MMM is taking an Easter break. Normal service will resume on or after 13 April.

Global industrial output – as proxied by production in the Group of Seven (G7) major economies and seven large emerging economies (the "E7") – fell by 14% between February 2008 and February 2009. This was the largest peacetime decline since the 1930s, though comparable with a 12% fall in G7 output between May 1974 and May 1975, following the first oil shock. (G7 production is a reasonable measure of global output in the 1970s, when today's emerging economies were much less influential.)
 
At the output trough early last year most economic forecasters – including the IMF and OECD – expected any revival in activity to be delayed and weak. As discussed in a post last May, however, this was at odds with the "Zarnowitz rule" that "deep recessions are almost always followed by steep recoveries". Faster money supply growth, moreover, supported a more optimistic prognosis. A year on, a "V"-shaped recovery has been confirmed: G7 plus E7 output had risen by 11% from its February 2009 low by January 2010, to stand only 4% below the February 2008 peak. The recovery has been led by the E7, where output is 9% above its pre-recession peak and rising capacity strains signal a need for significant monetary policy tightening.
 
The 2008-09 output fall, as noted, resembled the 1974-75 contraction. The subsequent recoveries also look similar: G7 production had risen by 9% at the equivalent stage of the post-1975 upswing – see the first chart below. Both recessions were associated with a major shock – a four-fold oil price rise in 1974 and a financial crisis in 2008 – that caused firms to retrench aggressively. Final demand, however, proved more resilient than expected, resulting in an excessive decline in stock levels that, in turn, prompted a strong production rebound. Fiscal and monetary policies, moreover, were similar: the G7 structural budget deficit widened by 2-3% of GDP in both 1975 and 2009 while official interest rates were cut sharply to below inflation. (This contrasts with the aftermath of the second 1970s oil shock – governments eschewed a Keynesian fiscal response while official rates remained positive in real terms, contributing to a weaker upswing but lower subsequent inflation.) The current revival in G7 plus E7 output, therefore, could continue to track the post-1975 G7 recovery. As the first chart shows, this would imply further solid expansion during 2010, with production surpassing its February 2008 peak at the end of the year, but a significant slowdown in 2011. Indeed, the 2% gain between December 2010 and December 2011 suggested by the template might involve stagnant or contracting G7 industrial activity, allowing for much faster E7 trend growth.
 
This broad shape – strength for much of 2010 but a slowdown in 2011 – appears consistent with global monetary trends. Some monetary economists argue that an economic relapse is imminent because G7 real broad money is now contracting on a year-earlier basis – see the second chart. As discussed in several recent posts, however, negative real interest rates are reducing the demand to hold money by households and financial institutions so this weakness is unlikely to signal insufficient liquidity to finance an ongoing economic recovery. Supporting this interpretation, real narrow money, M1, and corporate broad money holdings – better leading indicators than aggregate broad money – are still growing solidly. M1 expansion, however, has declined since late 2009, consistent with slower economic momentum later this year, in line with the 1970s template.
 
While the economic outlook appears benign, monetary conditions are becoming less favourable for financial markets. The gap between annual G7 real M1 growth and industrial output expansion is a measure of "excess" liquidity available to flow into markets and push up prices. On average since 1970, global equities have outperformed cash by 11% per annum when money has outpaced output while underperforming by 5% pa at other times. The real M1 / output growth gap has been positive since late 2008 but is likely to reverse soon – second chart. Less exciting prospects for equities are also suggested by an analysis of historical recoveries after large bear markets. Prior to the 54% decline between October 2007 and March 2009, the US Dow Jones industrials index had fallen by 45-55% on six occasions since 1900. On average, the Dow recovered by 59% in the first year after these bear markets but by only 7% in the second year. The first-year gain in the current rally (i.e. from the trough on 9 March 2009) was close to the historical average, at 61%.
 
One reason that equities have tended to perform poorly when G7 real M1 growth has fallen beneath output expansion is that such cross-overs have been followed by a rise in short-term interest rates. There have been nine such signals since 1970; in all cases G7 short rates (i.e. a weighted average of national rates) were higher six to 12 months later. Reassured by central bankers' rhetoric about output gaps and the economic drag from future fiscal tightening, markets are currently assuming that monetary policies will remain unusually loose for a sustained period. Such complacency is certainly misplaced in many emerging economies now on the verge of overheating. Even in the G7, likely confirmation that the recovery is spreading to labour markets will allay “double dip” concerns and increase debate about the wisdom of maintaining official rates far below both current and target inflation. The linkage of prolonged periods of negative real rates with the formation of financial bubbles and subsequent damaging busts must surely now be recognised even by the neo-Keynesian dogmatists who populate the major central banks.

Housing market bears recently encouraged by a fall in mortgage approvals and slower price gains may have to retreat to the woods, judging from the Bank of England's first-quarter Credit Conditions Survey. The net percentage of banks expecting stronger demand for mortgages to finance house purchases rose to +40 – the highest in the survey's three-year history and up from +3 in the fourth quarter of last year and a low of -40 in the second quarter of 2008. Softer indicators in early 2010 appear to have reflected bad weather and the temporary impact of the ending of the previous stamp duty holiday.

A majority of banks also expects a rise in demand for unsecured consumer loans and corporate credit – see first chart.

Credit supply, meanwhile, should improve, with the net percentages expecting greater availability of corporate, mortgage and unsecured consumer loans all positive, the latter for the first time since 2007 – second chart.

A previous post suggested that the recovery in house prices would follow the pattern of the early 1980s, a possibility also mooted by MPC member Andrew Sentance. Inflation-adjusted prices have actually moved ahead of the 1980s path recently – third chart. The bears' assumption that restricted credit supply would offset the stimulus of low interest rates – supplemented now by an extension of the stamp duty holiday up to a higher threshold – looks increasingly questionable. Higher official rates may be needed to head off an overexuberant housing market.

The further upward revision to fourth-quarter GDP growth to 0.4% from an originally-reported 0.1% brings the official series into line with earlier expectations. The initial 0.1% estimate, released in late January, probably influenced the MPC members who considered expanding gilt-buying at the February meeting.

The revised figures also confirm that the fall in non-North Sea output in the recent recession was smaller than during the 1979-81 contraction. Gross value added (GVA) excluding oil and gas declined by 5.8% between the first quarter of 2008 and third quarter of 2009 versus a 6.4% drop between the second quarter of 1979 and first quarter of 1981 – see chart.

On top of the fourth-quarter upgrade, the fall in GVA excluding oil and gas in the third quarter was lowered from 0.2% to 0.1% (0.08% to two decimal places). Further revisions may show that the non-oil economy bottomed in the second rather than third quarter, as suggested by business surveys and labour market evidence.

The economic polling model discussed in prior posts suggested that the Conservative lead over Labour would fall into hung parliament territory in early 2010 but rewiden in the spring, mainly reflecting the negative impact on government popularity of a sharp increase in retail price inflation. Recent polls, showing a Tory fightback, are consistent with this "forecast".

The model uses ICM polling data, which extends back to the early 1980s. (ICM is well-regarded, having scored a notable success at the 1997 election.) Based on recent economic data and a forecast further rise in inflation to 4.5% by April, the model suggested a Conservative / Labour lead of seven percentage points in March, rising to nine in April and 11-12 in May – probably sufficient to produce a Conservative majority.

The latest ICM poll, published in the News of the World on Sunday, reported an eight point gap, up from six points a fortnight earlier.

The suggestion that the economy is turning less favourable for Labour is supported by the EU Commission consumer survey for March, showing a fall in the composite confidence indicator to -5 from -2 in February – a four-year high. This may reflect the impact of higher inflation on spending power – the net percentage of consumers reporting higher prices over the last 12 months rose to 18 in March, up from a low of 7 in November and above the average of 12 since 1990.

The Bank of England's favoured broad money measure – M4 excluding money holdings of non-bank financial intermediaries – rose by 0.3% in February, defying expectations of weakness following the cessation of the Bank's gilt-buying in January.

Within overall broad money, M4 holdings of private non-financial corporations rose by 0.5%, pushing three-month growth up to an annualised 4.6%. Companies also increased their foreign currency deposits while continuing to repay bank borrowing, resulting in a further rise in the liquidity ratio to its highest level since June 2007 – see chart. Corporate M4 and the liquidity ratio are better leading indicators of the economy than aggregate broad money.

Corporate credit contraction reflects demand weakness much more than inadequate supply – retained earnings are running well ahead of capital spending so firms must either increase their holdings of financial assets or repay debt. Credit demand should revive as investment and hiring recover. The decline in "sterling unused credit facilities" slowed to an annual 8.7% in February versus a peak of 19.5% last April.

While corporate money is picking up, financial institutions' M4 holdings – excluding intermediaries – fell again in February and have declined by 20% annualised over the last three months. Lower cash levels imply less "fuel" to propel asset prices higher, consistent with other evidence of a deteriorating liquidity backdrop for markets.

The rise in aggregate broad money in February reflected a strong positive influence from external and foreign currency flows, according to the Bank's "credit counterparts" analysis. The "externals" were heavily negative during 2009 as a portion of the liquidity created by the Bank's gilt purchases flowed overseas. This effect may now be reversing.