There are three messages from Eurozone monetary data for May released yesterday.

1. The region faces a major recession that is likely to extend into early 2023, at least.
2. Economic prospects are at least as bad for core countries as for the periphery.
3. Nominal monetary trends are consistent with inflation returning to – or falling below – the 2% target in 2023-24, arguing for an immediate suspension of ECB tightening plans.

The “best” monetary leading indicator of Eurozone GDP, according to ECB research, is real non-financial M1, i.e. holdings of currency and overnight deposits by households and non-financial corporations deflated by consumer prices.

The six-month rate of change of real non-financial M1 turned negative in January and fell further to -1.9% (not annualised) in May, below the lows reached before / during the 2008-09 and 2011-12 recessions – see chart 1.

Chart 1

Based on longer-run data for real M1, the current rate of real narrow money contraction is the fastest since 1981.

All previous recessions ended only after the six-month rate of change turned positive. The ECB research, meanwhile, found that real narrow money led GDP by three to four quarters on average. The suggestion is that an incipient recession will extend into Q1 2023, at least.

Chart 2 shows six-month rate of changes of real non-financial M1 deposits in the big four economies. (A country breakdown of currency holdings is unavailable.) In a reversal of the pattern before the 2011-12 recession, weakness is more pronounced in Germany and now France than in Spain and Italy. German divergence partly reflects higher inflation but nominal growth of deposits is also weaker in France / Germany than Spain / Italy.

Chart 2

Eurozone nominal money trends, meanwhile, indicate rapidly improving medium-term inflation prospects. Annual growth of broad money, as measured by non-financial M3, slowed to 4.8% in May, with three-month momentum down to 2.8% annualised, the lowest since 2018 – chart 3.

Chart 3

The slowdown has occurred despite a rise in annual growth in bank loan to a post-GFC high of 5.3% in May. This pick-up does not contradict the negative monetary signal – lending is a coincident or lagging indicator of GDP (confirmed by the ECB research). The coincident / lagging relationship partly reflects a correlation of corporate credit growth with the stockbuilding cycle – demand for short-term loans is strongest as inventories swell at the peak of the cycle. Consistent with this explanation, loans to corporations with a maturity of up to a year grew by an annual 7.0% in May.

The counterparts analysis of M3 shows that the slowdown has been driven by the ending of QE but also a significant balance of payments outflow, reflected in a fall in banks’ net external assets. This outflow is the mirror-image of a basic balance deficit, which has widened as a current account surplus has been wiped out by high energy prices while the Ukraine crisis and other factors have triggered an exodus of capital from the region.

Economic “optimists” argue that UK / US recessions will be avoided because households and firms have accumulated a “war chest” of excess monetary savings that will be deployed to support spending. The assessment here is that high inflation is rapidly eroding excess money balances while households / firms are unlikely to reduce precautionary savings against a backdrop of deteriorating economic / financial conditions.

Chart 1 is a recreation of one used to support the optimistic case. The suggestion is that UK households have amassed £170 billion of excess monetary savings, equivalent to 11% of annual disposable income.

Chart 1

A statistical issue here is the reliability of a measure of “trend” calculated over just two years.

More importantly, the demand to hold money depends on a host of influences, of which the most important is the price level. Any assessment of the magnitude of excess money balances should, at a minimum, take account of inflation.

Chart 2 recasts the analysis in real terms, while calculating “trend” over a 10-year period. The suggestion is that high inflation has already eroded a large proportion of the monetary excess, with the current deviation equivalent to 3% of disposable income.

Chart 2

Real money holdings were 2.7% above trend in April. Household M4 grew at a 4.2% annualised rate in the latest three months. If this pace were to be maintained, nominal money holdings would rise by 2.4% by Q4 2022. The Bank of England’s May forecast of CPI inflation of 10.2% in Q4, meanwhile, implies an increase in prices of 5.0% between April and then. These projections would entail a further 2.5% contraction in real money holdings by Q4. With “trend” increasing by 1.2% between April and Q4, the current positive deviation would swing to a small negative.

Shorter-term leading indicators are confirming the negative signal for US economic prospects from monetary trends.

An independent calculation of the OECD’s US composite leading indicator suggests another fall in the indicator in June along with upward revisions to declines in prior months – see chart 1.

Chart 1

The indicator is calculated as a ratio to trend, i.e. a decline indicates that output will lag its trend rate of growth. The extent of the shortfall should be related to the speed of descent of the indicator. The current pace has been consistent with a recession historically.

The June indicator estimate incorporates new information for four of the seven components: housing starts, consumer sentiment, stock prices and the yield spread between 10-year Treasuries and Fed funds. Data for the remaining three – durable goods orders, the ISM manufacturing PMI and average weekly hours worked in manufacturing – will be released on 27 June, 1 July and 8 July respectively.

The indicator’s decline is notable for its breadth as well as speed: all seven components have contributed to recent weakness.

The June indicator estimate assumes little change in the three missing components. The ISM PMI could fall significantly. The Philadelphia Fed manufacturing survey for June reported a plunge in new orders (average of current and future balances), mirroring weakness in May’s Richmond Fed survey and suggesting a crash in the ISM orders index – chart 2. The latter has a 20% weight in the PMI and usually leads the other components.

Chart 2

A vicious real money squeeze, meanwhile, is intensifying. A weekly broad money measure calculated here was unchanged in nominal terms in early June from its level at the start of the year – chart 3. With consumer prices up by 4.1% over December-May and expected to post another large rise in June, real broad money will have contracted by about 5% (10% annualised) during H1.

Chart 3

Global six-month real narrow money momentum – a key monetary leading indicator of the economy – is estimated to have moved deeper into negative territory in May, suggesting that a likely recession over the remainder of 2022 will extend into early 2023 – see chart 1.

Chart 1

The May estimate is based on monetary data for countries accounting for a combined 65% weight in the G7 plus E7 aggregate tracked here, along with 93% CPI coverage. Missing numbers are assumed to have maintained stable rates of change.

Real money momentum of an estimated -1.2% (not annualised) compares with lows of 0.4% and -0.5% associated with the 2001 and 2008-09 recessions respectively.

Chart 2 shows a longer-term history using G7-only data. The current rate of contraction of G7 real narrow money was reached only twice over the last 50+ years – in 1973 and 1979 before severe recessions. The rate of contraction of real broad money is faster than during those episodes.

Chart 2

Global real narrow money weakness intensified in May despite stable growth in China, mainly because of faster US contraction – chart 3. China’s positive monetary divergence may explain recent better equity market performance, with the MSCI China index now outperforming global indices year-to-date – chart 4.

Chart 3

Chart 4

The fall in global six-month real money momentum in May was driven by a further slowdown in nominal money growth, with six-month CPI inflation stabilising after a January-April surge – chart 5.

Chart 5

CPI momentum will almost certainly fall back in H2 – the relationship in chart 6 suggests that commodity prices would have to rise by a further 50% by December to prevent a decline.

Chart 6

A CPI slowdown, however, could be offset by further loss of nominal money momentum – unless rising growth in China (22% weight in the G7 plus E7 aggregate) offsets likely weakness in the US / Europe.

Chinese May money numbers give a moderately positive message for economic prospects, suggesting that recent policy easing is gaining traction. Assuming that pandemic disruption is contained, domestic demand is expected here to recover during H2 2022 and into 2023, partially shielding the economy from export weakness due to G7 recessions.

Six-month broad money growth rose further in May and is around levels reached during previous successful monetary / fiscal stimulus campaigns since the GFC – see chart 1.

Chart 1

Narrow money growth, however, continues to lag*, suggesting that improving monetary conditions will take longer than usual to feed through to the economy.

The likely explanation, of course, is that pandemic disruption is holding back demand both directly and via reduced consumer / business confidence, with restraint reflected in a preference to hold additional money in the form of time / savings deposits (for now) rather than ready-to-spend demand deposits.

Still, narrow money growth has recovered significantly since late 2021.

With Chinese CPI inflation contained within its post-GFC range, real as well as nominal money growth rates have improved – chart 2.

Chart 2

As an aside, the relative quiescence of Chinese CPI inflation blows apart US / European central bankers’ claims that current overshoots mainly reflect supply-side shocks. China has suffered the same shocks but pass-through to CPI inflation has been much smaller because of the PBoC’s monetary orthodoxy in 2020-21.

Information through April on the credit counterparts of broad money indicates that the recent growth pick-up has been driven by stronger net lending to government – consistent with expansionary fiscal policy – as well as banks increasing their reliance on monetary funding. Growth of lending to households and firms has moved sideways.

*”Narrow money “= “true” M1 = official M1 + household demand deposits. The May data point is estimated pending release (next week) of a sector breakdown of demand deposits.

G7 GDP data confirm that stockbuilding gave an unusually large boost to growth in the year to Q1. Stockbuilding is almost certain to fall over coming quarters, implying that the growth impact will turn from positive to (probably large) negative. Prospective weakness in stockbuilding reinforces the recessionary signal from real money contraction.

Japanese and Eurozone GDP details released today showed “surprisingly” large increases in inventories in Q1, mirroring similar surges in the US, UK and Canada. For the G7 group, stockbuilding is estimated here to have reached 1.0% of GDP (real data).

GDP growth is related to the change in stockbuilding. G7 stockbuilding was negative in Q1 2021 – inventories fell by 0.1% of GDP. So stockbuilding as a share of GDP rose by 1.1 percentage points in the year to Q1 2022, i.e. stockbuilding “accounted for” 1.1 pp of GDP growth in the year to Q1 – see chart 1.

Chart 1

Q: Why is stockbuilding almost certain to fall from its Q1 level?

A: Because its estimated 1.0% share of GDP in Q1 is a record in data extending back to the 1960s, matched only in Q2 1974 (which immediately preceded a severe recession).

Its average share over 1965-2019 was 0.2%. If the actual share were to fall to this level in Q1 2023, the contribution of stockbuilding to annual GDP growth would be -0.8 pp in that quarter, representing a huge -1.9 pp swing from Q1 2022.

The annual change in G7 stockbuilding as a share of GDP is used here to date lows in the stockbuilding cycle. The cycle has averaged 3 1/3 years historically and the last low was in Q2 2020, suggesting another trough in H2 2023.

The extreme Q1 reading is consistent with a cycle peak but there is a chance that the annual change in the stockbuilding share will rise even further in Q2, reflecting a positive base effect – inventories fell by 0.4% of GDP in Q2 2021.

The argument that the stockbuilding cycle is about to become a major drag on global growth does not, it should be emphasised, rely on a forecast that firms will reduce inventories from their current level, only that the rate of accumulation will slow. Stockbuilding is often still positive at cycle lows.

Following such extreme accumulation, however, a liquidation of inventories is certainly possible and would, of course, reinforce recessionary dynamics.