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.
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.