The term “excess money” describes a monetary backdrop in which growth of the stock of money exceeds the rate necessary to support economic expansion. Excess money is associated with increased demand for financial assets and upward pressure on their prices, other things being equal.

Excess money cannot be measured directly. Two global proxies are followed here: the gap between six-month growth rates of real narrow money and industrial output; and the deviation of 12-month real narrow money growth from a slow moving average.

These measures have been strongly correlated with equity market performance historically. Between 1970 and 2020, global equities outperformed US dollar cash by 17.9% pa on average when the two measures were positive (allowing for reporting lags). They underperformed by an average 3.6% pa when one of the measures was negative and by 9.2% when both were.

The first measure remains positive despite a large fall in six-month real narrow money growth because of offsetting weakness in industrial output – see chart 1. Output growth has been held back by supply constraints and is likely to bounce back temporarily as these ease.

Chart 1

12-month real narrow money growth is estimated to have fallen below the slow moving average in October, turning the second measure negative – chart 2.

Chart 2

The long-term performance of equities / cash switching rules based on the individual measures has been similar. The second measure, however, has outperformed in the recent past – the associated rule recommended cash at the start of 2020, switched to equities in April and now suggests a move back into cash.

The rule associated with the first measure recommended equities in 2020 but switched to cash for several months in early 2021, reflecting a spike rebound in industrial output growth. Equities continued to climb during this period.

The lesson from this experience is that output volatility due to temporary non-cyclical factors – in this case the covid shock – should be discounted when using this measure. For example, the V-shaped fall and rebound in global industrial output during 2020 could (should) have been removed from the measure by using the alternative series shown in chart 3. An excess money measure incorporating the adjusted series indicated that the monetary backdrop remained favourable in early 2021.

Chart 3

A post a year ago presented a “monetarist” forecast that UK CPI inflation would rise to 3.2% by Q4 2021. The outturn will be significantly higher – projected here to be 4.5% – but the post at least anticipated current problems, unlike Bank of England and consensus forecasts at the time.

The pessimistic view was based on two considerations:

1) A surge in broad money during 2020 was expected to be reflected in upward pressure on “core” prices (i.e. excluding energy, food, VAT effects etc) during 2021-22.

2) An upswing in the global stockbuilding cycle was judged to have started and was expected to be associated, as usual, with a rise in energy and other industrial commodity prices. Global “excess” money, moreover, was likely to magnify this increase.

What does the same approach suggest now? As explained below, CPI inflation is projected to rise to a higher peak than expected by the Bank of England and consensus in H1 2022 but could return to target more quickly than implied by the Bank’s current forecast based on conventional energy price assumptions. The latter prospect, however, is conditional on a recent slowdown in money growth being sustained and no additional boost to inflation from exchange rate weakness – a significant risk given trade account deterioration and an overhang of overseas sterling balances at UK banks.

The six-month rate of change of core consumer prices, seasonally adjusted, surged from 0.6% (not annualised) in April 2021 to 2.3% in October. This mirrors a surge in six-month broad money growth between February and August 2020 – see chart 1.

Chart 1

The implied 14-month lead time is shorter than usual – the monetarist rule of thumb is that money stock changes precede price changes by about two years – and may reflect bottleneck / catch-up effects as the economy has reopened.

Six-month broad money growth has fallen significantly since August 2020, although the decline was held up by the MPC’s unwise further expansion of QE in November 2020. If the assumption of a 14-month lead is correct and this is maintained, the suggestion is that six-month core CPI momentum is peaking and will moderate through end-2022.

The projection for core CPI momentum in 2023 in the chart assumes that six-month broad money growth stabilises at its current level of 2.9%, or 5.9% annualised. This is above the pre-pandemic norm – annual growth averaged 4.5% over 2015-19 – and probably too high for core CPI inflation to return to 2% annualised or below; the projection assumes stabilisation at 2.25%.

A recent post discussed the global stockbuilding cycle and argued that the next low could occur in Q3 2023, based on the average length of the cycle. Industrial commodity prices typically fall in the 18 months leading up to a cycle low, on average retracing about half of their rise during the 18 months following a trough.

For the purposes of the forecast, the CPI energy index – which includes electricity / gas and vehicle fuels – is assumed to retrace about 40% of its increase between December 2019 and June 2022 by December 2023, with the decline occurring steadily over the latter period.

The electricity / gas index is assumed to rise by 26% in April 2022, in line with the Bank of England’s current projections for Ofgem tariff cap increases.

The final component of the forecast is an assumption about food price inflation, which remains low at an annual 1.3% in October but is projected to rise to 3.0% by December 2022. This could prove conservative, with producer output price inflation of food products now at 4.0% – chart 2.

Chart 2

Chart 3 shows forecasts for headline and core annual rates based on the above assumptions. CPI inflation peaks at 5.7% in April 2022 but a retracement of energy prices results in it falling slightly below 2% by Q2 2023. For comparison, inflation is 2.6% in Q2 2023 in the Bank’s conventional forecast, with a convergence to target delayed until a year later.

Chart 3

The possibility of an earlier return to target does not, of course, vindicate the MPC’s reckless decision to ease policy into a supply shock and double down with more QE in late 2020 despite an inflationary warning from monetary trends. On the forecast here, the level of the CPI in Q4 2022 will be 2.8% higher than projected by the Bank in November 2019, representing a 2.6% overshoot of the inflation target over this period.

A post in August argued that global monetary trends were at a critical juncture. A sustained fall in six-month real narrow money growth was signalling a slowdown in economic momentum during H2 2021. The money numbers, however, were showing signs of stabilising and a recovery during Q3 would warrant hopes of a stronger economy in H1 2022.

Far from recovering, real money growth has continued to decline, implying an intensification of the economic slowdown into Q2 2022, at least. Underlying weakness, however, could be temporarily obscured by a bounce-back in industrial output as supply constraints ease.

Chart 1 includes an October estimate of G7 plus E7 six-month real narrow money growth, based on monetary data covering 70% of the aggregate and near-complete inflation numbers. The October reading is the lowest since August 2019 and towards the bottom of the post-GFC range.

Chart 1

The further lurch down in October reflected both a continued nominal slowdown and a rebound in six-month consumer price momentum, although the latter remains below a July peak – chart 2.

Chart 2

A slowdown in commodity prices still suggests support for real money growth from a moderation of CPI momentum – chart 3. The timing, however, is uncertain and any inflation relief could be offset by a further fall in nominal money growth as central banks wind down stimulus / tighten.

Chart 3

While monetary trends are signalling a slowdown through Q2 2022, cycle analysis suggests that a stockbuilding downswing will be acting as a drag on the global economy by H2 2022 (assuming that the current cycle is of average length). The window for a growth pick-up in 2022, therefore, may be closing.

US money growth remained strong in H1 2021 while Chinese growth weakened further following (excessive) policy tightening during H2 2020. This divergence has been reflected in economic and equity market performance.

The tables could now be turning: US nominal money growth has slowed significantly, Chinese growth appears to have bottomed and inflation is exerting a bigger drag on real money in the US.

The previous base case scenario here was that Chinese money growth would recover in H2 2021 in response to modest policy easing since Q2. Economic momentum was expected to weaken further in H2 but a monetary recovery would signal better prospects for 2022.

Financial distress in the real estate sector threatened to derail this scenario by triggering a generalised tightening of credit conditions that would offset policy support for money growth. The PBoC's reluctance to provide additional stimulus magnified concerns.

October money data, however, were better than feared and suggest that the monetary recovery scenario remains on track, albeit possibly pushed back and weakened.

Six-month growth rates of narrow / broad money and credit rose last month, with the broad money series at an 11-month high – see chart 1.

Chart 1

Narrow money growth remains low but may follow broad money growth higher if risk aversion associated with the real estate crisis moderates, resulting in a rise in spending intentions.

The October data are consistent with the suggestion from the Cheung Kong business survey that credit conditions faced by firms were little changed last month.

By contrast, six-month growth of the US weekly money proxies calculated here continued to moderate into late October – chart 2. Growth of the broader M2+ measure (which includes large time deposits and institutional money funds) is now below that of the Chinese equivalent.

Chart 2

With QE tapering under way, a pick-up in bank lending is likely to be necessary to sustain high money growth. Six-month growth of commercial bank loans and leases has recovered significantly adjusting for the PPP distortion but the Fed's October senior loan officer survey was disappointing, showing a pullback in credit demand balances – chart 3.

Chart 3

The opposite moves in nominal money growth rates are more pronounced in real terms because of contrasting US / Chinese inflation experience. The differential between US and Chinese annual consumer price inflation rose to a record 4.7 pp in October, with the gap between six-month annualised rates of change at 6.8 pp.

Chart 4 shows six-month growth rates of real narrow money, incorporating October estimates. China crossed above the rest of the E7 in September and now appears to be overtaking a slowing US.

Chart 4

The Chinese monetary recovery needs to be confirmed and sustained to warrant shifting to a positive view. The value of monetary signals, however, is greatest when they conflict with consensus opinion. The consensus was bullish on China at the start of 2021 when money trends were flashing a warning; the hopeful October money data hint that current overwhelmingly negative sentiment may be similarly misplaced.

Global manufacturing PMI survey results for October are consistent with the base case scenario here of a progressive loss of momentum through end-Q1 2022, at least.

PMI new orders have moved sideways for two months but export orders and output expectations fell further last month, to nine- and 12-month lows respectively – see chart 1.

Chart 1

A striking feature of the survey was a further rise in the stocks of purchases index to a 15-year high – chart 2. Stockpiling of raw materials and intermediate (semi-finished) goods has been supporting new orders for producers of these inputs but the boost will fade even if stockbuilding continues at its recent pace, which is very unlikely. This is because output / orders growth is related to the rate of change of stockbuilding rather than its level.

Chart 2

Chart 3 illustrates the relationship between new orders and the rate of change of the stocks of purchases index, with the coming drag effect expected to be greater than shown because of the high probability that stockpiling will moderate.

Chart 3

Stockbuilding of inputs has been particularly intense in the intermediate goods sector – chart 4. This suggests that upstream producers – particularly suppliers of raw materials – are most at risk from relapse in orders. Commodity prices could correct sharply as orders deflate – see also previous post.

Chart 4

A similar dynamic is playing out in the US ISM manufacturing survey, where new orders fell last month despite the inventories index reaching its highest level since 1984, resulting in a sharp drop in the orders / inventories differential – chart 5. The survey commentary attributes the inventories surge to “companies stocking more raw materials in hopes of avoiding production shortages, as well as growth in work-in-process and finished goods inventories”.

Chart 5

The combination of an ISM supplier deliveries index (measuring delivery delays) of above 70 with new orders in the 50-60 range has occurred only four times in the history of the survey. New orders fell below 50 within a year in every case.

The global PMI delivery times index (which has an opposite definition to the ISM supplier deliveries index, so a fall indicates longer delays) reached a new low in October but a recent turnaround in Taiwan, which often leads, hints at imminent relief – chart 6. The view here is that current supply shortages reflect the intensity of the stockbuilding cycle upswing, with both now peaking.

Chart 6

Bank of England Governor Andrew Bailey is under fire for miscommunication in the run-up to this week’s MPC meeting. A much bigger error was the Committee’s decision a year ago to boost QE by a further £150 billion at a time when annual broad money growth – as measured by non-financial M4 – was running at 11.7%.

The extra QE contributed to annual money growth rising further to a peak of 16.1% in February 2021, with the additional monetary excess to be reflected in a higher inflation peak in 2022 and a slower subsequent decline than would otherwise have occurred.

So should the MPC have hiked this week? Annual non-financial M4 growth was still 9.3% in September but the three-month pace of expansion has moderated to an annualised 4.9%, not far above a 2015-19 average of 4.5% – see chart 1.

Chart 1

The view here has been that the MPC should move rates back to 0.5-0.75% to reinforce the recent monetary slowdown and then wait for guidance from the numbers. Sustained sub-5% expansion would be consistent with (core) inflation returning to target, though probably not before H2 2023.

Higher rates would be needed in the event of a credit-driven rebound in money growth. Bank lending expansion has weakened recently, partly reflecting the ending of the stamp duty holiday, but expected loan demand balances mostly improved in the latest Bank of England credit conditions survey – chart 2.

Chart 2

The MPC’s miscommunication / delay risks triggering a fall in sterling, which would magnify near-term inflation difficulties. The exchange rate appears to have been boosted in 2019-20 by overseas investors increasing their net sterling deposits at UK banks – chart 3. These inflows stopped in 2021 but a large stock position could be liquidated if investors lose faith in UK policy-making.

Chart 3