A Few Good Men at the MPC

There are a few good men on the Monetary Policy Committee, who can handle the truth about inflation, but others are wavering and to date two and most likely in February, three members want to carry out a code red on the economy to convince financial markets that they will not tolerate indiscipline for any reason. 

Base rates remain stuck at their lowest rate since the Bank of England was formed (by a Scotsman) in 1694. It is self evident that this cannot persist and the main focus is when rates will rise. We agree wholeheartedly with BOE Governor Mervyn King that rates do not have to rise immediately and that early interest rate increases would be destabilising as the economy endures the most severe fiscal austerity and constraint on real personal disposable incomes since the twenties.

The fifth consecutive quarterly letter to explain why inflation has exceeded the Government’s target provided a subtle but important change in the Governor’s stance when he noted that the balance of risks to inflation at the end of the MPC’s two year forecast horizon were evenly balanced on the assumption that base rates followed the path implied by market rates. Since market rates have discounted three 25bps base rate hikes by the end of year (matching the next three inflation reports in May, August and November).

The Bank’s market rate assumptions predict base rates reach 1.0% by the end of 2011 and further to 2.0% by the end of 2012. Although this is less than current market implied interest rates, it still produces a modal forecast at the end of the two-year horizon of 1.8%. The Bank will release its mean forecast with the MPC minutes next week and this is expected to be above the magic 2% level, albeit only marginally at 2.1%. We expect the minutes, which give proportionately more weight to external members’ views to be more hawkish than the Inflation Report with the vote in favour of stable rates likely to be 6-3 rather than the previous 6-2-1 vote.

In the press conference that followed the Inflation Report, the Governor denied that these forecasts are intended to pave the way for immediate interest rate hikes. In part this reflects the MPC rules that the interest rate decision is taken each month at the meeting and that there should be no pre-announcement. However, it also reflects the Governor’s view that the main sources of inflation are temporary, namely; sterling’s fall in 2008, higher international commodity prices and the impact of consecutive VAT hikes and other indirect tax measures, and consequently inflation will fall sharply during 2012. Indeed, currency weakness was necessary to drive the rebalancing of the economy and any inflation resulting from this cause should be viewed as necessary frictional inflation designed to shift the terms of trade in favour of exports.

Mervyn King is a fanatical monetarist economist and his focus is on money supply growth, lending and wages. For monetarists, inflation is driven by too much money chasing too few goods and services.  The wide (albeit unknown) output gap and weak money supply growth do not support inflation fears. Nominal GDP growth has been higher than predicted by broad money supply growth over the past year, but we believe that this is a temporary product of the Bank’s massive quantitative easing program and as the lagged impact of this unconventional monetary policy fades both nominal and real GDP growth will fade in the second half of the year. We expect the economy to grow by 1.3% during 2011, less than half the pace of a normal recovery, and by 1.5% during 2012. The Bank has lowered its forecast for 2011, but remains overly confident about 2012.

A large degree of this optimism undoubtedly relies on continued strong global growth. The IMF expects global growth to average 4.5% over the next five years, led by emerging economies. We expect inflation to peak in April, but this presents a window of opportunity for the MPC to raise rates in May.  The global economy is likely to match the IMF’s forecast in the first half of the year leading to higher commodity prices over the next three months. This biases inflation to the upside and growth to the downside. Mervyn King is hoping that the threat of higher interest rates will curtail consumer spending wage demands and retailers’ willingness to pass on higher costs.

While a May rate hike is possible, we do not think that it is necessary and have maintained a neutral position in short-dated forward gilt rates, which already more than discount potential rate hikes, and have concentrated our overweight position in longer dated forward rates, which will benefit from renewed structural demand from pension funds and insurance companies.

There are a few good men on the Monetary Policy Committee, who can handle the truth about inflation, but others are wavering and to date two and most likely in February three members want to carry out a code red on the economy to convince financial markets that they will not tolerate indiscipline for any reason.  The MPC voted for unchanged interest rates last week in the knowledge that the Governor would be forced to write a fifth successive letter of explanation to the Chancellor explaining the repeated overshoot of inflation relative to target over the past few years.  The Governor has made it clear that he believes that the current inflation surge is temporary and that it will fall back next year.

The Governor is aware that base rates cannot remain at current record lows indefinitely and his latest letter focuses on the risks of to inflation at the end of the two year forecast horizon will be evenly balanced on the assumption that base rates follow the market profile for interest rates. This is an important change in assessment and has been seized upon by market hawks as proof that rate hikes are imminent. It is certainly a shift from the previous assumption that inflation would be below target on a two year horizon on unchanged base rates. However, Mervyn King’s letter also expressed concern that a rapid move to bring inflation in line with target would cause unnecessary economic volatility and could result in inflation being below target at the end of the forecast period. We view his stoicism in the same vein as St Thomas Aquinas and conclude that he wants to raise rates eventually, but not just yet.

His justification for this dovish stance is well rehearsed and ascribes the surge to the combination of the lagged impact of Sterling’s collapse in the wake of 2008 credit crunch, the rebound in commodity prices and the fiscally inspired indirect tax hikes.  The Governor’s guilty secret is that he believes the collapse in Sterling was a necessary goal to rebalance the economy away from consumption towards savings, investment and exports. He knew that there would be significant pass through from this currency weakness but hoped that there would be some resistance from consumers. He said as much in November 2009 when he gave his famous SOBER speech in which he claimed that the NICE decade of constant expansion, negligible inflation was over and would be replaced by Savings, Orderly Budgets and Equitable Rebalancing of the economy. Indeed, his biggest forecasting error over the past two years was not to anticipate that consumers would run down their savings in response to last year’s VAT hike.

The permanent income hypothesis tells us that consumers do not respond to temporary tax cuts or hikes, any improvement in real personal disposable income is saved rather than spent, but when the temporary tax cuts are reversed the opposite is true with consumers absorbing the additional costs by running down their savings. This is evident in both the savings data and the ASDA real income tracker that highlighted the resilience of consumer spending in the first half of last year, although in retrospect we were surprised just how resilient consumption was during the first half of the year, which contributed to the strength of GDP during the second and third quarters. More importantly, ASDA’s data showed that real personal disposable income turned negative over the summer and this has been reflected in the slowing pace of consumer spending, particularly on consumer services.

The governor is correct to dismiss higher commodity prices as a symptom of inflation. They are relative priced movements and represent a terms of trade shock. The commodity super-cycle notwithstanding, commodity prices are highly unlikely to repeat last year’s performance and while stronger global growth during the first half of the year can propel industrial commodity prices higher in the near-term, we believe that slower global economic activity in the second half as the inventory cycle peaks and the combination of higher market rates and margin pressures from input costs causes growth to slow during the second half of the year. This slowdown is likely to coincide with the withdrawal of emergency funding, provided during the credit crunch in the UK, Europe and the US.

There is a clear separation between prescription and description and it is dangerous for economists to confuse the two. Our prescription is the same as Mervyn King’s, namely that base rates should not be raised in response to temporary inflation, when growth is being constrained by fiscal austerity. King view is further supported by anaemic money supply growth and sluggish wage inflation. There is likely to be a modest acceleration in private sector wages, particularly in manufacturing where demand is strong, but we do not expect this modest increase to fully compensate for higher inflation nor for the constraints in public sector wages or employment. Consequently, we expect real consumer spending to contract during 2011, alongside an expected contraction in real government expenditure.  The 4% January consumer price inflation data is history, monetary policy cannot affect the January data, or indeed the inflation outcome over the first half of the year.

Consequently, we believe that the most important economic release this week will be the retail sales data on Friday. Sales are expected to bounce back in January after the weather related decline in December. The ONS has struggled to produce accurate monthly data and the combination of weather, tax and seasonals will complicate computation this month, but we are assuming that headline sales increased by 0.2% after a 0.3% fall during December, although revisions to December are inevitable. More importantly, these sales were concentrated at the start of the month as purchases bounced back from the severe weather disruptions and prior to the VAT hike. More importantly, we expect sales to have been largely flat over the two months and to slip further over the next few months.

Prescription says no rate hikes for the UK, but description is more nuanced recognising that the balance of opinion within the Committee is gradually shifting towards higher rates. We expect Adam Posen to temporarily suspend his demand for more quantitative easing and vote with the majority and while the minutes of the January MPC meeting found that there were a number of committee members wavering over higher inflation levels. Presumably these were not decisive during February despite prior knowledge of the January inflation outcome although there is a risk that the minutes prove to be more hawkish than the Inflation Report by signalling a 6-3 rather than 7-2 vote in favour of the status quo.

There are two arguments in favour of higher interest rates. First, central bank credibility is a key deterrent to inflation expectations and hence second round impact of higher commodity prices. This argument is favoured by past MPC members, but is easily disputed by reference to the mortgage data. Inflation has been above the Bank’s 2% target for 39 out of the past 48 months, but few would argue that the Bank should have raised rates in 2008 or 2009 and while hindsight and the QE-inspired surge in growth in the second and third quarters may have presented a window of opportunity for the central bank to hike rates. During last year’s fiscal phoney war that prevailed between March and June (during the election campaign and it’s immediate aftermath) there was a chance to raise interest rates when growth was benefiting from the lagged impact of quantitative easing, if only to provide the MPC with room to cut rates when the economy slowed. However, this would have been the central banking equivalent of a futile gesture that the Governor warned against in his press conference.

These calls were reinforced by the qualitative CIPS business sentiment surveys, but the service sector survey in particular exaggerated the bounce back from the weather. The rise from 49.1 to 54.5 was impressive, but surveyor Markit estimated that this was consistent with quarterly growth of 0.4% and consequently, because of the disruption and tax increases the two quarters should be averaged.  This moment has passed and we believe that there is a greater risk to credibility from forcing the economy into a double dip recession.

We believe that it is wrong to dismiss the risks of a double dip. These risks are driven by the housing market and consumer incomes rather than the output gap, which in a service dominated economy, is extremely difficult to measure accurately. The latest mortgage data from the Bank of England suggests that around 70% of the £1.24tr mortgage market is on variable rate mortgages. Forward Sonia rates imply 75bps cumulative base rate hikes in 2011 coinciding with the quarterly Inflation Reports in May, August and November and a full percentage point is priced into base rates by March 2012. 

Banks’ mortgage spreads are very high and there has been some wishful thinking that some of the assumed base rate hikes would be absorbed through lower spreads, but with banks scheduled to repay £110bn of the SLS emerging funding during 2011, with a consequent increase in wholesale funding rates, it is reasonable to assume that retail mortgage spreads will be relatively stable and that a 1% rise in base rates will boost the average floating mortgage rate from 3.15% to 4.15%. Consumers are highly geared to variable rate mortgage increases and based on average earnings; RBS estimates that a full 1% rate hike would cost the average household £1,100 per annum. This comes on top of the VAT and commodity tax increases and in combination would produce maximum contraction of real personal disposable income. We estimate that this contraction would be up to 8% and could not be absorbed into household savings rates.

Indeed, we believe that the Bank has lowered estimates for real GDP growth in 2011 in the Inflation Report to 1.8%, but remains overly optimistic about 2012 with growth expected to exceed 3%. We believe that these forecasts are still too high, but crucially are below the Bank’s own estimate of productive potential. The Bank is also likely to raise its estimate of inflation over the next few months to reflect the greater pass through of commodity prices and VAT. This is also likely to boost the crucial estimate at the end of the two year horizon from November’s low level of 1.6% to 1.9%, just below the 2% target level. Taken together the Inflation Report is likely to be more dovish that the MPC minutes.

The second justification for higher interest rates has greater merit and has been acknowledged by BOE Deputy Governor Charles Bean. This view believes that the global economy is expected to enjoy a prolonged period of above trend growth, led by emerging markets. The IMF expects global growth to average 4.5% per annum over the next five years, which in turn is likely to lead to higher global inflation. In a small open economy these higher imported inflation rates are likely to be reflected in domestic prices. Hawks argue that globalisation led to lower imported goods price inflation in the nineties and noughties, enabling the Bank to run domestic demand at a faster rate in order to compensate for this lower imported inflation. By the same token, the Bank should restrain domestic demand in order to allow the global economy to run at a faster rate and meet its 2% target over the medium term.

This is mathematically possible, but there are two concerns. First, hindsight has proved that the Bank should not have allowed the domestic economy and in particular consumer spending, to grow at a faster rate than domestic productive potential. This contributed to the expansion of both financial and consumer leverage. This was clearly a mistake and we believe that deliberately constraining the domestic economy would be equally misguided.

Our second and most important concern is that IMF forecasts are rarely correct and basing monetary policy on a highly political forecasting organisation is dangerous. In particular, the assumption that the business cycle will be both prolonged and strong is a legacy of the leveraged bubble. We believe that we are in the VILE decade, characterised by volatile inflation and limited expansion. This deleveraging environment of high government debt and weak growth suggests that business cycles will be considerably shorter than the past three decades.

Nevertheless, the medium term global growth outlook is a value judgement and we cannot rule out the risk that another one or two members will be persuaded of the merits of credibility and/or global growth. Consequently, we are tactically neutral short-dated forward gilt rates, but are expecting to go overweight when one of two conditions is satisfied. The most likely condition will be the slowdown of the global economy over the summer, but would also go overweight in the unlikely event of a policy error masquerading as a rate hike.

However, in terms of deploying our risk budget we are determined to choose our battles wisely and are focussed on overweight positions in medium and long dated forwards. The chart below shows that the proxies for these two sectors, the 5y5y and 15y15y rates are above levels prevailing during the leverage bubble, whereas the shorter dated forwards, proxied by the 1y1y are still substantially below historical averages.  Long dated forwards are a proxy for structural demand from insurance companies and pension funds. The Pension Protection Fund’s PPF7800 index proxy for pension fund solvency improved during January to a surplus of £46.1bn from £21.7bn at the end of December as the funding ratio improved from 102.3% to 105%. Furthermore there were 2,864 out of a total of 6,560 schemes in surplus. Structural demand for long dated forwards has been conspicuous by its absence since the start of the credit crunch.

Our Bad Santa model, which combined the FTSE All Share index and the forward 5yr gilt yield in 20 years time and has a 69% correlation with the PFF7800 index shows a sharp drop in the yield over the past few days. This is consistent with reports in Monday’s FTFM magazine detailing the results of a study by Aon Hewitt of 200 defined benefit pension funds, which showed that nearly three-quarters of these funds intend to de-risk their liabilities over the next decade.

The argument in favour of medium dated forwards is less obvious given the outlook for strong global growth over the next few months, but the latest survey of global fund managers by Bank of America Merrill Lynch suggests that investors have already more than discounted this liquidity driven activity.  The survey suggests that institutional investors already have record equity and commodity overweights in their asset allocation and the strongest risk appetite since January 2004 and near record low exposure to fixed income. At the same time, just 13% of those surveyed expect the global economy to slow over the next twelve months, whilst inflation expectations have surged over the past month to 75% to reach their highest level since June 2004 and by implication surpassing the summer 2008 commodity price spike. These extreme levels of investor sentiment support our modest overweight in medium dated gilt forward interest rates. Sterling remains biased stronger over the next few months as inflation continues to accelerate towards its April peak and real activity is resilient.  We believe that the currency could reach as high as $1.65 matching the January 2010 high, but slower inflation and real activity in the second half of the year will undoubtedly cool interest rate expectations and with it Sterling’s value against the Dollar.

Download the full version of Stuart Thomson’s journal