The global economy is weak but not recessionary. GDP in the G7 developed economies and seven large emerging economies (the “E7”) rose by 1.1% between the second and fourth quarters of 2015, equivalent to an annualised rate of 2.1%*. The latter compares with average growth of 2.9% per annum (pa) since 1997 but is no weaker than in the same period of 2012 – see first chart.
Chancellor George Osborne presented another hyperactive Budget combining apparent fiscal rectitude with a range of popular measures. The reality is that his forecast numbers rely on accounting tricks, unspecified future spending reductions and more stealth taxes, and would be blown out of the water by another recession or a rebound in borrowing costs.
As expected, the Office for Budget Responsibility revised up its baseline borrowing numbers significantly, despite another cut in forecast debt interest payments, reflecting greater pessimism about trend productivity growth. How, then, did Mr Osborne manage to claim that he remains on track to achieve a fiscal surplus of more than £10 billion in 2019-20 and 2020-21?
There were two main tricks. First, he shifted a significant chunk of revenue from 2017-18 and 2018-19 into the two later years by delaying a previously-announced acceleration of corporation tax payments. That is, he will borrow more in 2017-18 and 2018-19 to “fund” his surpluses in the later years.
Secondly, he pencilled in large but unspecified cuts in current spending in 2019-20 and 2020-21. He disguised part of this reduction as an increase in pension contributions by public sector employers – these higher contributions will be met from existing budgets, implying that savings must be found elsewhere.
The remainder of the Budget consisted of more tax system meddling to conjure up revenue to fund his populist announcements. A problem here is that the additional yield from the revenue-raising measures is more uncertain than the cost of the giveaways.
As usual, the Chancellor expects a further attack on “avoidance and evasion” to do the heavy lifting, with a list of 14 measures forecast to raise more than £3 billion in 2019-20. This essentially pays for the announced increases in the personal allowance and higher rate thresholds, generous changes to the ISA regime and another fuel duty freeze.
The business tax changes are similarly self-financing, with cuts in a range of exemptions benefiting large corporations and higher stamp duty on commercial property transactions used to fund a big rise in rate relief for small businesses and a reduction in the main corporation tax rate to 17%.
Contrary to the Chancellor’s claims, there is still a gaping hole in the UK’s fiscal roof. Lowered spending targets will be tough to achieve and the OBR’s forecasts also rely on doubly-favourable assumptions of sustained economic growth and little rise in interest rates. For all his bravado, Mr Osborne may be hoping for a move out of no. 11 before the economic weather changes.
Chinese economic activity numbers for January-February were disappointing but may have been depressed by New Year timing effects. Money / credit trends continue to give a positive signal for prospects.
Annual growth in industrial output fell from 5.9% in December to 5.4% in January-February. The decline may reflect an unfavourable base effect due to Chinese New Year falling unusually late in 2015 – 19 February versus 8 February this year. Late New Year dates seem to boost February production at the expense of March, probably because factories take time to return to normal operation after the holiday. So production may have been higher than trend in February 2015 but below it in March. This would depress annual growth in January-February 2016 but suggests a rebound in March.
This, indeed, was the pattern after the New Year was last similarly late, in 2007 (18 February). Annual production growth in January-February 2008 was 2.0 percentage points (pp) below the December level but rebounded by 2.4 pp in March.
There were several brighter spots in the January-February data releases. Annual growth of total fixed investment value recovered from 8.2% in December to 10.2%, driven by a 41% rise in new projects. The pick-up, however, was state-led, with private investment growth slipping further to 6.9%.
Housing market activity, meanwhile, strengthened, with floorspace sold up by 30% from January-February 2015, suggesting a further recovery in house prices. The start of the year, however, is a relatively quiet period for transactions – January-February accounted for only 9% of full-year sales in 2015.
While economic news was, on balance, disappointing, money / credit trends continue to suggest brighter prospects. Monthly changes in the key aggregates weakened in February after a super-strong January, but six-month growth of real (i.e. inflation-adjusted) narrow money* has risen markedly since mid-2015, with a smaller but still significant increase in real total social financing expansion** – see chart. Allowing for a typical nine-month lead from monetary changes to the economy, activity news should improve soon.
*The preferred narrow money measure here is “true M1”, comprising currency in circulation and demand / temporary deposits of corporations and households. The official M1 measure omits household deposits. True M1 is not yet available for February.
**Total social financing (TSF) = domestic fund-raising by households and non-bank corporations. TSF does not take account of repayments of external corporate debt but also omits recent heavy bond issuance by local governments, the proceeds of which have been used in part to repay bank debt of related corporate financing vehicles. The net effect of these influences has probably been to depress recorded TSF growth.
Having mislaid his bazooka in December, Mario Draghi has returned to the fray firing a blunderbuss. The ECB announced an unexpectedly wide range of easing measures, including cuts in all three key interest rates, an expansion and broadening of asset purchases, and a new TLTRO lending programme under which banks will be paid to borrow. While superficially impressive, this scattershot approach will probably have limited impact on monetary conditions and the economic outlook.
The main positive surprises in today’s announcements were: 1) a 5 basis point (bp) cut in the main refinancing and marginal lending rates, in addition to a 10 bp reduction in the deposit rate; 2) a €20 billion expansion of the monthly rate of asset purchases, with the programme extended to non-financial corporate bonds; and 3) new four-year TLTRO operations under which banks can borrow at the negative deposit rate if they expand their lending by modest amount over the next two years*.
These initiatives, however, are marginal. Market rates are now tied to the deposit rate, not the main refinancing rate. The cut in the latter will lower interest payments for banks currently borrowing from the ECB but will simultaneously reduce interest received on current account balances (i.e. required reserves) – the net impact on banks in aggregate will be insignificant.
Buying €80 billion rather than €60 billion of securities per month, meanwhile, is unlikely to exert much additional downward pressure on yields, although the extension to corporate bonds should depress spreads.
The new TLTROs will be welcomed by liquidity-short banks but institutions with excess reserves have little incentive to borrow, and the net impact on banking system income will be, at best, neutral – funds lent by the ECB will be reflected in a larger outstanding balance in the deposit facility, on which banks will be charged 40 bp, offsetting the TLTRO subsidy.
Relative to market expectations, the main negative surprises today were that the deposit rate cut was limited to 10 bp while the ECB has ruled out introducing a tiered payment system, which has been widely regarded as necessary for Eurozone rates to fall further towards Swiss / Danish levels. Indeed, Mr Draghi stated that he does not anticipate a further reduction.
The net impact of the package on monetary conditions and the economic outlook is likely to be small. The market reaction appears logical, with the euro stronger on reduced prospects of a further deposit rate cut, “core” government bond yields little changed and bank shares rallying as the deposit rate and TLTRO news has calmed fears of a squeeze on net interest margins.
*The requirement is to expand the stock of eligible loans by 2.5% between 1 February 2016 and 31 January 2018, or by less if such loans were reduced in the year to 31 January 2016.
Posts here in late 2014 and early 2015 argued for optimism about Eurozone economic prospects because monetary trends had strengthened significantly. Growth was solid in 2015 and domestically-generated inflation recovered. Monetary trends continue to give a reassuring message. Further monetary policy stimulus, therefore, does not appear to be warranted and – depending on the form it takes – may prove counterproductive.
Revised data released yesterday show that Eurozone GDP rose by 1.6% in the year to the fourth quarter of 2015 – see first chart. This is well above EU Commission, OECD and IMF estimates of potential growth in 2015 – 1.0%, 1.2% and 1.0% respectively. Potential growth was more than 2% when EMU began in 1999. In terms of the impact on the “output gap”, therefore, GDP growth of 1.6% now is equivalent to about 2.75% then.
The economy, moreover, was held back last year by a significant decline in net exports, reflecting global demand weakness. Eurozone domestic demand expanded by 2.2% in the year to the fourth quarter, the fastest annual growth rate since the third quarter of 2007 – first chart.
The labour market, meanwhile, has recovered solidly. The unemployment rate fell by a full percentage point between January 2015 and January 2016. The most recent employment statistics showed a 1.6 million* rise in the year to the third quarter of 2015, the largest annual increase since the second quarter of 2008.
Monetary policy doves claim that deflation risk has increased. The annual change in consumer prices fell below zero again in February, mainly reflecting further oil price weakness around the turn of the year, which has since reversed. Core inflation, however, has remained comfortably positive and above its 2014-15 low. The most comprehensive gauge of domestically-generated price pressure is the GDP deflator, which measures labour costs and profits per unit of output of all domestically-produced goods and services. The annual change in the deflator bottomed at 0.7% in the second quarter of 2014 and recovered to 1.3% in the second quarter of 2015, remaining at this level in the third and fourth quarters – second chart.
Monetary trends, meanwhile, remain solid. The monetary measure with the strongest correlation with future economic activity, according to ECB research, is non-financial M1, which rose by 9.8% in the year to January. Broad money M3 increased by 5.0% over the same period, above the ECB’s 4.5% “reference value” deemed to be consistent with its inflation target.
Based on the above, the case for further monetary policy stimulus is unproven. The ECB may argue that action is required as insurance against downside risks. The danger is that, far from providing stimulus, the measures under consideration will cause banks to slow balance sheet expansion while damaging consumer and business confidence.
*Figure corrected from earlier version of post.