Posts here from the summer onwards argued that faster Eurozone monetary growth, particularly of the narrow M1 measure, was signalling notably better economic performance in early 2015. The monetary signal was starkly at odds with consensus gloom, including recession warnings from the IMF and others, but has been vindicated by recent data. The Citigroup Eurozone economic surprise index has been strongly positive since early February, while the composite PMI output index rose to a 46-month high in March, according to this week’s flash data.
The earlier posts noted that narrow money growth was particularly strong in Spain, where the central bank now estimates that GDP will rise by 0.8% in the current quarter, following a 0.7% fourth-quarter gain.
The positive trends in M1 and the broader M3 measure continued in February, with media reports of the data containing numerous quotes from commentators about the bullish implications for economic prospects. Where were these experts six months ago?
M1 and M3 rose by 0.9% and 0.6% respectively in February alone. Six-month M1 growth increased to 5.7%, or 11.8% annualised – the highest since November 2009; the corresponding M3 measure was 2.5%, or 5.0% annualised – see first chart.
One reason for the change in the consensus interpretation of the data is that private sector credit is now expanding. Adjusted for sales and securitisations, bank loans to the private sector grew by 0.5%, or 2.2% annualised, in the latest three months. As noted with monotonous regularity in previous posts, the historical evidence for the Eurozone and elsewhere shows that money tends to lead the economy while credit is coincident or lagging. The credit pick-up, nevertheless, is significant because it confirms the positive message from other coincident data and will support broad money growth going forward.
The second chart shows the drivers of six-month M3 growth, based on the ECB’s monetary counterparts analysis. As well as the turnaround in private sector credit, M3 expansion has been pushed higher by bank buying of government securities, encouraged by the ECB’s TLTROs, and a switch in bank funding from bonds and other longer-term liabilities to deposits, reflecting lower interest rates. By contrast, growth in banks’ net external assets, which was a major supportive factor in 2013-14, has slowed sharply. With the current account surplus remaining high, this implies that Eurozone non-banks have been exporting capital – the ECB’s monetary boost, in other words, has partly spilled abroad.
A key issue is whether QE leads to further monetary acceleration. The assessment here is that QE programmes had limited impact on broad money trends in the US, UK and Japan. Annual growth in Japanese M3, for example, was 2.9% in February versus 2.5% in March 2013, just before newly-installed Bank of Japan Governor Kuroda launched his monetary blitz. The small impact of these programmes is judged to be for two reasons. First, central bank purchases of government securities were partly offset by sales (or reduced buying) by banks, whose demand for liquid securities fell as QE expanded their reserves. The effect on broad money depends on the combined transactions of the central bank and banks. Secondly, the payment of interest on reserves meant that banks were content to “hoard” their increased balances rather than use them to expand their assets. Asset expansion would not have reduced the total amount of reserves but would have increased their velocity of circulation.
Eurozone QE is also likely to involve offsetting transactions by banks; they appear, indeed, to have started already, with banks selling €25 billion of government securities in February, following the ECB’s QE announcement on 22 January. The second-round effect of higher reserves on bank balance sheets, however, could be larger than in the US, UK and Japan because banks are penalised for holding excess balances via the negative (-0.2%) deposit rate. The expansion of reserves, in other words, is less likely to be fully offset by a fall in their velocity.
Current Eurozone money supply trends signal that monetary conditions are already sufficiently, and possibly excessively, loose. A further acceleration in response to QE would suggest that the ECB will be forced to call time on the programme well before the indicated September 2016 termination date.
The annual change in consumer prices fell to zero in February, prompting media headlines about “record low” inflation. A more correct statement is that CPI inflation is at a 25-year low, since official statistics do not extend back before 1989.
For a longer-term perspective, it is necessary to use the previously-targeted RPIX (retail prices excluding mortgage interest) measure*. The annual change in RPIX was 1.0% in February, matching a low reached in June 2009. Looking further back, RPIX inflation was below the current level in 1963, 1960, 1959 and 1954. So “record low” is incorrect even confining attention to post-WW2 history.
The current deviation of the annual CPI change from the 2% target is explicable by energy and food price weakness and sterling strength. “Core” inflation excluding energy, food, alcohol and tobacco was 1.2% in February, while sterling’s appreciation has probably lowered the core rate by at least 0.5 percentage points.
Services prices are a better guide to domestic inflationary pressures, since they are less affected by changes in commodity prices and the exchange rate (though not impervious**). Services inflation was stable at 2.4% in February versus a 2014 average of 2.5%.
Solid monetary trends continue to suggest that the next big move in domestically-generated inflation will be higher. The headline rate may rebound surprisingly strongly later in 2015 and in 2016 as the commodities / sterling drag unwinds.
*A recent paper by a former government economist disputes the official view that the CPI is statistically superior to the RPI / RPIX.
**Examples of effects include food costs on catering services, energy costs on transport services and the exchange rate on foreign holidays.
The gap between the dividend yield on UK equities and the interest rate on a competitive bank / building society savings account remains historically high, even taking into account the Budget decision to exempt small savers from tax on interest income.
The dividend yield on the UK market for a basic rate taxpayer is currently 3.22%, while a competitive savings account pays 1.16% net, according to Bank of England data. The 2.06 percentage point yield premium on equities is near the top of the historical range – see green line in chart*.
The maximum yield advantage of equities, of 2.46 percentage points, occurred at the bear market low in March 2009.
Equities have mostly yielded much less than cash since WW2. The yield difference averaged -1.86 percentage points between 1954 and 2014 (61 years).
The Budget introduced a £1,000 interest income allowance for basic rate taxpayers. Savers with less than £69,000, therefore, can earn the gross interest rate of 1.45%, rather than the net 1.16%. This cuts the yield premium on equities to 1.77 percentage points – still high by historical standards.
In contrast to 2009, the current wide gap reflects low interest rates rather than cheap equity prices – the net dividend yield is close to its long-run average. Income-famished savers lured from cash into shares may underappreciate the risk of a future market set-back offsetting the higher yield.
*The chart shows the dividend yield on equities on an as-published basis and net of basic rate tax. The published yield refers to actual dividends paid since 1998; basic rate taxpayers are treated as having paid tax on such dividends so the published and net yields are the same. Before 1998, the published yield was calculated on a gross basis, i.e. including a tax credit that was reclaimable by tax-exempt investors; the net yield applies the basic or standard rate of (dividend) income tax to this gross measure. The yield data refer to the FTSE all-share index from 1963 and the FT30 index for earlier years. The deposit rate series links together interest rate data for bank / building society savings products that were competitive historically. The rate used in recent years is the average quoted rate on two-year fixed-rate bonds. This series begins in 2009; the effective rate on one- to two-year household time deposits is used between 2004 and this date. Earlier figures refer to the average or recommended building society ordinary share rate.
The Chancellor had less fiscal room for manoeuvre than some had expected, so needed to raise extra revenue to finance modest giveaways. His key announcements have a clear political rationale but lack economic logic. The fiscal plans continue to rest on an assumed large cut in current spending of questionable deliverability.
The most costly measure is a further increase in the personal allowance, but a rise in the NI threshold would have been a better way of targeting low earners.
The Chancellor also spent money on a new savings income allowance and an ISA subsidy for first-time homebuyers. The former further complicates the taxation of savings, while the latter will mainly boost house prices rather than housing supply.
These measures are paid for partly by a further raid on the banks, which will be passed on in lending and deposit rates. In addition, the lifetime pension allowance is reduced again, discouraging long-term saving. The Chancellor, instead, should have taken the opportunity provided by lower oil prices to raise fuel duty.
The underlying borrowing path has been revised down by less than expected, with lower debt interest and welfare costs offset by a fall in North Sea revenues and weaker stamp and excise duties.
The debt to GDP ratio now begins falling in 2015-16, a year earlier than before. However, this is achieved by bringing forward asset sales, in the form of UK Asset Resolution mortgages and Lloyds shares – the public sector’s net wealth is unchanged.
As expected, the Chancellor raised his public spending assumption for 2019-20, so that expenditure as a share of GDP now bottoms out just above its level in 1999-2000, rather than falling to its lowest since the 1930s. This undermines a key Labour attack line with one keystroke.
As before, the Chancellor’s claim that the deficit is on a smooth glide path to elimination by 2018-19 rests on an ambitious cut in the share of current spending in GDP in the early years of the next parliament. The share is projected to fall by 3.7 percentage points of GDP in the three years to 2017-18, a pace of reduction previously achieved only in boom conditions in the late 1980s – see chart. A major weakness of the current system of fiscal planning is that the OBR must incorporate the government’s spending assumptions in its forecasts, despite an absence of detail and widespread doubts about their achievability. Mr Osborne referred to the tendency of former Chancellors to fudge their figures but he is equally guilty of fantasy forecasting.
The real yield on intermediate-maturity government bonds in the Eurozone has moved beneath the minimum level reached in the US in 2012, ahead of a significant market sell-off.
The real yield is defined here as the average redemption yield on 7-10 year government bonds minus the consensus longer-term inflation forecast. The latter is sourced from the quarterly surveys of professional forecasters conducted by the Philadelphia Fed and ECB*.
Using month-end data, the US real yield reached a low of -1.2% in May 2012, ahead of the launch of QE3 in September. This reflected a nominal yield of 1.3% and expected longer-term inflation of 2.5%.
The Eurozone real yield is currently -1.3%, reflecting a nominal yield of 0.5% and a longer-term inflation forecast of 1.8%.
The US real yield returned to positive territory in July 2013 as the nominal yield rebounded, even though QE3 remained in full swing until December. 7-10 year Treasuries suffered a price reduction of 9.6% between May 2012 and December 2013, when the Fed announced its first “taper”. Including coupon income, the loss was 5.4%.
The view here is that the ECB has overreacted to a dubious inflation scare and monetary conditions are now excessively loose, evidenced by a surge in narrow money and rapid euro depreciation**. QE had limited economic impact in the US, UK and Japan but may prove more powerful and distortionary when combined with a negative interest rate on excess bank reserves. Eurozone bond investors may be running greater risks than their US counterparts in 2012.
*The forecast horizons in the Philadelphia Fed and ECB surveys are ten and five years respectively. The Eurozone yield is calculated by Datastream and covers 12 markets.
**M1 rose at a 14% annualised rate in the three months to January. The Bank of England’s euro trade-weighted index is down by 10% since end-December.