The ECB must launch full-scale QE, say its supporters, because the recent oil price fall will push the economy into “deflation”, defined as a year-on-year fall in headline consumer prices. When this happens, consumers and businesses will stop spending, believing that they will be able to buy more cheaply in the future. Current economic weakness will then turn into a slump.
Hang on a minute. If the decline in the headline CPI is due to oil, why should this affect spending on other goods and services, whose prices are still rising, albeit weakly? Isn’t the opposite impact more likely, i.e. consumers will use the cash released from lower energy bills to spend more on other items before they become more expensive?
Eurozone “core” CPI inflation – excluding energy, food, alcohol and tobacco – is moving sideways not falling: November’s 0.7% was unchanged from December 2013.
You’re forgetting about expectations, retort the QE enthusiasts. The headline CPI fall may be solely due to oil but it will mislead stupid consumers into believing that all prices are about to decline.
What’s the evidence for this unlikely hypothesis? The QE enthusiasts point to falling medium-term inflation expectations priced into bond markets. These “expectations”, however, are partly determined by investors positioning for QE and knowing that market prices will influence the ECB’s behaviour. The circularity makes your head spin.
The classical definition of deflation is a contraction of money and credit that leads to falling prices. Eurozone broad money M3 and narrow money M1 are nowhere near contraction, growing by 2.5% and 6.2% respectively in the 12 months to October.
ECB President Draghi may well push through sovereign QE against German-led opposition in early 2015 but such action is not needed to head off deflation. The effects on the economy and core inflation would probably be miniscule, as in Japan. (President Draghi’s claim that QE was successful in the US and UK is not supported by previous analysis here suggesting little impact on monetary growth.)
The QE debate is obscuring a material improvement in Eurozone economic prospects signalled by monetary trends and leading indicators – see previous post. This improvement is much more important for investors than the QE decision. Stronger-than-expected German manufacturing orders released today are consistent with a developing positive scenario: orders rose by 2.5% in October to their highest since 2011 barring July’s holiday-distorted strength, suggesting that production also increased in the month – see chart.
In June 2010, the Office for Budget Responsibility (OBR) judged that the new coalition government was on track to meet its “fiscal mandate”, defined as a balanced cyclically-adjusted current budget in five years’ time, i.e. in 2015-16. This forecast was wrong: the OBR now projects a deficit of 2.2% of GDP.
In its latest Economic and fiscal outlook, the OBR again claims that the mandate will be met, with a forecast cyclically-adjusted current surplus of 2.3% in five years’ time, i.e. in 2019-20. This projection is also likely to be undershot significantly.
The June 2010 forecast was wrong mainly because the OBR was too optimistic about the pace of the economic recovery and its impact on tax receipts. The December 2014 forecast is likely to be wrong because the OBR has been forced to factor in the government’s fantasy spending plans.
The chart tells the story. The government’s plans imply that current spending as a share of GDP will fall by 5.0 percentage points (pp) in the five years from 2014-15 to 2019-20, to its lowest level since 1972-73. This is much larger than the 3.1 pp reduction over the last five years and will supposedly be achieved despite continued ring-fencing of health, education and overseas aid, which account for about one-quarter of spending, and a largely uncontrollable welfare budget.
It won’t happen. The next government, of whatever complexion, will struggle to repeat the 3.1 pp cut in the spending share in the current parliament. This, in turn, suggests that the cyclically-adjusted current budget will, at best, be roughly balanced in 2019-20.
The obvious conclusion is that a new government will attempt to raise the tax share of GDP to allow for a more realistic spending profile. The economy, however, is not under-taxed, as the chart shows: the share of non-oil taxes in GDP is equal to its average since 1980. Tax-raising measures may yield much less than expected, as they have over the past five years.
The G7 longer leading indicator calculated here rose again in October, providing further support for the expected scenario of a revival of global growth into early 2015.
The leading indicator is designed to predict turning points in the six-month change in industrial output. It bottomed in May, trod water over the summer and increased sharply in September / October – see first chart. The six-month output change has recovered from a low in August and should continue to rise through early 2015, at least.
Importantly, the G7 industrial pick-up is expected to reflect growth recoveries in Japan and Eurozone countries (i.e. Germany, France and Italy) rather than US acceleration. The Eurozone longer leading indicator rose again in October, confirming the recent positive message from monetary trends and signalling an early improvement in business surveys – see previous post and second chart.
In Japan, production projections from the METI survey suggest that the six-month industrial output change – still negative in October – will rise to about 4% (not annualised) by year-end. The output recovery follows a solid rebound in retail sales – third chart.
Previous posts (e.g. here) described a simple investment rule for switching between global equities and cash based on the G7 longer leading indicator. The rule prefers equities or cash depending on whether the leading indicator is above or below its long-run average. The indicator is now marginally above the average, suggesting benign conditions for equities. (The alternative rule based on G7 “excess” money growth continues to favour equities.)
UK monetary growth remains broadly stable, suggesting continued solid economic expansion and rising domestic inflation.
The broad and narrow monetary aggregates judged here to be most informative for forecasting purposes are M4 and M1 excluding financial sector deposits*. Annual growth in the M4 measure was 4.9% in October, equal to the average over the past two and a half years. Annual growth in non-financial M1 was significantly stronger, at 9.0%, though has fallen from a peak of 12.0% in October 2013.
Previous posts argued that broad money growth of more than about 4% per annum (pa) is inconsistent with achievement of the 2% inflation target over the medium term, unless interest rates rise significantly. This is because the velocity of circulation of broad money is increasing as households and firms economise on money balances in response to negative real deposit interest rates. Measured velocity** has risen by 0.5% pa since the recession ended in the second quarter of 2009. This compares with a fall of 2.9% pa in the prior 10 years, when real interest rates were significantly positive – see chart.
Current broad money growth of about 5% pa coupled with a velocity increase of 0.5% suggests nominal economic expansion of about 5.5%. Trend real economic growth is unlikely to be more than 2.5% pa, so nominal expansion of 5.5% implies an eventual rise in inflation to about 3%.
The forecast increase in nominal expansion is well advanced: annual growth in nominal gross value added (GVA) rose to 5.3% in the third quarter of 2014, a post-recession high, according to preliminary data. This was split between a 2.9% increase in output and domestically-generated inflation of 2.3%, as measured by the GVA deflator – see previous post. With the economy now operating near capacity, the output growth / inflation split is likely to become less favourable.
*Financial sector deposits are volatile and contain less information about near-term economic prospects.
**Nominal gross value added divided by non-financial M4 six quarters earlier. The six-quarter lag is a compromise based on the Friedmanite rule that money leads activity by about two quarters and inflation by about two years.
Eurozone monetary trends and leading indicators continue to strengthen, suggesting a significant pick-up in economic growth in the first half of 2015, barring external shocks.
Both narrow and broad money have surged since the ECB imposed a negative interest rate on excess reserves in June. Narrow money M1 rose by 9.8% annualised in the four months to October, with the broader M3 measure up by 4.6%.
Real or inflation-adjusted monetary trends anticipate changes in economic activity about six months ahead, according to the monetarist rule. Six-month growth of real M1 and M3 is the highest since October 2012 and March 2009 respectively – see first chart.
Pessimists will focus on a continued contraction of private sector credit. Money leads the cycle while credit usually lags or detaches. There was a similar money / credit divergence in the UK in late 2012. The monetary signal was correct: economic growth surprised positively in 2013.
The encouraging message from monetary trends is confirmed by the longer leading indicator*, which bottomed in May and rose further in October – second chart. The indicator typically leads turning points in six-month industrial output momentum by 4-5 months, suggesting that an economic pick-up is already under way.
Narrow money is growing solidly in all four major economies, with Spain strongest and Germany lagging slightly – third chart.
*The indicator uses the same components as the OECD’s Eurozone leading indicator but is designed to give earlier warning of growth turning points. It is calculated independently, allowing an estimate for a particular month to be produced by the end of the following month.