Chinese money supply figures for February warrant continued concern about downside economic risks, while a larger-than-expected fall in inflation may partially reverse in March, delaying necessary significant policy easing.

The forecasting approach employed here emphasises the six-month rate of change of real narrow money – M1 in China’s case.  This turned negative in January but was expected to rebound in February as New Year holiday timing distortions unwound. It did, but only back to zero. Similar weakness in mid 2008 preceded a rare contraction in industrial output – see first chart.

Broad money and loans are growing faster in real terms now than then but six-month changes seem to have peaked in December – first chart. A provisional verdict is that monetary trends are signalling a loss of economic momentum during 2012 following a brief revival late last year but the extent of the slowdown is unclear. The OECD’s Chinese leading index – released on Monday – will provide further clues.

Annual consumer price inflation of 3.2% in February, down from 4.5% in January, was probably flattered by a post-holiday fall in food prices occurring earlier this year than last, suggesting a partial reversal in March. Producer price inflation may also recover as firms pass on recent rises in input costs – second chart. Early further policy easing is expected but lingering inflationary pressures may prevent action on a scale necessary to avert a bumpy economic landing.

As previously discussed, global real narrow money is suggesting a peak in growth – as measured by the six-month rate of expansion of G7 plus emerging E7 industrial output – in May. Such a peak, however, has yet to be confirmed by a shorter-term leading indicator derived from the OECD’s country leading indices – next update on Monday.

A May peak in output momentum would be expected to be preceded by a top in purchasing managers’ manufacturing new orders indices, possibly in March or April. G7 PMI new orders fell back in February following a solid recovery in December / January. This raises the possibility that a slowdown is emerging earlier than suggested by the monetary runes.

Changes in equity analysts’ views about the earnings prospects of the companies they follow provide a higher frequency and more timely cross-check of the PMIs. The global “earnings revisions ratio” – the net number of analyst upgrades, expressed as a proportion of the number of forecasts – is strongly correlated with G7 PMI manufacturing new orders. The ratio retreated in January, signalling the February fall in PMI orders, but has since rebounded strongly, reaching its highest level for a year – see chart. The suggestion is that the February orders decline will be reversed in March.

Investors inclined to become defensive in anticipation of an economic slowdown later in 2012 may be on the right track but risk missing out on near-term gains as news remains favourable for a while longer and recent central bank liquidity injections filter into markets. The view here is neutral awaiting further monetary evidence – including important February Chinese data due shortly – and the leading indicator update.

As suggested in a post last week, the second ECB three-year LTRO had a much larger impact on bank reserves than the first such operation in December, despite gross lending being only moderately higher. Banks’ current account and deposit facility balances at the ECB rose by €341 billion or 60% in the week to Friday versus a €165 billion or 32% increase in the week to Friday 23 December, following the first three-year LTRO on 21 December.

Total bank reserves in the US, Japan, Eurozone and UK, therefore, rose by $395 billion or 13% last week to a new record 10% above the prior weekly closing high on 23 December – see chart.

The further increase suggests near-term liquidity support for markets but reserves may now plateau. The US component has been flatlining since QE2 ended in June and may decline if an easing of financial market tensions reduces foreign demand for the Fed’s dollar swap loans. Eurozone reserves will probably drift lower as banks use part of the cash borrowed in the three-year LTROs to repay shorter-term loans as they fall due. Japanese and UK reserves should rise as a consequence of ongoing QE operations (although the former, strangely, have fallen recently) but may not offset a US / Eurozone decline.

Can markets keep rising without additional infusions of central bank cash? Fed Chairman Bernanke last week downplayed talk of further stimulus but QE3 would return to the table in the event of US economic data disappointing, as seems possible – see Friday’s post. A liquidity boost, however, might be delivered only after a market correction sufficiently scary to suppress opposition to further monetary experimentation.

Recent solid US economic and stock market performance was signalled by earlier monetary strength. Six-month growth of real narrow money, however, peaked in October and is estimated to have fallen sharply in February, based on weekly monetary data – see chart.

The earlier narrow money surge was partly but not completely explained by distortions due to regulatory changes, as described in a previous post. The recent slowdown may reflect an unwind of this regulatory effect. Six-month real growth is still healthy. This would argue for retaining a positive view of economic prospects.

An alternative possibility, however, is that the monetary slowdown is the consequence of QE2 stimulus fading – the expansion of the Fed's securities holdings stopped in June. “Operation twist and shout” – Fed purchases of longer-dated Treasuries financed by selling shorter-maturity bonds coupled with a campaign to talk down interest rate expectations – does not inject cash directly into the economy so is less powerful. The slowdown, on this view, signals deteriorating economic prospects.

The October peak in six-month real money growth suggests an April top in industrial output expansion, allowing for the typical six-month lead. The fall in the ISM manufacturing new orders index in February reported yesterday – which had been foreshadowed by other indicators – is consistent with such a scenario.

Optimistic economic commentary may be overemphasising lagging labour market indicators and underestimating the temporary positive effect of mild weather as well as leap year data distortions. It is early days but first-quarter GDP growth could be surprisingly weak. January real personal consumption was unchanged from the fourth-quarter average. Nominal capital goods shipments – a proxy for business equipment investment – fell by 1.6% on the same basis. Stockbuilding was 0.4% of GDP in the fourth quarter versus an average of 0.25% since 1995, suggesting a decline this quarter. Real government spending may fall for the sixth successive quarter. A rise in GDP, therefore, may depend on strength in construction investment and net exports – possible but not guaranteed.

The weakness of UK broad money growth in recent years misled most monetarist economists into underpredicting inflation. The view taken here, by contrast, was that this weakness would be more than offset by a rise in the velocity of circulation of money in response to negative real interest rates. The eroding real value of money, in other words, would result in households and firms wishing to hold less of it. The attempt to get rid of “excess” balances would cause money to circulate faster, with a given stock associated with a higher level of nominal GDP and prices.

An ex post measure of velocity is the ratio of nominal GDP to the broad money stock. (Broad money is defined here as M4 excluding holdings of “intermediate other financial corporations”, or M4ex. Figures before 1998 are estimated by linking to M4.) Velocity bottomed in the second quarter of 2009 and had risen by 6.4% by the fourth quarter of 2011. This represents the largest cumulative increase since the late 1970s, when real interest rates were similarly heavily negative – see chart.

The maximum rate of nominal GDP growth compatible with the 2% inflation target over the medium term is about 4% per annum, assuming 2% trend real economic expansion. The 6.4% rise in velocity over the last 10 quarters implies a 2.5% pa rate of increase. Assuming that velocity continues on its recent trend, therefore, inflation is likely to exceed 2% if broad money growth is more than 1.5% pa. Annual M4ex growth was 2.9% in January and has been above 2% in six of the last seven months. Accordingly, the view here is that inflation will continue to overshoot barring a “shock” that causes money demand to increase.