Eurozone real narrow money, M1, has stagnated over the last six months, suggesting that economic growth will slow sharply in early 2011 – see previous post.

M1 comprises currency in circulation and overnight deposits. The first chart shows the six-month change in real overnight deposits broken between the "core" and "periphery" (currency figures are not available by country).

The pace of contraction in the peripheral group eased in October but still signals economic stagnation, at best, in early 2011. The further fall in Eurozone-wide growth last month reflected a loss of momentum in the core, casting doubt on the ability of these economies to continue to decouple from peripheral weakness.

The second and third charts show a country breakdown. Real M1 deposits have contracted over the last six months in all five peripheral economies and also in Belgium and the Netherlands.

The ECB may have contributed to this weakness: its decision to withdraw 12- and six-month lending facilities has resulted in a 20% fall in the monetary base since June, in turn pushing up EONIA and increasing funding pressures on struggling banks. A reinjection of liquidity is urgently required but policy-makers are reluctant to reopen the lending window for fear of being swamped by demand from weaker sovereigns seeking back-door support via local banks.

The Office for Budget Responsibility under its new leadership today issued a 152-page report that makes rounding error changes to the economic and fiscal forecasts presented at the time of the June Budget. One of the few significant amendments is a downward revision to the loss of general government jobs over the next four years, from 490,000 to 330,000, although – like all the numbers in the report – this is "subject to a large degree of uncertainty".

The basic story is that a below-par but sustained economic recovery combined with the coalition's tax and spending plans will return the public finances to sustainability by 2015-16. Growth will be constrained, according to the OBR, by tight credit conditions, desired private sector debt reduction and the fiscal consolidation itself.

The OBR, like the consensus, is probably too downbeat about economic prospects. Forecast GDP growth of 2.4% per annum over the five years 2010-14 compares with 3.4% achieved over 1994-98 despite fiscal retrenchment on a similar scale. Claims that the private sector is in a weaker position to take up the baton than in the early 1990s are unconvincing: corporate finances are in better shape and households have been insulated from the consequences of higher debt by low interest rates, resulting in fewer arrears cases and repossessions. There were similar concerns about credit supply in the 1990s, following a large hit to banks' capital from residential and commercial property busts.

Rather than a growth shortfall, the key risks to the fiscal outlook are that, first, the coalition fails to implement planned spending cuts and / or tax increases yield less revenue than expected and, secondly, higher interest rates boost debt servicing costs. A useful ready-reckoner table on page 117 of the report shows that each 1 percentage point rise in interest rates and inflation raises debt interest spending in 2015-16 by £10.7 billion, or 0.6% of GDP.

The net percentage of UK consumers expecting prices to rise at a faster pace over the next year is at its highest level since July 2008, according to the November EU Commission consumer survey – see chart.

The net percentage reporting an increase in prices over the last 12 months also rose further and is well above its long-run average.

The forward-looking indicator usually leads swings in inflation and the latest rise is consistent with the forecast here of a pick-up in the headline CPI rate to 4% or more in early 2011, a prospect also mooted by MPC member Andrew Sentance in an article yesterday.

UK monetary trends are consistent with an ongoing economic recovery but growth is likely to moderate from its recent bumper pace:

• M4 excluding intermediate other financial corporations (i.e. M4ex) rose by 2.9% annualised in the three months to October. Growth remains weak by historical standards but is sufficient to support solid nominal income expansion because of a rising trend in the velocity of circulation, caused partly by negative real interest rates. (Velocity – defined as the ratio of nominal GDP to M4ex – increased by an annual 4.4% in the third quarter.)

• Within M4ex, money holdings of private non-financial corporations rose by 6.6% annualised in the latest three months. Stripping out the overleveraged property sector, the corporate liquidity ratio (i.e. non-financial companies' sterling and foreign currency deposits divided by their bank borrowing) is at a record high in data extending back to 1998. The ratio leads business spending (i.e. fixed investment plus stockbuilding), which is up by 25.7% from a trough in the fourth quarter of last year.

• Household M4 growth – 2.6% annualised in the three months to October – continues to be depressed by a portfolio switch out of bank and building society deposits into higher-yielding investments. Retail inflows to unit trusts and OEICs totalled £24.9 billion in the 12 months to September, equivalent to 2.5% of household money holdings (October figures are released on Wednesday).

• Two considerations suggest a slowdown in GDP growth from 3.9% annualised in the second and third quarters. First, while M4ex is rising at a satisfactory pace, faster price increases – due to the coming VAT hike and higher food and energy costs – will cut real expansion, implying less monetary stimulus for economic activity. Secondly, narrow money has slowed recently, with annual M1 expansion falling from 8.3% in June to 3.0% in October.

Eurozone monetary statistics for October are disappointing, showing a further decline in annual growth of narrow money M1 (from 6.2% to 4.9%) and continued sluggishness in the broader M3 measure.

Real (i.e. inflation-adjusted) M1 is the best monetary leading indicator of the economy and has stagnated over the last six months, signalling a sharp slowdown in Eurozone industrial output in early 2011 – see first chart. Recent buoyancy in business surveys is unlikely to last.

M3 grew an annual 1.0% in October. The counterparts analysis reveals mutual support operations by banks and governments last month – credit to general government rose by €165 billion, or 5%, while central governments increased their deposits and holdings of bank securities by €70 billion. Also notable was a €108 billion fall in banks' net external assets, consistent with non-bank residents moving funds out of the Eurozone area.

The slump in six-month real M1 growth contrasts with a strong pick-up in the US, suggesting that the US economy will outpace Euroland in early 2011 – second chart. With the US trend improving, G7 real M1 growth remains consistent with respectable global economic expansion. 

Monetary trends suggest that the global economy will grow at a respectable pace during the first half of 2011. The liquidity backdrop for markets remains unfavourable currently but may improve early next year.

The forecasting approach here places weight on the Friedmanite rule that movements in the real (i.e. inflation-adjusted) money supply lead the economy by about six months. Consistent with this rule, a slowdown in G7 industrial output growth from an annual 10% in May to about 5% currently was presaged by a fall in real narrow money expansion from 14% in August 2009 to 4% by early this year – see first chart.

Real money growth, however, has stabilised at 4% since early 2010 – above its long-term average and historically consistent with solid output expansion. As the chart shows, the five global recessions over the last 50 years were preceded by a contraction in real narrow money.

The liquidity backdrop for markets depends less on the level of real money growth than whether it is higher or lower than output expansion – a positive differential may imply that there is "excess" money available to drive up asset prices. Empirical evidence supports this approach: on average, world equities have outperformed cash by a substantial margin when the gap has been positive while underperforming at other times – see earlier post.

Real money growth fell beneath output expansion in early 2010 and remains lower currently, warranting a cautious stance on equities, which have trod water since the spring. The annual output rise, however, should slow further over coming months, partly reflecting base effects, suggesting that the gap will turn positive by early 2011 if real money expansion is stable – second chart. Near-term weakness in equity markets, therefore, could present a buying opportunity.