Eurozone real non-financial M1* – the best monetary leading indicator of the economy, with a flawless track record in recent years – continues to signal improving prospects. Real money expansion is now stronger in peripheral economies than the core.

Six-month growth of real non-financial M1 rose to 3.7% (not annualised) in January, equalling November’s result, which was the strongest since February 2010. The six-month change turned negative before the 2008 and 2011 recessions and positive before the 2009 and 2013 recoveries – see first chart. The recent pick-up suggests that industrial output and GDP growth will firm through the late summer (at least).

The ECB publishes country data on overnight deposits, which dominate swings in M1. Six-month growth of real deposits in the peripheral grouping** rose to 3.8% in January versus 2.2% for the core – second chart. Peripheral expansion was lower than in the core in every month between September 2008 and October 2013.

The groupings conceal significant country variation, with Spain now the strongest of the big five, followed by Germany / Italy. French growth is modest but still consistent with an ongoing economic recovery; negative risks are greater in the Netherlands – third chart.

*Notes and coin in circulation plus overnight deposits of households and non-financial corporations divided by consumer prices, seasonally adjusted.
**Greece, Ireland, Italy, Portugal and Spain.

The official estimate of fourth-quarter GDP growth has been maintained at 0.7%, although revisions to earlier quarters have resulted in the annual increase falling from 2.8% to 2.7%. As expected here, services output undershot the 0.4% December rise assumed in the preliminary GDP estimate (increasing by 0.2%); the impact on the quarterly GDP rise, however, was offset by upward revisions to earlier months.

The key takeaway from the details of today’s report is that recent solid growth has been broadly based and balanced, increasing confidence in its sustainability. Consumer spending rose by less than GDP in the year to the fourth quarter – 2.4% versus 2.7%. Investment, meanwhile, soared by 8.7%; business fixed capital formation grew by 8.5%, with a stronger rise in housing investment*. Net exports were little changed over the four quarters – import penetration**, encouragingly, fell. The only negative in the expenditure breakdown was relatively high stockbuilding during the second half of 2013; the stockbuilding numbers, however, incorporate a balancing adjustment and are often revised significantly.

Solid growth is occurring across sectors and most activities: output of services, industry and construction rose by 2.7%, 2.3% and 4.3% respectively in the year to the fourth quarter. Services strength does not reflect finance – output of “financial and insurance activities” actually fell by 1.8% in the latest four quarters, subtracting 0.2 percentage points from GDP growth.

The income breakdown shows a 3.9% nominal rise in total employee compensation – including employers’ social (pension) contributions – in the year to the fourth quarter. The number of employees increased by 1.1% over the same period, according to last week’s labour force survey. So average compensation grew by 2.8% – more than CPI inflation of 2.1% in the fourth quarter***.

Adding in profits and other income, nominal GDP rose by an annual 4.4% in the fourth quarter. With potential output probably growing by less than 2% per annum, this rate of increase is incompatible with achievement of the 2% inflation target over the medium term.

*The difference between total and business investment suggests that the housing component grew by about 12%.
**The import share of domestic demand.
***A fourth-quarter breakdown between wages / salaries and employers’ social contributions is not yet available.

A large rise in US narrow money in the first week of February was only partially reversed the following week. The recent pick-up, if confirmed, suggests improving economic prospects for the second half of 2014.

Bad weather has exaggerated weakness in recent economic data but a slowdown had been expected here, partly reflecting softer monetary trends during the first half of 2013. Six-month growth of real narrow money* fell from 7.4% (not annualised) in December 2012 to 2.7% in June 2013.

Real money expansion, however, stabilised after mid-2013 and picked up to 4.7% in January. Data for the first two weeks of February imply a further increase to 5.5% or more. Underlying economic growth may remain soft through mid-2014 but second-half prospects appear to be brightening.

The chart incorporates a US February estimate along with January and December numbers for Japan and the Eurozone / UK respectively**. US real money expansion fell back into the middle of the pack in 2013 but is now diverging positively again, suggesting economic and equity market outperformance.

Narrow money is held mainly for transactions purposes and changes usually occur ahead of spending variations, explaining its leading properties. US spending plans, in other words, seem to be firming despite QE “tapering”, supporting the view here that QE changes have weak economic effects except under conditions of extreme financial stress.

*Currency plus demand deposits divided by consumer prices.
**January data for the Eurozone and UK are released on 27 February and 3 March respectively.

Weak services sector turnover in December raises the possibility of a cut in the current official estimate that GDP grew by 0.7% between the third and fourth quarters of 2013 – a revised number will be issued on 26 February.

The 0.7% estimate released last month – 0.70% before rounding – incorporated output changes in services, industry and construction of 0.8%, 0.7% and -0.3% respectively. The latter two have since been revised to 0.5% and 0.2%. These changes are offsetting, implying no change to the (unrounded) GDP growth estimate.

The quarterly services rise of 0.8% assumed growth of 0.4% between November and December. The Office for National Statistics collects separate data for retail, financial and government services and relies on the turnover survey for the rest of the sector. The retail input is based on sales volume, which rose by 2.5% between November and December, implying a +0.2 percentage point (pp) contribution to services output growth, allowing for the 7% weight of the industry in the sector. Finance and government – with a combined 37% weight – could plausibly add a further 0.1 pp.

The turnover survey, however, suggests that output of other services fell in December. The turnover series is in current price terms and is not adjusted for seasonal variation; the raw numbers were adjusted here using the standard X-11 procedure. The chart compares output excluding retail, financial and government services with seasonally-adjusted turnover. The relationship is imperfect but monthly changes in the two series have been in the same direction in three out of four months since the start of 2011.

Turnover fell in both November and December. Output rose in November; the odds are that it will not diverge from turnover for a second month.

The suggestion, therefore, is that retail strength in December will be offset by weakness in other services, resulting in total output undershooting the assumed 0.4% monthly rise incorporated in the current fourth-quarter GDP estimate. A revision down to 0.1% would be sufficient to reduce GDP growth to 0.6%, after rounding.

It should be emphasised that the revisions process is only beginning and a downgrade could be reversed as further information becomes available. Any services weakness in December, in addition, may be attributable to poor weather. A lowering of the fourth-quarter estimate, however, is not expected – some analysts think it will be raised – so could have a short-run negative impact on market interest rates and sterling.

A measure of private sector pay incorporating a 12-month smoothing of bonuses rose by more than consumer prices in the year to December, suggesting that real wage growth is resuming earlier than expected.

Private sector regular weekly earnings rose by 1.5% in the year to December, below CPI inflation of 2.0% in that month. Bonuses, however, increased by 8.7% in the 12 months to December from a year before. A measure of total pay calculated by adding regular earnings and a 12-month moving average of bonuses, therefore, rose by an annual 2.1% in December. This pay growth measure was last above CPI inflation in June 2008 – see chart.

Whole-economy growth, i.e. incorporating public sector workers, is still below inflation at 1.7% in December but the gap is the smallest since 2008.

Most aspects of today’s labour market report were strong. The labour force survey unemployment measure ticked up from 7.1% to 7.2% but a continued rapid decline in the claimant count signals that the break in the downward trend will prove temporary. Vacancies, meanwhile, rose further – the vacancy rate (i.e. the stock of unfilled vacancies expressed as a percentage of employee jobs) is now 2.1% versus a post-1995 average of 2.0%, casting doubt on the Bank of England’s claim of still-significant labour market slack.

Why has UK CPI inflation fallen and will the improvement be sustained? The view here is that the recent decline is a lagged response to economic weakness in 2011-12, which in turn reflected insufficient money supply expansion in 2010-11. Monetary trends recovered strongly in 2012-13, laying the foundations for the current economic boomlet and a probable revival in price pressures in 2014-15.

The monetarist rule is that money supply changes filter through to inflation with a long and variable lag averaging about two years. The first chart shows that trend changes in broad money growth over the last decade have preceded sustained swings in core CPI inflation in the same direction by about two years, consistent with the rule.

Broad money growth bottomed in August 2011, rising strongly through early 2013. Based on the average two-year lead, this suggested that core inflation would reach a low in late 2013 and revive during 2014 – see post from September. The decline, in fact, has continued into early 2014, partly reflecting recent exchange rate appreciation. Unless sterling strengthens further, however, a turning point is likely to be evident by the spring.

The second chart shows illustrative projections for core and headline CPI inflation based on the rise in broad money growth over 2011-13 and reasonable assumptions about energy and unprocessed food prices and student tuition fees*. The headline rate is forecast to fall slightly further in February / March before reviving to end the year at about 2.75%. Such a rise, of course, would shock the Bank and undermine its new forward guidance.

Business survey pricing plans are consistent with an imminent inflation trend change. The third chart shows the headline CPI rate together with an average of price expectations balances from the EU Commission surveys of services, manufacturing, retail and construction. The survey measure has firmed since mid-2013, with the January reading the strongest since May 2011.

The suggestion that inflation is bottoming is also supported by the alternative RPIJ measure, based on the components and weights of the RPI and the CPI’s calculation method. This measure revived from a low of 1.9% in October to 2.1% in January. The recent divergence with CPI inflation is due partly to RPIJ’s inclusion of housing costs but mostly to other coverage differences. RPIJ is considered a superior measure of UK wage-earner inflation, since its population base excludes the top 4% of the income distribution, pensioners mainly dependent on benefits and foreign visitors.

*Domestic energy, motor fuel and unprocessed food prices rise by 3% per annum while tuition fees have the same upward impact on the CPI in October 2014 as in October 2013.