Paul Krugman recently drew a parallel between the Federal Reserve’s plans to raise interest rates in 2015 and the ECB’s ill-fated 2011 policy tightening, which was swiftly followed by a recession. The monetary context is different, however, casting serious doubt on the comparison.
Former ECB President Jean-Claude Trichet bears the unfortunate distinction of having raised rates on two separate occasions in the teeth of an oncoming recession – August 2008 and April / July 2011 (a double increase). These decisions were astonishing from a monetarist perspective because they were taken against the backdrop of a contracting real (i.e. inflation-adjusted) money supply, as measured by the narrow M1 aggregate – see chart. The associated recessions, in other words, would have occurred anyway but were certainly magnified by the ECB’s actions.
US real M1 growth has fallen back since mid-2014 but remains at a respectable level. A pick-up around end-2013 signalled economic strength in mid-2014 – GDP is currently estimated to have grown at a 4.2% annualised rate in the second and third quarters, although this partly reflects payback for a weak start to the year. The recent real M1 slowdown may herald a moderation in GDP expansion to a 2-3% pace. Monetary trends would need to weaken significantly further to suggest economic danger from a small interest rate rise.
Professor Krugman’s worries, therefore, are premature. The ECB, meanwhile, may be repeating its 2008 / 2011 mistakes in reverse, with President Draghi and his allies seemingly determined to push through sovereign QE in early 2015 despite recent strong monetary growth and building evidence of an economic upswing.
Today’s UK labour market statistics cast doubt on the MPC majority forecast of a slow recovery in pay growth accompanied by improved productivity performance. Private sector regular earnings rose by 2.3% in the year to October, the largest annual gain since March 2012. Earnings in the latest three months grew by 4.2% annualised from the previous three.
Aggregate hours worked, meanwhile, rose by 0.7% in the three months to October from the previous three, suggesting that a slowdown during the summer was noise rather than indicative of a step-up in underlying productivity growth.
Earnings acceleration is consistent with historical evidence of a lagged relationship with job openings (vacancies), discussed in a post in September. The job openings rate (i.e. vacancies as a percentage of filled and unfilled jobs) rose further in the three months to November, moving closer to its 2008 peak – see chart.
The current commodities-driven plunge in headline CPI inflation is obscuring a pick-up in domestic cost pressures, evidenced by a faster rise in the gross value added (GVA) deflator as well as higher pay growth. Today’s MPC minutes made no mention of the increase in annual GVA inflation to 2.3% in the third quarter, a two-year high – see previous post. Complacent policy-makers may be sowing the seeds of another inflation overshoot.
Eurozone business surveys are starting to confirm the improved economic outlook signalled by monetary trends and leading indicators – see previous post.
The Eurozone manufacturing purchasing managers’ new orders index rose back above the breakeven 50 level in December after three months below it. This turnaround has occurred on schedule following a recovery in the longer leading indicator calculated here from a low in May – see first chart.
The December ZEW survey, meanwhile, reported a further solid gain in German economic expectations, which should be mirrored directionally by the more widely-watched Ifo survey released on Thursday – second chart.
These improvements are unlikely to deflect ECB President Draghi from attempting to drive through sovereign QE in early 2015. His hand has been strengthened by modest take-up of last week’s TLTRO2 lending operation. As the table shows, the TLTRO2 loan was less than half that required to offset the repayment of earlier three-year LTRO loans by end-February 2015. With private sector asset purchases unlikely to fill the gap, the balance sheet may contract slightly in early 2015, casting further doubt on the achievability of the ECB’s “intended” expansion of about €1 trillion on a reasonable time scale without sovereign QE.
|Longer-term refinancing operations|
|Repayment of three-year LTROs from 2011-12 by Feb-15||-271|
|Implied net change by Feb-15||-141|
|Covered bond / ABS purchases|
|Addition by Feb-15 assuming €5 billion per week||60|
|Combined impact by Feb-15||-81|
Japan’s economic outlook continues to improve, judging from further strong gains in monetary aggregates in November.
The six-month rate of change of M1, M2 and M3 peaked in late 2013 and fell sharply through July 2014. The real-terms change turned negative from April, when a rise in the sales tax from 5% to 8% boosted the consumer prices index by 2.1%*. This contraction was reflected in falls in GDP in the second and third quarters – see first chart.
All the Ms, however, have rebounded strongly since July, while the sales tax hike dropped out of the six-month inflation rate in October. Six-month real money growth, therefore, is back at levels consistent with solid economic expansion.
The slowdown and recovery in nominal money growth were unrelated to the Bank of Japan’s QE operations, which have proceeded steadily. The earlier weakness in broad money M3 was partly due to heavy sales of government bonds by banks and a worsening basic balance of payments, reflected in a fall in the banking system’s net foreign assets. Bond sales have slowed recently while net foreign assets have resumed growth.
Narrow money M1 is determined by demand for liquidity, usually for future spending purposes. The slowdown in early 2014 signalled that consumers and businesses were planning to cut spending after the sales tax rise, with the recent rebound suggesting returning confidence.
Six-month real M1 growth was much stronger in the US than Japan in early 2014, consistent with subsequent US economic and equity market outperformance. The tables have now turned, with the recent Japanese rebound coinciding with a slowdown in the US; the Eurozone, meanwhile, has moved to the top of the global ranking – second chart. Economic news is more likely to surprise positively in the Euroland and Japan than the US in early 2015.
*Bank of Japan estimate.
Last week’s fiscal forecasts from the Office for Budget Responsibility (OBR) assume that the “output gap” – i.e. the deviation of GDP from its “potential” level – was -0.8% in the third quarter of 2014. This assumption, however, looks optimistic relative to the OBR’s formal methods for estimating the gap. A neutral assumption, based on these methods, is that it has now closed. This would imply that the existing budget deficit is entirely structural while domestic inflation is likely to overshoot OBR and Bank of England forecasts.
The OBR uses nine separate methods for estimating the output gap, detailed in a recent working paper*. The current estimates from these methods range from -2.3% to +1.6%, demonstrating a very high degree of uncertainty. The OBR’s assessment that the true figure is -0.8% has received little critical attention. This is probably because -0.8% is close to the mid-point of the range and broadly agrees with the MPC consensus view that economic slack is currently about 1% of GDP.
The range mid-point, however, gives a misleading impression of the balance of evidence across the nine methods. Detailed results in a spreadsheet** of supplementary information on the OBR’s website show that six of the nine estimates are zero or positive. Only two suggest a negative output gap larger than -0.8%. The mean and median across the nine methods are +0.1% and zero respectively – see chart.
The OBR projects that public sector net borrowing will be 5.0% of GDP in 2014-15, of which 0.8 percentage points is attributable to the economy operating below capacity (i.e. cyclically-adjusted net borrowing is forecast to be 4.2% of GDP). If the true output gap is zero rather than -0.8%, there is an additional “structural” fiscal shortfall to be corrected of 0.8% of GDP, equivalent to £15 billion per annum.
A zero gap now, meanwhile, implies that it will turn significantly positive next year, based on OBR and Bank of England growth forecasts, pushing up domestic inflation. As previously noted, an upswing in domestic inflation is already under way, with the annual increase in the deflator for gross value added at a two-year high in the third quarter, based on preliminary data.
*Working Paper No. 5 by Jamie Murray, Output gap measurement: judgement and uncertainty.
**December 2014 Economic and Fiscal Outlook, Economy supplementary tables, table 1.18.