The US economy performed robustly over the spring and summer. GDP growth, admittedly, fell from 3.9% at an annualised rate in the second quarter to 1.5% in the third, according to preliminary data. This slowdown, however, largely reflected a decline in stockbuilding: final sales rose by an annualised 3.0% last quarter. GDP growth averaged a solid 2.7% across the two quarters.

Economic health in mid-2015 had been signalled by narrow money trends at end-2014. Six-month growth of real narrow money fell sharply in summer 2014, warning of a loss of momentum in early 2015, allowing for the usual lag. It rebounded strongly from October, however, peaking in February 2015 – see first chart. The message was that the poor start to the year – exacerbated by bad weather – represented a temporary soft patch, with news likely to improve significantly later in 2015.

The consensus expects growth to remain strong by the standards of the upswing to date. The mean forecast for annual GDP expansion in 2016 is 2.6%, according to Consensus Economics, with the IMF projecting 2.8%. This compares with average growth of only 2.1% annualised from the recession trough in the second quarter of 2009 through the third quarter of 2015.

This optimism is questionable, for two reasons. First, real narrow money has slowed again since the spring, with six-month growth in August / September the lowest since January 2010, and weekly data suggesting no recovery in October. Real M2 and bank lending are holding up better but have also lost momentum – first chart.

Secondly, stock changes are likely to be a further drag on GDP growth over coming quarters. The 3-5 year Kitchin stockbuilding cycle last bottomed in 2012, so another trough is due in 2016 or 2017. As previously discussed, the ratio of non-farm inventories to final sales of goods and structures is usually above its long-run downward trend at the peak of the cycle, and below it at the trough. It remained elevated at end-September, despite the fall in stockbuilding last quarter – second chart.

Strengthening non-US real narrow money growth – particularly in China – suggests that the global economy can regain momentum even if the US slows. Economic “rebalancing” from the US to the rest of the world would be favourable for markets, supporting equity earnings while allowing the Fed to go slow on rate rises. The current monetary evidence supports this benign scenario but further US narrow money weakness, or a relapse in China or the Eurozone, would warrant a reassessment.

 

Annual growth of broad liquidity held by UK households and private non-financial corporations (PNFCs) rose from 6.1% in August to 6.2% in September, the fastest since June 2008. Corporate money, in particular, is surging, suggesting strong prospects for business spending. If the recent stability of the velocity of broad liquidity were to persist, sustained growth at the current pace would cause inflation to overshoot the 2% target over the medium term.

The strengthening of liquidity trends is underappreciated because most commentary focuses on the Bank of England’s M4ex* broad money aggregate, annual growth of which has remained at about 4% (3.9% in September) – see first chart. The increase in M4ex over the past 12 months, however, was depressed by 1) older savers switching out of bank deposits into National Savings (NS) pensioner bonds and 2) a fall in financial sector money. Neither development is of economic significance**.

A better guide to the availability of liquidity to finance private sector spending at present is the sum of M4 money held by households and PNFCs – i.e. “non-financial M4” – and outstanding NS. Of the 2.3 percentage point gap between the annual growth rates of this aggregate (6.2%) and M4ex (3.9%), about two-thirds is due to the NS effect and one-third to falling financial sector deposits.

The velocity of circulation of this liquidity measure has been broadly stable in recent years – see previous post. If velocity were to continue to move sideways, sustained 6% liquidity growth would be reflected, in time, in an equal rate of increase of national income. This, in turn, would imply inflation of about 3.5%, assuming 2.5% trend output expansion.

Annual growth of both corporate and household liquidity has risen over the past year but the former is much stronger – 12.4% versus 4.8%. Significant changes in corporate liquidity growth have foreshadowed economic fluctuations in recent years. Corporate liquidity contracted before the 2008-09 recession and the 2011-12 “double-dip” scare, but rebounded sharply in 2012 ahead of the positive GDP growth surprise in 2013 – second chart. The further increase in liquidity expansion this year casts doubt on the consensus forecast of slower GDP growth in 2016 than 2015.

The suggestion that monetary conditions have loosened, requiring an early policy response, is supported by still-robust expansion of narrow money, as measured by non-financial M1, and a continued pick-up in bank lending to households and PNFCs, annual growth of which reached 2.2% last month, the fastest since April 2009 – third chart. Leading indicators suggest further credit acceleration: mortgage approvals reached another post-recession high in value terms last month, while annual growth of arranged but undrawn credit facilities rose to 6.0%, the fastest since December 2004.

*M4ex = M4 excluding holdings of “intermediate other financial corporations”.
**The £11 billion fall in financial sector M4 in the year to September may partly reflect a switch from bank deposits to other liquid instruments: private-sector holdings of Treasury bills and other central government debt (mainly short-term repo borrowing by the Debt Management Office) rose by £8 billion over the same period.

Eurozone monetary trends remain consistent with solid economic growth but there has been no further pick-up since QE began in March. This suggests that 1) further monetary policy easing is unwarranted and 2) more QE would, in any case, be ineffective.

The best monetary measure for forecasting purposes, according to ECB research, is real (i.e. inflation-adjusted) non-financial M1, comprising holdings of currency and overnight deposits by households and non-financial corporations. Six-month growth of this measure surged between spring 2014 and early 2015, signalling improving economic prospects – see first chart. GDP growth moved up from 0.7% at an annualised rate in the first three quarters of 2014 to 1.6% in the fourth quarter and 1.8% in the first half of 2015. Survey evidence suggests a similar pace in the third quarter. This appears to represent above-trend expansion, judging from an accompanying decline in the unemployment rate and a rise in manufacturing capacity utilisation.

Six-month growth of real non-financial M1 has retreated from a peak reached in January 2015 but has remained robust and rebounded in September. Growth in real non-financial M3 has followed a similar pattern. The message is that GDP expansion should continue at around its recent pace through early 2016, at least.

QE has not resulted in a further rise in money growth because the positive impact of asset purchases has been neutralised by reduced buying of government bonds by banks and an external capital outflow. This mirrors experience in the US, UK and Japan, discussed in previous posts. The lack of monetary impact suggests that the economic benefits of QE have been much smaller than its promoters claim.

Country-level data show a recent slowdown in real M1 deposits in the core countries but an offsetting pick-up in the periphery – second chart. Spain moved back to the top of the big four ranking last month, with Italy also rebounding; growth has cooled but remains solid in France and Germany – third chart.

Global economic momentum is reviving, consistent with a forecast based on monetary trends, which continue to give a reassuring message.

The monetary measure used for forecasting here is the six-month change in global real narrow money, with “global” defined as the G7 plus seven large emerging economies (the “E7”). Statistical testing shows that this leads the six-month change in industrial output by nine months on average. Turning points in industrial output growth, meanwhile, usually coincide with those in GDP growth.

Real narrow money growth strengthened around end-2014, suggesting a pick-up in industrial output momentum during the second half of 2015. Output has been weaker than expected but the six-month change bottomed in June and appears to have returned to positive territory in September, judging from partial data – see first chart. GDP has been more resilient than industrial output this year, reflecting services strength.

Real narrow money growth moderated over the spring and early summer but has bounced back in August / September, offering reassurance that the global economy will perform respectably in the first half of 2016 – first chart.

The view that the global economy is lifting is supported by news this week, including stronger Japanese / Taiwanese exports in September and upbeat October “flash” PMIs for the Eurozone and Japan. The October Chinese MNI business survey was also stronger.

The rise in global real narrow money growth in August / September mainly reflects a surge in China, discussed in several recent posts, most recently on Monday. With China accounting for about half of the E7, this surge has resulted in real money growth in the E7 crossing above that in the G7 – second chart.

In addition to the re-emergence of a positive gap with the G7, the available September data suggest that E7 six-month real money growth has risen above the 4% level historically associated with emerging market equities outperforming developed markets – see previous post.

Today’s batch of Chinese economic data contains grist for both optimists and pessimists. Bears will focus on a further slide in annual nominal GDP growth to 6.2% in the third quarter – below a 6.5% trough reached during the 2008-09 downturn. Real GDP growth was maintained at a solid 6.9% only via an annual fall in prices, as measured by the GDP deflator.

Bulls, however, can point to improvements in monthly data to argue that stimulus efforts are starting to bear fruit. Six-month growth of industrial output and real retail sales rose further in September – see first chart. Housing floorspace started registered its first year-on-year gain this year. The annual change in auto sales also returned to positive territory. Government spending, meanwhile, rose 27% from September 2014.

These positive signs are consistent with a recovery in real narrow money growth since early 2015. The PBOC released additional monetary data for September today, allowing calculation of the “true M1” measure followed here. Six-month growth of real (i.e. CPI-adjusted) true M1 surged to its highest level since 2010, suggesting a further acceleration in industrial output and other activity measures into early 2016 – first chart.

Recent intervention to support the renminbi, meanwhile, may have been larger than current market estimates. Foreign exchange reserves were earlier reported to have fallen by $180 billion during the third quarter but this figure mixes valuation effects with transactions. The transactions element is separated out in the balance of payments accounts but these have yet to be released for the third quarter. The transactions series, however, correlates closely with the change in financial institutions' “position for forex purchase”, which fell by 1.73 trillion yuan, or $275 billion, last quarter – second chart. The monthly decline in the forex purchase position, moreover, was larger in September than August, casting doubt on the suggestion from the reserves data that intervention slowed last month.

Money supply analysis plays no role in policy formation under the current Monetary Policy Committee (MPC). Historically, policy-makers have run into trouble when they have ignored money and credit trends. Broad liquidity of households and non-financial firms is currently growing at the fastest rate since 2008. The velocity of circulation, meanwhile, has been stable in recent years, having fallen steadily during the 1990s and 2000s. If this stability persists, or velocity rises, liquidity growth at the current pace will cause inflation to overshoot the 2% target over the medium term.

It is clear from the Inflation Report and meeting minutes that the current MPC membership regards the behaviour of money and credit quantities as irrelevant for policy-making. The August rejig of the format of the Inflation Report involved the removal of the previous chapter on “Money and asset prices”. The word “money” did not appear in the August publication. It was similarly absent from the September minutes, except in the heading “Money, credit, demand and output”; the following section focused exclusively on GDP data and other activity news.

The further downgrading of the role of money supply analysis has coincided with a pick-up in broad liquidity growth. The quantity of M4 money and National Savings held by households and private non-financial corporations rose by 6.3% in the year to August, the fastest annual growth rate since June 2008  – see first chart*. It is important to include National Savings to capture a switch from bank deposits into NS pensioner bonds earlier this year: M4 holdings alone grew by an annual 5.3% in August. The pensioner bonds, and other NS products, are effectively “money” and would be included in M4 if they were issued by a bank rather than the government.



Historically, UK policy-makers have often ignored or explained away rises in money supply growth that were correctly signalling excessively loose policy. Annual growth of the above liquidity measure rose to nearly 9% in 2004, three years before the peak of the credit bubble and a subsequent sustained increase in inflation. Inflation Reports of the time – which did, at least, devote space to a discussion of monetary trends – suggested that strength was due to bank deposits being used as a savings vehicle following the equity bear market of the early 2000s. The signal, in any event, was ignored, with Bank rate cut in 2005, a change that served to sustain and increase monetary excess.

Chancellor Nigel Lawson, similarly, argued that the monetary aggregates were being distorted by financial liberalisation to justify suspending a target for broad money in 1985. Bank rate was cut in 1986-87 in response to temporarily weak price pressures, following which annual liquidity growth rose to over 15% in 1988, fuelling a housing market boom / bust and a surge in RPIX** inflation to a peak of 9.5% in 1990. Mr Lawson claimed that the monetary aggregates were “all over the place”; it was his policy, instead, that was in disarray.

Current liquidity growth of a little over 6% is far below prior extremes. The future inflation rate implied by a given growth rate, however, depends on the trend in the velocity of circulation – the value of national income supported by each pound of liquidity***. Velocity trended down in the late 1990s and 2000s, i.e. households and firms wanted to increase their liquidity holdings faster than national income – second chart. The decline over 1995-2009 averaged 2.1% per annum. Liquidity growth of 6% during this period, therefore, would have implied a rate of increase of income of about 4% per annum. Allowing for a trend rate of output expansion of about 2.5%, this would have been too low to achieve the 2% inflation target.



Velocity, however, recovered slightly after 2009 and has been broadly stable in recent years. One reason is that the interest rate on bank deposits has been much lower relative to inflation than in the past, reducing the attraction of money as a savings vehicle. If velocity were to continue to move sideways, sustained 6% liquidity growth would be reflected, in time, in an equal rate of increase of national income. This, in turn, would imply inflation of about 3.5%, assuming 2.5% trend output expansion.

The pick-up in liquidity growth argues for bringing forward an interest rate increase, despite current near-zero inflation. Suggestions that the next policy move should be to ease – or the first rate rise should be postponed until late 2016 or 2017 – are dangerous, recalling the 1986-87 and 2005 mistakes. There are two risks to raising rates now. First, the liquidity pick-up may turn out to be temporary; growth may subside back to the 2013-14 average of 4.75%, a level broadly consistent with the inflation target assuming stable velocity. Strengthening credit trends, however, suggest that faster liquidity expansion will be sustained. Bank lending to households and private non-financial corporations rose by 2.5% annualised in the six months to August, the largest such increase since November 2008. Leading indicators such as mortgage approvals and arranged but unused credit facilities are positive, while M&A activity may spur additional corporate borrowing. Liquidity growth has also been boosted recently by capital inflows from overseas, possibly partly reflecting spill-over from the ECB’s QE programme, which is scheduled to be sustained for another year.

The second risk is that recent velocity stability will give way to a renewed decline, implying that 6% liquidity growth is compatible with meeting the inflation target. This would mirror developments in the 1990s, when velocity stabilised for several years after the 1990-91 recession before resuming a downtrend later in the decade. This fall occurred, however, only after interest rates had been raised to well above the prevailing level of inflation, restoring the attraction of bank deposits as a savings vehicle. Governor Carney’s suggestion that the future norm for rates will be no higher than 2.5%, however, implies that real deposit rates will remain low or negative for the foreseeable future.

The current environment may bear greater similarity with the late 1960s / early 1970s, when a period of velocity stability gave way to a sustained rise, partly because interest rates failed to keep pace with an increase in inflation, resulting in savers wishing to reduce their money holdings. A velocity pick-up now would guarantee a future inflation overshoot.

Money supply analysis is rarely straightforward and analysts can reasonably disagree about the interpretation of current trends. The MPC should, at least, examine and explain the issues. The current mix of doctrinal aversion and lack of interest is a recipe for another policy mistake.

*The money / liquidity growth data in the chart refer to end-quarters, except for the final points, which are for August.
**RPIX = retail prices excluding mortgage interest.
***Velocity is calculated here as the ratio of GDP at market prices at an annualised rate to the stock of broad liquidity eight quarters previously. A lag is applied to allow for the delayed impact of monetary changes on output and prices.