UK monetary trends continue to support a positive view of economic prospects – the forecast here remains that GDP will rise by about 2% in 2013 versus a sub-1% consensus.

The monetary aggregates most relevant for assessing the immediate economic outlook are broad money M4 and narrow money M1 excluding holdings of financial corporations (i.e., comprising holdings of the household sector and non-financial corporations). Six-month growth of non-financial M1 rose to 5.6%, or 11.6% annualised, in April – the fastest since October 2005. Non-financial M4 has slowed modestly since early 2013 but six-month growth was still a solid 2.5%, or 5.1% annualised – higher than between June 2008 and July 2012.

Faster growth of M1 than M4 signals that the collapse in bank deposit interest rates since last summer is affecting consumer and business behaviour – the movement of money into more liquid forms is a likely precursor of a pick-up in spending.

Empirically, future economic activity is more closely related to real (i.e. inflation-adjusted) than nominal monetary trends. Real money expansion has been further boosted by a sharp, though probably temporary, drop in inflation – see charts. Recent real money trends suggest that growth prospects are at least as good as in mid-2009 – GDP is currently estimated to have risen by 2.4% in the year to the third quarter of 2010.

The consensus remains too negative on economic prospects partly because of continued credit weakness. While money leads the cycle, credit is a coincident or lagging indicator. There are signs, in any case, that the credit cycle is turning: M4 lending to households and non-financial corporations was unchanged in the six months to April while arranged but undrawn credit facilities – a leading indicator – are rising for the first time since 2007.

Eurozone monetary trends are signalling a return to growth over the remainder of 2013, with the periphery participating in the recovery during the second half – a development that would stun a bearish Keynesian consensus.

Eurozone-wide and country real (i.e. inflation-adjusted) narrow money trends have been an excellent guide to economic prospects in recent years, forewarning of the 2008-09 and 2011-12 recessions as well as widening core / periphery divergence. Eurozone real M1, however, resumed expansion in mid-2012 and is now growing solidly – by 3.1%, or 6.4% annualised, in the six months to April. Allowing for the usual half-year lead, this suggests a rise in Eurozone GDP / industrial output in the second quarter and faster growth during the second half – see first chart.

M1 comprises currency in circulation and overnight deposits – forms of money more likely to be related to economic transactions, explaining forecasting relevance. The ECB publishes a breakdown of overnight deposits by country of the receiving bank. The second chart shows the six-month change in real overnight deposits split between core and periphery (i.e. Italy, Spain, Greece, Portugal and Ireland). Peripheral contraction slowed during 2012 and deposits have surged in early 2013, partly reflecting a reversal of capital flight. Peripheral GDP should fall again in the second quarter but a second-half recovery may result in growth converging with the core by end-2013.

Economists who pay attention to the monetary data typically focus on broad money and credit so are likely to miss the positive message from narrow money. Real M3 has been an inferior leading indicator historically – it failed to warn of the 2008-09 recession – but is expanding modestly, consistent with economic recovery. Private-sector credit is a coincident or lagging indicator. Real loan contraction has slowed recently, consistent with a turning point in the economic cycle – first chart.

The pick-up in peripheral real narrow money has been led by Italy although Spain has also improved – third chart. Only Portugal is still contracting on a six-month basis. France moved into positive territory in April but continues to lag, as does the Netherlands. The core / periphery distinction, in other words, is becoming less relevant.

A recent post suggested reducing equity exposure on the grounds that monetary and leading indicator evidence has turned mixed, having been clearly positive in late 2012. This ambiguity is illustrated by two formal equity versus cash investment rules.

The first rule, discussed in several previous posts (e.g. here), invests 100% in global equities if G7 annual real narrow money growth is above industrial output expansion but holds 100% US dollar cash otherwise*.

The second rule is based on a G7 “double-lead” indicator derived here from OECD country leading index data. The rule invests 100% in equities unless the leading indicator suggests below-average economic growth.

The first chart compares the cumulative return relative to cash of the two rules with a buy-and-hold strategy. The “excess money” rule would have delivered an excess return averaging 3.6% per annum since 1970 relative to buy-and-hold. The leading indicator rule would have delivered 5.2% pa.

These returns are hypothetical because they are based on currently-available data. This is less of a problem for the excess money rule – annual real money and industrial output growth could have been calculated in real time and subsequent data revisions would probably have made little difference to the timing of cross-over signals. By contrast, the leading indicator series incorporates changes over the years in the construction and constituents of the OECD’s country leading indices. Data revisions to these indices, moreover, are sometimes significant. The historical return of the leading indicator rule, therefore, is unlikely to have been achievable in practice.

The two rules are now giving an opposite signal for the first time since August 2012. G7 real money growth remains above industrial output expansion on both an annual and six-month basis, although the surplus has fallen since late 2012. Accordingly, the excess money rule is still invested in equities.

By contrast, the G7 double-lead indicator fell marginally below its long-term average in March, causing the associated investment strategy to shift into cash – second chart.

Still-solid global real money growth raises the possibility that the weakness of the double-lead indicator will prove to be a false signal that is either revised away or reversed over coming months. Greater caution, however, may be warranted until the signals from the two approaches become realigned – either positively or negatively.

*A six-month lag is applied before buying equities after a positive cross-over.

The second estimate of first-quarter GDP growth was unchanged at 0.3% (0.31% versus a preliminary 0.30% before rounding). Monthly output, however, rose by more during the course of the quarter than previously assumed, supporting the view here that GDP could post an outsized second-quarter increase.

Specifically, monthly GDP – based on output data for services, industry and construction, together accounting for 99.4% of GDP – grew by 0.1%, 0.7% and 0.2% in January, February and March respectively. The March reading was 0.35% above the first-quarter average – GDP will rise by this amount in the second quarter even if monthly output is static at the March level. Earlier data suggested a smaller carry-over effect of 0.25%.

As previously discussed, second-quarter GDP may also benefit from a rebound in construction output from weather-related weakness. A return to fourth-quarter activity – consistent with a rise during the second half of 2012 in construction new orders, which lead output – would boost GDP by about 0.3% relative to the March level. The combination of the carry-over and construction effects, in other words, could produce a 0.65% second-quarter GDP gain, before allowing for possible further growth in the rest of the economy.

The first-quarter GDP revision was accompanied by a first estimate of the GDP deflator (i.e. prices), which rose by a surprisingly strong 1.6%. Quarterly deflator changes are volatile but it is noteworthy that annual growth in current-price GDP jumped from 1.5% in the fourth quarter to 3.4% – the strongest since the third quarter of 2011.

A monetarist view is that this pick-up is being driven by an earlier recovery in broad money growth – annual expansion of M4 excluding money holdings of financial corporations has been moving up since the third quarter of 2011. The money supply typically leads economic activity by about six months and prices by about two years, suggesting an impact on current-price GDP after approximately 15 months. The rise in current-price GDP expansion in early 2013, in other words, is consistent with the late 2011 increase in money growth, which was sustained during 2012.

CPI inflation was expected to fall in April because of lower petrol prices and a favourable Budget base effect but the outturn of 2.4% was below a projection here of 2.6% (also the consensus forecast). The chart shows a revised profile incorporating the modest good news in today’s release. Inflation is projected to rebound to a peak of 3.3% in June before falling back to average 2.8% during the second half of the year.

Suggestions that today’s news marks the start of a new favourable trend are unconvincing:

• Price expectations balances in business and consumer surveys are in the middle of their ranges in recent years, during which inflation has consistently overshot the 2% target.

• Import prices have yet to respond fully to sterling weakness since late 2012.

• Wholesale petrol prices are rising again. The drag effect on annual inflation will reverse even assuming stable pump prices.

• A continued revival in economic momentum during 2013 may encourage more firms to raise prices, given modest spare capacity and below-average margins.

• Stronger monetary growth since late 2011 should begin to exert upward pressure from late 2013, based on Friedman’s average two-year lead from money to prices.

The recent inflation fall, nevertheless, has improved economic prospects for the remainder of the year by giving a further boost to real money supply expansion.

The new CPIH inflation measure incorporating owner-occupiers’ housing costs fell to 2.2% in April. Such costs, however, are supposedly rising at an annual rate of only 1.0%. This is difficult to reconcile with other information: the CPI index of actual rents increased by an annual 2.6% in April, while the deflator for imputed rents in the national accounts climbed 5.7% in the year to the fourth quarter of 2012.

A post in December suggested that UK GDP would grow by about 2% in 2013. This was based partly on a simple forecasting rule-of-thumb that judges prospects for the coming calendar year to be “good” if both real money growth and share prices are higher than a year before. This condition was met at the end of last year for the first time since December 2005. Historically, growth has averaged 4.1% in years following such a signal – see the earlier post for details.

The current consensus is for growth of only 0.8% this year, according to the Treasury’s monthly survey of forecasters. 2% expansion is, on the face of it, out of reach. Current official statistics show that GDP in the first quarter was only 0.4% above the 2012 level. This implies that it would need to rise at a 4.1% annualised rate over the remaining three quarters to produce full-year growth of 2% (assuming an equal increase in each quarter).

Such arithmetic, however, is misleading because it ignores the potential for upward revisions to current official data. Quarterly GDP changes over 2009-11 (i.e. three years) have so far been revised up by an average of 0.18 percentage points since first reported. Assume that the initial estimates since the first quarter of 2012 are upgraded by the same amount. The first-quarter level of GDP would then be 0.8% above the 2012 level, rather than 0.4%. The economy would need to expand by “only” 3.0% annualised over the remaining three quarters to produce a full-year increase of 2%.

A further reason for retaining the 2% full-year forecast is the possibility of an outsized second-quarter GDP rise. Based on current official information, the March level of GDP was 0.25% above the first-quarter average*. Construction output was hit by poor weather in early 2013 and is likely to bounce back in the second quarter – a return to fourth-quarter activity would raise GDP by 0.35 percentage points relative to its March level. If the rest of the economy expands by 0.1% per month, GDP could rise by 0.8% this quarter (i.e. 0.25 carryover effect plus 0.35 construction boost plus 0.2 trend growth).

A 0.8% second-quarter gain, combined with the suggested upward revisions to earlier data, would imply a required growth rate of 2.6% annualised during the second half of 2013 in order to achieve 2% expansion for the year.

The suggested scenario would involve GDP growth of 2.6% between the fourth quarters of 2012 and 2013. This is not unrealistic: GDP rose by 2.4% in the year to the third quarter of 2010 and recent money supply expansion has been faster than in 2009-10.

*Based on actual industrial and construction data and the official assumption for March services output incorporated in the preliminary first-quarter GDP estimate.