A post a month ago argued that the US unemployment rate would have fallen to 7.0% in October, rather than risen to 7.3%, but for the government shutdown, which caused a surge in temporary layoffs. The rate duly reached this level (7.02% unrounded) in November as the shutdown distortion unwound – see chart.
In his June press conference, Fed Chairman Bernanke stated that continued labour market improvement supported by a pick-up in economic growth would cause the FOMC to moderate the pace of securities purchases later in 2013. “In this scenario, when asset purchases ultimately come to an end, the unemployment rate would likely be in the vicinity of 7%.”
Mr Bernanke has boxed himself in. He, and his successor, are reluctant to signal the end of QE, partly out of concern that this would cause markets to advance expectations of policy tightening. However, failing even to begin moderating purchases when unemployment is already at the stated terminal value risks undermining the credibility of the Fed’s interest rate guidance.
As previously discussed, one solution would be to announce a reduction in QE purchases this month but simultaneously cut the interest rate on bank reserves from 0.25% to, say, 0.10%. This would underline that QE decisions have no implications for interest rate policy, while raising the possibility that an increase in the velocity of circulation of reserves will offset a slower rate of liquidity injection.
The Office for Budget Responsibility’s forecast that the public sector deficit will be eliminated in 2018-19 depends on the share of current public spending in GDP dropping by a whopping 5.2 percentage points over the next five years. The spending share has retreated from a post-war record 42.4% in 2009-10 and 2010-11 but remains historically high, at a projected 40.8% this year – see chart.
A reduction on the required scale occurred in the late 1980s but was achieved with the aid of strong economic growth – GDP rose by an annual average 4.3% in the five years to 1989 in real terms and by 9.9% in nominal terms. The OBR projects growth of only 2.5% and 4.3% respectively over the next five years.
Sceptics argue that a spending overshoot will necessitate further tax increases after the 2015 election. Excluding oil revenues, however, the tax share of GDP is already projected to rise to the top of its range in recent decades – see chart. The share has been significantly higher in only two years in the post-war period – 1969-70 and 1970-71. Labour Chancellor Roy Jenkins imposed a vicious fiscal squeeze following the 1967 sterling devaluation, probably losing the party the 1970 election. Increased international mobility of capital and labour casts doubt on whether a future Chancellor could achieve a similar tax grab.
Most of the measures in the Autumn Statement had been preannounced, are small in scale and will have limited macroeconomic impact. The main “news” is in the updated Office for Budget Responsibility (OBR) projections. The OBR has refused to endorse the Chancellor’s bullishness, arguing that recent economic and fiscal improvement is entirely cyclical, while growth will slow significantly in 2014. Mr. Osborne will be hoping that its latest forecasts are as unreliable as those made in March.
The OBR grudgingly accepts that the economy has expanded by 2.6% in the year to the fourth quarter of 2013, far ahead of its 1.0% March projection. In contrast to other forecasters, however, it does not believe that stronger momentum will carry over into next year. The OBR maintains its prior assumption of quarterly growth of 0.5% during 2014. This implies that the annual GDP increase will peak at 2.7% in the first quarter and slow to 2.0% by year-end.
The OBR will have further disappointed the Chancellor by ascribing the 2013 growth surprise entirely to cyclical strength, with no contribution from better supply-side performance. With its estimates of productive potential little changed, the negative “output gap” (i.e. the shortfall of actual GDP relative to potential) is judged to have narrowed to 2.2% in the third quarter – below the average estimate of other forecasters. This, in turn, means that the structural budget deficit forecasts are no better – in fact, slightly worse – than in March, despite falling headline borrowing.
The OBR’s bottom line, therefore, is that the Chancellor is doing just enough to meet his “medium-term fiscal mandate” of balancing the cyclically-adjusted current budget five years ahead but has no scope for “giveaways” before the 2015 election. Economic news, moreover, will become less favourable in the run-in to the election, with growth slowing and unemployment levelling off at 7%.
The assessment here is that the OBR is underestimating 2014 growth but overestimating the output gap. Its two formal methods for calculating the gap, indeed, give an average result of 1.3% for the third quarter – this has been overridden by “judgement” to arrive at 2.2%. The key pre-election economic risk for the government, therefore, is rising inflation and an early interest rate hike rather than slowing growth. A smaller output gap, of course, also implies that the structural budget deficit is larger than the OBR estimates – fiscal healing, in reality, has barely begun.
Six-month growth in global* industrial output is estimated here to have reached a 20-month high in October – see first chart. The recent pick-up was predicted by strong expansion of real narrow money in the second half of 2012 and first half of 2013. Solid November manufacturing purchasing managers’ surveys suggest that growth quickened further last month.
Six-month real narrow money expansion, however, has moderated from a peak in May. Its excess over industrial growth, therefore, has narrowed to its smallest since spring 2012, when equity markets last weakened significantly**. The gap between real broad money expansion and output growth is now negative. The liquidity backdrop for markets, in other words, has deteriorated.
Recent real money trends suggest that economic growth is at or close to a peak but will remain respectable in early 2014. A return to a significantly positive real money / output growth gap, accordingly, seems unlikely, barring further central bank monetary stimulus. A rising gap due to economic weakness, in any case, would not be bullish for equities in the short run.
Improving labour markets and stable inflation argue against further policy stimulus. Six-month global* consumer price momentum has firmed slightly since early 2013 and commodity prices are not signalling increased deflation risk – second chart. Recent lower-than-expected inflation in the Eurozone partly reflects currency strength and is balanced by a big rise in Japan.
Optimists argue that corporate earnings expansion can drive equities higher as long as central banks do not tighten policies abruptly. They may underestimate a liquidity withdrawal that is occurring automatically as economic activity strengthens. The key bullish risk to the cautious view here is that the Federal Reserve will offset an early decision to taper QE by cutting the interest rate on bank reserves, prompting parallel reductions by the ECB (to negative) and Bank of England. Such action seems unlikely while growth remains solid.
*G7 plus emerging E7.
**The MSCI World Index fell by 13% in US dollar terms between 19 March and 4 June 2012.
UK monetary conditions remain expansionary but this does not reflect any boom in mortgage lending – yesterday’s changes to the funding for lending scheme, although probably inconsequential, were misguided.
Six-month growth of real non-financial M1* – the favoured monetary aggregate here – eased back in October but remained robust at 4.4%, or 9.1% annualised. Growth of real non-financial M4 is much lower but was little changed in October at 1.0%, or 1.9% annualised – see first chart.
As in the Eurozone but to a greater extent, economic strength is being driven by households and firms “dishoarding”, i.e. mobilising existing monetary savings, rather than by rapid expansion of broad money and credit. Such dishoarding involves a shift of funds out of time deposits and notice accounts into M1, explaining its superior forecasting performance. Put differently, the velocity of circulation of the existing stock of broad money is increasing.
Credit weakness is gradually abating but the stock of net lending to individuals, excluding student loans, grew by only 1.6% annualised in the latest three months. Talk of a borrowing binge, in other words, is nonsense. As previously discussed, repayments of mortgage debt have risen more or less in line with gross advances, resulting in little change in the net lending flow – second chart.
If economic strength caused by dishoarding / rising velocity is judged to pose an inflationary risk, the appropriate policy action is to raise Bank rate rather than throw another spanner in the credit machinery. A Bank rate hike would filter through to deposit rates, reducing the incentive to spend monetary savings. The knock-on effect on borrowing rates could be mitigated by making funding for lending and the capital regime more, not less, generous.
*Non-financial M1 = sterling notes / coin and sight deposits of households and private non-financial firms. M4 = M1 plus other sterling deposits, repos, bank bills / commercial paper and other bank securities of up to five years’ original maturity.