The Eurozone economy performed solidly in 2016. GDP rose by 1.7% in the year to the third quarter, equal to growth in the US and well above “potential” expansion estimated by the EU Commission at only 1.0% in 2016. Domestic demand increased by 1.9%. Available evidence suggests a similar pace of growth in the fourth quarter, while the OECD’s Eurozone leading indicator has strengthened.

GDP expansion was above potential in 2016 for the third successive year. Accordingly, the unemployment rate has fallen steadily from a 2013 peak of 12.1% to 9.8% in October 2016. The decline of 0.8 percentage points (pp) over the latest 12 months compares with drops of 0.4 pp in the US, 0.2 pp in Japan and 0.4 pp in the UK.

Monetary trends suggest that respectable growth will continue. Narrow and broad money rose strongly in November, reversing October softness. The preferred measure for economic forecasting purposes here is the six-month growth rate of real (i.e. consumer price inflation-adjusted) non-financial M1, comprising holdings of currency and overnight deposits by households and non-financial corporations. This rebounded to a four-month high in November and is robust by historical standards – see first chart.


Will the ECB’s decision to reduce QE securities purchases from €80 billion per month to €60 billion from April 2017 have a negative impact on monetary trends? Probably not. As previously discussed, the boost to broad money from QE has been more than offset an outflow of capital from the region – “excess” liquidity, in other words, appears to have been exported, pushing down the euro, rather than feeding through to stronger domestic demand. The view here is that solid economic performance reflects falling interest rates and an easing of fiscal austerity, with QE of little import.

The planned reduction in QE may curb excess liquidity creation and slow capital outflows, with the extent of any decline dependent partly on political developments. The current account surplus, meanwhile, remains strong – €344 billion in the 12 months to October, equivalent to 3.2% of GDP. Six-month real narrow money growth is higher in the Eurozone than in the US and Japan, though lower than in China – second chart. The Eurozone / US gap casts doubt on the consensus view that US relative economic strength will drive a further widening of interest rate differentials in favour of the US dollar during 2017.

Consensus pessimism about UK consumer spending prospects partly reflects the low level of the official household saving ratio measure. The accuracy of this measure, however, is questioned by other official data suggesting that saving has increased over the past year and is at a respectable level by historical standards.

The official measure of the household saving ratio fell further to 5.6% in the third quarter, the lowest since 2008 and well below an average of 8.4% over 1996-2015 (20 years). According to the consensus view, the ratio is unlikely to decline much further, so an expected inflation squeeze on real income growth in 2017 should result in a significant slowdown in consumer spending.

The official measure of the ratio is derived from the household income account, with saving defined as the difference between disposable income, adjusted for the change in pension entitlements, and consumer spending.

An alternative measure, however, can be calculated from the financial and capital accounts. This measure defines saving as new investment in financial or tangible assets minus borrowing. The two definitions of the ratio are theoretically equivalent but differ in practice because of measurement errors.

The first chart shows the two saving ratio measures plotted as four-quarter moving averages, to reduce quarterly volatility. The alternative measure based on the financial / capital accounts is usually higher than the official measure derived from the income account but the current divergence is unusually wide. In contrast to the official series, the alternative measure has risen strongly since the first half of 2015 and is close to its 20-year average – households, that is, have been adding to their net assets at a faster pace recently even while increasing consumer spending solidly.


The financial / capital account detail shows that the increase in the alternative saving ratio measure has been driven by stronger growth of household money holdings and faster accumulation of life insurance and annuity entitlements.

The Office for National Statistics prefers the income-based saving measure because it has greater confidence in the income account data. The recent rise in the alternative measure, however, accords with expectations that households would increase precautionary saving before and after the Brexit vote. The healthier financial position implied by the alternative measure, meanwhile, tallies with solid consumer spending growth. The rise suggested by the alternative measure is also supported by a recent fall in the net percentage of households planning to increase saving in the EU Commission monthly consumer survey: this percentage has been negatively correlated with the saving ratio historically (i.e. a higher current level of the ratio is usually associated with lower savings intentions) – see second chart.


If it is assumed that the alternative measure of the saving ratio is more accurate at present, the implication is that either consumer spending has been over-recorded or disposable income under-recorded in the income account. Supporting the latter possibility, a sizeable divergence has opened up recently between the net percentage of households reporting an improvement in their financial position over the past 12 months in the EU Commission survey and the annual rate of change of real disposable income – third chart.


If household saving has been higher than officially reported in recent quarters, saving of other sectors must have been correspondingly lower, since aggregate saving (including the financial surplus of the overseas sector) must equal aggregate investment. An examination of the financial accounts of other sectors suggests that the savings positions of the overseas sector and financial corporations are weaker than reported in the income accounts. According to the financial account data, for example, the overseas sector financial surplus (i.e. saving minus investment) was £71.9 billion in the year to the third quarter – significantly lower than the reported current account deficit of £93.4 billion.

UK GDP is on track to rise by about 0.4% in the fourth quarter, while the currently-reported 0.49% increase in the third quarter may be revised up slightly. Assuming a 0.9-1.0% gain across the two quarters, and no revisions to earlier data, GDP will rise by 2.1% for 2016 as a whole, versus 2.2% in 2015. Solid performance was predicted by monetary trends and growth would probably have been significantly stronger but for the Brexit referendum.

Services turnover numbers released yesterday suggest that output in the sector rose further in October, offsetting declines in industrial and construction activity. GDP is estimated here to have been 0.2% above its third-quarter level in October, while third-quarter expansion seems likely to be revised up by several basis points.  If GDP were to rise by 0.15% per month in November and December – in line with estimated average growth between June and October – the increase for the fourth quarter as a whole would be 0.4%.

Such an outcome would be broadly consistent with simple tracking estimates based on vacancies and the CBI’s expected growth indicator – a composite business survey measure.  Both the rate of change of vacancies and the CBI indicator have eased recently, with the latest readings suggesting quarterly GDP expansion of 0.31% and 0.50% respectively – see first and second charts.

GDP growth of 0.9-1.0% in the third and fourth quarters combined would compare with official / consensus forecasts of stagnation or recession after the Brexit referendum. Some Brexit supporters cite respectable GDP expansion as evidence that the referendum result has had little if any negative economic impact. An alternative view is that the economy would have expanded much more robustly in the absence of the vote.

Monetary analysis supports the latter view. Six-month growth of real non-financial M1 rose strongly between September 2015 and June 2016, suggesting that GDP would have accelerated in the second half of 2016 and into early 2017 in the absence of the Brexit vote shock, allowing for the usual six- to 12-month lead – third chart. The two-quarter increase in GDP reached 1.8% in the second quarter of 2014 after real non-financial M1 growth reached a similar level in the third quarter of 2013. Assuming that similar expansion was in prospect before the vote, a GDP rise of 0.9-1.0% during the second half of 2016 would imply a Brexit growth drag of as much as 0.75 percentage points (pp), or 1.5 pp at an annualised rate.

Incoming news is consistent with the forecast here of a global economic “boomlet” in early 2017. Economic acceleration reflects a loosening of monetary conditions in early / mid 2016 but global real narrow money is now slowing, suggesting a loss of momentum in mid 2017. The combination of falling real money growth and rising economic growth may indicate reduced liquidity support for equity markets.

Global business survey results released this week have been strong. In the US, an average of the new orders components of the New York and Philadelphia Fed manufacturing surveys rose to the top of its historical range, suggesting that the new orders index of the national Institute for Supply Management (ISM) survey will move above 60 – see first chart.


In the Eurozone, the new orders index of the manufacturing purchasing managers’ survey rose to a 68-month high. The corresponding Japanese index also strengthened significantly and has yet to incorporate the full effect of recent yen weakness. In the UK, CBI manufacturing output expectations remained buoyant despite a modest recovery in sterling.

Emerging global economic strength was predicted by a surge in six-month growth of G7 plus E7 real narrow money to a peak in August 2016. This peak suggests that economic momentum will top out in spring 2017, allowing for an average nine-month lead. Incoming monetary data, meanwhile, hint at a significant subsequent slowdown.

A November estimate of the G7 plus E7 narrow money aggregate tracked here is now available but has been heavily distorted by India’s “demonetisation” programme, which has resulted in a 23% fall in the M1 money stock, partly reflecting a temporary shortage of replacement bank notes. This decline is very negative for Indian near-term economic prospects but the global implications are probably limited. Even assuming that Indian M1 had remained at its October level, however, six-month growth of G7 plus E7 real narrow money would have fallen further in November, based on available data* – second chart.


A slowdown in US real narrow money has been a key driver of the recent global decline: US six-month real money growth is at its lowest level since February, with a reduction in nominal expansion mainly responsible, rather than a pick-up in inflation. Japanese real money has also slowed sharply, while Chinese growth has moderated, though remains strong – third chart.


The formal equities versus cash switching rules described in a previous post recommend moving into cash if 1) G7 annual real narrow money growth falls beneath industrial output growth, 2) real money growth falls beneath 3% or 3) real money growth falls by 3 percentage points within six months. None of these conditions has yet been met. The real money / output growth gap, however, is narrowing, suggesting that the portion of money growth destined to flow into securities is diminishing. Markets, in other words, may have less liquidity “insulation” from negative shocks.

*November estimate based on c.70% data coverage; annual money growth assumed stable for missing countries.

The Federal Reserve delivered the expected quarter-point rise to 0.625% in the federal funds rate* and signalled a modest hawkish shift in its policy intentions, with the median assessment of the 17 meeting participants of the appropriate funds rate at end-2017 rising from 1.125% in September to 1.375%. The median forecast overstates the collective change of view – the mean assessment rose by only 6 basis points (bp), i.e. from 1.31% to 1.37%. The shift reflects recent mostly-solid economic data – in particular, a further fall in the unemployment rate to 4.6% – and an increased probability of fiscal stimulus. A cynic might suggest, in addition, that some Committee members previously suppressed more hawkish intentions in an effort to support the status quo candidate in the presidential election.

The Fed’s policy guidance often proves unreliable, particularly when it conflicts with monetary trends. The median forecast in December 2015 was for a 100 bp rise in rates during 2016, despite real narrow money slowing sharply into late 2015, signalling that economic growth was likely to disappoint. It did, and the Fed was forced to backtrack.

Narrow money rebounded strongly in early 2016 but is now slowing again, though less dramatically than in 2015. Six-month growth of real narrow money peaked in August 2016 and is likely to have fallen further in November – data will be released later today. Allowing for an average nine-month lead, the suggestion is that the economy will remain solid through spring 2017, possibly supporting two quarter-point Fed hikes during the first half, but will lose momentum in the summer.

A hawkish counterargument is that fiscal stimulus will sustain robust economic growth later in 2017 and in 2018. The view here, however, is that the effects of fiscal policy are incorporated in narrow money trends: shifts in money demand are largely driven by changes in spending intentions of households and firms, which would strengthen in response to an effective fiscal stimulus. Narrow money growth, in other words, would need to rise in early 2017 to support the hawkish view. Even if it does, the recent slowdown suggests a “soft patch” for the economy next summer.

The path to higher rates is unlikely to be smooth and the risks to the Fed’s guidance for the level of rates at end-2017 are judged here to be weighted modestly to the downside, based on current monetary trends.

*Mid-point of target range.

China bears have been arguing for more than a year that capital outflows would tighten domestic monetary conditions, leading to economic weakness and deflation. The “monetarist” view has been that the bears have had the causation the wrong way round: loose policy since early 2015 has resulted in strong monetary growth, part of which has been exported, putting downward pressure on the currency. Capital outflows, in other words, have been a symptom of monetary laxity, not a cause of tightening.

The differing interpretations colour exchange rate forecasts for 2017. The bears argue that the capital exodus is related to overvaluation and financial system risks, and will continue. The monetarist view, by contrast, is that mounting inflationary pressures will force the authorities to tighten policy in early 2017, resulting in slower monetary growth and a corresponding reduction in outflows. With the current account remaining in healthy surplus (2.5% of GDP in the third quarter of 2016), this view suggests a resumption of upward pressure on the currency – unless the new US administration starts a trade war.

Domestic economic developments have largely followed the monetarist script during 2016. Policy loosening in early 2015 was reflected in a rise in monetary expansion between mid-2015 and mid-2016, with narrow money, in particular, surging. The monetary pick-up was followed by a strong acceleration of house prices from late 2015, a rebound in industrial profits from early 2016 and a return to producer price inflation more recently – see first chart.


Economic growth has also revived, although by less than was expected here, possibly due to a structural shift away from heavy industry, which may have reduced potential expansion. GDP growth, nevertheless, rebounded from an annualised 5.7% in the fourth quarter of 2015 / first quarter of 2016 to 7.6% in the second / third quarters, according to the National Bureau of Statistics (NBS). Business surveys, meanwhile, signal a much-improved climate: an average of NBS and Markit purchasing managers' indices covering manufacturing and non-manufacturing / services reached its highest level since 2013 in November.

Policy, however, is turning less expansionary in response to rising inflationary pressures. The authorities have introduced measures since October to take the froth off the housing market and could raise official interest rates in early 2017 as producer / consumer prices continue to accelerate – producer prices climbed 3.3% in the year to November, the largest annual gain since 2011. Recent firmer market rates may be early evidence of a policy shift, with the authorities choosing not to sterilise fully the impact of foreign exchange intervention and year-end demand for liquidity – in contrast to their approach earlier in 2016.

The weakening trend of the renminbi measured against the special drawing right (SDR) basket started as money growth picked up following policy loosening in early 2015 – second chart. Tighter policy and a monetary slowdown could be associated with upward pressure on the currency in 2017.