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Monday March 12, 2007 - 11:01:20 GMT
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Economics Weekly: Fast growth in UK M4 implies robust growth, and inflation; Weekly economic data preview: US data this week could dampen market expectations of rate cuts

Economics Weekly:

Fast growth in UK M4 implies robust growth, and inflation

Fast growth in UK money supply and in house prices are usually quoted as two reasons why the Bank of England may still have to raise UK interest rates, despite the fact that base rates were left on hold at the March meeting of the Monetary Policy Committee (MPC). With monetary growth in the broad measure, known as M4, still rising in double digits, 13% in the year to January, the prospects for UK economic growth in 2007 are good but, unfortunately, it also means that the risks to inflation are upwards. We look at which sectors of the economy are big holders of M4 and how this correlates with activity in those sectors and the consequences of these trends for UK economic growth, inflation and interest rates. Our conclusion is that the current rate of growth of money supply is not consistent with stable inflation and implies that UK economic growth will remain above trend this year and hence interest rates are likely to remain high, or rise further, in consequence.

Money matters, a lot
The European Central Bank (ECB) has cited fast growth in money supply as a key reason why it has raised interest rates seven times in the last 2 years. In contrast, money supply has never been quoted by the MPC as a direct reason for moving short term official interest rates, but in fact UK money supply growth is more rapid than that in the eurozone, rising 13% a year compared with 9%. Looking at chart a, it is clear that nominal (volume + inflation) growth in UK gdp and nominal growth in money supply are linked, with the current fast pace of M4 consistent with above trend, i.e., long run average, growth in the economy. Chart b shows that most of this M4 growth in the last few years has been due to the financial sector (excluding banks) and to this extent is thought to be less threatening to general price trends in the economy. Growth in financial sector M4 holding in January this year was just under 25% a year, compared with 13% for companies and just 8% for households. So is this really less worrying for price inflation? Unfortunately, charting the link between price inflation and M4 money supply growth in the same way as for economic growth, shows that the link is actually stronger between inflation and M4 than between M4 and
economic growth. This suggests that it does not matter where amongst the holders of M4 excess liquidity is concentrated it is still - ultimately inflationary, see chart c. Moreover, as chart d shows, the link between financial companies’ holdings of M4 and the movement of the UK stock market is uncanny. Indeed, it is rather worrying, as the last time that M4 holdings of these financial firms was as strong was just before the equity market crash in 2000/1. But the main point we are making here is that higher share prices raise household equity market wealth, making it more likely that they save less, spend more and so add to price inflation pressure by a greater willingness to consume today.

What does company holdings of M4 tell us about the economy?
Chart e shows that business investment spending is likely to benefit from the strong rise in M4 company liquidity, as one would expect, though it is worth noting that in the last few years investment spending has lagged well behind M4 growth, implying that some of this increase was spent on other things (acquisitions and mergers) or deposited with financial institutions. What about household holdings of M4? This appears less worrying. Chart f shows why this is: there has been an overall slowdown - though at just under 12% a year mortgage borrowing remains around three times the rate of growth of average earnings in the UK. However, the real change has been in consumer credit borrowing growth, which has plummeted. Of course, this should be expected, given the background of rising bankruptcy and higher interest rates, that led many debtors to realise that the cost of non-mortgage borrowing is relatively high. But with house prices rising again, it is unclear whether mortgage borrowing growth will not now accelerate as well.

What does the rise in M4 mean for economic growth, inflation and interest rates?
Taking excess liquidity as being the difference between nominal growth in M4 money supply and nominal economic growth, i.e. including economy wide inflation, shows it is at a high level. This measure of excess liquidity is suggesting that economic growth will accelerate further and remain strong, see chart g. Given that the UK economy is in its 15th consecutive year of growth, it is no surprise to see that excess liquidity implies that inflation is under upward pressure. Although chart h shows that excess liquidity is falling from a high level, it suggests that annual consumer price inflation may not fall back to 2% but remain around 2.5%. The chart also shows that UK base rates need to rise further, by at least 0.25% and possibly more, if M4 growth does not continue to slowdown.
Trevor Williams, Chief Economist

Weekly economic data preview

US data this week could dampen market expectations of rate cuts

• After last Friday's solid payrolls report, US economic data this week could further reduce prevailing market expectations of a near-term cut in interest rates. We remain of the view that underlying inflation pressures are unlikely to diminish any time soon, with spare capacity scarce, rising unit labour costs and wages and a possible pick up in economic growth in the second-half of the year. The Fed will be very cautious about cutting rates, with a real risk still that they could hike again.

• US inflation data this week will show underlying price pressures remain well above the Fed's stated comfort level (1-2%). February'core' CPI, on Friday, is expected to have stayed close to 2.7%, while both import and producer prices are forecast to rise. Recent strong employment growth may have supported a rebound in retail sales in February and also underpinned University of Michigan consumer sentiment in March. The dollar could find some positive support this week, should the Q4 current account deficit narrow below $200bn and the Treasury Capital Inflows data rebound.

• The first view of UK average earnings growth in 2007 will attract keen interest on Wednesday, as it is key to any rise in interest rates. We expect wage growth to pick up in the months ahead, underpinned by higher RPI inflation (see chart). The labour market report may also show a fifth consecutive fall in the claimant count in February. The trade data, on Tuesday, could hit sterling, if the external goods deficit topped £7bn in January.

• Euro zone interest rates rose to 3.75% last week and we expect a further hike to 4% by the end of Q2. However, with the ECB likely to be data watching over the next few months, economic news from the euro zone this week may have only limited market impact.

The February US labour market report last Friday underlined the main reasons why we believe US interest rates are unlikely to be cut over the near-term and why they could even rise towards the end of the year. Non-farm payrolls have risen by an average of 156,000 over the past three months, consistent with around 3% trend economic growth, while rising earnings growth and the low unemployment rate suggest overall spare capacity is limited. This suggests that underlying inflationary pressures are unlikely to abate significantly over the near-term and could actually intensify, if economic growth strengthens.

Although there are still some key risks to the economic outlook, notably the downturn in the sub-prime mortgage market and depressed construction activity, recent labour market indicators clearly point to a rebound in economic growth. The challenge facing the Fed will be illustrated by upcoming US data this week. Although 'core' consumer price inflation has eased back from its high in September (2.9%), it still remains well above the Fed's perceived comfort level. Data published on Friday are expected to show the core annual rate stayed at 2.7% for a second consecutive month in February, while the headline CPI rate may have accelerated to 2.5%. Ahead of the CPI release we have February producer and import prices data on Thursday, with higher oil prices expected to lead to a rise in both. We believe continuing solid employment growth and rising earnings should underpin US consumer spending and support housing market activity, leading to faster growth in the second half of 2007. Retail sales data, on Tuesday, should show a rebound in February from January, while University of Michigan confidence, on Friday, should remain firm. Industrial production, on Friday, has declined in four of the last five months but the manufacturing ISM suggests output may have risen in February. Possibly more important for currency markets, Treasury Capital Inflow data for January are due on Thursday, with a strong rebound forecast after foreign purchases fell to their lowest in five years in December. The Q4 2006 US current account deficit, on Wednesday, may be $ supportive, if it is back

UK data this week could offer some clues as to the timing of the next interest rate rise. The labour market report on Wednesday, will show whether the pace of earnings growth has picked up in 2007, a key uncertainty facing the BoE. Anecdotal evidence suggests we could see a strong rise in January. The report may also show another fall in the claimant count in February, already down by 34,000 in the past four months. The RICS survey has been one of the few to suggest slowing house price inflation in recent months and will be closely watched. The external trade data, later on Tuesday, could put some downward pressure on sterling, if the goods deficit again surpassed £7bn in January.

Economic news from the eurozone is limited this week and unlikely to be market moving. The highlight is possibly the German ZEW survey of investor confidence on Tuesday.
Lloyds TSB Bank,
Financial Markets
Faryners House,
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London EC3R 8BQ
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