Thursday 23 October 2008

Here’s That Rainy Day

Like the visitation of a medieval plague, Recession seems to have returned to our shores. These events are rare. So what exactly is a recession? I quite like Christopher Dow’s (Major Recessions, Britain the World, 1920-1995, OUP, 1998) definition of a fall in the level of GDP in one year compared to the previous year. According to Dow we only had five major recessions in the post-WW1 20th century (three after WWII) and it looks as though we are about have our first of the 21st century. In a book which will now be re-read, Dow finds that in these recessions, which typically have duration of around 1-3years, the level of output typically falls by up to 10% below the level it would have arrived at if trend growth was maintained. (He attributes around half this fall to a reduction in productivity.) During these episodes unemployment typically rises by up to 3-4% points.

A key additional finding is that recessions seem to have been unpredictable in real time, reflect changes in demand as much as any supply reductions and occur nearly simultaneously in major economies. Clearly the simultaneous occurrence of negative growth across economies might well be a candidate explanation for the severity, as trade multipliers will be running at full pelt. I do not know whether this recession will be a major one or not but the extent of the fall today in Sterling (closed on 22nd October 88.3 compared to previous day at 90.4 with Sterling falling over 6c against the US$ alone) and in the equity index (FTSE-100 and FTSE All-Share both fell by over 4%) suggests that the financial markets expect both a strong negative domestic interest rate response, which drags down sterling, and a large fall in corporate profitability, which drags down the equity index (recall that equity prices should be present value of expected corporate profits, which are in return a function of output).

In a speech on Tuesday, the Governor of the Bank of England gave two reasons for the recession. The credit market shock, which has deprived household and firms of liquidity against their collateral in some degree and so reduced demand, and a global price shock to fuel and commodities that has reduced household disposable income, rather like a large unanticipated tax rise levied by a foreign government. I suspect the financial shock has another consequence. The impecunity of the UK household balance sheet has been exposed - as perceptions of net wealth have been eroded with sustained falls in asset prices. And this means that the UK private sector balance sheet, currently well in deficit to the tune of around 5% of GDP, is certainly even more in need of a sustained bout of savings, which will surely reduce demand further.

Each of these arguments concern demand and so can, to some extent, be offset by appropriate interest rate policy. The Table above dates the trough and peak in the business cycles around the time of Dow’s major recessions. I also note level of policy rates at around the same time with their nearest peaks and troughs.

The peaks in interest rates occurred sometime after the business cycle peak but there is no clear pattern in the interest rate troughs (as in the most recent recession, policy rates were constrained by ERM membership). When inflation was more of a problem, in the earlier recessions, interest rates did not move especially far in proportional terms – falling by around 25-30% of their peak value in both cases. But when inflation was reasonably under control, as in the most recent recession, interest rates fell by a much larger fraction, by around 65%. If we mechanically apply these boundaries to the current scenario, we arrive at a corridor for base rate at 4.00% to 2.00% as the floor this time round. Clearly the current consensus is for inflation to reduce radically as commodity prices fall in response to lower world demand and the increasingly large negative UK output gap drives down pricing power of firms.

And so we might conclude for the moment that the markets have priced more of the latter scenario in than the former and hence the large exchange rate and equity price responses we have observed. But as ever we shall have to wait and see what that rainy day actually brings.

1 comment:

NightBlue said...

This weekend I spent most my time by exploring the Bank of England`s September 2008 report on monetary and banking statistics.

The first thing takes my attention is the capital level of the UK banking system. According to the table B.1.2, the liability of the system is £7,3trillion at the end of August 2008. The corresponding capital level is £139 billion. The ratio of capital to assets is only 1.8. The same ratio was as 1% in August 2007. This partly highlights the persistent high spreads in the interbank market. The more real estate prices are eroding, write-offs are increasing and the value of assets is melting the more the net worth of the sector is decreasing and going into insolvency. As a result of this insolvency risk, banks are offering high borrowing rates. Furthermore, as the report indicates, they do not have many choices to deal with the risk, except with the money injection by the monetary authority.

The second thing is that the total sterling amount of the sight and the time deposits of the UK banks rose from £370 billion in June 2005 to £612 billion in June 2007 without any hesitation in the trend. When the liquidity is raining from the sky to the vaults of the banks, they did not reserve sufficient cushion against a financial shock. The amount of two most liquid items of the assets-notes and T bills- decreased from £19 billion in June 2005 to £17 billion in June 2007.

The third thing is that the UK residents` response to the market crisis is very timely and strong. The amount of time deposits decreased from £463 billion in August 2007 to £147 billion in September 2007, whilst the sight deposits decreased by £68 billion in the same period. Briefly, the UK banks` liabilities eroded £384 billion in one month. How did the banks respond this squeeze? The answer is: they implemented the costliest way: reduced loans. The market loans were diminished from £640 billion in August 2007 to £249 billion in September 2007. The response of banks in their assets is covering the squeeze in liabilities.

However, the breakdown in bank lending has some negative effects on consumers and corporations (and in turn for the financial system) by leading a recession. Tight lending conditions are creating a tight monetary environment without a tight monetary policy implemented by the Bank of England.

The analysis of the report reveals that UK residents` confidence do not turn back yet. The amount of time deposits has decreased by another £36 billion to £111 billion in August 2008. The amount is still far away from its` 2004 level which is £191 billion. The current situation is affecting consumers in two different ways: Consumers are implementing defensive behaviours due to the serious declines in value of their largest single asset and tight credit conditions.

If consumers do not lend their savings to banks, how the banks can increase their lending? Maybe the policies address to the improvement in consumer confidence and spending might be more effective than the implementation of monetary policies.

We have still one 1 point to go in interest rate responses: Interest rates decreased till 3.5% in 2003 and the inflation was 1.3% in that year. Today, we have 4.5% interest rate but the inflation rate is 5.2%. The high level of inflation rate is narrowing the Bank of England` s playground, so it has a limited opportunity to decrease it further.

If the authorities can achieve to foster consumer confidence and spending, the monetary policy can be used as a nominal anchor: The relatively high interest rates will break the expansionary powers and balance the growth.