UK money supply figures for December are a mixed bag but suggest that the economy will continue to struggle during the first half of 2012. The positive monetary impact of QE has been offset by bank disposals of non-domestic assets, probably in response to funding difficulties and regulatory pressure to boost capital ratios. Rather than force feed more cash into the gilt market, the Bank of England should offer ECB-style longer-term liquidity support to stem further deleveraging.

Bears are likely to alight on a 2.1% fall (not annualised) in the M4 broad money supply during the fourth quarter but this measure continues to be badly distorted by falling deposits of “intermediate” financial corporations – institutions channeling interbank business whose activities have little relevance to the “real” economy. The Bank’s preferred “M4ex” measure excluding these deposits declined by 0.2% last quarter.

This latter drop, moreover, was accounted by a fall in non-intermediate financial companies’ deposits, largely due to securities dealers – probably temporary. M4 holdings of households and private non-financial corporations rose by 0.7% during the fourth quarter, implying no generalised liquidity squeeze.

These numbers, however, are disappointing against the backdrop of an estimated £50.9 billion of gilt purchases by the Bank last quarter, equivalent to 3.3% of the M4ex measure. The counterparts analysis of M4 changes indicates that the positive monetary impact of QE was offset by banks’ efforts to contract their balance sheets, specifically by cutting their net external and foreign currency assets – by £28.2 billion over the quarter. Domestic assets, by contrast, were spared, with M4ex lending actually rising by £15.8 billion or 0.8%.

Monetary trends are probably not recessionary but faster expansion is necessary to revive economic growth. Further QE is unlikely to achieve this goal without accompanying action to enable banks to fund their balance sheets. The Bank insiders who control monetary and financial policy, however, refuse to contemplate ECB-style lender-of-last-resort operations – despite their hardline approach having resulted in a worse banking crisis in the UK than elsewhere in 2008-09.

The more hostile policy environment for banks in the UK than in Euroland has been reflected in a continued grind higher in the sterling three-month LIBOR / OIS spread even as the equivalent euro spread has fallen sharply – see first chart. This divergence has been reflected in UK bank stocks recently underperforming their Eurozone equivalents, following a large relative gain last year – second chart.

US recession fears have dissipated in response to stronger-than-expected economic news in recent months. The expectation here remains that the economy will grow respectably during 2012 but the data flow may turn more mixed near term, triggering renewed recession worries.

Fears reached a peak last autumn soon after a 30 September recession call by the highly-regarded Economic Cycle Research Institute (ECRI). The Intrade prediction market 2012 US recession contract topped at $5.0 on 10 October, implying a 50% probability of two consecutive quarterly GDP declines – see first chart. (The contract pays out $10 if the latter condition is met in 2012 and zero otherwise.)

A post in early October argued that a recession would be highly unusual against a backdrop of rapid real money expansion. 10 out of 11 post-war US downturns were preceded by a contraction of the real narrow money supply – second chart. The exception was the 1953-54 recession, apparently caused by severe fiscal tightening as defence spending was slashed after the Korean war.

The monetarist view seemed to receive support in late 2011 as economic news surprised positively, contributing to a fall in the Intrade contract. The implied probability rebounded towards 50% in mid December after the ECRI reaffirmed its recession call but has since collapsed to below 20% – first chart. (The contract closed last week at $1.86.)

Economic news, however, could turn less favourable near term, reviving recession nerves. Activity is likely to have been artificially boosted in late 2011 by businesses bringing forward spending on capital goods (including autos) ahead of a reduction in the bonus depreciation allowance from 100% to 50% – this boost should turn to a drag in early 2012. A rise in stocks last quarter increases the risk that any demand set-back will be reflected in lower production.

In addition, some analysts argue that seasonal adjustments to economic data were unduly favourable in late 2011, with the effect likely to unwind during the first half of 2012. Adjustment algorithms, it is claimed, have been distorted by a collapse in activity in late 2008 / early 2009, part of which is being wrongly assigned to normal seasonal variation, with the pattern extrapolated to later years.

Monetarist analysis continues to suggest a low probability of a recession but is less clear-cut than last autumn. Real narrow money is still expanding and has been the best single monetary indicator of downturns. Real broad money, however, has slowed while the real monetary base has fallen since July – third chart.

Eurozone monetary statistics for December confirm that banks have shifted from selling to buying government bonds in response to the ECB’s interest rate cuts and liquidity injections. However, the positive monetary impact of these purchases, and the ECB’s own buying via its securities markets programme, has been offset by a fall in private sector lending.

Banks bought €5.1 billion of euro-denominated government bonds in December after an upwardly-revised €4.6 billion in November – see first chart. The sums are small relative to cumulative sales of €57.5 billion over the prior four months, and to a €267.1 billion increase in the ECB’s monetary policy lending to banks between 28 October and 30 December. Purchases, however, are likely to have increased in January, judging from recent peripheral yield declines.

The boost to broad money M3 in December from bond buying was swamped by a €75.7 billion contraction of loans to the private sector. This number was distorted downwards by a fall in lending to quasi-banks (i.e. unrelated to the “real economy”) but there was also a significant reduction in loans to non-financial corporations. M3 declined by 0.5% in December following drops of 0.1% and 0.5% in November and October respectively.

The best monetary leading indicator of the economy is real narrow money M1. Worryingly, the six-month change in this measure returned to negative territory in December for the first time since June, suggesting falling output during the first half of 2012 – second chart. The hope – realistic but yet to be supported by the data – is that real M1 will revive in early 2012 in response to the ECB’s policy actions, setting the stage for an economic recovery late in the year.

The country breakdown of real M1 deposits continues to show respectable growth in the core offset by a slump in the periphery – third chart. The six-month core increase, indeed, rose to a 15-month high in December, reflecting strength in Germany and the Netherlands, with French real deposits flat. The peripheral change, by contrast, was -3.8%, or -7.4% annualised, with the smallest decline in Spain, followed by Italy, Ireland, Portugal and Greece – fourth chart.

The implied scenario of core economic resilience with deep recessions in the periphery suggests further trouble ahead, with the Bundesbank likely to veto additional aggressive ECB easing even as weak peripheral economies derail fiscal consolidation plans.

The US Conference Board has overhauled its leading indicator index, making changes to four of the 10 components. The new version has performed more weakly in recent years and over the last 12 months – see chart. It has recovered, however, from a low in September to reach a five-month high in December.

The revision is of questionable value. The Conference Board claims that the new index is a more accurate predictor of business cycles since 1990 but its earlier performance is inferior – as the chart shows, it failed to turn down before the 1960-61 recession, in contrast to its predecessor.

An important change is the replacement since 1990 of the real M2 money supply with a new “leading credit index”. This partly explains why the new index weakened last summer while the old version continued to rise. This weakness, however, appears to have been a false signal, based on recent solid US economic data. Had the new index been in operation, in other words, it would have encouraged dubious recession calls.

The view of this journal, of course, is that real money is a key forecasting tool and should be included in a composite leading index, although in most countries a narrow measure outperforms M2 and broader aggregates.

Recession-mongers will probably claim that the new index is consistent with their forecast since, despite the recent recovery, it has yet to regain the July 2011 peak. They can also argue, with some justification, that the index remains biased upwards by its inclusion of the 10-year Treasury yield / federal funds rate spread – the assumed positive implication of a steep yield curve is questionable when official interest rates are close to zero*. (The view here is that this bias is counterbalanced currently by a downward distortion from the omission of real money.)

* The economy entered a recession in 1937 with a similar Treasury yield curve to currently.

Global business surveys continue to surprise positively, the latest examples being the German Ifo and UK CBI manufacturing polls released today and yesterday’s Eurozone flash PMIs.

A cautionary note, however, is sounded by recent earnings revisions by equity analysts. The world revisions ratio (i.e. analyst upgrades minus downgrades as a proportion of the number of estimates) correlates with G7 PMI manufacturing new orders and fell back in January – see chart.

The suggestion is that the remaining PMIs released next week will break the run of favourable survey news. US ISM manufacturing new orders, in particular, could subside from an elevated December level.

The view here is that any such setback will prove temporary, based on continued solid global real money expansion and firmer leading indicators, discussed in prior posts.

The official first guess that GDP declined by 0.2% in the fourth quarter is within the margin of error of a flat economy. There may have been a small depressing effect on the number from a combination of mild weather, the public sector strike and one fewer working day in the quarter compared with the prior four years. (Mean temperatures in October, November and December were above long-term averages, contributing to lower electricity and gas consumption.)

GDP is estimated to have risen by only 0.9% in 2011 but there was a big drag effect from the North Sea – the onshore economy grew by 1.4%.

Business surveys and labour market indicators suggest marginally firmer activity as the quarter ended. The hope is that the economy will benefit from global lift and an abatement of the inflation squeeze on consumers and businesses as 2012 progresses. Inflation, however, may fall by less than the Bank and consensus expect – see post last week – while monetary trends have yet to show significant improvement (December numbers are released next week).