Eurozone monetary trends were arguing against ECB policy tightening before the negative shock of Russia’s invasion of Ukraine.

Three-month growth of non-financial M3* – the preferred broad money aggregate here – slowed further to 4.2% annualised in January, the lowest since January 2020 and below a mean of 4.9% over 2015-19, when CPI inflation averaged 1.0% – see chart 1.

Chart 1

Current high inflation reflects excessive money growth in 2020-21 and supply side disruption. It is too late for an ECB response. Any second-round effects will swiftly burn out if money growth maintains its recent subdued pace.

The broad money slowdown has occurred despite ongoing QE, raising the prospect of outright weakness when it stops. The hope is that money growth will be supported by private credit expansion, which has strengthened recently – chart 1. The suspicion here is that corporate loan demand has been boosted by restocking and will fade as this slows.

Growth of narrow money (non-financial M1) has also normalised while high inflation has pushed the six-month rate of change in real terms marginally into negative territory – chart 2. Negative readings preceded every recession over 1970-2019, although there were several false signals (e.g. 1994-95) – chart 3.

Chart 2

Chart 3

The six-month rate of change of real narrow money deposits is now negative in Italy as well as Germany, with France still showing relative resilience – chart 4.

Chart 4

*M3 holdings of households and non-financial corporations.

Recent market weakness reflects an unfavourable monetary backdrop as well as negative geopolitical developments.

The monetarist view is that asset prices respond to imbalances between the supply of money and the demand to hold it. “Excess” money growth is associated with increased demand for financial assets and upward pressure on their prices, assuming no change in supply.

Excess money growth can’t be measured directly because the demand to hold money – based on current economic conditions and prices – is unobservable. Two proxy measures of global excess money are tracked here: the difference between six-month growth rates of real (i.e. CPI-deflated) narrow money and industrial output; and the deviation of 12-month real money growth from a slow moving average.

Historically, global equities outperformed cash significantly on average when both measures were positive but underperformed significantly when both were negative. Mixed signals were associated with a small return shortfall, i.e. no reward for assuming equity risk – see table 1.

Table 1

A post in early January noted that the second measure had turned negative in October while the first appeared to have followed in November, based on partial data. This “double negative” signal was confirmed later in January.

A January estimate of global real narrow money is now available, along with a firm data point for December industrial output. Both excess money measures remain negative.

12-month growth of global real money is estimated to have fallen further below its moving average in January – chart 1. An early reconvergence seems unlikely – CPI inflation is probably peaking but a decline may be offset by a further slowdown in nominal money growth as large monthly increases a year ago drop out of the 12-month comparison.

Chart 1

Meanwhile, six-month real narrow money growth was little changed in January and below December industrial output growth – chart 2. Six-month output growth may stay at or above the December level through March: a temporary production catch-up is in progress as supply constraints ease, US output rose solidly in January and base effects are favourable (output fell between June and September 2021).

Chart 2

The excess money measures have also been correlated with sector relative performance historically, with double negative signals associated with strong outperformance of the defensive sectors basket (which includes energy) and underperformance of cyclicals, including tech (IT and communication services) – table 2.

Table 2

Year-on-year headline and core CPI inflation rates rose further in January, to 7.5% and 6.0% respectively, but six-month momentum remained below peaks reached in July-August – see chart 1.

Chart 1

The fundamental cause of current high inflation is excessive monetary expansion in 2020-21 but six-month growth of broad money has returned to its pre-pandemic pace – chart 2. Weekly numbers have stagnated since December, when tapering started.

Chart 2

The year-on-year core rate of 6.0% overstates underlying inflation because of base effects and a one-off surge in vehicle prices. Year-on-year was only 1.4% in January 2021 so core prices have risen at an average rate of 3.7% pa over the last two years.

The CPI component for new and used vehicles soared by 28.1% between January 2020 and January 2022, boosting core CPI by 2.5 pp – vehicles had a 9.1% weight in the core basket in January 2020.

Stripping out vehicles, core CPI rose by “only” 2.7% pa in the two years to January. Two-year inflation on this measure reached a higher peak in the 2000s – chart 3.

Chart 3

Vehicle prices should correct as supply constraints ease and high fuel prices depress demand. A recent fall in car / truck rental rates may be a harbinger – chart 4.

Chart 4

Suppose that core CPI ex. vehicles rises by 3.5% over the coming 12 months, above its two-year rate of increase of 2.7% pa. If vehicle prices were to correct by 10% over this period, the conventional core rate would fall to 1.9% in January 2023.

Actual and imputed rents are widely expected to exert upward pressure on core inflation. However, year-on-year rental inflation would have to rise from the current 4.4% to 8% to offset a 10% fall in vehicle prices. Rental inflation hasn’t breached 6% since the mid 1980s.

The Fed and other central banks are focused on backward-looking inflation indicators, including wage growth and (adaptive) inflation expectations, rather than money trends. Even these are showing signs of peaking: NFIB small firm worker compensation plans eased in January while New York Fed consumer expected inflation measures fell – charts 5 and 6.

Chart 5

Chart 6

The global economic slowdown signalled by monetary trends appears to be playing out. The global manufacturing PMI new orders index fell to an 18-month low in January and is now 5.1 points below a May peak – see chart 1.

Chart 1

A decline in global six-month real narrow money growth into November suggests a further PMI fall into mid-year, at least, allowing for a typical 6-7 month lead. Real money growth recovered marginally in December but could weaken again in January – a provisional number will be available by early next week. Eurozone growth is likely to have turned negative based on last week's CPI data, showing a further spike in six-month momentum.

The manufacturing PMI stocks of purchases index reached a record level in December but fell back in January, consistent with the view here that the stockbuilding cycle has peaked and is about to enter a 12-18 month downswing. The coming inventory slowdown (and eventual liquidation) is likely, as usual, to be associated with a significant weakening of goods price pressures – chart 2.

Chart 2

Optimists argue that services strength as pandemic disruption ends will outweigh any industrial slowdown. The (Keynesian) understanding here is that economic fluctuations are driven by goods spending and investment in particular. GDP growth swings mirror those in industrial output: the correlation coefficient of year-on-year changes was +0.89 over 1965-2020  – chart 3. There is no independent cycle in services demand. A services rebound as conditions normalise is likely to burn out swiftly if the industrial slowdown deepens.

Chart 3

The supposedly “blowout” US jobs report has no implication for the assessment here, except to increase the likelihood of a Fed policy mistake. Labour market data are not forward-looking and the details of the report were much less impressive than the headlines.

Huge upward revisions to November / December payrolls growth reflected new seasonal factors, with offsetting downgrades to June / July numbers – chart 4

Chart 4

Payrolls rose solidly in January (with a boost from the new seasonal factor) but pandemic disruption showed up in falls in aggregate hours and the household survey employment measure – chart 5.

Chart 5

The drop in weekly hours may explain the larger-than-expected hourly earnings increase, assuming that lower-earners were more likely to have their hours cut. Weekly earnings growth remains range-bound – chart 6.

Chart 6

The PMI fall has been reflected in underperformance of MSCI-defined cyclical sectors versus defensive sectors but there is significant variation within the groupings, most notably the continued strength of financials – chart 7.

Chart 7

This resilience, of course, reflects rising bond yields and is likely to fade if waning economic momentum and easing price pressures pull these lower.

The view here remains that the rise in bond yields – like the outperformance of value versus growth – reflects a less favourable monetary backdrop for markets rather than a reprise of the “reflation trade”. Both “excess” money measures tracked here remain negative – chart 8.

Chart 8

The “monetarist” view is that central banks should conduct policy with the aim of stabilising growth of (broad) money at a non-inflationary rate.

Major central banks – the Fed and Bank of England in particular – trashed this principle in 2020-21, pursuing policies that caused money growth to explode, with the inflationary consequences still playing out.

The MPC’s decision in November 2020 to launch a further £150 bn of QE when annual broad money growth – as measured by non-financial M4* – was already at 12% was one of the worst in its 25-year history.

So what is the monetarist policy recommendation now?

In the UK, it is to do nothing. Broad money momentum slowed sharply during 2021, with non-financial M4 rising by 1.9% or 3.9% at an annualised rate in the six months to December. This is close to the average in the five years preceding the pandemic and, if sustained, would be consistent with core CPI inflation returning to around target over the medium term – see chart 1.

Chart 1

The H2 broad money slowdown occurred despite QE continuing until November. Monthly growth of non-financial M4 fell to just 0.1% in December.

The combination of high inflation due to 2020-21 policy mistakes and the recent monetary slowdown has resulted in a contraction of real money balances, suggesting already-weak economic prospects – chart 2. Policy tightening into such a contraction risks pushing the economy into a recession.

Chart 2

The MPC, on the view here, should wait for a rebound in money growth before raising rates and starting to reduce its gilts portfolio. Such a rebound is likely to depend on a pick-up in private sector credit growth, of which there is no sign in recent lending data or the Bank of England’s credit conditions survey – chart 3.

Chart 3

A consensus view is that the MPC needs to tighten to prevent high inflation becoming embedded in expectations. The best way of anchoring inflation expectations is to maintain low, stable money growth.

Another argument is that a period of weak money growth is warranted to offset excess expansion in 2020-21. Such attempts at monetary fine-tuning are hazardous and liable to create more volatility. The suspicion here is that “excess” money balances have already been largely absorbed by asset price / wealth gains (and an associated rise in the portfolio demand for money) and the current inflation surge.

*M4 holdings of the household sector and private non-financial corporations.