The February Merrill Lynch global fund manager survey reports that a net 43% of respondents are overweight emerging market equities, the highest proportion for 12 months. The degree of enthusiasm is surprising because emerging equities have failed to deliver in recent years: the ratio of MSCI emerging and developed market indices is currently 17% below a peak reached in September 2010* – see first chart.

Less favourable liquidity conditions have contributed to this underperformance. The price relative peaked as the gap between E7 and G7 real six-month narrow money expansion narrowed sharply, turning negative in early 2011 – second chart. The glory days of emerging equities in 2009-10 and before the financial crisis, by contrast, occurred against the backdrop of relative monetary buoyancy.

The real money growth gap remains negative but has narrowed recently, raising the possibility of a “buy signal” for emerging equities later in 2013. A better January E7 number, however, is mainly due to China, where the late timing of the New Year holiday may have imparted a temporary boost – see previous post. Monetary trends remain soft in other large emerging economies – third chart.

With overseas investors already overweight, better relative performance of emerging equities may depend on a pick-up in domestic buying, in turn suggesting awaiting more convincing evidence of an improving monetary backdrop before adding to exposure.

*Based on month-end data and yesterday’s close.

News that three MPC members voted to expand QE at the February meeting surprised markets, leading some commentators to claim that the Committee’s “reaction function” has changed to allow higher inflation. While this is possible, the vote was consistent with the prediction of the “MPC-ometer” model followed here – it was, in other words, explicable by recent data.

The MPC-ometer predicts the outcome of each month’s meeting based on the latest values of 12 economic and financial inputs, including business survey activity measures, the quarterly GDP change, manufacturers’ price-raising plans, consumer inflation expectations, credit spreads and equity prices. The forecast is in the form of the “average interest rate vote” of the Committee’s members; for example, if four vote to cut Bank rate by 25 basis points (bp) while five prefer no change, the average vote is -11 bp (i.e. four-ninths of -25 bp). The February prediction was -9 bp, consistent with three members voting for a 25 bp rate cut. The same number, instead, sought to expand the QE programme by £25 billion.

The February forecast was influenced by the weak fourth-quarter GDP estimate and also took into account the tendency for policy changes to occur in Inflation Report months. The dovish impact on the model of the GDP number will drop out next month, although the bias revealed by the three February dissents works in the opposite direction. With seven inputs available, the current prediction for March is -4bp, suggesting that a majority will again vote for no change. The final reading will depend importantly on any fourth-quarter GDP revision and February consumer and purchasing managers' surveys. (The chart incorporates the current March estimate.)

The Bank of England’s efforts to revive borrowing have dealt a further heavy blow to bank and building society savers in recent months. A faster erosion of the real value of such savings may trigger an upward shift in the velocity of circulation of money, with longer-term inflationary consequences.

According to Bank data, the average gross interest rate on new two-year fixed-rate bonds fell from 3.24% in June 2012, just before the introduction of the Funding for Lending Scheme (FLS), to 2.23% in January. The rate on instant-access deposits, including bonuses, declined from 1.55% to just 1.04% over the same period.

The prospective real return on such investments has suffered an even greater drop because the Monetary Policy Committee (MPC) has sanctioned a higher inflation rate. In the May 2012 Inflation Report, the consumer prices index was forecast* to rise by 2.1% per annum over the subsequent two years. In the February 2013 Report, this two-year projection was raised to an estimated 2.6%. The prospective real interest rate on two-year fixed-rate bonds, therefore, has fallen from 1.1% in May-June last year to -0.4% currently. The position, of course, is much worse for tax-payers and / or those unable to tie up their cash for two years.

A cut in savings rates was an inevitable consequence of supplying banks with cheap funds via the FLS, thereby reducing their need to bid for retail deposits. The scale of the declines, however, may have surprised the MPC, while the pass-through to borrowing rates has been disappointing. The average interest rate on new two-year fixed-rate 90% loan-to-value (LTV) mortgages fell by 97 basis points (bp) between June and January but the reduction was 64 bp for 75% LTV deals – below the 101 bp cut in the equivalent-term savings rate. The impact on floating rates has been even less: new two-year 75% LTV loans cheapened by only 16 bp between June and January, while average standard variable rates and overdraft rates have risen.

Banks are required to maintain or grow their loan books to qualify for the cheapest FLS terms. The above evidence suggests that they have reduced borrowing rates by the minimum necessary to achieve this goal, allowing the remainder of the cut in funding costs to boost spreads. A rise in banks' margins is desirable to allow them to build capital in order to support future lending but the current increase appears excessive. Savers, in other words, are paying too high a price to achieve the reduction in borrowing rates craved by the MPC.

Aside from distributional arguments, increasing the effective penalty for holding bank and building society deposits risks triggering a sharp reduction in the demand to hold such money, with inflationary consequences. An individual can cut his or her money holdings by investing in other assets or buying goods / services but this is not possible for the economy as a whole – “excess” money passes like a hot potato to other individuals, who undertake their own corrective transactions. Reduced money demand, in other words, results in a rise in the velocity of circulation, with an identical impact to additional monetary expansion.

The Bank’s M4ex broad money aggregate grew by an annual 5.2% in December while the velocity of this measure has risen by an average of 1% per annum since the recession trough in the second quarter of 2009. The latter trend could plausibly increase to 2-3% as money-holders anticipate faster erosion of their purchasing power – velocity rose by 5-6% a year during the late 1970s when real interest rates were last heavily negative. Unless monetary trends weaken significantly as a result of the suspension of QE, therefore, the sum of money growth and the trend velocity rise is likely to exceed the 4-5% per annum compatible with an optimistic assessment of potential economic expansion and achievement of the 2% inflation target.

*Mean forecast based on unchanged policy.