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.
The global longer leading indicator followed here suggests that economic growth will strengthen through the current quarter before stabilising / moderating later in 2014. This is consistent with recent narrow money trends.
The longer leading indicator is derived from OECD data and gives advance warning of turning points in six-month industrial output expansion. The average lead time in recent cycles has been five months. The indicator rose sharply between January and April, suggesting a pick-up in output growth from June through September, based on the average lead. It partially retraced this increase in May / June – see chart.
This pattern mirrors recent monetary developments: global six-month real narrow money expansion, which typically leads the economy by about six months, rose between November and February before easing slightly over the spring – see previous post for more discussion.
The recent declines in real money growth and the leading indicator are too small to warrant concern about growth prospects. Both have been affected by Japanese data volatility due to the April sales tax rise. Real money expansion stabilised between May and June, suggesting that the leading indicator will level off in July, allowing for the former’s slightly longer lead. Real money trends, moreover, should be supported by a near-term slowdown in consumer prices and recent lower market interest rates.
A post last week suggested that economic fluctuations in recent decades can be explained by the interaction of three cycles. The current post applies this idea to post-WW2 US economic data.
The three cycles of interest are: the 3-5 year Kitchin stockbuilding cycle; the 7-11 year Juglar business investment cycle; and the 15-25 year Kuznets housebuilding cycle.
The upper part of the first chart shows the peak-to-trough declines in US industrial output in the 11 post-war recessions identified by the National Bureau of Economic Research (solid bars). Each decline is plotted in the year in which the recession trough occurred, e.g. the 2008-09 fall is plotted in 2009. A fall in output in 1966-67 is also included (outline bar), although the associated economic downswing did not qualify as a recession.
The lower part of the chart shows the trough years of the Kitchin, Juglar and Kuznets cycles. These troughs were identified judgementally by examining detrended national accounts data on stockbuilding, business investment and residential investment. Possible dates of future cycle troughs are also shown (outline bars).
This exercise yields the following insights.
First, as suggested in the earlier post, severe recessions occur when the three cycles reach a trough in the same year. There were three such years – 1958, 1975 and 2009. Industrial output declined by 14%, 13% and 17% respectively.
There was the potential for another synchronised trough in 1990-92. In the event, the three cycles bottomed a year apart. The associated recession was mild, measured in terms of the peak-to-trough industrial output. Economic weakness, however, was extended.
Secondly, years in which Kitchin and Juglar cycle troughs coincide are associated with “average” recessions. There were two such years – 1949 and 1982. Industrial output declined by 10% and 9% respectively.
There was the potential for synchronised Kitchin / Juglar troughs in 1967-68 and 2001-02 but, again, the cycles bottomed a year apart, so a recession was avoided in the former case and was mild in 2001.
Thirdly, Kitchin cycle troughs, in isolation, are not usually associated with recessions. There were 10 years in which the Kitchin cycle bottomed more than a year apart from the other two cycles. Recessions occurred in four of those years – 1954, 1961, 1970 and 1980. The 1954, 1970 and 1980 recessions were partly the result of “shocks” – significant fiscal tightening, a prolonged auto workers’ strike and the imposition of credit controls respectively.
The last Kitchin cycle trough occurred in 2012. There was no recession but economic weakness resulted in the Federal Reserve launching open-ended QE.
What are the implications for the timing of the next recession? The 3-5 year Kitchin cycle is scheduled to reach another trough between 2015 and 2017, while the 7-11 year Juglar cycle should bottom between 2016 and 2020. If the Kitchin trough is late and / or the Juglar trough arrives early, the cycles may synchronise, resulting in a recession. The most likely years for a recession to occur are 2016 and 2017, since the Kitchin cycle will embark on another upswing by 2018.
Note that these timings relate to cycle troughs. A 2016 recession trough would imply economic weakness beginning in 2015.
Monetary policy will affect the outcome. The Federal Reserve plans to raise interest rates gradually by about 2 percentage points between end-2014 and end-2016. This suggests a maximum negative impact on the economy in 2016-17, coinciding with cyclical vulnerability. Fed policy, that is, could deepen the Kitchin trough and bring forward the Juglar downswing, thereby increasing the risk of a recession.
If the Fed believes that a higher level of interest rates is necessary for medium-term inflation control reasons, there is a case for it making the adjustment by mid-2015 at the latest, while the Kitchin cycle is still in an upswing.
Any recession in 2016-17 should be of average or mild severity, since the 15-25 year Kuznets cycle is not scheduled to reach another trough until 2024 at the earliest.
How should recession risk be monitored? As discussed in a post in 2010, real narrow money contracted before 10 out the 11 post-WW2 recessions, the exception being the 1954 downturn, which – as noted earlier – had a large fiscal element*. Real narrow money is currently rising strongly, consistent with recent faster economic growth being sustained into early 2015, at least – second chart.
*Real government spending fell by 6.4% between 1953 and 1954.
The average interest rate on the stock of UK bank lending to households rose marginally from 3.91% in May to 3.93% in June, while the average rate on household deposits eased from 1.19% to 1.15%* – see first chart. The lending / deposit rate spread, therefore, widened to 2.77 percentage points – the largest since February 2011.
While the lending rate has stabilised recently, it has fallen since late 2012; the deposit rate, however, has declined by more. The combined household interest rate, i.e. an average of the lending and deposit rates, is 0.42 percentage points (pp) lower than at end-2012 – second chart. The level of the combined rate at end-2012 was sufficiently stimulatory to generate strong growth and a rapid erosion of economic slack in 2013. The fall since then represents an unwarranted additional loosening of monetary conditions – see previous post for more discussion.
The further decline in the deposit rate has contributed to continued rapid narrow money expansion. Non-financial M1** rose by 5.1% in the six months to June, or 10.4% annualised – third chart. Narrow money correctly signalled economic strength in 2013 and the first half of 2014; current buoyancy suggests that growth will remain robust and may even rise further during the second half, contrary to MPC and consensus expectations.
*Lending / deposit rates on outstanding stocks estimated from Bank of England rate / volume data for different types of business.
**Notes / coin and sterling sight deposits held by households and private non-financial corporations.