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.

US stocks have displayed a positive correlation with bank reserves (i.e. banks’ account balances at the Fed) since QE1 was launched in late 2008. A post on 18 September noted that the Dow Industrials index, then at 13,553, was 1,300 points above the level implied by the current level of reserves, based on the historical relationship. This suggested that QE3 was priced in.

Subsequent market weakness resulted in this gap closing to 970 points by the time of an update post on 30 October. The Dow, moreover, was then slightly below the level implied for end-March 2013 assuming continued unsterilised Fed bond purchases of $40 billion per month and no offsetting changes to its balance sheet. A buying opportunity, in other words, seemed to be developing, especially if the Fed was thought likely to boost its bond buying when “operation twist” expired at year-end.

With the further fall this month, the Dow closed last week 450 points above the level implied by current reserves but 570 points below an end-March “forecast” assuming QE3 continues at its recent pace and 1,160 points lower than a prediction based on bond purchases stepping up to $85 billion from year-end – see first chart. The relationship, that is, suggests a rise in the Dow of between 5% and 9% by next spring. Last week’s dovish October minutes have shortened the odds that the Fed will announce an expansion of bond buying at its 11-12 December meeting.

A market rally between late 2012 and spring 2013 would maintain the similarity with movements 25 years ago, albeit that recent fluctuations have been smaller in magnitude* – second chart. The Dow rallied 19% from a low on 4 December 1987 to a short-term top on 12 April 1988, working its way gradually higher over the remainder of that year.

*A post in May noted this resemblance and suggested that it would continue.

Global six-month real narrow money expansion remained solid in October, judging from data for countries with a combined 60% weighting. Allowing for the typical half-year lead, the money measure continues to signal a revival in global economic momentum from late 2012 into spring 2013.

The global real money growth measure monitored here covers the G7 and seven large emerging economies (the “E7”). It fell sharply between December 2011 and February 2012, forewarning of recent economic weakness – G7 plus E7 industrial output declined by 0.3% between March and September.

Six-month real money expansion, however, bottomed at 1.5% (not annualised) in May, recovering over the summer  to reach 3.7% in September – above an average of 3.0% since 2005. October is currently estimated at 3.6% – the final reading will depend importantly on Eurozone numbers released on 28 November.

The global measure continues to be supported by strong growth in the US, while China and Japan rose again last month – second chart. Indian real money, by contrast, is still giving a recessionary message, while a promising revival in Brazil during the first half of 2012 has tailed off more recently.