Global growth picked up during 2013, ending the year at a solid pace. This strength should carry over into early 2014 but momentum is likely to wane as the year progresses. The global economy may be entering the late stage of the cycle, characterised by rising capacity constraints, increased inflationary pressure and tightening liquidity.

Monetary trends predicted recent economic improvement. A year ago, global* real (i.e. inflation-adjusted) money supply growth was strong and higher than output expansion. This signalled that economic prospects were brightening and there was “excess” liquidity available to boost financial markets. Global industrial production grew by 5% annualised in the six months to November 2013, up from just 1% a year earlier. Equities, of course, have performed strongly.

Current monetary signals are less favourable. Global real money growth is still respectable but has declined since spring 2013. With economies strengthening, it has fallen beneath output expansion. This suggest that economic momentum is close to a peak, while markets no longer enjoy a liquidity tailwind.

Most forecasters and investors expect current strength to be sustained. The IMF recently signalled increased optimism, raising its 2014 growth projections for the US and Japan. According to Merrill Lynch, three-quarters of global fund managers judge the economy to be in the early or middle part of the cycle, implying that the upswing has several more years to run. This view is questionable on numerous grounds.

First, the cycle already looks mature by historical standards. Global industrial output has risen by 30% since February 2009 and is 12% above its prior peak – see first chart. The upswing has lasted 58 months versus an average duration of 78 months for the previous four trough-to-peak output rises. If the current cycle were to match the average, another recession would begin in 2015.

Secondly, stronger growth is running into supply-side constraints. In the US, the Institute for Supply Management business survey indicates that the economy-wide operating rate is above average – at odds with claims that there is still a large “negative output gap”. Firms globally are finding it difficult to recruit skilled labour: skill shortages are at their most acute since 2007, at the end of the last cycle, according to the world business survey conducted by Germany’s Ifo Institute – second chart.

Thirdly, there are signs that inflationary pressure is reviving in response to capacity tightening. Global inflation was broadly stable in 2013, with falls in strong currency areas – in particular, the Eurozone – offset by rises in Japan and elsewhere. Business price expectations in the Ifo world survey rose notably in late 2013, to their strongest since spring 2011 – third chart. Commodity prices have firmed recently.

Central banks are trying to extend the cycle by promising to defer official interest rate increases until after inflation rises. Liquidity conditions, however, tighten endogenously at the end of a cycle as stronger activity and price gains push up longer-term yields and cause the gap between real money and output expansion to close. This process is under way. Central banks usually lag market-driven liquidity tightening, often magnifying its effect at the wrong time. The current cycle is unlikely to be different.

Rather than loose policy, the best hope of extending the cycle is a surge in business investment that boosts supply capacity and defers higher inflation. Capital spending intentions have firmed but are not signalling a major shift towards expansion. Continued business reluctance to increase capacity, ironically, probably partly reflects additional uncertainty created by central banks’ “monetary activism”.

2013 was a better year for financial markets than main street. The reverse may be true in 2014, as forward-looking markets begin to anticipate more difficult economic conditions in 2015.

*”Global” figures quoted refer to the G7 major countries and seven large emerging economies (the “E7”).

An abridged version of this article appeared in today's City AM.

Narrow money trends suggest that the UK economy will continue to grow solidly in the first half of 2014 while Eurozone expansion will revive further.

The first chart compares six-month growth rates of real (i.e. inflation-adjusted) narrow money in the major developed economies. The measure used for the UK and Eurozone is “non-financial M1”, comprising currency and sight deposit holdings of households and non-financial corporations – ECB research has confirmed that this measure is the best monetary leading indicator of the cycle. Headline M1 is shown for Japan but this is already a non-financial measure, since the “money holding sector” is defined to exclude financial corporations. The US monthly monetary statistics do not provide a breakdown between sectors – the chart shows narrow M1, comprising currency and demand deposits.

Real narrow money growth picked up across Europe during the second half of 2012 and first half of 2013 but was particularly strong in the UK, correctly signalling recent economic outperformance. The UK trend has stabilised since the spring at a robust level; Eurozone expansion had also flattened out but rose to a new high in November, probably partly reflecting the ECB’s interest rate cut that month. This suggests that the UK / Eurozone economic growth gap will narrow during the first half as the latter strengthens.

Japanese real money expansion remains disappointing, with recent faster nominal gains neutralised by higher inflation. US growth is respectable by international standards but has trended lower over the last year, casting doubt on forecasts of faster economic expansion during 2014.

Eurozone pessimists cite continued weakness in broad money and credit. The view here is that this is not an immediate constraint on the recovery because lower interest rates and reviving confidence are causing households and firms to use existing monetary resources more intensively – rising velocity, in other words, is compensating for slow broad money expansion. The pick-up in narrow money is indirect evidence of this shift.

The recent further rise in Eurozone real money growth has been led by the periphery, with Italy rebounding strongly from summer weakness and Spain also now above Germany and France – second chart.