Economics Weekly
Focus on UK GDP and German IFO Business Survey
UK and eurozone economic data take centre stage this week. UK retail sales for June are due on Thursday, ahead of the first estimate of Q2 GDP on Friday. We expect the economy to have expanded by 0.2% in Q2, compared with 0.3% in the previous quarter, therefore confirming below-trend growth, but not recession. The Bank of England will publish minutes of the July 9-10 MPC meeting when interest rates were kept on hold at 5%. The minutes are likely to highlight downside growth risks, but that rising inflation risks mean there is no room for further policy easing to support growth. In the eurozone, the German IFO survey and the eurozone PMI surveys will be closely examined to see whether business confidence deteriorated. In the US, initial jobless claims, durable goods orders, new home sales and the Beige Book report are among the releases scheduled. Elsewhere, Japan, Australia and Canada will release latest CPI figures, which are all expected to rise, while New Zealand is expected to maintain interest rates at 8.25%, with an outside chance of a rate cut.
The key focus for the UK next week is the first estimate of Q2 GDP, which we expect to show growth at 0.2%, compared with 0.3% in Q1. Retail sales for June should show a correction from the stellar 3.5% rise in May. Overall growth is therefore expected to have remained below trend, which should reduce inflationary pressures. However, rising food and energy prices will continue to push price inflation higher in the coming months, and the risk is that this raises inflation expectations and entrenches what should be a short-term rise in prices. In such an environment, the minutes of the July 9-10 MPC meeting will likely confirm that there is agreement of little room to cut interest rates (with Blanchflower perhaps dissenting from this view) and, indeed, they may have again discussed the possibility of a rate rise. The CBI industrial trends survey is also due and will include the more detailed quarterly survey this month. Overall, we expect the week's events to confirm our view that the BoE will leave interest rates on hold at 5% for the remainder of the year, but that there is a serious risk they may have to raise them.
In the eurozone, the main focus will be on business surveys, including the German IFO, eurozone PMI, and French INSEE surveys. Business confidence could be weighed by renewed financial market turbulence and further oil price rises in the past month, as well as the ECB rate rise on July 3. We expect German IFO to have fallen to 100 in July from 101.3, while the eurozone manufacturing and services PMI surveys may also have weakened. Also due are eurozone M3 money supply and French consumer spending. M3 growth for June is expected to have remained above 10% and, although some of this reflects precautionary demand for money, it nevertheless signals upside inflation risks. The M3 data should also show growth in lending to non-financial corporates remaining robust (14.2% in May), despite the credit crunch, though growth in lending to households has been decelerating for some time.
In the US, there no major big hitters in terms of releases, but market interest will be on durable goods orders, new home sales and final University of Michigan consumer sentiment. The Fed's Beige Book regional survey is also due. We expect durable orders to have risen 0.2%, while new home sales may have remained steady around 510k, adding to signs that the housing market may be stabilising. The preliminary University of Michigan survey for July showed the first rise (albeit a marginal one) in consumer sentiment since January and this should be confirmed in the final release. Initial jobless claims will garner interest ahead of next week's non-farm payrolls. So far this month, jobless claims have averaged 357k, below the 390k average in June, suggesting a smaller fall in employment. Fed speakers in the calendar include board members Mishkin and Kohn, as well as Philly Fed voting President Plosser.
Chart 1: UK GDP is forecast to have risen 0.2% in Q2, reducing year-on-year growth to 1.6%
Chart 2: German business confidence has fallen from last year's highs, but remains above historical average
UK Money Supply Growth Still Too Fast
Many have argued recently that UK interest rates should be cut, despite the recent acceleration in price inflation, because money supply growth is collapsing. We think this view is based on an incorrect reading of recent M4 data. It is true that M4 growth is decelerating but it still remains higher than is consistent with a withdrawal of monetary stimulus from the economy. It is well above its long run average and so still consistent with accelerating price inflation. It thus seems extremely odd for ardent followers of money supply as a guide to policy to be arguing for cuts in interest rates at a time that price inflation is actually accelerating and money supply growth is still above the pace necessary solely to 'fund' economic activity. Cutting interest rates to help induce faster growth would make sense but would be inconsistent with using it to keep inflation low and stable and with a belief that, in the long run, there is no trade off between growth and inflation and that “inflation is always and everywhere a monetary phenomenon.”
UK money supply growth is decelerating sharply...
It is clear that money supply growth is slowing sharply in the UK. From a peak of 14% in the year to May 2007, growth in UK broad money, M4, fell to a low of 10% in May this year before accelerating to 11% on provisional figures for June. Of course, the last 12 months covers the credit crisis and suggests that, thus far, the solvency issues and lack of liquidity in banking markets and massive marking down of financial assets has not led to an outright fall in M4. But chart a shows that it has just taken its growth back to 2006 rates, which at the time were considered as too fast and incompatible with stable economic growth and so inflationary. M4 lending has also not fallen back much from its peak and is not signalling that there is a shortage of liquidity in the economy as a whole.
However, in spite of the June acceleration in M4, there has been a deceleration of 2.5 percentage points over the past year and it is even more observable if one takes a closer look at the breakdown of M4 holdings, chart b. The details of M4 holdings – or deposits – shows that growth for financial institutions, excluding banks and building societies, has decelerated but not collapsed, which might have been expected had there been widespread bankruptcy in the sector resulting from pressures created by the credit crisis. Meanwhile, households M4 deposit growth has remained steady. So the fall in total UK M4 growth from the peak of 14% last year to the current 11.5% seems mainly down to a sharp fall in growth of M4 holdings by the industrial and commercial sector. This rate has dropped dramatically, from over 15% last year to slightly negative in May, implying that industrial and commercial companies withdrew deposits from the M4 banking sector that month. It may be that one of the reasons for the sharp rise in M4 in June is that some of this reversed. (However, we will not know if this is indeed the case until the full breakdown of June’s M4 data are released in early August). But it is one clear sign of the credit crisis which has shut down capital markets, so companies cannot easily issue bonds or rollover debt or are unhappy with the deposit rates being offered relative to lending rates. They may also be facing greater cash flow concerns reflecting weaker trading conditions. However, chart c shows that companies are still utilising bank loans, despite a widening of spreads and reduced loan availability. Indeed, looking at the flow of lending one sees few signs of a household credit crunch, with slower growth in mortgage lending being partly offset by a rise in consumer credit.
...but this fall is not enough to bear down on inflation...
However, the point about monetary analysis is that while understanding what is driving the total growth rate is important, it should not overshadow the overall message that aggregate growth is giving. In this case, the message is that it is still too strong and is inconsistent with stable inflation, never mind falling inflation. This is shown more clearly in charts d and e, which highlight the link between growth in UK M4 and gdp and thence between M4 growth and consumer price inflation. It may not be stable and it may not be the best way of setting policy rates, but there is an association over time that makes looking at monetary data useful in analysing monetary policy risks. Our approach is to consider the excess of money growth over nominal gdp growth.
...the reason is that loose policy created massive excesses, manifested in housing and capital markets...
In a modern economy, with a rising share of financial services in gdp as people get wealthier and age and demand ever more sophisticated financial products to look after their affairs, it is clear that there should be some tendency for M4 to grow faster than nominal incomes. This means that financial services exhibit a growth rate faster than that of average incomes. We have estimated this is consistent with money growth of around 3% above that of nominal gdp. The problem for the UK economy occurs when this limit is breached and does so in a consistent manner for some considerable period. Using this measure of excess liquidity shows a very close link with gdp and inflation and our calculations show that it explains over 3/4 of the variation in gdp and price inflation in the UK in the last 20 years. The issue for the moment and ahead is that excess M4 monetary liquidity has been rising strongly and consistently since 2003. It is in this period that the monetary excesses occurred and manifested in the housing markets and in capital markets. Using this approach it is clear that a sharp rise in price inflation was inevitable, unless reined in by higher interest rates. Charts f and g show that UK interest rates were far to low to offset this rise in excess money supply, and possibly still are.
...it will therefore take a sustained slowdown in the economy to generate a fall in excess money supply to levels that are compatible with stable price inflation.
Our analysis suggests that money supply growth has to fall to under 8% a year and stay there. And, this fall does not preclude the necessity for interest rates to rise from current levels to bring this about. In fact, to bear down on growth and excess money supply, interest rates will have to rise and, on this analysis, should certainly not be cut. So this is why it seems odd for those that like to use the monetary data to help guide policy rates to be calling for rate cuts. Although there has been some slowdown in M4 money supply growth, the evidence is that this slowdown is not enough to warrant a cut in Bank rate and, in fact, suggests that rates should rise.
Chart a: UK money supply growth has slowed sharply, but is still too fast
Chart b: Slowdown due to corporate sector as capital markets shutdown...
Chart c:...but bank borrowing by all sectors is still growing
Chart d: UK money supply and gdp growth are closely linked
Chart e: UK money supply and inflation are closely linked
Chart f: 'Excess' money supply growth in the UK is still inflationary
Chart g: 'Excess' money supply needs to fall much further before interest rates are cut
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