Central bankers have ignored the lessons of their 2020-21 policy blunder and deserve the opprobrium they are likely to attract as an economic debacle continues to play out over coming quarters.

Policy-making can be accurately described as anti-monetarist, not merely in the sense that money data are ignored but rather that decisions are the precise opposite of those warranted by monetary trends.

The central banks continued to pursue ludicrously outsized QE in 2020-21 even as money growth surged to a level that would have embarrassed their 1970s predecessors; and they ripped up earlier guidance and tightened aggressively this year despite monetary trends screaming recession and now deflation risk.

June money data for the US, Eurozone and UK published this week highlight the scale of the policy fiasco under way before this month’s further tightening moves. (The Bank of Japan deserves an honourable mention for refusing to join the lemming rush.)

With Canada yet to release June data, the six-month rate of change of G7 real narrow money is estimated to have fallen further to -3.1% (-6.1% annualised), a level previously reached only before / during severe recessions in the mid 1970s and early 1980s. Real broad money, meanwhile, is contracting faster than during those episodes – see chart 1.

Chart 1

Until April, real money weakness was attributable mainly to high inflation – six-month growth of nominal narrow money, though slowing sharply, was still in the middle of its pre-pandemic range. No longer: six-month nominal growth fell to 1.6% (3.3% annualised) in June – chart 2.

Chart 2

The impact of this year’s policy tightening is better reflected in the three-month rate of change, which crossed below zero in June, a rare occurrence signalling recession and / or price declines historically – chart 3.

Chart 3

The narrow money measures calculated here for the US and UK fell month-on-month in June, while the Eurozone measure was flat.

Narrow money is more sensitive to policy changes than broad money but the broad numbers are no less alarming. Three-month growth of G7 broad money slumped to 1.3% annualised in April, moving sideways in May and June – chart 4.

Chart 4

The monetary evidence, therefore, is that policy settings had already reached overkill territory by mid-year, suggesting a severe recession with rising medium-term deflation risk.

One false counter-argument to this assessment cites the strength of bank loan growth, particularly in the US. Non-monetarists offer this as evidence that financial conditions are not yet restrictive. Even some monetarists have suggested that lending strength is relevant for assessing rate settings, since money growth will recover if lending momentum is sustained.

It won’t be. Bank lending is a coincident / lagging indicator of the economy. It is normal for loan growth to be strong and / or rising before a recession – chart 5.

Chart 5

Corporate loan demand has been inflated by an unusually large surge in stockbuilding that is now starting to reverse – chart 6. The ECB’s latest bank lending survey signalled a sharp fall in credit demand, along with tightening supply – expect the corresponding Fed survey next week to give the same warning.

Chart 6

The assessment of global economic prospects here in recent quarters has been consistently more pessimistic than the consensus forecast. The consensus is now shifting to acceptance of US / European recessions but these are widely expected to be “mild” and / or “short-lived”. The view here remains bleaker, based on three considerations.

First, global six-month real narrow money momentum continued to weaken during H1 2022, reaching a level historically associated with serious recessions. The further decline into mid-year suggests no economic recovery before Q2 2023, allowing for an average nine-month lead.

Secondly, the 3.33 year stockbuilding cycle is judged to have peaked in Q1 2022, with a downswing likely to last at least 12 months, again suggesting no recovery before Q2 2023. The prior upswing, moreover, was exaggerated by overordering of inputs due to perceived supply shortages, raising the possibility of a larger-than-usual drag during the downswing.

Thirdly, recessions involve self-reinforcing dynamics that magnify and prolong weakness unless offset by policy intervention. Evidence that a tipping point into a serious recession may have been reached includes:

Weak business surveys. US / Eurozone PMI composite output indices fell below 50 in July, while an average of current and future new orders balances in the Philadelphia Fed manufacturing survey plunged to a level reached only before / during major recessions – see chart 1.

Chart 1

Earnings downgrades. The MSCI ACWI earnings revisions ratio had been holding up relative to business surveys but has recently fallen sharply – chart 2.

Chart 2

Commodity price falls. The CRB raw industrials index is now down on a year ago, confirming that a stockbuilding cycle downswing is under way, during which prices are likely to soften further– chart 3.

Chart 3

Credit restriction. Credit tightening and demand balances in the July ECB bank lending survey reached recession-consistent levels – chart 4.

Chart 4

Softer labour markets. The 13-week change in a four-week moving average of US initial claims is at a level historically associated with recessions, while the monthly increase in UK payrolls in June was the smallest since March 2021, with recent downward revisions to initial data suggesting an actual fall – chart 5.

Chart 5

Chinese monetary data for June confirm that policy easing is gaining traction but narrow money growth remains modest compared with previous reflationary episodes and a H2 economic recovery is likely to be dampened by weaker exports.

GDP fell by 2.6% between Q1 and Q2 but monthly activity data indicate a significant recovery from an April trough, with June exports and retail sales particularly strong – see chart 1.

Chart 1

Six-month growth rates of narrow and broad money, meanwhile, rose further in June, to 17- and 22-month highs respectively – chart 2.

Chart 2

Six-month growth of real narrow money has moved sideways, with faster nominal expansion matched by a rise in consumer price momentum. Nevertheless, positive and stable real money growth compares favourably with deepening contractions in the US, Europe and many emerging economies – chart 3.

Chart 3

What is driving faster money growth? The credit counterparts analysis of broad money shows major contributions from banks’ net lending to government, reflecting expansionary fiscal policy, and from unspecified items within non-monetary net liabilities. Growth of bank lending to other sectors bottomed last year but has yet to establish a rising trend – chart 4.

Chart 4

Six-month growth of broad money is close to levels reached in previous successful reflationary episodes since the GFC but narrow money growth remains well below the corresponding highs – chart 2. The judgement here is to place more weight on the less upbeat message from narrow money. The demand for broad money may have been boosted by risk aversion due to housing and equity market weakness, as well as the pandemic. Domestic credit expansion, like narrow money growth, is below previous reflationary highs – chart 4.

A fall in global six-month real narrow money momentum below zero in March signalled a shift in the economic outlook from slowdown to recession. A subsequent further decline in momentum to its weakest since 1980 suggests a deep recession extending into Q1 2023, at least. Economic contraction will release liquidity for markets, with "safe" bonds and quality stocks possible beneficiaries. Chinese real money momentum is diverging positively, supporting relative economic / equity market prospects.

Global (i.e. G7 plus E7) six-month real narrow money momentum in May was below its GFC low and the weakest on record in data extending back to 1995. In longer-run G7-only data, the current rate of contraction was matched in 1973 and 1979 before severe recessions – see chart 1.

Chart 1

A further recessionary consideration is the recent pace of stockbuilding: the G7 stockbuilding share of GDP matched a 1974 high in Q1 – chart 2. The cycle upswing was supercharged by firms overordering inputs because of supply shortages. With final demand falling away, a liquidation of inventories will be amplified back through supply chains – the “bullwhip” effect.

Chart 2

The assessment of market prospects here is informed by two measures of global “excess” money: the gap between six-month real narrow money and industrial output momentum; and the deviation of 12-month real money momentum from a slow moving average. Both measures were negative by end-January, a condition historically associated with weak equity markets – table 1.

Table 1

The expected recession and a likely sharp fall in six-month consumer price momentum suggest that the first measure – the real money / output momentum gap – will return to positive territory in H2, possibly in Q3. The second measure may remain negative: 12-month real money momentum is currently far below its moving average and will be slower to recover. The implication is a possible shift from the bottom right quadrant in the table to top right – still an unfavourable backdrop for equities but less grim than during H1.

The excess money indicators are informative about sector and style performance. Recent outperformance of defensive sectors and underperformance of tech accords with the historical pattern under “double negative” readings – table 2. A switch to the upper right quadrant would suggest a tech recovery but further outperformance of defensive vs. non-tech cyclical sectors. Within the defensive basket, however, energy has historically performed poorly under this regime.

Table 2

Style-wise, recent outperformance of high dividend yield stocks accords with the historical pattern in the bottom right quadrant but quality has not on this occasion proved defensive, probably reflecting its inverse correlation with Treasury yields and the magnitude of the H1 rise in the latter – table 3. This suggests that quality will stage a come-back if yields reverse, with a potential shift to the upper right quadrant an additional positive – this was the best regime for quality and growth historically.

Table 3

Six-month real narrow money momentum is similarly weak in the US and Europe but China and, to a lesser extent, Japan are diverging positively – chart 3. A further pick-up in China would support a forecast of economic recovery despite an export drag from recessions elsewhere. The latest PBoC bankers’ survey is consistent with monetary acceleration, indicating substantial policy easing and an increase in loan supply – chart 4.

Chart 3

Chart 4

Global inflation prospects have improved dramatically. Having warned of the current overshoot, monetary trends are now consistent with inflation rates returning to target. G7 annual broad money growth was down to 4.9% in May from a peak 17.3% and is on course to move below its 2015-19 average of 4.5%: the money stock expanded at an annualised pace of only 1.3% in the latest three months.

The monetarist rule of thumb is that money growth leads inflation with a long and variable lag averaging two years. G7 annual broad money growth peaked in February 2021 so this average would suggest no inflation relief before early 2023. Some monetarist economists argue that the 2020-21 money growth surge has left a large monetary overhang, raising the possibility of a longer-than-average lag.

The view here is that the historical variability of the money growth / inflation lag partly reflects the position of the stockbuilding cycle, which is a key driver of commodity prices. The assessment that the cycle has peaked and will be in a strong downswing in H2 2022 suggests that recent commodity price weakness will be sustained, in which case their current large positive impact on annual CPI inflation rates will moderate through H2 and turn negative by early 2023.

Core inflation is widely expected to remain high into 2023, reflecting labour market tightness. Recession and monetary weakness, however, suggest that firms will lack pricing power to pass on increases in labour costs, which may, instead, squeeze historically generous margins and trigger early job cuts. Labour markets could weaken surprisingly sharply, with signs of an imminent unemployment reversal appearing recently in a range of sensitive indicators.