Chief Economist's Weekly Brief – 11 May 2009

Central banks in the spotlight

Last week was a busy one for banking announcements, but it was central banks that stole the show. The US Fed returned a verdict of “must try harder” with banks’ test results, the Bank of England opened its wallet, saying it would spend even more, and the European Central Bank threw caution to the wind announcing its own version of unconventional policy.

The Bank of England extended its asset purchase scheme while keeping rates at their historic low of 0.5%. At its monthly meeting last week, the UK’s Monetary Policy Committee increased the size of the kitty earmarked for purchasing assets by another £50bn. This came in addition to the £75bn announced in March, three-quarters of which has already been spent.

A significant improvement in business survey results were the most striking piece of good news in the UK. The composite PMI, the most reliable business barometer for the manufacturing, service and constructions sectors, came in at 47.8, up from 44.6 in March. This figure still implied that overall activity was declining, but was doing so at a much more modest pace than before. Marked improvements in new order books were particularly encouraging. Unfortunately, the severity of job cutting did not significantly abate.

Federal Reserve Chairman Ben Bernanke was noticeably more upbeat in his testimony to the US Joint Economic Committee as the flow of ‘green shoots’ data continued. The ISM non-manufacturing survey, a measure of conditions in the services sector, rose substantially in April. At 44, the headline index remained well below the 50 mark that separates expansion from contraction, but the new orders index, a forward-looking indicator of activity, jumped to 47. However, conditions in the labour market continued to deteriorate: non-farm payrolls decreased by 539K in April, bringing the unemployment rate within a whisker of 9%.

The much-anticipated results of the banking sector stress tests were something of an anti-climax. The 19 banks tested hold two-thirds of the assets and more than 50% of the loans in the US banking system. Regulators used an “adverse scenario” of a 3.3% decline in GDP in 2009, and an average unemployment rate of 8.9% this year (which now looks optimistic), and 10.3% in 2010. The results showed that losses could total $600bn over two years and that ten US banks need to raise $74.6bn between them. The government has given banks until June 8th to develop a plan to raise cash from private investors, otherwise it will step in and take a larger stake in troubled institutions. In the short term at least, this should reduce uncertainty in financial markets.

The European Central Bank cut its headline interest rate by 25bps to 1%. More significantly, it announced it would embark on a bond purchase programme to the tune of €60bn. This put to rest questions as to the ability of the ECB to buy assets, though whether these will be public and/or private bonds, and from which euro area country won’t be known till June.

Signs of stabilisation in the euro area kept popping up. Whilst too early to say conclusively, data out last week suggested a moderation in the pace of the recession. The improvement in Eurozone PMIs was sustained for another month in April (though gains were slight), and German factory orders rose 3.3% m/m in March, the best outturn since October 2007. Industrial production in Europe's largest economy held steady following a sharp slide over the last six months. However, signs of improvement were not universal: bankruptcies in Spain quadrupled compared to last year and the rate of decline in industrial output accelerated to -25% y/y.

In Japan, the first stage of “quantitative easing” is taking effect. Many feared that the Bank of Japan’s efforts at printing money would simply lead to commercial banks “hoarding money” by stashing the cash at the central bank, with no real impact on the wider financial system. There are encouraging signs that money is finding a way through, as current account balances have been rising strongly, accelerating to 9% m/m in April. This has yet to translate into a meaningful boost to spending or production. Policymakers will be desperately hoping that it starts to have an impact soon, as data releases for March have been dreadful. Unemployment saw its fastest m/m rise since 1967, while a second month of falling prices suggested that deflation is returning.

Crude oil prices benefited from increased optimism, remaining close to $58 per barrel after starting the week at $52pb. The recent strength reflects the same upbeat sentiment that has also helped equity markets in the wake of last week’s US banks’ stress test results. Overall, recent economic indicators have suggested that the drop in output is at least slowing, suggesting that demand growth for oil has bottomed out. In stark contrast to sentiment, actual demand fundamentals remain extremely weak. Four-week oil demand in the U.S. is the lowest in almost ten years and stocks are close to 19-year highs.

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