Delusions Of Grandeur

By Paul Warner, 6 September, 2016

Economists and central bankers forget at their peril that an economy is driven as much by psychology as it is by their mathematical calculations. According to Mark Carney as he addressed the Treasury committee of MPs, it was the swift action of the Bank of England which was responsible for the bounce in August's surveys of businesses and consumers. We would suggest that it was the speed with which we had a new Prime Minister and the confidence that she imbued. As we said last month, with a 52% vote to leave the EU, we had a good proportion of the population who believed that things would get better because of the vote. The swift coronation of Theresa May gave confidence to those that voted to remain that a calm hand was on the tiller, and that the process of withdrawing from the EU would be done in an ordered manner. Whether this actually happens is not relevant, as long as the population believes that things are under our control.

How Mr Carney believes that the Bank’s actions gave confidence to the consumer to go out and spend, we have no idea. Only days after the cut in interest rate we saw a leaflet from NatWest entitled “our old and new interest rates explained”. If you had £25,000 in their Premium Saver account your rate of interest has been cut from 0.75% to 0.25%. Under £25,000 your rates gone from 0.1% to 0.01%. Is it no wonder that 'the man in the street' feels that QE has done nothing for him. No doubt Carney would argue that the decision to buy corporate bonds will make borrowing cheaper for companies. Whilst this is true for companies large enough to use the  bond market, for small businesses we doubt that any of the Bank’s measures will have raised their confidence levels. We are not sure that a small company wanting to borrow £10,000, who now saw the cost of that drop by £25 a year due to the cut in interest rates (that is if they were very lucky and the rate drop was passed on) would have received a significant boost to their confidence.

We have been talking to Simon Ward, the chief economist at Henderson and a highly respected monetarist who has been good at forecasting future GDP growth and inflation trends using his monetarist techniques. About 18 months ago we were talking to him about the velocity of broad money. Readers may recall the equation MV = PT, where M is money supply the V is velocity of circulation, P is price level and T is transactions or output. There has been a long downtrend averaging 2% a year of the velocity of money since the 1960s. This was due to people getting wealthier so the money supply grew more rapidly. Since the financial crisis the velocity of money has stopped falling and stabilised. Monetary growth (M) has been growing strongly for some time. Without the offsetting decline in velocity, to a monetarist this means that nominal GDP (PT) will also rise by the equivalent of the rise in monetary growth. The fall in the exchange rate will be the catalyst of the pickup in inflation driven by monetary growth. It is therefore quite plausible that the 7% growth in M4ex money supply will eventually cause nominal GDP to rise by 7% per annum. M4ex has risen 14.7% annualised in the last three months. Simon therefore believes that the MPC is gambling that the Brexit shock will cause this recent monetary pickup to reverse.

Simon said that unless there is a sharp drop in money supply, (there was no sign of weakness in the July only data), we can expect growth and inflation to start to rise over the coming months. No doubt this will initially be greeted by the Bank of England enthusiastically, telling us how clever their actions were. It was only 12 months ago that Carney was warning markets that the next move in interest rates would be upwards. Now we have the Bank warning us the next move will be downwards. If the monetary growth does feed through into a pickup in nominal GDP, how long will it take the Bank to change its tack again? We could also get Philip Hammond in his first Budget loosening the fiscal strings in order to promote growth, and potentially adding petrol to the flames. This has important implications to us as investors. If inflation starts to rise, and most economists expect this due to the falling pound, how can bond investors be happy with 10 year gilts yielding under 0.7%? The question for equity investors is how quickly will bonds adjust? Hopefully, it will be a slow process helped by the fact that the fall in the pound will be seen as a one-off. If however bond markets take fright, we could have a repeat of 1994 when a sharp rise in gilt yields (fall in price) took equities down sharply as well.

One of the things that we have questioned for a long time is how continually pushing interest rates downwards is actually beneficial for economic growth, bearing in mind that the consumer represents nearly 70% of the economy. Simon was very helpful in giving us some links to the data we were looking for on the Bank of England's website and the Office for National Statistics (ONS) website. The Banks very own figures show that the amount of money held by the household sector was £1,326bn in July. On the other hand, the amount of money borrowed by the household sector was £1,295. This means that an equal percentage fall in deposit and lending rates will now result in a larger loss to savers than it would a gain to borrowers. The amount of money saved versus the amount borrowed became greater in 2014. From the ONS website, we find that annual interest receipts for households have fallen from £44bn in 2007 to just £16bn in 2015. That's a fall of £28bn. At the same time payment of interest by households fell from £95bn to £59bn, or a fall of £36bn. On the face of it this looks good as it looks like more has been gained by the falls in interest rates. On top of this, it has always been thought that borrowers have a greater propensity to spend. Whilst this may be true, in percentage terms the saver has seen their interest earned fall be 63%, whereas the borrower has seen their total payments fall by 38%. So it is arguable that letting interest rates drop by so much is hampering a large part of the population’s (savers’) ability to spend. It is no wonder that there is such a growing groundswell of opinion that thinks they have been economically left behind.