it did before the 2008-09 recession and is starting to suggest a revival in industrial momentum later in 2011. The near-term output downturn, moreover, has been exacerbated by supply-chain disruption caused by the 11 March Japanese earthquake and tsunami. Japanese manufacturing output plunged by 15.5% in March but started to recover in April, rising 1.0%, and is expected to climb 16% in May-June, according to a METI survey.
The Japan effect, in other words, may have served to concertina output weakness warranted by the late 2010 real money slowdown into an unusually short period. The monetary drag will continue to operate over the summer but could be offset by a normalisation of production schedules as Japanese supply comes back on line. On this interpretation, purchasing managers’ new orders indices may bottom out at or around May levels before recovering later in the summer rather than continuing down as the bears predict. This could come as an unwelcome shock to interest-rate markets that have rallied strongly on the view that official rate rises have been further pushed back and economic weakness could yet provide a pretext for another QE sugar rush.
The key risk to this scenario may lie in emerging economies, where – in contrast to the G7 – real money growth is still slowing and inflationary concerns are likely to preclude early policy easing. A revival in G7 industrial momentum later in 2011, in other words, could be offset by emerging-world weakness. Real narrow money has slowed sharply in China over the last six months while contracting in India and Brazil, suggesting bumpy landings in late 2011 / early 2012. A further deceleration of “E7” industrial output, however, would contain a silver lining in the form of likely downward pressure on commodity prices. (Six-month changes in E7 output and industrial raw material prices have shown a 0.87 correlation over the last 15 years.) A reversal of the commodity-price drag on G7 real incomes would boost prospects for domestic demand, possibly neutralising the direct negative impact of the E7 slowdown.
* Keynesian attempts to pin the blame for the slowdown on fiscal tightening are unconvincing: the G7 structural deficit is forecast by the IMF to expand by 0.1% of GDP in 2011, with loosening in the US and Japan offsetting European restriction.