The latest world economic survey conducted by the German Ifo institute suggests that G7 consumer price inflation will firm during 2014.
A post in October reviewed the implications of monetary trends, the Kondratyev cycle, spare capacity measures and house prices for inflation prospects, concluding that a minor upswing was likely in 2014-15. The consensus view, of course, is that inflation will remain low, with risks weighted to the downside.
The chart shows G7 annual CPI inflation and a GDP-weighted average of country price expectations measures from the Ifo survey*. Inflation finished 2013 at 1.4%, down from 1.6% a year before but up from a low of 0.9% in April. The composite expectations measure moved significantly higher in late 2013 and remained elevated in the first quarter, consistent with a near-term inflation uptick.
Commodity prices have firmed a little recently – the CRB futures index is currently 4% above its fourth-quarter average – but core pressures may also contribute to an inflation rise. The second chart, an update from the earlier post, shows that house prices have led core inflation in recent years and suggest an increase through early 2015.
*The survey polls “economic experts of multinational firms and institutions”. The survey results are constructed to equal five when the numbers of positive and negative responses are the same.
Mark Carney’s motivation for introducing forward guidance was to persuade consumers and businesses to spend more by convincing them that Bank rate would remain at 0.5% at least until after the 2015 general election. His latest policy innovation will allow him to continue to pursue this goal.
The MPC’s first guidance effort was time-based, in the form of a statement in the July 2013 decision press release that the market-implied future path of Bank rate was “not warranted by the recent developments in the domestic economy”. This was swiftly brushed aside by markets as much too weak.
The second, more serious initiative was the commitment in August 2013 to defer an interest rate rise at least until the unemployment rate fell to 7.0%, a condition Bank of England economists confidently expected not to be met for three years. This was admirably clear and Mr Carney cannot be blamed for the Bank staffers’ woeful forecast. He has, however, learnt his lesson.
Forward guidance 3, therefore, provides Mr Carney with maximum wiggle room by: 1) giving a central role to the unobservable "output gap”, the Bank’s estimate of which can be manipulated to suit policy objectives; and 2) setting central expectations for a number of other variables that – he thinks – are unlikely to be challenged sufficiently to force an early rate rise.
The Bank has pronounced that the output gap is “about 1-1.5% of GDP” but has provided no calculation details, no history of its measure and no information about its estimate of current potential output growth – the latter would allow markets to infer changes in the gap as new GDP data are released. It has, in other words, given itself maximum flexibility to revise its assessment to suit the MPC’s policy judgement.
The new forecast, meanwhile, includes central expectations that: 1) unemployment will fall by a further 0.5 percentage points by the third quarter of 2014; 2) average earnings growth will pick up from 0.9% currently to about 2% by the same date; and 3) productivity expansion will revive only to about 1% by then. These judgements imply a high hurdle for the MPC to be surprised sufficiently to tighten policy this year.
Markets have interpreted the vagueness of the new guidance as increasing the probability of an early rate hike. This vagueness, however, is Mr Carney’s strength as he seeks to continue to postpone action.
The Achilles’ heel of the new policy is inflation. The MPC is unlikely to raise rates soon, even with super-strong growth and a further unemployment collapse, if the headline CPI rate remains at or below the 2% target, as the Bank predicts. Investors should expect an early rate rise only if they share the view here that recent inflation relief is temporary.
UK banks’ net revenues from households have been unusually low in recent years but are now recovering as interest margins widen and payment protection insurance (PPI) compensation payouts slow.
The first chart shows average interest rates on deposits from and lending to households, derived by weighting together Bank of England rate and volume data for different forms of business. Lax monetary policy and inadequate regulation contributed to the lending / deposit rate spread narrowing from 4.0 percentage points (pp) in 1999 to 2.5 pp in late 2007, when the credit bubble burst.
Contrary to popular mythology, banks have not rebuilt their finances by widening their margin on household business. The spread, indeed, fell to a new low of 2.3 pp at the start of 2013. Easier funding conditions, however, have allowed banks to cut deposit rates by more than lending rates in recent months, resulting in the spread returning to 2.6 pp at end-2013.
Further widening is likely as maturing deposits are refinanced more cheaply. The average interest rate on the outstanding stock of time deposits, for example, is significantly higher than the rate banks are paying for new business – 2.3% versus 1.6%. The difference between existing and new lending rates is smaller: banks are earning an average 3.1% on new secured loans versus 3.3% on the outstanding stock.
The lending / rate deposit spread could return to 3.0 pp by end-2014. Assuming deposits of £1,150 billion, this would imply revenues* from intermediating household business of £34.5 billion in 2015, up from £25 billion in 2012**.
PPI payouts, meanwhile, totalled £6.3 billion in 2012 and are on course to reach £5.2 billion in 2013. They may subside to £3 billion or less next year – second chart.
Combining the spread and PPI assumptions, therefore, banks’ net revenues may rise from £19 billion in 2012 to £32 billion in 2015, implying a small drag on household cash flow and spending – a £13 billion increase is equivalent to 1.2% of 2013 disposable income.
*Revenues not earnings.
**Deposits from and lending to households were £1,118 billion and £1,190 billion respectively at end-2013.
Global leading indicators are signalling a downshift in economic growth in the first half of 2014, confirming the message from slower real narrow money expansion between spring and autumn 2013. Monetary trends improved at end-2013, tempering concern here about a serious loss of economic momentum; January money supply data will be important for refining the assessment.
The first chart shows six-month growth in global (i.e. G7 plus emerging E7) industrial output together with short and longer leading indicators, calculated by combining and transforming OECD country leading indicator data. The indicators lead growth turning points by an average 2-3 months and 4-5 months respectively. As expected, both moved lower again in December, following peaks in October and September 2013. This suggests that output growth will register a peak in January 2014.
The declines in the indicators follow a slowdown in real narrow money expansion between May and November 2013 – second chart. Real money growth, however, rebounded in December, possibly indicating that economies will regain momentum from mid-2014. The view here will remain cautious pending 1) January money supply data* and 2) a bottoming out of the longer leading indicator**.
The recent decline in the longer indicator, surprisingly, reflects weakness in the G7 rather than emerging E7 component – third chart. E7 economic growth may remain respectable during the first half despite tighter financial conditions in several countries.
*The US, Japan, China and Brazil will release January numbers during the course of this week.
*A mid-year economic reacceleration would be signalled by a rise in the longer indicator probably in February or March.
Global growth may have peaked at end-2013 but G7 unemployment should continue to decline through mid-2014. Business survey evidence of rising labour shortages, moreover, suggests that the jobless rate is already at or below a level consistent with stable inflation.
The G7 unemployment rate has fallen from a peak of 8.4% in October 2009 to 7.0% in November 2013 but remains above its post-1995 average of 6.6%. Consumer surveys signal a continued decline: a GDP-weighted average of net percentages of households giving a negative assessment of labour market conditions typically leads major turning points in the jobless rate by about five months and fell to a new recovery low in January – see first chart.
The second chart shows a longer history of the unemployment rate together with a measure of skill shortages derived from the Ifo global business survey. The scales have been adjusted to equalise the averages of the two series. Skill shortages are above average and comparable with late 2006, towards the end of the last economic upswing, despite a jobless rate that remains elevated and about 1.25 percentage points higher than then.
The suggestion that “structural” unemployment has risen significantly, of course, will continue to be strongly resisted by dovish monetary policy-makers – next week’s UK Inflation Report, indeed, will probably claim that the "equilibrium" jobless rate is lower than previously thought to provide cover for the MPC to continue its “forward guidance” experiment.