Weekly Economic Commentary

The change at the top of the Bank of England comes at a delicate time

June 7, 2013
by Carl Tannenbaum and Asha Bangalore

View PDF version

The change at the top of the Bank of England comes at a delicate time
• The May U.S. employment report will not sway the Fed either way
• Eurozone and China PMI reports – interpret with caution

Not long ago, I was speaking with a leader from the Bank of England (BoE) about the Federal Reserve reaching its 100th birthday this year.  It is a milestone that I thought worthy of celebration.  He politely acknowledged the centennial, but noted that his organization was founded in 1694.   Americans simply cannot compete with Europeans in a history contest.

Yet both central banks have evolved considerably from their initial designs.  Once relatively anonymous, leaders of the two institutions have become well-known figures, with much expected of them.  They are tasked with promoting growth, limiting inflation, securing financial stability and keeping an eye on currency values.  Not the easiest of optimization problems.

So the upcoming leadership transition at the Bank of England has attracted a good deal of attention.  The outgoing governor has been an important fixture on the global scene for many years, while the incoming governor is the first non-Briton to ascend to that post.  And the handoff comes amid delicate economic times in the United Kingdom.

Mervyn King’s tenure at the Bank of England covers more than 20 years.  That interval spans the creation of the euro, Britain’s decision to opt out, the global financial crisis and the implementation of non-traditional monetary strategy.  King was among those who identified the excesses in housing 10 years ago but was unable to prevent a disorderly unwinding.

Since the financial crisis, the UK economy has struggled to find its footing.  A “triple-dip” recession was narrowly avoided when gross domestic product (GDP) grew (albeit very modestly) in the first quarter of this year.  This certainly cannot be laid at the feet of the Bank of England; the austerity program undertaken by the coalition government and the poor performance of the eurozone economies have generated powerful headwinds.

Weekly Econ Commentary 06072013 Chart 1
 
The spending reductions passed by Parliament are the harshest in 80 years.  The stated aim has been to get government debt held by the public, which currently stands at about 75% of GDP, onto a declining path within five years.  Yet the severe economic costs of the program have led policy-makers to lengthen their target timelines to limit further damage. 

This seems to be the right call, given that the United Kingdom is having little trouble financing itself even after a debt downgrade earlier this year.  Unemployment has stabilized, at a level (7.8%) that is high by British standards but much lower than joblessness in most European countries.

The poor performance of the eurozone has also been a substantial limitation.  Exports make up about 30% of British GDP, and roughly half of them go to fellow members of the European Union (EU).  Demand from the continent has been soft, and the appreciation of the pound against the euro has not helped.

Weekly Econ Commentary 06072013 sidebar 1For most of the last generation, EU members generally viewed positively the linkages within the EU. Freer trade and freer movement of labor both worked to Britain’s benefit.  But the financial crisis led many nations to reevaluate the merits of association.  Prime Minister Cameron assailed the cost of EU administration, and the potential for financial and economic contagion shows the downside of close ties.

Despite a promised referendum on continued association, few think the United Kingdom will ultimately withdraw.  Businesses attracted to Britain because of modest taxes, excellent infrastructure and educated labor might reconsider their decisions if it became harder to move goods and people in and out of the country.  The possibility of referendum may, however, win some leverage in discussions over the terms of Britain’s EU membership.

As is the case in other countries, the United Kingdom’s central bank tried to compensate for the limitations of fiscal policy.  With interest rates standing at their lower bound, the BoE implemented several rounds of quantitative easing.  Mervyn King would have liked even more of this medicine but was out-voted in the past several meetings of the Monetary Policy Committee (MPC), the equivalent of the U.S. Federal Open Market Committee (FOMC).


Weekly Econ Commentary 06072013 Chart 2 

The BoE has a single mandate for monetary policy: limiting inflation to 2%.  If it exceeds that level, the MPC is charged with bringing inflation down to the target level over a two- to three-year period.  As the chart above shows, increases in the price level have exceeded that during the past several years.  Some one-off factors (higher sales taxes, to name one) are at play, but imports of energy and food have been persistently expensive.

Chancellor of the Exchequer George Osborne provided some additional working room in March, allowing the
MPC a little more latitude on restoring inflation to its target level.  The MPC is also now allowed to provide forward guidance, such as promising to keep rates low for a considerable period.  This could be another tool applied to stimulate growth. 

Weekly Econ Commentary 06072013 sidebar 2The BoE also implemented a “Funding for Lending Scheme” in an effort to generate more activity among small businesses.  But the program has had only limited success, reaching just £17 billion out of a £80 billion allocation.  Banks administering the program have not distributed the additional credit effectively, partly because of poor health.

Therein lies another challenge for the central bank: two of the three largest financial institutions in Britain are owned by taxpayers and are ill-positioned to support improved economic activity.  The BoE regained a place in bank supervision when the Financial Services Authority was abolished last year and will need to mull how best to leverage this role.

So as Mark Carney begins his new job on July 1, he faces a difficult task.  He arrives with strong credentials, and many look forward to some fresh thinking.  But he replaces a legend at a time when domestic and international conditions are shifting rapidly.  His organization has new tools and authority that need leveraging.  He faces an anxious public and some skeptical colleagues.

Governor King plans to take at least six months off after retiring.  He apparently promised his wife that he will spend the time learning how to dance.  If the recovery in Britain does not take deeper root, his successor will be expected to show some pretty fancy footwork, too.

U.S. Labor Market: Not Strong Enough for Fed to Change Course Yet

The May employment report reinforced expectations that the Federal Reserve will not alter its quantitative easing program at the June 18–19 FOMC meeting. 

Weekly Econ Commentary 06072013 Chart 3

The news was certainly not bad: job creation was solid, and the unemployment rate moved up fractionally because the labor force grew by 420,000.  The growth of the labor force is a big plus, as it raised the participation rate, whose decline has created concerns about the labor market’s underlying fundamental status.

Weekly Econ Commentary 06072013 sidebar 3Payroll employment rose 175,000 in May, nearly matching the average gain seen over the past 12 months but a bit slower than the three-month moving average of 208,000 posted in April. Revisions of March and April estimates resulted in a give back of 12,000 jobs. 

Weekly Econ Commentary 06072013 Chart 4

During May, were concentrated in professional and business services (+57,000), leisure and hospitality (+43,000), retail trade (+28,000), temporary help (+26,000) and health care (+10,700).  Construction employment rose, which is consistent with the housing sector’s momentum. Factory employment fell 8,000, marking the third consecutive monthly decline, and job losses occurred largely in non-durable goods industries. 

In May, the work week was slightly longer, and hourly earnings were essentially flat.  The manufacturing man-hours index has dropped for three consecutive months and appears to justify the weakness conveyed by the May Institute of Supply Management manufacturing survey.  These numbers imply that factory production could be on the soft side in May. 

Markets have been volatile since Chairman Bernanke indicated that tapering of asset purchases could commence in the “next few meetings.”  The overall tone of the employment report suggests that labor market conditions are moving closer to the Fed’s goal of a “substantial improvement in the outlook,” but the May data are not strong enough to initiate tapering at June’s FOMC meeting.  In the meanwhile, tapering rhetoric will remain on the table, with the timing of tapering action being data-dependent.

Eurozone and China PMI below 50, but Not Equal

The May 2013 Purchasing Managers’ Index (PMI) published earlier this week for the world’s major economies did ruffle markets. But markets often misconstrue these reports. 

Surveys of purchasing managers gather information about new orders, production, inventories, employment, backlogs, prices, supplier deliveries, exports and imports.  Respondents indicate whether activity has risen, fallen or remained unchanged over the month. 

The index for each category is computed by adding half of the percentage of respondents reporting “no change” to the percentage of those reporting an increase in activity and then applying a seasonal factor.  The result is what economists call a “diffusion index.”  The composite index is a weighted average of new orders, production, employment, inventories and supplier deliveries.  A reading above 50 implies that activity expanded during the month, while a reading below 50 denotes contraction. 

The economic signals from these surveys are useful because they provide insights before actual data become available.  However, diffusion indexes do not reflect differences between small and large changes, and each respondent firm is assigned the same weight regardless of size.  The index also reflects responses from thriving and challenged firms alike, but the absence of granularity conceals these differences. 

Weekly Econ Commentary 06072013 sidebar 4Despite these drawbacks, the composite indexes do show a notable correlation with industrial production. Their primary advantage stems from the fact that markets get a preview of the course of cyclical activity such as industrial production. 

Markets are anxious to assess the economic status of the eurozone.  At the same time, there is concern about the direction of the Chinese economy.  Against this backdrop, the May PMI numbers for the eurozone and China were market movers but have been misinterpreted somewhat. The eurozone PMI at 48.3 in May is a tad better than the 46.7 mark of April, and markets viewed it in a positive light.  At the same time, the HSBC PMI of China slipped to 49.2, down from 50.4 in the prior month, justifying the views of China bears.

Weekly Econ Commentary 06072013 Chart 5

But the official PMI of China moved up to 50.8 from 50.6 in April. The discrepancy in these numbers traces to the former’s focus on small business (largely in exports) and the latter’s emphasis on state-owned enterprises. 

Although PMIs of China and the eurozone are each below 50.0, the message from them is different. The eurozone PMI is the 22nd monthly mark below 50 in an economy plagued with a record-high jobless rate, declining factory production and the longest recession on record. This compares with a less-severe economic situation in China.  Therefore, placing the PMI survey information within the context of the entire economic picture is essential for a cogent analysis.

The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.
© 2014 Northern Trust Corporation
Northern Trust - Daily Economic Commentary

The change at the top of the Bank of England comes at a delicate time

June 7, 2013
by Carl Tannenbaum and Asha Bangalore

View PDF version

The change at the top of the Bank of England comes at a delicate time
• The May U.S. employment report will not sway the Fed either way
• Eurozone and China PMI reports – interpret with caution

Not long ago, I was speaking with a leader from the Bank of England (BoE) about the Federal Reserve reaching its 100th birthday this year.  It is a milestone that I thought worthy of celebration.  He politely acknowledged the centennial, but noted that his organization was founded in 1694.   Americans simply cannot compete with Europeans in a history contest.

Yet both central banks have evolved considerably from their initial designs.  Once relatively anonymous, leaders of the two institutions have become well-known figures, with much expected of them.  They are tasked with promoting growth, limiting inflation, securing financial stability and keeping an eye on currency values.  Not the easiest of optimization problems.

So the upcoming leadership transition at the Bank of England has attracted a good deal of attention.  The outgoing governor has been an important fixture on the global scene for many years, while the incoming governor is the first non-Briton to ascend to that post.  And the handoff comes amid delicate economic times in the United Kingdom.

Mervyn King’s tenure at the Bank of England covers more than 20 years.  That interval spans the creation of the euro, Britain’s decision to opt out, the global financial crisis and the implementation of non-traditional monetary strategy.  King was among those who identified the excesses in housing 10 years ago but was unable to prevent a disorderly unwinding.

Since the financial crisis, the UK economy has struggled to find its footing.  A “triple-dip” recession was narrowly avoided when gross domestic product (GDP) grew (albeit very modestly) in the first quarter of this year.  This certainly cannot be laid at the feet of the Bank of England; the austerity program undertaken by the coalition government and the poor performance of the eurozone economies have generated powerful headwinds.

Weekly Econ Commentary 06072013 Chart 1
 
The spending reductions passed by Parliament are the harshest in 80 years.  The stated aim has been to get government debt held by the public, which currently stands at about 75% of GDP, onto a declining path within five years.  Yet the severe economic costs of the program have led policy-makers to lengthen their target timelines to limit further damage. 

This seems to be the right call, given that the United Kingdom is having little trouble financing itself even after a debt downgrade earlier this year.  Unemployment has stabilized, at a level (7.8%) that is high by British standards but much lower than joblessness in most European countries.

The poor performance of the eurozone has also been a substantial limitation.  Exports make up about 30% of British GDP, and roughly half of them go to fellow members of the European Union (EU).  Demand from the continent has been soft, and the appreciation of the pound against the euro has not helped.

Weekly Econ Commentary 06072013 sidebar 1For most of the last generation, EU members generally viewed positively the linkages within the EU. Freer trade and freer movement of labor both worked to Britain’s benefit.  But the financial crisis led many nations to reevaluate the merits of association.  Prime Minister Cameron assailed the cost of EU administration, and the potential for financial and economic contagion shows the downside of close ties.

Despite a promised referendum on continued association, few think the United Kingdom will ultimately withdraw.  Businesses attracted to Britain because of modest taxes, excellent infrastructure and educated labor might reconsider their decisions if it became harder to move goods and people in and out of the country.  The possibility of referendum may, however, win some leverage in discussions over the terms of Britain’s EU membership.

As is the case in other countries, the United Kingdom’s central bank tried to compensate for the limitations of fiscal policy.  With interest rates standing at their lower bound, the BoE implemented several rounds of quantitative easing.  Mervyn King would have liked even more of this medicine but was out-voted in the past several meetings of the Monetary Policy Committee (MPC), the equivalent of the U.S. Federal Open Market Committee (FOMC).


Weekly Econ Commentary 06072013 Chart 2 

The BoE has a single mandate for monetary policy: limiting inflation to 2%.  If it exceeds that level, the MPC is charged with bringing inflation down to the target level over a two- to three-year period.  As the chart above shows, increases in the price level have exceeded that during the past several years.  Some one-off factors (higher sales taxes, to name one) are at play, but imports of energy and food have been persistently expensive.

Chancellor of the Exchequer George Osborne provided some additional working room in March, allowing the
MPC a little more latitude on restoring inflation to its target level.  The MPC is also now allowed to provide forward guidance, such as promising to keep rates low for a considerable period.  This could be another tool applied to stimulate growth. 

Weekly Econ Commentary 06072013 sidebar 2The BoE also implemented a “Funding for Lending Scheme” in an effort to generate more activity among small businesses.  But the program has had only limited success, reaching just £17 billion out of a £80 billion allocation.  Banks administering the program have not distributed the additional credit effectively, partly because of poor health.

Therein lies another challenge for the central bank: two of the three largest financial institutions in Britain are owned by taxpayers and are ill-positioned to support improved economic activity.  The BoE regained a place in bank supervision when the Financial Services Authority was abolished last year and will need to mull how best to leverage this role.

So as Mark Carney begins his new job on July 1, he faces a difficult task.  He arrives with strong credentials, and many look forward to some fresh thinking.  But he replaces a legend at a time when domestic and international conditions are shifting rapidly.  His organization has new tools and authority that need leveraging.  He faces an anxious public and some skeptical colleagues.

Governor King plans to take at least six months off after retiring.  He apparently promised his wife that he will spend the time learning how to dance.  If the recovery in Britain does not take deeper root, his successor will be expected to show some pretty fancy footwork, too.

U.S. Labor Market: Not Strong Enough for Fed to Change Course Yet

The May employment report reinforced expectations that the Federal Reserve will not alter its quantitative easing program at the June 18–19 FOMC meeting. 

Weekly Econ Commentary 06072013 Chart 3

The news was certainly not bad: job creation was solid, and the unemployment rate moved up fractionally because the labor force grew by 420,000.  The growth of the labor force is a big plus, as it raised the participation rate, whose decline has created concerns about the labor market’s underlying fundamental status.

Weekly Econ Commentary 06072013 sidebar 3Payroll employment rose 175,000 in May, nearly matching the average gain seen over the past 12 months but a bit slower than the three-month moving average of 208,000 posted in April. Revisions of March and April estimates resulted in a give back of 12,000 jobs. 

Weekly Econ Commentary 06072013 Chart 4

During May, were concentrated in professional and business services (+57,000), leisure and hospitality (+43,000), retail trade (+28,000), temporary help (+26,000) and health care (+10,700).  Construction employment rose, which is consistent with the housing sector’s momentum. Factory employment fell 8,000, marking the third consecutive monthly decline, and job losses occurred largely in non-durable goods industries. 

In May, the work week was slightly longer, and hourly earnings were essentially flat.  The manufacturing man-hours index has dropped for three consecutive months and appears to justify the weakness conveyed by the May Institute of Supply Management manufacturing survey.  These numbers imply that factory production could be on the soft side in May. 

Markets have been volatile since Chairman Bernanke indicated that tapering of asset purchases could commence in the “next few meetings.”  The overall tone of the employment report suggests that labor market conditions are moving closer to the Fed’s goal of a “substantial improvement in the outlook,” but the May data are not strong enough to initiate tapering at June’s FOMC meeting.  In the meanwhile, tapering rhetoric will remain on the table, with the timing of tapering action being data-dependent.

Eurozone and China PMI below 50, but Not Equal

The May 2013 Purchasing Managers’ Index (PMI) published earlier this week for the world’s major economies did ruffle markets. But markets often misconstrue these reports. 

Surveys of purchasing managers gather information about new orders, production, inventories, employment, backlogs, prices, supplier deliveries, exports and imports.  Respondents indicate whether activity has risen, fallen or remained unchanged over the month. 

The index for each category is computed by adding half of the percentage of respondents reporting “no change” to the percentage of those reporting an increase in activity and then applying a seasonal factor.  The result is what economists call a “diffusion index.”  The composite index is a weighted average of new orders, production, employment, inventories and supplier deliveries.  A reading above 50 implies that activity expanded during the month, while a reading below 50 denotes contraction. 

The economic signals from these surveys are useful because they provide insights before actual data become available.  However, diffusion indexes do not reflect differences between small and large changes, and each respondent firm is assigned the same weight regardless of size.  The index also reflects responses from thriving and challenged firms alike, but the absence of granularity conceals these differences. 

Weekly Econ Commentary 06072013 sidebar 4Despite these drawbacks, the composite indexes do show a notable correlation with industrial production. Their primary advantage stems from the fact that markets get a preview of the course of cyclical activity such as industrial production. 

Markets are anxious to assess the economic status of the eurozone.  At the same time, there is concern about the direction of the Chinese economy.  Against this backdrop, the May PMI numbers for the eurozone and China were market movers but have been misinterpreted somewhat. The eurozone PMI at 48.3 in May is a tad better than the 46.7 mark of April, and markets viewed it in a positive light.  At the same time, the HSBC PMI of China slipped to 49.2, down from 50.4 in the prior month, justifying the views of China bears.

Weekly Econ Commentary 06072013 Chart 5

But the official PMI of China moved up to 50.8 from 50.6 in April. The discrepancy in these numbers traces to the former’s focus on small business (largely in exports) and the latter’s emphasis on state-owned enterprises. 

Although PMIs of China and the eurozone are each below 50.0, the message from them is different. The eurozone PMI is the 22nd monthly mark below 50 in an economy plagued with a record-high jobless rate, declining factory production and the longest recession on record. This compares with a less-severe economic situation in China.  Therefore, placing the PMI survey information within the context of the entire economic picture is essential for a cogent analysis.

The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.
 
©2014 Northern Funds
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