By Ambrose Evans-Pritchard, Telegraph.Co.UK | 26 June 2008
Britain's lonely band of monetarists fear that the Bank of England will trigger a severe crunch if it overreacts to the inflation spike and keeps interest rates too high as the downturn gathers pace. An abstruse and little-understood measure of the money supply— "adjusted M4"— is flashing serious warning signals of distress over coming months, replicating a pattern that led to a vicious slump in the early 1980s. The M4 money data— which includes a wide range of bank accounts as well as cash— often gives advance warning of major shifts in the economy.
Simon Ward, New Star's chief economist, says the growth rate of M4 holdings of corporations (excluding banks) has plummeted from 16.1% a year ago to 1% in April. Past falls of this kind have heralded economic contraction. It is the speed of the decline that matters most, rather than the absolute level. "This slowdown is contributing to a dangerous liquidity squeeze on companies. We're not in a recession yet, but it is approaching rapidly," he said.
"It would be disastrous if the Monetary Policy Committee tried to over-compensate for their errors in 2006 and 2007 by tightening too hard now," he said. Leading monetarists such as Professor Tim Congdon from the London School of Economics warned three years ago that surging M4 growth would lead to a property bubble and inflation. This is exactly what occurred, although a surge in global food and oil prices have been a crucial factor.
Mr Congdon say the risk has now inverted as the credit crisis eats into bank lending. "The money supply is plummeting. This is potentially serious," he said. The warnings come amid a flurry of gloomy reports from City banks. Lehman Brothers warned that UK house prices would fall 28% from peak to trough, the grimmest forecast to date. BNP Paribas said the UK faced a "significant risk" of a deep and protracted recession.
The Bank of England says the overall M4 figure— growing at 11.1%— is distorted by strains in the interbank markets. Once this effect is stripped out, the M4 growth rate is down 16% a year ago to 4.5% in the first quarter. The money markets have already begun to price in two to three rate rises this year, so some degree of tightening is already happening. "A rate rise is out of the question. The Bank may soon need to start cutting," said Mr Ward.
The Bank's Governor, Mervyn King, pays close attention to M4 data. This might explain why he has played down the surge in inflation to 3.3% in May, the highest since the Labour era began. Mr King's letter to the Chancellor, Alistair Darling, stressed that the commodity spike was "not the same as continuing inflation" and that there was no sign of a broad-based jump in wages. "In recent months the growth rate of the broad money supply has eased and credit conditions have tightened. This will restrain the growth of money spending in the future," he wrote.
It is less clear whether the MPC fully agrees with him. Economists are deeply split over the balance of risks in the world as the commodity boom and imported inflation from the emerging world collide with an economic downturn in the West. Hawks fear that Britain is on the cusp of a 1970s wage price spiral: doves fear a deflationary crunch that may lie beyond as the triple effects of the lending squeeze, the housing slump, and the global slowdown all combine to send prices into a sharp fall.
BoE: Stubborn As Economy Melts
June 06, 2008
The Bank of England (BoE) remains fixated on inflation risks and opted to leave the official Bank Rate unchanged at 5%, as expected.According to the BoE's May Inflation Report, the central bank sees the risks in the current macro environment as very asymmetric, with inflation posing a significant threat and weak but manageable downside for growth. We disagree with the central bank's assessment and hold a much more bearish outlook for growth. Indeed, the latest macro data suggests that the economy is deteriorating rapidly. Real estate prices are already plunging faster than our models had warned, with Nationwide house prices down 4.4% YoY and commercial real estate price inflation contracting at a double digit pace.
Consumer confidence continues to drop to new cyclical lows and the PMI services index has slipped below its boom/bust line. While retail sales volume growth has held up reasonably well, this is largely due to aggressive price discounting and our models warn that dramatic headwinds are building. In turn, it is likely that consumer price pressures will ease in the coming months.
Bottom line: Stay overweight gilts within a global hedged fixed income portfolio. The BoE is making a policy mistake by remaining hawkish and will be forced to play catch up later this year.
Normxxx
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