Markets are discounting two quarter-point rises in Bank rate over the next 12 months but an analysis of recent monetary developments suggests current policy settings are already restrictive against the backdrop of the ongoing credit “crisis”. Monetary trends are not yet signalling a contraction in economic activity but recession risk is rising and is higher than at any time since the early 1990s.
Current inflationary problems partly reflect excessive monetary buoyancy over 2005-2007, when the broad measure M4 was allowed to grow at a 12-13% annual pace. To return CPI inflation sustainably to the 2% target, M4 expansion needs to fall to 6-8% pa. (This assumes trend GDP growth of about 2.5% and a decline in M4 velocity of 2-3% pa, in line with the average over 1992-2004, when inflation was close to 2%.) However, it is also important to avoid undershooting this range, thereby exacerbating current economic weakness unnecessarily. Such an undershoot was a feature of the prolonged early 1990s recession.
Annual M4 growth was still up at 10.0% in May but – as explained here – the headline figure has been inflated by a rise in money holdings of certain financial corporations, which may be acting as a conduit for interbank business. Stripping out these corporations, M4 rose by an annual 8.8% in March – the latest available date – versus 11.8% for the headline measure. Assuming the gap has remained stable since March, May’s headline increase of 10.0% implies growth in the adjusted measure of about 7%, or 2.5% in real terms (relative to RPIX) – the lowest since 1999. (June figures for adjusted M4 will be available in early August.)
Of particular concern is recent weakness in corporate money trends, since empirical evidence shows that companies’ decisions about investment and hiring are sensitive to changes in their liquidity. From a peak of 16.1% in May last year, annual growth in M4 holdings of private non-financial corporations (PNFCs) slumped to just 1.0% in April. By contrast, PNFCs’ bank borrowing has continued to expand rapidly (an annual 14.7% in April), partly reflecting diminished access to other forms of credit. These divergent trends have resulted in the corporate liquidity ratio (i.e. money holdings divided by borrowing) falling below 50% – its lowest level since the early 1990s. Sub-50% readings have occurred on six previous occasions over the last 40 years and in every case business investment subsequently contracted.
Narrow money measures have yet to confirm the worrying message of the broader aggregates. Empirically, “non-interest-bearing M1” – comprising notes and coin in circulation and non-interest-bearing deposits – has the strongest correlation with future output growth. Annual growth in NIB M1 fell well below inflation before each of the three recessions since the mid 1960s but is still higher currently (8.5% in April). However, shorter-term trends are less reassuring: the aggregate is little changed over the last six months, implying a contraction in real terms.
The chart below shows annual GDP growth together with the output of a simple forecasting model based on the above monetary measures as well as interest rates, the effective exchange rate and a measure of credit spreads. The model predicts GDP three quarters in advance and would have signalled the last three recessions. Based on the latest data, it suggests annual GDP growth will fall from 2.5% in this year’s first quarter to just 1.2% by the first quarter of 2009. Taking into account historical forecast variability, this implies a 16% probability of a recession – defined strictly as an annual contraction in GDP – by early next year. The model uses headline M4 growth rather than the adjusted measure discussed above, reflecting a lack of long-term data for the latter. If recent values of adjusted M4 are substituted for the headline numbers, forecast GDP growth falls further to 0.7% in the first quarter of next year, boosting the implied recession probability to 28%.
Market fears of higher interest rates are understandable given that CPI inflation may approach 5% later in 2008 and will remain well above the target until the second half of 2009 (see here for a discussion). However, it is too late for the MPC to affect this prospect and it would be a mistake to try to compensate for policy laxity over 2005-2007 by adopting too restrictive a stance now. As argued above, current monetary trends are consistent with inflation returning to target in 2010 and beyond. If money growth continues to slow over coming months, the MPC should consider easing policy further, even while inflation and inflation expectations remain high, to avoid an unnecessary recession.
