Is the UK in a “technical recession”, as claimed by the OECD, which yesterday forecast that GDP would fall by 0.1% in the first quarter following a 0.3% fourth-quarter decline?

The first point is that the fourth-quarter decline could yet be revised away. Neither the widely-watched purchasing managers’ surveys nor labour market data suggested output contraction – aggregate hours worked in the economy rose by 0.4% in the fourth quarter. As an example of the revisability of GDP data, a 0.4% decline originally reported for the third quarter of 2009 has since changed to a 0.2% rise.

The Office for National Statistics releases its initial estimate for the first quarter on 25 April. It has already published January output data for the services and industrial sectors, which account for 92% of GDP. Combined output was 0.4% above the fourth-quarter level. With little reason to expect a relapse in February and March, this has led some commentators to expect a solid quarterly GDP print.

The fly in the ointment, however, is – again – the construction sector. Unadjusted construction output plunged in January to stand 19% below its fourth-quarter average. An attempt to adjust for seasonal weakness implies a still-large 10% decline. Combining this with the 0.4% rise in services / industrial output in January suggests that GDP was 0.4% lower than in the fourth quarter – see first chart. So a rebound is needed in February and March to prevent a quarterly contraction.

Construction output is highly volatile and it is reasonable to expect a big bounce in February and March. This may not, however, arrive early enough to be fully reflected in the initial quarterly GDP estimate. The notion that construction will act as a drag on first-quarter GDP, moreover, is supported by earlier weakness in orders, which usually lead output – second chart.

The view here is that the two-quarter GDP decline definition is misleading and the UK is not in a recession as properly defined as a “pronounced, pervasive and persistent” decline in economic indicators, to use the formulation of the US Economic Cycle Research Institute. The odds are that the first-quarter print will be positive but the ability of official statisticians to wreck the hopes of Chancellors should never be underestimated.

UK monetary trends are giving mixed signals for economic prospects. Broad money has picked up in both nominal and real terms, partly reflecting QE2, but narrow money remains weak. Narrow money would normally be accorded greater weight here but may have been depressed by a rise in term interest rates, resulting in funds shifting out of current accounts. Based on the broad money pick-up, the economy could surprise to the upside.

Broad money trends cannot be assessed by reference to the traditional M4 aggregate, which is artificially weak because of a fall in money holdings of “intermediate other financial corporations” – these corporations are essentially a conduit for interbank business, which is of little relevance to the economy. (Direct interbank business is excluded from money supply definitions). The preferred broad measure here is non-financial M4, comprising holdings of households and private non-financial companies. This rose by a solid 2.3%, or 4.6% annualised, in the six months to February.

Narrow money is best measured by M1, comprising cash in circulation and sight deposits. Unlike broad money, this remains weak, falling by 0.6% in the six months to February. This weakness, however, may be partly explained by banks’ bidding more aggressively for term funding, thereby encouraging households and firms to economise on current account balances. The average interest rate on household time deposits has risen from 2.54% to 2.77% over the last year.

The chart shows two-quarter or six-month changes in non-oil GDP and the two money measures, now expressed in real terms (i.e. deflated by seasonally-adjusted consumer prices). Real non-financial M4 rose by 0.6%, or 1.3% annualised, in the six months to February – the fastest since early 2009, just ahead of a spurt in growth. Real M1 is much weaker, showing a 2.2% decline. This is, however, better than a year ago, when real non-financial M4 was also contracting.

A provisional verdict is that monetary trends are signalling economic improvement but to an unknown extent – a revival in M1 would strengthen the case for optimism.

Eurozone money supply figures for February confirm a positive impact from the ECB’s liquidity injections but real money trends have yet to signal a recovery in economic activity.

An optimistic interpretation would highlight a turnaround in broad money M3 since the ECB’s first three-year LTRO in December – M3 rose by 0.5% in January and 0.8% in February following a 0.8% fall during the fourth quarter of last year. The pick-up mainly reflects a resumption of the sovereign carry trade: banks bought €40.5 billion of euro-denominated government bonds last month following €55.2 billion in January – see first chart. The large drawdown at the second three-year LTRO at the end of February suggests that purchases will remain strong near term.

Of the €95.8 billion of bond buying in January and February combined, Italian and Spanish banks accounted for €45.6 billion and €38.7 billion respectively.

Narrow money M1, however, is a better leading indicator of the economy than M3 and has shown less improvement, rising by 0.1% and 0.6% in January and February respectively. Both M1 and M3, moreover, remain below their level six months ago in inflation-adjusted terms – second chart. The six-month real M1 change turned heavily negative in early 2011, warning of the current recession (as it had the 2008-09 downturn, unlike real M3). The recent decline is smaller but still suggests economic contraction.

M1 comprises currency in circulation and overnight deposits. The ECB publishes a country breakdown of deposits but not currency. A 1.1% (not annualised) fall in Eurozone real M1 deposits in the six months to February conceals a respectable 1.8% rise in “core” economies (defined as Austria, Belgium, France, Germany, Luxembourg and the Netherlands) offset by a 5.6% plunge in the “periphery” (i.e. Greece, Ireland, Italy, Portugal and Spain), or 10.9% annualised – third chart. The peripheral rate of contraction has accelerated, not slowed, since the first three-year LTRO, suggesting a faster decline in output in mid 2012, allowing for the usual half-year lead.

The country decomposition confirms a continuing collapse of the Greek monetary system, with real M1 deposits down by 13.9% in the six months to February, or 25.9% annualised – fourth chart. (Real M3 deposit contraction is similar, at 13.6%.) The pace of decline in Ireland, Portugal and Italy is also alarming – 15.7%, 14.0% and 13.8% annualised respectively. Spanish real M1 deposits are falling more slowly than before the 2008-09 recession but this relative resilience may prove fleeting, with market pressures increasing again this month.

Peripheral monetary weakness, of course, partly reflects capital flight but this does not diminish its significance for economic prospects – collapsing confidence in banking systems signals extreme risk aversion that should be reflected in economic behaviour while money transferred abroad is less likely to be spent on domestic goods and services.

Previous posts argued that UK CPI inflation would remain comfortably above the 2% target during 2012, reflecting stubborn “core” pressures and an expected rise in global industrial commodity prices. A central scenario envisaged the headline rate troughing at 2.5% in the autumn and moving higher into 2013.

The consensus, by contrast, had bought into the Bank of England’s assertion that inflation would reconnect with the target in late 2012 and move beneath it in early 2013. In the December 2011 edition of Consensus Forecasts, the average prediction for CPI inflation in the first quarter of 2013 was 1.9%.

The consensus, however, is shifting in response to rising global energy costs and recent disappointing outturns. The UK economics team of a major US investment bank last week revised up its projection for December 2012 CPI inflation to 2.9% from 2.0% at the end of last year. The energy price “shock” accounts for 0.4 percentage points of this forecast change with a raised assumption for core inflation contributing a further 0.25 percentage points.

The emerging new consensus implies that CPI inflation will be above the 2% target for the seventh consecutive December, in turn suggesting that the MPC was wrong to launch QE2 in October 2011, as argued in previous posts.

The inflation forecast here is essentially unchanged since recent developments do not represent “news” relative to its assumptions, while a slowdown in global economic growth from the spring is expected to relieve upward pressure on energy prices. The chart shows a profile for the headline rate and a core measure excluding unprocessed food and energy.

In a Guardian interview a year ago the MPC’s leading dove, Adam Posen, predicted that inflation would tumble to 1.5% by the middle of 2012 and stated that: “If I have made the wrong call, not only will I switch my vote, I would not pursue a second term.” Will Dr. Posen honour his pledge or try to shift the goalposts by appealing to economic weakness or claiming his forecast was blown off course by yet more “one-off” shocks?

As previously discussed, a fall in six-month global real narrow money expansion since November 2011 suggests a decline in six-month industrial output momentum from May 2012, allowing for the typical half-year lag. The level of real money growth, however, remains respectable, consistent with an economic slowdown rather than anything worse – see first chart.

Eurozone money supply figures for February released on 28 March will be important for confirming this assessment. The hope is that the ECB’s liquidity injections have stabilised the banking system and restored confidence, thereby improving spending prospects. Such a scenario should be reflected in a shift of funds into M1 deposits – a usual precursor of a recovery in economic activity. Faster Eurozone real M1 growth could compensate for a slowdown in the US, supporting the global measure at a level consistent with continued moderate economic expansion – second chart.

The optimistic scenario was dented by yesterday’s disappointing “flash” Eurozone PMI surveys for March – the key manufacturing new orders index fell to a three-month low. It is too early, however, for the positive effects of the ECB’s actions to show up in such surveys. The results, moreover, are at odds with a continued improvement in the balance of equity analysts’ earnings upgrades and downgrades, suggesting a PMI rebound next month – third chart.

Posts since 2009 have argued that the late 1970s provides a template for the current global economic cycle. The fourth chart updates a comparison of six-month industrial output expansion across the two periods, demonstrating a similar “pulse”, with recent economic acceleration occurring on schedule. The suggestion is that momentum will peak in mid 2012 and slow into 2013, while remaining positive – consistent with the current message of the monetary data.

A February post suggested that Chinese economic data would show renewed weakness, based on soft monetary trends and a downturn in leading indicators. The forecast receives support from today’s Markit “flash” manufacturing PMI survey for March, showing a fall in the key new orders index to its lowest level since November – see first chart.

The authorities need to accelerate policy easing to avert the risk of a “hard landing”. Repo rates have fallen recently, which may presage another cut in the system-wide required reserves ratio or even official interest rates – second chart. (The reserves ratio was reduced yesterday for selected branches of the Agricultural Bank of China.)

Policy-makers, however, may be cautious ahead of the March CPI inflation release, which may show a rebound from February’s 3.2% print due to New Year timing effects and recent firmer food prices – third chart.