US stocks have displayed a positive correlation with bank reserves (i.e. banks’ account balances at the Fed) since QE1 was launched in late 2008. A post on 18 September noted that the Dow Industrials index, then at 13,553, was 1,300 points above the level implied by the current level of reserves, based on the historical relationship. This suggested that QE3 was priced in.

Subsequent market weakness resulted in this gap closing to 970 points by the time of an update post on 30 October. The Dow, moreover, was then slightly below the level implied for end-March 2013 assuming continued unsterilised Fed bond purchases of $40 billion per month and no offsetting changes to its balance sheet. A buying opportunity, in other words, seemed to be developing, especially if the Fed was thought likely to boost its bond buying when “operation twist” expired at year-end.

With the further fall this month, the Dow closed last week 450 points above the level implied by current reserves but 570 points below an end-March “forecast” assuming QE3 continues at its recent pace and 1,160 points lower than a prediction based on bond purchases stepping up to $85 billion from year-end – see first chart. The relationship, that is, suggests a rise in the Dow of between 5% and 9% by next spring. Last week’s dovish October minutes have shortened the odds that the Fed will announce an expansion of bond buying at its 11-12 December meeting.

A market rally between late 2012 and spring 2013 would maintain the similarity with movements 25 years ago, albeit that recent fluctuations have been smaller in magnitude* – second chart. The Dow rallied 19% from a low on 4 December 1987 to a short-term top on 12 April 1988, working its way gradually higher over the remainder of that year.

*A post in May noted this resemblance and suggested that it would continue.

Global six-month real narrow money expansion remained solid in October, judging from data for countries with a combined 60% weighting. Allowing for the typical half-year lead, the money measure continues to signal a revival in global economic momentum from late 2012 into spring 2013.

The global real money growth measure monitored here covers the G7 and seven large emerging economies (the “E7”). It fell sharply between December 2011 and February 2012, forewarning of recent economic weakness – G7 plus E7 industrial output declined by 0.3% between March and September.

Six-month real money expansion, however, bottomed at 1.5% (not annualised) in May, recovering over the summer  to reach 3.7% in September – above an average of 3.0% since 2005. October is currently estimated at 3.6% – the final reading will depend importantly on Eurozone numbers released on 28 November.

The global measure continues to be supported by strong growth in the US, while China and Japan rose again last month – second chart. Indian real money, by contrast, is still giving a recessionary message, while a promising revival in Brazil during the first half of 2012 has tailed off more recently.

The two key messages of the November Inflation Report are that CPI inflation will be significantly higher next year than the MPC predicted in August but the Committee nevertheless remains firmly biased in the direction of more ease. The latter can be inferred from the sub-2% mean expectation for inflation in late 2014 and 2015 based on unchanged policy. The Report, indeed, raises suspicions that the MPC would have expanded gilt purchases at last week’s meeting but for the Chancellor’s QE income manoeuvre.

At the August press conference, Sir Mervyn King opined: “A year ago inflation was rising and heading towards 5%. It has now fallen to within touching distance of the 2% target. The big picture in today’s Report is of a further decline in inflation, as external influences fade and domestic cost pressures ease …”

A post at the time argued that this represented wishful thinking and so it has proved. Ogling the fan charts, the MPC’s mean expectation for inflation in 2013 now appears to be 2.5-2.6% versus 2.1% in August. A fall below 2%, meanwhile, has been pushed back by a full three quarters, from the fourth quarter of next year to the third quarter of 2014. December inflation, in other words, is expected to be above the target in 2013 for an eighth successive year.

Most but not all of the 2013 forecast rise is explained by higher-than-expected domestic energy prices and undergraduate student tuition fees. Energy prices are now projected to climb by 8% around the turn of the year versus 2.5% in the August Report, adding about 0.25 percentage points (pp) to 2013 inflation. The tuition fee boost, meanwhile, turned out to be 0.3 pp rather than the assumed 0.2 pp. This suggests that the MPC’s forecast for “core” inflation in 2013 has been raised by 0.15-0.25 pp.

The view here remains that average 2013 inflation will exceed 3%, reflecting stronger core pressures than assumed by the MPC and a likely further increase in global commodity prices stemming partly from central bank liquidity largesse. Sir Mervyn is attempting again to deploy the argument that a continued inflation overshoot reflects “idiosyncratic” factors but this will be difficult to sustain if, as expected, further upward revisions – and more letter-writing – prove necessary.

Three recent news items support the forecast here that China has returned to a moderate, stable growth path. First, six-month industrial output expansion revived further to 5.5% (not annualised) in October, up from a low of 1.5% in August*. This is not far beneath the post-2005 average of 6.8% and accords with recent below-par but satisfactory purchasing managers’ survey results – see first chart.

Secondly,  a transformed version of the OECD’s Chinese leading indicator was little changed in September at a level consistent with a further recovery in output expansion – second chart. The indicator, admittedly, has overpredicted recent growth, though seems correctly to have ruled out a “hard landing”. (Claims that the economy has been much weaker than reported are unconvincing, since official output statistics broadly agree with coincident indicators such as the PMIs and equity analysts’ earnings revisions.)

Thirdly, real narrow money M1 – the best monetary leading indicator of the economy – continues to recover, with six-month expansion rising to 4.9% (not annualised) in October. The pick-up, however, pales in comparison with 2009, when six-month growth peaked at 21.6%. Economic prospects are improving at the margin but growth will remain subdued by recent standards. Low inflation, however, implies scope for further policy stimulus should the recover falter.

China faces major structural challenges but the authorities appear to have managed the cycle skilfully, maintaining restrictive monetary conditions long enough to break inflationary psychology but easing just in time to avert a crash landing for the economy – a risk when real M1 was contracting in late 2011 / early 2012.

*Based on an output levels series estimated from official data on year-on-year growth and monthly values / prices.

A forecasting measure for global growth derived from the OECD’s country leading indicators rose again in September, confirming June as a recent low. The indicator’s improvement is consistent with the forecast here of a revival in global industrial momentum in late 2012, allowing for an average three-month lead time – see first chart.

An accompanying “leading indicator of the leading indicator”, moreover, rose for a fifth consecutive month, suggesting that the indicator itself will continue to recover in October and November – second chart. (The “double-lead” indicator is explained in a previous post.) This, in turn, would imply a further pick-up in growth in the first quarter of 2013.

The basis for the forecast was a rise in global real narrow money expansion from a bottom in April / May – real money leads industrial output by six months and the leading indicator by three months, on average. The real money measure continued to climb in September – also consistent with the coming global upswing extending until next spring, at least.

Such a scenario, of course, would be at risk were the US economy facing a 2013 fiscal cliff of 4% of GDP, rather than the 2% or less likely to result from an eventual budget deal (despite the predictable hardline posturing of the parties ahead of negotiations). Assuming a Keynesian multiplier of 0.5 (not contradicted by recent data, as explained in a previous post), fiscal tightening of 2% of GDP would lop 1 percentage point off growth next year – modest relative to the boost from current expansionary monetary conditions.

Previous posts suggested that capital flowed back into Spain and Italy in September / October following the ECB’s backstopping of sovereign bond markets via the outright monetary transactions (OMT) programme. This suggestion is supported by Banco de Espana and Banca d’Italia balance sheet data for end-October, showing further declines in their Target 2 borrowing of €19.7 billion and €14.0 billion respectively. Outstandings, however, remain huge – a combined €647.2 billion.

The fall in their borrowing of €76.6 billion since end-August must have a counterpart in either a decline in lending into the system by the Bundesbank / other creditor central banks or increased borrowing by other debtors. The Bundesbank’s credit position fell by €56.0 billion in September but rebounded by €23.9 billion in October, according to the University of Osnabruck. Lending into Target 2 by the Finnish central bank, meanwhile, declined by €1.5 billion over the two months. This leaves €43.0 billion yet to be explained. (No other central bank has released end-October data.)

One possibility is that investors pulled money out of France in October in response to the tax-heavy austerity Budget unveiled in late September. (Banque de France Target 2 borrowing was negligible at €2.6 billion at end-September.) Alternatively, the large credit position of the Dutch / Luxembourg central banks may have fallen. It seems unlikely that borrowing by the “bailout three” central banks has risen significantly, given recent sovereign yield spread compression.