Open Nav

Normalisation will be far from normal

Markets have cried wolf on normalisation before, and they could again.

At the most recent meeting of the IEA Shadow Monetary Policy Committee I voted for a quarter point rate rise for the first time in a decade. But even as I was doing so, I had my doubts. You might wonder why, given that Mark Carney gave his biggest hint yet, last week, that interest rates are set to rise, with his remarks that “some withdrawal of monetary stimulus” could be required to bring inflation back towards its 2% target.

Here are my 3 reasons for doubting that normalisation in the UK (over the next 12-18 months) will get beyond a quarter point increase and may not even reach that.

First, the Bank of England’s M4x measure of broad money supply growth has noticeably weakened – having strengthened last year. The latest year on year growth rate was just 4.5%. Last time I checked, every interest rate rise in the past 30 years was made against a backdrop of double-digit growth in the broad money supply. Of course, past performance is not necessarily a guide to the future, but if sub 5% growth in the money supply continues, the inflationary threat will recede.

Interestingly broad money supply M3 growth in the Euro zone has also weakened to 4.5% (yr-on-yr), and M3 shadow stats for the US show sub 5% (yr-on-yr) broad money growth as well. This is not the backdrop for an acceleration in growth and inflationary pressure.

Second, as I’ve discussed before in this column, auto enrolment has the potential to slow the UK economy in the first half of next year. In April of next year employee contribution rates will increase from 1% (on qualifying earnings) to 3%. The employer contribution rate will also increase from 1% to 2%, and this is likely to take the edge of pay awards as employers attempt to keep total employee costs under control. Around 8.5 million eligible job-holders have been enrolled into an auto enrolment pension scheme. The full macroeconomic impact is difficult to ascertain, but there will be a withdrawal of consumer spending power. For somebody with £25,000 of qualifying earnings above the baseline threshold, the extra 2% employee contribution would amount to £10 per week.

Third, the macroeconomic icebergs are still lurking out there. US equities look very expensive. The euro-zone crisis could yet return via the Italian banking system. And possibly most significant of all is the risk of a China crisis. The IMF has warned of “dangerous” levels of debt in China. Total domestic non-financial sector debt has reached 250% of GDP and based on continued 6%+ GDP growth is projected to hit 300% of GDP within a few years. The household debt to GDP ratio in China has tripled to 46% over the last decade and there is clear evidence of a consumer lending frenzy, with total outstanding yuan loan growth around 13% (yr-on-yr) and short term consumer credit soaring by three times this rate. This could all end in tears. Managing a hitherto unexperienced credit cycle is a new and significant challenge for the authorities, who are simultaneously trying to maintain GDP growth and double the size of the economy between 2010 and 2020. If things do come unstuck, Chinese growth could slow sharply and provide a significant deflationary impetus to the world economy.

Markets have cried wolf before on normalisation, and could do so again.