An interesting feature of the August MPC minutes is that the “Money, credit, demand and output” section includes, for once, a discussion of monetary trends. This may reflect the influence of the Bank of England’s new chief economist, Andrew Haldane.
The discussion is relatively extensive and implies that monetary trends are consistent with continued strong economic growth, in line with the assessment here. In particular, it is suggested that households hold “excess” broad money balances that will be spent, while rapid expansion of corporate deposits supports optimism about business investment. There is also an indirect reference to narrow money buoyancy in an observation about households switching from time to sight deposits.
Mr Haldane was co-author of a 1995 Bank of England working paper Money as an Indicator, which found “strong and significant effects from narrow money through to nominal GDP and, in particular, prices”. As the paper noted, this matched a much earlier (1970) Bank study by Andrew Crockett, which concluded that “the money stock, narrowly defined (M1), seems to be positively related to subsequent changes in expenditure”.
If the above interpretation is correct, Mr Haldane will be placing significant weight on monetary trends and, if current strength continues, is likely to shift into the interest-rate-rise camp. (July monetary statistics are released on 1 September.)
Japanese monetary trends continue to suggest remarkably little impact from the country’s QE experiment.
Annual growth of broad money M3 stood at 2.1% when the Bank of Japan (BoJ) launched QE in October 2010; it was 2.5% in March 2013, when the programme was expanded significantly; it was 2.5% also in July this year.
As discussed in a post in June, the BoJ’s injection of money via its purchases of Japanese government bonds (JGBs) has been neutralised by an opposing shift by banks, who were expanding their lending to the government in 2010 but have been cutting it back more recently – see the “monetary counterparts” chart below. A key reason for this change is that QE has raised banks’ reserves at the BoJ, allowing them to reduce their JGB holdings while still meeting their liquidity targets. The BoJ and banks have, in effect, swapped JGBs and reserves, with no impact on the supply of money to households and firms.
There has been an additional drag on M3 growth recently from a reduction in banks’ net foreign asset position, following expansion in late 2012 and 2013. This, in turn, reflects the balance of payments basic balance moving from surplus to deficit – second chart. The main driver of this shift has been an increase in portfolio outflows, probably related to QE.
Japan’s experience supports the view here that QE has little impact on monetary trends under normal circumstances. Extending / expanding the BoJ’s bond-buying operation would be unlikely to make much difference. Banks’ outstanding lending to the government remains substantial – equivalent to 25% of M3 – and they would probably sell more JGBs to offset the additional reserves boost from higher BoJ purchases.
QE might have a larger monetary impact if the BoJ bought equities rather than bonds. Banks’ equity holdings are much smaller – less than 2% of M3. They would, however, still have an incentive to offload JGBs to counter reserves expansion. The BoJ could be constrained from switching QE away from bonds because of the smaller size of the equity market – the current ¥50 trillion annual pace of JGB buying is equivalent to 11% of stock market capitalisation.
Additional BoJ easing, in whatever form, could encourage further portfolio outflows, implying a negative external effect on money growth.
Rather than further monetary experimentation, Japan needs action on mooted “third arrow” structural reforms to boost supply-side economic performance. By enhancing confidence in medium-term prospects, such reforms could cause a rise in the velocity of circulation of the existing money stock while encouraging private sector credit growth – a firmer basis than QE for stronger M3 expansion.
Eurozone annual consumer price inflation fell further to 0.4% in July versus 0.7% in January and 1.6% in July 2013. This decline, however, is largely explained by lower energy and food costs. “Core” inflation, i.e. excluding energy, food, alcohol and tobacco, was 0.8% in July versus 0.7% in January and 1.1% in July last year – see first chart.
The modest reduction in core inflation over the past year, moreover, partly reflects a smaller boost from indirect tax rises. Tax rate changes contributed 0.2 percentage points (pp) to CPI inflation in July 2014, down from 0.4 pp a year earlier, according to Eurostat*.
A fall in inflation due to lower imported energy and food costs and smaller tax rises is positive, not negative, for demand and activity, ceteris paribus.
The stabilisation of core inflation since late 2013 is consistent with the “monetarist” rule that price developments echo money supply trends about two years earlier. Annual growth in narrow money M1 bottomed in mid-2011, though recovered significantly only after mid-2012 – second chart. The rule suggests that core inflation will firm through mid-2015. A prior large rise in M1 growth in 2008-09 preceded a faster rise in core prices in 2010-11.
Annual M1 expansion fell back from spring 2013. The ECB cut official rates in November and June and will offer additional liquidity via targeted longer-term repo operations (TLTROs) from next month. It also plans to buy asset-backed securities. Six-month growth in M1 (and M3) recovered between April and June. Launching large-scale QE would probably have limited additional impact on monetary trends, based on experience elsewhere**.
The ECB blundered in 2011, tightening policy when real money was contracting, thereby guaranteeing a recession. It corrected this mistake in 2012 and its current stance is reasonable, assuming a continuation of recent monetary trends.
*These estimates assume 100% pass-through.
**Japanese money growth, for example, is little changed from October 2010 and April 2013, when QE was introduced and expanded respectively – see previous post for more discussion.
Markets have interpreted the August Inflation Report as signalling further delay in monetary policy normalisation. Bank of England Governor Mark Carney’s press conference remarks admittedly gave little encouragement to those expecting the first rise in Bank rate to occur this year. The Inflation Report forecasts, however, imply that the Monetary Policy Committee (MPC) as a whole has revised up its assessment of the amount of policy tightening needed to meet the inflation target over the medium term.
A summary measure of whether policy is on track to hit the target is the mean forecast for inflation two years ahead based on unchanged policy. This rose from 2.35% in May to 2.52% in August – the highest since May 2011, when three out of nine MPC members voted to hike Bank rate.
The 0.52 percentage point deviation of the two-year-ahead forecast from the target, indeed, has been matched or exceeded in only three out of 69 Inflation Reports since the MPC’s inception in 1997 – see chart. The two other occasions when the MPC signalled a similar need to tighten – in 1997 and 1998 – were followed by a rate rise within four months.
Since May, the MPC has become more optimistic about near-term growth prospects while lowering – again – its projections for productivity and unemployment. These changes imply a faster erosion of slack and are consistent with the upwardly-revised inflation forecast based on unchanged policy.
The main counterargument deployed in the Report is the continued weakness of wage growth, suggesting a larger excess supply of labour than estimated in May. This permits the claim that economic slack is still “broadly in the region of 1% of GDP”, versus an assessment of 1.0-1.5% three months ago.
The Report states that “uncertainty about how much slack there is has increased” and “there is a wide range of views on the Committee”. The higher inflation forecast implies that the balance of opinion has shifted towards earlier and / or more policy tightening since May. Governor Carney chose not to draw attention to this shift, perhaps to avoid frontrunning next week’s minutes, which may reveal hawkish dissent.
Chinese economic momentum has strengthened as predicted by monetary trends and business surveys. Six-month industrial output growth rose to 4.4% in July, or 9.1% annualised, the highest since December. A further increase is likely, based on new orders readings in the latest manufacturing purchasing managers’ surveys – see first chart.
July monetary statistics, meanwhile, were mixed, with six-month real M2 growth falling back from a 20-month peak but the narrow M1 measure gaining pace – second chart. The M2 slowdown, if confirmed, would suggest a loss of economic momentum at the start of 2015. A positive cyclical view remains warranted for now.