Behind the gloomy headlines, today’s update of the OECD’s leading indicator indices suggests that global economic weakness is abating, consistent with an earlier improvement in monetary trends.

The forecasting approach employed here relies on the Friedmanite rule that changes in the real money supply lead economic activity by about six months. Confirmation of the message from the monetary data, however, is sought from an indicator derived from the OECD's country leading indices. This transformed indicator provides an earlier signal than the raw indices, with a typical lead time of about three months.

Six-month expansion of the global (i.e. G7 plus emerging “E7”) real narrow money supply slowed in late 2010 and early 2011, warning of current economic weakness. It has recovered, however, since May, consistent with economic momentum bottoming in November. Confirmation of such a scenario required an upturn in the G7 plus E7 leading indicator. This was duly delivered in the September update released today.
The leading indicator, admittedly, remains in negative territory, implying that economic news will remain soft into year-end. One of its advantages, however, is that trend changes tend to be sustained – there is a good chance that the September improvement will be followed by further gains. This would be consistent with the steady acceleration of real money over the summer.

The G7 / E7 breakdown of the indicator shows, unsurprisingly, relative strength in emerging markets – the E7 component rose for the fifth consecutive month in September. Interestingly, this continues a recent pattern of the E7 indicator leading changes in G7 momentum and suggests that these economies are now playing a driving role in the global cycle.

Rises in the leading indicator tend to be associated with stronger investor risk appetite – the September increase is consistent with recent better equity market performance.
The E7 indicator is at a level suggesting a rise in emerging market equities.

The pick-up in the E7 indicator mainly reflects the dominant Chinese component.

A revival in E7 momentum would be expected to be associated with a recovery in commodity prices.

Faster real narrow money expansion since the spring suggested that global economic momentum would revive from late 2011. Consistent with the scenario, the G7 PMI manufacturing new orders index recovered marginally in October while equity analysts’ earnings revisions have become less downbeat. OECD leading indicator data released on Monday will provide more evidence – confirmatory or otherwise.

Previous posts argued that Chinese monetary conditions were restrictive and needed to loosen to prevent a “hard landing”. Encouragingly, six-month growth of real M2 and loans continued to recover in October, although real M1 remains relatively weak. The revival reflects both stronger nominal trends and a fall in inflation that should extend as food prices slow sharply.

Italian economic and financial woes were foreshadowed by a contraction in real M1 deposits from late 2010 – see previous post. The decline, however, has eased, with a larger fall in Spain over the last six months. French real M1 deposits are stagnant while German figures have been artificially boosted by capital flight. Bottom line: Italian economic prospects, while downbeat, may be no worse than in other Eurozone economies.

The claim that peripheral membership of the Eurozone is doomed by chronically poor competitiveness is questionable, judging from the ECB’s harmonised competitiveness indicators based on unit labour costs, showing each country’s performance compared with a basket of its trading partners. Spanish relative costs have risen by little more than in France and the Netherlands since 1999. Italian performance has been slightly worse but Germany is a much more significant outlier, suggesting that it must bear the burden of adjustment.

The recent run of good labour market news in the US continued this week with a solid September rise in private-sector job openings, which lead payrolls.


October UK inflation figures next week may, for once, surprise favourably, judging from a significant slowdown in the British Retail Consortium food and non-food shop price indices. (The BRC indices only cover goods but services inflation is unlikely to rise further after a spike last month.)

Anyone reliant solely on media economic reporting to form a view of markets would be mystified by the 12% rally in world equities since early October (MSCI World index in US dollars). The commentariat, as usual, has chosen to focus obsessively on negative developments – in this case, the interminable Eurozone crisis – while ignoring important supports for the global economy and asset prices.

A key reason for doubting that the world was about to fall into an abyss was a recovery in global real money supply expansion from spring 2011, implying both a liquidity cushion for markets and stimulus for the economy from late 2011, allowing for the typical six-month lag between monetary trends and activity. Six-month growth in G7 plus emerging “E7” real narrow money fell marginally in September but remains healthy.

As discussed in several previous posts, monetary strength has been focused on the US, suggesting that economic news would surprise to the upside. Third-quarter GDP growth was a respectable 2.5% annualised and recent labour market evidence has been modestly encouraging – see Friday’s post. An improving jobs picture is also suggested by the Conference Board employment trends index (ETI), which reached a new recovery high in October. (The ETI is a composite of eight forward-looking labour market indicators.)

The Eurozone crisis could tighten US money and credit conditions, leading to renewed economic weakness next year. The latest Fed survey of senior loan officers, however, shows that more domestic banks loosened credit standards on commercial and industrial loans than tightened in the three months to October, although the balance was smaller than in August. Historically, recessions have usually been preceded by a large tightening majority.

A Chinese “hard landing” has been another favoured theme of gloomsters. The issue here is whether inflationary pressures will abate sufficiently to allow the authorities to loosen a restrictive monetary stance before the economy suffers serious collateral damage. Weekly indicators suggest that food prices are falling, a trend that – if sustained – will result in a rapid drop in consumer price inflation. (Soaring food prices accounted for an estimated 4.0 percentage points of the 6.1% rise in the CPI in the year to September.)

In the UK, pessimists expect rising unemployment to trigger a slide in housing market activity and prices, with negative implications for consumer spending. The view here remains more upbeat partly because of the demand / supply imbalance, reflected in strong growth in rents, against which house prices are not expensive. The new buyer enquiries and sales expectations balances in the October RICS survey were the highest since May 2010, consistent with a further recovery in turnover and mortgage approvals.

The launch of QE2 at the October MPC meeting was predicted by the “MPC-ometer” model – a statistical representation of the Committee’s decision-making based on 12 economic and financial inputs.

The model, in fact, had suggested that a narrow majority would vote to ease at the September meeting. In recent testimony to the Treasury Select Committee, Bank of England Governor Sir Mervyn King stated that “we came very close to voting for asset purchases in September”.

The model is again at odds with the consensus this month, judging incoming news to be consistent with further MPC easing. This could be in the form of a £25-50 billion rise in the current gilt purchase programme (i.e. to £100-125 billion) although a cut in Bank rate from 0.5% to 0.25% should not be ruled out.

The consensus expectation of inaction is questionable since the October minutes state that the MPC considered a £100 billion initial purchase target and would adjust the programme “depending on developments in the euro area and financial markets” – negative, on balance, over the last month.

In terms of its inputs, the MPC-ometer’s further dovish shift reflects weaker business and consumer surveys, below-par third-quarter GDP growth (after adjusting for the distortion created by the additional second-quarter bank holiday) and wider bank funding spreads – see chart.

The model is designed to predict the immediate policy decision but can be used to forecast further ahead based on assumptions about the inputs. This suggests that QE2 will be expanded by a cumulative £75-100 billion by January (i.e. to £150-175 billion) if current input values are sustained.

The MPC-ometer attempts to predict actual policy rather than that consistent with the inflation target. The view here remains that the UK is not currently suffering from a shortage of liquidity so additional QE is unwarranted and carries significant medium-term inflationary risk.

US non-farm payrolls rose by 80,000 in October while the gain in August and September was revised up by 102,000. These numbers are consistent with the recent strength of withheld tax receipts – see previous post.

The Monster index of online vacancies, meanwhile, rose solidly in October (after adjusting for seasonal variation), suggesting a further employment increase into year-end. The Monster index rolled over well before the onset of the last recession in December 2007.

ECB exposure to Greece could spiral as political chaos accelerates capital flight from the country’s banking system and the Bank of Greece plugs the gap with “emergency liquidity assistance”. Some ECB officials may favour suspending Greek access to liquidity facilities to contain the ultimate loss to the Eurosystem.

The latest balance sheet statement on the Bank of Greece’s website refers to 31 August and shows liabilities to the Eurosystem of €110.0 billion. This represents money borrowed from other Eurozone central banks mainly for on-lending to Greek banks via standard repo operations and “emergency liquidity assistance” (ELA) against inferior collateral. Standard lending was €93.1 billion on 31 August while ELA was reportedly €6.4 billion as of that date.

Bank of Greece borrowing from the Eurosystem has probably expanded significantly since August as deposit outflows from the banking system have necessitated further ELA. Eurozone monetary statistics released last week show that Greek M3 deposits contracted by €5.6 billion in September while yesterday’s Financial Times referred to an estimated €10 billion outflow in October. The Eurosystem’s exposure to the Bank of Greece, therefore, may now be about €125 billion.

This exposure, of course, is additional to the estimated €45 billion of Greek government bonds bought under the ECB’s “securities markets programme”.

Greek M3 deposits stood at €187.0 billion at the end of September, of which €77.4 billion were overnight deposits. It is reasonable to expect a significant proportion of this instantly-accessible cash to leave the banking system amid current political chaos that has increased the probability of a disorderly Greek default and EMU exit. Eurosystem lending to the Bank of Greece, therefore, may soon surpass €150 billion if the ECB keeps the liquidity tap turned on.

Eurosystem lending is against collateral on which haircuts have been applied while the ECB’s purchases of Greek government bonds were made at a large discount to par. The mark-to-market value of these assets in the event of a disorderly EMU departure, however, would probably be no more than half of the current balance sheet amount. The Eurosystem, in other words, could suffer a loss of about €100 billion, assuming exposure of €200 billion (i.e. lending to the Bank of Greece of more than €150 billion plus bond purchases of €45 billion). This compares with capital and reserves of €81.5 billion but additional revaluation gains (on gold and foreign exchange) of €383.3 billion – convertible, presumably, into capital in an emergency.

What should the ECB do? Shutting down the Bank of Greece’s “poison pill” ELA operation would probably trigger an immediate banking system collapse and could be interpreted as de facto exclusion of Greece from monetary union. Keeping the tap on, however, would accommodate further capital flight, allowing Greek depositors to transfer their exposure to the Eurosystem and, by extension, tax-payers in other EMU countries.

Greece, of course, has an incentive to delay default while wealth-holders are still able to transfer their assets to safety, courtesy of the ECB.

ECB President Draghi faces an unenviable choice between current blame for pulling the plug on Greece and possible future blame for squandering the bank’s capital on a lost cause.