The “outright monetary transactions” programme may be stuck on the slipway but ECB President Draghi is already winning the battle to stabilise the Eurozone economy and financial markets. Narrow money M1, comprising physical cash and overnight deposits, surged by a further 1.7% in August, for a three-month gain of 3.4% or 14.1% annualised. Six-month real M1 expansion (i.e. deflated by consumer prices, seasonally adjusted) rose to 3.2%, the highest since February 2010 and a level historically consistent with solid subsequent economic growth – see first chart.

Real M1 accelerates before economic upswings as households and firms shift their money holdings into more liquid form ahead of a rise in spending. It is more reliable than real broad money M3, which failed to signal the 2008-09 recession, as well as bank lending to the private sector – a coincident indicator at best. Consensus commentary ignores M1 and will probably interpret the August numbers negatively, since M3 rose by only 0.2% on the month while lending was unchanged.
 
M1 is reviving in response to President Draghi’s campaign to  reverse disastrous Bundesbank-inspired monetary policy tightening in 2010-11. Repo rate cuts, liquidity injections, looser collateral rules and zero interest on banks’ excess reserves have combined to reduce three-month euro LIBOR from 1.5% in November 2011 when President Draghi entered office to 15 basis points – below US dollar and sterling rates of 35 bp and 60 bp respectively.

The country breakdown of real M1 (i.e. overnight) deposits shows a further pick-up in six-month growth in the core while the rate of contraction in the periphery has slowed – second chart. A recovery in core activity should restore Eurozone-wide economic expansion in early 2013 but the periphery will remain stagnant at best, although recessionary pressures should ease.

Hopes of a lasting break in the crisis rest on a resumption of real money expansion in the periphery to lay the foundations for economic recovery. With capital flight apparently arrested – see yesterday’s post – the six-month change in real M1 deposits could feasibly turn positive by October. Such a scenario, of course, requires governments – in core as well as peripheral countries – to proceed with agreed plans, along with President Draghi’s continued success in suppressing Bundesbank opposition to monetary largesse.

A precondition for lasting respite in the Eurozone crisis is a reversal of capital flight from peripheral economies. This is needed to restart monetary expansion, without which fiscal austerity will ensure continuing recessions.

A return of capital would probably show up initially in a fall in aggregate ECB lending to banks as funding pressures on peripheral institutions eased – aggregate loans can be tracked weekly. It would be confirmed by a decline in TARGET 2 imbalances, i.e. the intra-system credits and debits of national central banks – month-end data are generally available with a one- or two-week lag. Full monetary statistics, published with a one-month lag, would offer definitive proof.

Recent evidence is hopeful but inconclusive. Aggregate ECB loans to banks, incorporating “emergency liquidity assistance”, fell by €19 billion between end-June and end-August but this proved a false signal; subsequent monthly data showed no reduction in peripheral banks’ reliance on ECB funding while TARGET 2 imbalances rose further – see previous post.

Aggregate loans, however, have fallen faster since end- August: they were down by €28 billion as of last week – see chart – while repo lending has contracted by a further €10 billion this week. There is a better chance that TARGET 2 imbalances will have declined during September, although any reduction will be small relative to the prior surge.

Some caution, however, is warranted until these positive hints are confirmed by the full monetary data. An optimistic scenario would involve the six-month change in peripheral real M1 deposits becoming less negative in August and returning to zero or positive territory in September – August numbers are released tomorrow.

The average yield on index-linked gilts of more than 15 years maturity has risen from -0.2% in January to 0.3% yesterday, with more than half of the increase occurring this month, probably reflecting expectations that the Consumer Prices Advisory Committee (CPAC), following its recent meeting, will recommend changes to the method of calculation of the retail prices index to reduce or eliminate the “formula effect” inflation gap with the CPI and that such a recommendation will – if necessary – be sanctioned by a Chancellor keen to minimise future debt interest expenditure. (US TIPS yields, by contrast, have fallen slightly in September.)

The rise in the yield compensates future investors for a smaller prospective inflation element of the return from holding index-linked gilts. If the RPI calculation were “harmonised” with that of the CPI – one of the options being considered by CPAC – the current annual RPI inflation rate would fall by 0.9 percentage points. The recent yield rise looks modest relative to this possibility, which could also warrant a larger “risk premium” by setting a precedent and opening the door to additional formula “refinements” that could further lower recorded inflation.

Rises in index-linked yields, historically, have often preceded equity market set-backs. The current increase may differ because it does not represent a rise in the prospective real return with which stocks must compete. The mooted RPI change, nevertheless, is judged here to be negative for the UK investment climate, since it increases uncertainty and represents another example of officials intervening to affect financial outcomes in an unpredictable fashion – cynical investors will view the defensible technical arguments as a smokescreen for more “financial repression”.

Chinese industrial output is estimated here to have risen by only 1.5% (not annualised) in the six months to August, after adjusting for seasonal and holiday effects – the slowest growth since February 2009. This weakness was foreshadowed by stagnation of real narrow money, M1, between mid 2011 and spring 2012 – see first chart.

Real M1 has since recovered, its six-month change rising from -0.3% in June to 5.1% in July before easing to 2.6% in August. Allowing for the typical half-year lead, this suggests better economic news around end-2012. Growth, however, remains modest by historical standards – the six-month real M1 rise averaged 7.1% over 1998-2007. A proper economic recovery, involving above-trend expansion, requires further real money acceleration.

It is, therefore, concerning that Chinese monetary policy has been on hold since a cut in official rates in July. Market rates, indeed, have drifted up recently, a development attributed by some to the authorities failing to offset a liquidity drain due to a balance of payments deficit (i.e. capital outflows outpacing the still-large current account surplus) – second chart. Apparent complacency may reflect a focus on broad money, M2, and bank loans, which are growing faster than M1 but have an inferior recent forecasting record.

Chinese economic prospects are improving at the margin but caution remains warranted pending additional policy relaxation and / or a further recovery in real M1 expansion.

As discussed in Wednesday’s post, a pick-up in US real narrow money growth over June-August implies that the Fed’s decision to launch QE3 was at best otiose and at worst will prove destabilising. The rise appears to have gathered pace in September, judging from weekly monetary data. Six-month growth in the real money measure monitored here is on course to climb from 5.1% (not annualised) in August to 8.5-9%, the highest since January – see chart. (This estimate uses the average level of the nominal money supply in the first two weeks of the month while assuming that the six-month rise in consumer prices is unchanged from August.)

This strength cannot be attributed directly to the Fed, which contracted its balance sheet between March and early September. It reflects, instead, a voluntary decision by households and firms to shift funds into cash and checkable deposits from less liquid forms of money – such a shift usually precedes a rise in spending or financial investment. This decision, of course, may have been influenced by expectations that the Fed would deliver additional easing, thereby punishing savers further and raising the risk of future inflation, in turn increasing the incentive to spend now.

Allowing for the typical half-year lead to demand / output, the monetary surge will hit in early 2013 as the economy simultaneously negotiates a “fiscal cliff” of uncertain steepness – this will be determined in political wrangling after the November elections. The ideal scenario, of course, would be for money-signalled stimulus exactly to offset fiscal restraint, resulting in stable economic expansion. The bias here is to view the monetary boost as more powerful, particularly with the Fed pouring fuel on the flames and a rising (though currently still low) probability of a Democratic clean sweep in the elections – this would allow a swift deal on the “cliff”, though at longer-term fiscal cost.

The concern, however, is that nominal GDP buoyancy in early 2013 due to the current monetary surge will be reflected in inflation rather than economic activity. The “transmission mechanism” would be further strength in commodity prices enflamed by the Fed’s over-activism and an imbalance between demand and supply early next year, with firms unprepared for a pick-up in spending because of exaggerated concern about the impact of fiscal restraint. Yet again, incompetent, short-termist policy-making risks wrecking a promising economic outlook.

An earlier write-up of July Eurozone monetary statistics drew attention to a contraction of real M1 deposits in France, in contrast to rising growth in Germany and other “core” countries. The six-month fall in French real M1 deposits in July, indeed, was on a par with Spain and Italy, suggesting dismal French economic prospects:

Today’s “flash” purchasing managers’ surveys for September provide earlier-than-expected evidence that France is diverging negatively from the rest of the core. The Eurozone manufacturing PMI edged up from 45.1 to 46.0, driven by a rise from 44.7 to 47.3 in the German index. France’s manufacturing PMI, by contrast, slumped from 46.0 to a three-and-a-half-year low of 42.6. The French services survey also weakened as Germany’s strengthened – the following chart, from PMI compiler Markit’s press release, shows the French composite output index:

The French government is forecasting GDP growth of only 0.8% in 2013 but even this requires a swift recovery in monetary trends. Tax-heavy fiscal tightening aimed at reducing the budget deficit from 4.5% of GDP in 2012 to 3.0% next year, to be confirmed in the 2013 Budget released on 28 September, looks increasingly misguided and self-defeating.