G3 bank reserves have risen to a new record, reflecting Japanese foreign exchange intervention and an increase in the ECB’s repo lending:


The ECB’s bond purchases have contributed to a debt-weighted average of Eurozone 7-10 year government yields falling to its lowest level since November:

US money measures have picked up further, implying ample “sideline” cash available to flow into the economy and markets when risk aversion abates:

Eurozone monetary weakness, in the view of the author of these notes, has been the key driver of the recent deterioration in global economic and financial conditions. Various posts over the last year drew attention to a contraction of the real narrow money supply, M1, initially in the periphery but spreading to the core in early 2011.

By February 2011, Eurozone-wide real M1 was 2.1% lower than six months before (not annualised). The six-month change has turned negative on seven previous occasions over the last 40 years, in five cases signalling an oncoming full-scale recession and the other two instances a significant contraction in industrial output – see first chart below.

Against this backdrop, it was astonishing that the European Central Bank, which trumpets its adherence to monetary analysis as a distinguishing feature of its modus operandi, chose to rein back its longer-term repo lending in late 2010 and raise official interest rates in two quarter-point moves in April and July. This was a repeat of its error of 2008, when it hiked by a quarter-point in July despite a fall in real M1 – the economy, in fact, had already entered a recession in the second quarter.

Real M1 contraction, predictably, has fed through to economic weakness and heightened risk aversion, reflected in ongoing sovereign debt woes and increased banking system stress. Conventional economic leading indicators are now confirming the recessionary signal from monetary trends. Our proprietary transformation of the OECD’s leading index for the Eurozone, for example, is at a level only previously reached before major downturns – second chart.

The hope was that Euroland’s economic relapse would be tempered and offset globally by favourable monetary trends elsewhere – particularly the US and Japan, where real M1 rose by 4.5% and 3.4% respectively in the six months to June. As previously noted, G7 real money expansion has revived since early 2011. The global loss of confidence stemming from the Eurozone’s unravelling, however, threatens to “freeze” these cash balances – the monetary pick-up, in other words, could be neutralised or outweighed by a fall in the velocity of circulation.

On this diagnosis, a reversal of current negative drift requires the ECB to admit its mistake and embark on a major loosening of policy, cutting the repo rate and stepping up government bond purchases to inject cash directly into the economy. These purchases should be spread across national bond markets rather than focused on Italy / Spain – it is not the ECB’s role to engage in quasi-fiscal transfers. The aim, in other words, should be to reduce peripheral yields by driving core rates towards zero rather than targeting spreads.

ECB “QE” would be much more effective than Fed easing, partly because it addresses the fundamental cause of current global difficulties and partly because a further injection of US cash would risk tanking the dollar and renewing upward pressure on commodity prices, thereby reversing the recent welcome relief to G7 real incomes from slowing inflation. Unilateral ECB loosening would allow the overvalued euro to depreciate – another necessary escape-route for struggling peripheral economies.

The consensus is that any such action would be vetoed by the Bundesbankers and their allies, although recession looms even for Germany. Incoming ECB President Draghi, however, has every incentive to be bold. A majority of the Governing Council would probably support large-scale policy easing. If EMU is to break up, let it be through the voluntary withdrawal of Germany rather than the forced exit of peripheral economies pushed into a depression by hardliners masquerading as monetarists.

The Federal Reserve yesterday gave markets a strong steer that official interest rates will remain at rock-bottom levels for a further two years. Despite the Governor downplaying the suggestion, the Monetary Policy Committee has delivered a similar message in the August Inflation Report.

A key summary measure of the MPC’s policy intentions is its mean forecast of inflation in two years’ time based on unchanged policy. In May, this stood at 2.54%, representing the largest positive deviation from the inflation target in the MPC’s history – see chart. This gave a strong signal that the Committee foresaw policy tightening on a one- to two-year horizon, despite divisions over the timing of the first move.

In the August Report, the mean two-year-ahead forecast has been slashed to an estimated 2.1%, based on chart 5.13 (p.46). This projection, moreover does not incorporate the risk of “an intensification of concerns about sovereign debt” in the euro area, which the MPC judges “almost impossible to calibrate”, but will take into account in setting policy. Since this risk merited a separate box in the Report (p.38), it is, presumably, regarded as significant. The implication is that, were a full risk-weighted computation possible, the mean forecast in two years’ would be below 2%.

This, in turn, supports the prediction of the “MPC-ometer” that the Committee shifted to an easing bias last week. The model forecasts an “average interest rate vote” of -7 basis points, the most negative reading since November 2009, consistent with the two rate-hike proponents backing down and one or more members of the middle group joining Adam Posen in voting for more QE – see previous post for more details.

The cut in the medium-term inflation projection since May looks out of proportion with a modest downgrade to growth, raising further doubts about the Bank’s forecasting credibility. The suspicion is that the Committee has shifted dovishly in response to recent market turbulence and the inflation projection has been adjusted to be consistent with the new stance, rather than the forecasting process itself driving policy.
 
Surprisingly, the shorter-term inflation forecast is little changed from May. With commodity prices softening, CPI inflation may peak below the 5.0% level predicted by the Bank and fall more quickly into early 2012 while remaining above target further out, partly reflecting further exchange rate weakness promoted by the MPC’s dovish stance.

The recent collapse in investor confidence threatens the forecast here of a revival in global economic momentum this autumn, based on faster real money supply growth since early 2011. The scenario is still tenable but requires an early stabilisation of markets – possible given oversold sentiment and renewed liquidity support from central banks.

G7 real narrow money has been a reliable predictor of economic fluctuations before and since the 2008-09 financial crisis, warning late last year of the current economic slowdown – see January post. The pick-up in real growth to an annualised 7% in the six months to June, therefore, should not be dismissed. The risk, however, is that the stimulative impact is neutralised by a fall in the velocity of circulation, reflecting weakened confidence.

To avoid this scenario, equities and other risk assets must stabilise. The MSCI World index in US dollar terms has given back most of its gain since the Fed signalled QE2 last summer and is in an important support zone:The Credit Suisse risk appetite measure fell into panic territory last week, a development normally signalling that equities are nearing a low (exception: September 2008):

Policy is shifting rapidly. Last week, the Bank of Japan expanded asset purchases by ¥5 trillion while the Swiss National Bank injected CHF50 billion of bank reserves, i.e. cumulative stimulus of about $130 billion. Today, the ECB seems to have bought Italian and Spanish bonds in size, judging from a large fall in yields. The intervention will be formally “sterilised” by issuing term deposits but banks are likely to regard these as a close substitute for reserves. Emerging-world central banks, meanwhile, are easing off on the brakes. The Chinese one-week repo rate is at a three-month low:
Until markets plunged, the forecast of a stabilisation of global economic momentum was on track. G7 real retail sales, for example, rebounded solidly in the three months to June, consistent with an imminent bottom in PMI new orders:
Emerging economies, meanwhile, looked poised to reaccelerate, with a growth leading indicator (based on a proprietary transformation of the OECD’s country indices) improving for the second consecutive month in June: