Equity Markets fall heavily whilst the Bank of England’s Quarterly Inflation Report disappoints again

Yesterday turned into the morning after the night before as markets appeared to revise their opinion on the FOMC statement. This was combined with reaction to poor US balance of trade figures and led to a day where equities fell heavily,US government bond yields fell again and currencies swung wildly. The US Dow Jones Industrial Average opened heavily down and ended up some 265 points lower and European equities fell heavily too with the UK FTSE 100 dropping 131 points and the German Dax fell 132 points. This is another stage in a long running saga as we seem to be repeating a cycle of heavy falls which are then recovered over time and when you look at the index levels we appear trapped in a range for now.

US Balance of Trade Figures

On a one month basis these were disappointing as a trade deficit of US $49.9 billion was a fair bit worse than the expected repeat of Mays US $42 billion deficit. The detail on the numbers appear to indicate rising imports as the cause as they rose more quickly than exports. Regular readers will be aware that I think that any individual months trade figures are very unreliable so I looked further into the figures.

Looking at the three-month average for the US trade deficit I found that it is currently US $44.1 billion and that this figure has been rising steadily but unevenly since the recent low back in June 2009 when it was US $27 billion. So a worsening trend there. If you compare the trade deficit in  first six months of 2010 which was US $247.5 billion with the first six months of 2009  which was US $170.9 billion again you are left with the idea of a worsening trend. Looking at the individual figures for this year at -35.1;-40.1;-40;-40.3;-42; and now -49.9 (all in US $ billions) one is again left with the idea of a worsening trend.

Now even looking back a year does not give you trade figures which are completely reliable,in my view, but the statistics on this occasion do appear to back up the monthly figures. Whilst there are plainly issues for the US in an increasing trade gap there is also one fundamental point. The causes of the credit crunch are considered to be associated by many with imbalances in the world economy leading up to it. One of those was the size of the US trade deficit and the corresponding surpluses elsewhere in the world. If you believe this to be true then one of the causes appears to be back, a bit like in the horror film The Shining when Jack Nicholson cries “Here’s Johnny”.

A Follow-on impact for second quarter growth in the United States

There is a corollary in these trade figures for the numbers that the Bureau of Economic Affairs produced for second quarter economic growth which were 2.4%. The BEA would have assumed that the trade figures in June would have been similar to May’s so there will be a downwards revision from this. In addition we have seen poor durable goods figures and revisions to past data and also questions over inventory levels. So when we get the revised figures from the BEA they look like they will be revised down possibly substantially. The way that America presents annualised figures will exacerbate this as for example we would represent their growth as 0.6% for the quarter so a fall of 0.3% on that basis which is quite conceivable now would reduce growth to 1.2% on the US measure.

Should this take place the US economic growth would go 5%,3.7% and then 1.2% which would feed fears of a slowdown and possibly the famed “double-dip” and could easily unsettle markets.

US Treasury Bond yields

These fell again yesterday across the spectrum with the only exception being the two-year which as decided that 0.5% is low enough for now. The five-year dipped to 1.42% and the ten-year to 2.68%. I like to stop when I read these numbers and imagine what buyers of these bonds must think the economic future is going to be like for them to be willing to accept which I consider to be extremely low levels of income and it does not make for comfortable thoughts.

The thirty-year yield has been the most volatile as the original use of longer term in the FOMC statement made investors think it was included in the new Fed moves and then the press release said it was not as the range was from two to ten years. So down for yield and then back up followed by an announcement from the Fed yesterday which had on the 26th August programme maturities out to 5/15/2040. Investors will not enjoy taking part in this version of the hokey cokey and the Fed needs to be more professional than this. Anyway the yield is now 3.93%.

The Bank of England’s Quarterly Inflation Report

This report was awaited on several fronts. The first was that revisions were expected to the Bank of England’s forecasts as they were out of line with general consensus views. The second was how the Bank of England would address the fact that its economic forecasting record has recently varied between poor and completely inaccurate. Thirdly would it address the fact that if its forecasts are wrong and it bases policy on the forecasts then its policy has been wrong too? Fourthly how long will it maintain official interest rates at the historically low-level of 0.5%.

Forecasting Revisions

We got the expected downgrade in expected UK economic growth with it falling from 3.5% to 3% for 2012 as an example.

The most likely outcome for GDP growth is lower than in the May Report, reflecting the softening in business and consumer confidence, the faster pace of fiscal consolidation and a slower improvement in credit conditions.

We also got a raising of the near-term inflation forecast which is now expected to be above target for the rest of 2010 and all of 2011.

Inflation is likely to remain above the 2% target for longer than judged likely in May, in large part reflecting the increase in the rate of VAT to 20% in 2011 The forthcoming increase in VAT was expected to keep CPI inflation above the 2% target until the end of 2011. 

In a clue to the consensus view on the Monetary Policy Committee I notice that in two-years time inflation is (conveniently) predicted to fall back to 1.5%. So we get the answer to point 4 above, there is no planned move in official interest rates for quite some time, apart from one dissenter Andrew Sentance. Unless events  overtake the MPC then interest rates will remain where they are well into 2011.

Is the MPC concerned by the fact that inflation has mainly been over target?

It says that it is concerned by its record but when you look at its actions and the way this Report is written I believe one has to question this. Let me start with a quote from the Report I agree with.

But the MPC is very conscious that there are significant risks to that view – notably, the possibility that the continuing experience of high inflation over the next year, coming after several years during which inflation has been above the target for much of the time, might cause inflation expectations to rise. If that were to occur, it would be costly to bring inflation down again.

followed by a quote which I partially agree with.

The crucial issue for monetary policy is the extent to which elevated inflation is likely to persist

Whilst this is correct monetary policy also needs faith that if elevated inflation is likely to persist then the MPC will realise this and then act. However this in my view is where things fall down. The Report is full of excuses and statements which are only partially true. For example

Over the past three years, a series of sharp movements in relative prices have led to more volatile inflation than in the preceding ten years.

This sort of statement gives the impression that the moves in inflation have been balanced and two-way. In fact a brief dip has been followed by consistently high inflation and Spencer Dale’s ( an MPC member) recent interview where he pointed out that inflation had been over target for 41 of the last 50 months comes to mind.

So to my mind the MPC is still not fully addressing this issue.

Implications

In his webcast accompanying this Mervyn King made some revealing points. I notice that he used the phrase “with the benefit of hindsight” when talking about critics. Also when he was asked an excellent question “would your decisions have been any different if you knew what you know now” he waffled and ducked it. The significance of this question was that implied in it was the point that the Bank of England’s forecasting record has been shocking and that if the MPC bases its policy on it as it says it does then the policy has been as wrong as the forecast.

The main implication is that the consensus view on the MPC is to keep rates low at 0.5% and they are more likely to ease further by for example indulging in more asset purchases or QE than tighten policy. At what point they would consider inflation dangers to be high enough to be worthy of a response remains undefined.

Bank of England forecasting

There has been a lot of debate over this. Not only because of its inaccuracy but also because of the way it presents it. I took a look at its forecast for UK economic growth on its fan chart and gave it a “sense check”. When you look at the range from -0.5% to 6% for 2012 you hit a problem. You see UK economic growth has very rarely exceeded 4% but from it we are expected to believe that 5% or 6% growth is more likely than say -1%. Mathematical symmetry is not particularly appropriate here. I will leave you to think for yourself which is actually more likely in reality.

Coverage of the Report

I watched some coverage on Sky News where an economic reporter said that “cynics” would criticise the Bank of England’s performance. I thought about this as his definition of cynic presumably included me! Quickly this was replaced by the question is it not much more cynical to pretend that everything is okay when in fact there are serious problems and issues?

 UK Unemployment and Employment

The Office for National Statistics produced numbers yesterday which on the face of it were good but still disappointed a little. On the good side the quarterly labour market survey reported that employment rose by 184,000 in the three months to June and unemployment fell by 49,000 to 2.46 million. However in a trend that has been apparent for some time the quarterly increase in total employment was mainly driven by part-time workers, which increased by 115,000 on the quarter to reach 7.84 million, the highest figure since comparable records began in 1992. Also the fall in the monthly claimant count at 3800 was less than expected.

So overall good but as we move forward and we see public-sector job cuts then the picture will be more mixed and unemployment may rise again.