With no fiscal room for manoeuvre, the Chancellor nevertheless managed to deliver a major reform of savings along with other headline-grabbing measures that will please his political supporters.
The changes to pensions and ISAs should enhance long-term economic performance by encouraging saving and promoting a more productive allocation of capital, partly by reducing “structural” flows into long-term gilts as annuity rules are relaxed.
The time-limited doubling of the business investment allowance, on the other hand, is a tinkering measure designed to give a boost to capital spending and the wider economy ahead of the 2015 election, with payback from 2016.
A further rise in the personal allowance, cuts in alcohol and air passenger duties, the higher investment allowance and energy reliefs for businesses are paid for by another attack on tax avoidance / planning, lower public sector pension costs and a positive near-term effect on receipts from the savings reforms.
The introduction of competitive National Savings bonds for pensioners from January 2015 will have the effect of tightening monetary conditions, assuming that the Bank of England has not already raised Bank rate by then. The assumption is that one-year bonds will yield 2.8%, which compares with an average rate on one-year bank instruments currently of 1.4%. The bonds will raise £10 billion, equivalent to about 4% of the household sector’s stock of time deposits. The competition is likely to force banks to improve their own rates, with a knock-on effect on interest costs for borrowers.
The Office for Budget Responsibility’s (OBR) assessment that the Chancellor is meeting his fiscal mandate rests on its judgemental assumptions that GDP was still 1.7% below its sustainable potential level at end-2013 and potential will grow by 2.1% per annum over 2014-18. The former is at odds with its statistical analysis of cyclical indicators, which suggests that the GDP / potential gap is negligible or even positive.
In a plausible alternative scenario in which potential output is 2% lower than in the central case and gilt yields 100 basis points higher, the cyclically-adjusted current budget would still be in small deficit in 2018-19, based on the OBR’s ready reckoners. The fiscal position, in other words, remains fragile and the OBR has arguably given the Chancellor too easy a ride.
A measure of private sector pay incorporating a 12-month smoothing of bonuses rose by 0.9% more than consumer prices in the year to January, confirming that real wages are picking up more strongly than the Bank of England and consensus expected.
Private sector regular weekly earnings rose by 2.2% in the year to January versus CPI inflation of 1.9% in that month. Bonuses, meanwhile, increased by 8.7% in the 12 months to January from a year before. A measure of total pay calculated by adding regular earnings and a 12-month moving average of bonuses, therefore, rose by an annual 2.8% in January. This pay growth measure was below CPI inflation between July 2008 and November 2013 – see first chart.
Whole-economy growth, i.e. incorporating public sector workers, is lagging the private sector but was also above inflation in January, at 2.2%.
The earlier-than-expected resumption of real wage growth further undermines the Bank’s claims of economic fragility and may have a significant political impact – statistical analysis confirms that real wage trends influence the poll gap between the main governing and opposition parties.
A key issue is whether the real wage pick-up reflects a recovery in productivity growth or a shift in the balance of power in favour of workers, due to a tight labour market. Productivity optimists will cite an increase in aggregate hours worked of only 0.1% in the three months to January from the prior three months – well below quarterly GDP growth currently estimated at 0.7% in the fourth quarter. Some productivity catch-up, however, had been expected following dismal performance in the year to the third quarter, when whole-economy output per hour rose by only 0.1%.
The vacancy rate – the stock of unfilled positions expressed as a percentage of employee jobs – continues to suggest that labour market slack has been eliminated, rising further to 2.1% in the three months to January versus a post-1995 average of 2.0%. The divergence between the vacancy and unemployment rates casts strong doubt on the Bank’s view that the latter can fall to 6-6.5% without generating inflationary pay pressures – second chart.
The Federal Reserve is likely to taper bond purchases by a further $10 billion to $55 billion a month at its policy meeting this week and may stop buying by the end of the third quarter as the economy reaccelerates.
The chart shows a long history of the “headline” policy rate* together with an indicator** designed to summarize data influences on the Fed’s thinking. The indicator gave advance warning of changes in interest rate direction up to and including the 2008-09 crisis, and has been informative about QE policy more recently.
The indicator was below zero, suggesting policy easing, when the Fed launched QE1 and QE2 in December 2009 and November 2010 respectively. It turned significantly positive in early 2011, however, signalling that QE2 would not be extended beyond its scheduled end in June. A renewed slide towards zero during 2012 preceded the launch of QE3 in September of that year and its expansion in December.
The indicator had been recovering for several months when the Fed announced tapering in December 2013. It has risen further in early 2014 and is just below its level ahead of the suspension of QE2 in June 2011.
Monetary trends signalled that economic growth would moderate in early 2014 but are now suggesting another pick-up from mid-year – see previous post. If correct, the policy indicator may stabilise near term before pushing higher again in the summer. Economic reacceleration may cause the Fed to end QE3 in July or September rather than in the fourth quarter, as implied by tapering of $10 billion per meeting.
*The Fed has announced publicly its target for the Fed funds rate since February 1994; the discount rate was the immediately visible policy rate before that date.
**The indicator is based on changes in core CPI inflation and unemployment and the ISM manufacturing vendor deliveries index, which measures supply chain delays. The latter two components are responsible for the current positive reading.
QE enthusiasts expected the bond-buying blitz launched by incoming Bank of Japan Governor Kuroda in April 2013 to boost the broad money supply substantially – one commentator suggested a 10% increase over a year. The view here was sceptical, on the grounds that higher BoJ purchases would be largely offset by stepped-up selling by banks, whose demand for liquid securities would fall as QE expanded their reserves – see previous post.
This view, so far at least, has proved correct. Banks reduced their investment account holdings of Japanese government bonds by a further ¥5.8 trillion in January (the latest available month), neutralising two-thirds of the impact of BoJ buying of ¥8.4 trillion. Annual growth of the broad M3 money supply measure slipped back to 3.2% in February – little changed from 2.5% in March 2013.
The QE lift to nominal money supply growth has been more than offset by higher inflation due mainly to the weaker yen. Real money expansion is lower now than in early 2013, helping to explain recent disappointing economic performance – see chart.
What happens next? Inflation will be boosted mechanically by next month’s sales tax hike but the yen effect is now fading and wage rises remain muted. If nominal money growth is stable, real trends may improve later in 2014 as price rises moderate, promising better economic conditions in 2015.
The risk is that the BoJ will raise the QE stakes, leading to further yen weakness that keeps inflation elevated and real money growth depressed – assuming, reasonably, that QE pass-through to nominal money trends remains minimal.
The BoJ, in other words, may sacrifice economic growth on the altar of its obsession to achieve 2% inflation.
Global short and longer-term leading indicators followed here suggest that recent slower economic growth will persist through late spring. As expected, the short indicator (average 2-3 month lead at turning points) fell further in January, while the longer measure (4-5 months) stabilised – see first chart. Six-month global industrial output growth appears to have peaked at end-2013 and, based on these readings, may decline into April / May.
The stabilisation in the longer-term leading indicator is tentative, subject to revision and should not be overemphasised. It is, however, consistent with a revival in global real narrow money expansion that started in December and continued in February, judging from early data – second chart*. Allowing for an average 6-7 month lead, this suggests a recovery in global economic momentum in mid-2014. The further rise in real money growth in February was driven by US strength and a reversal of weakness in China – see Monday’s post.
The investment implications of these divergent trends are open to debate. A possible scenario is that elevated equity markets will correct as near-term economic data softens before rebounding in anticipation of the stronger second half implied by monetary trends – assuming that the money growth pick-up is sustained. Bulls, of course, will argue that markets will look through a temporary soft patch, especially with data distorted by weather effects and a forward shift of Japanese demand / output ahead of April’s sales tax rise.
The uncertainty is mirrored by the two equities versus cash investment rules followed here – see previous post for more details. The first rule prefers equities if G7 real narrow money is growing faster than output; it remains invested currently. The second rule requires the G7 longer leading indicator to be above its historical average in order to hold stocks; it has recently shifted to cash. The last buy signals of the two rules were in September 2011 and August 2012 respectively.
*February monetary data are available for the US, China, Japan, India and Brazil, together accounting for about 60% of the global aggregate. Growth in other countries is assumed to be unchanged from January.