Eurozone monetary statistics for December confirm that banks have shifted from selling to buying government bonds in response to the ECB’s interest rate cuts and liquidity injections. However, the positive monetary impact of these purchases, and the ECB’s own buying via its securities markets programme, has been offset by a fall in private sector lending.

Banks bought €5.1 billion of euro-denominated government bonds in December after an upwardly-revised €4.6 billion in November – see first chart. The sums are small relative to cumulative sales of €57.5 billion over the prior four months, and to a €267.1 billion increase in the ECB’s monetary policy lending to banks between 28 October and 30 December. Purchases, however, are likely to have increased in January, judging from recent peripheral yield declines.

The boost to broad money M3 in December from bond buying was swamped by a €75.7 billion contraction of loans to the private sector. This number was distorted downwards by a fall in lending to quasi-banks (i.e. unrelated to the “real economy”) but there was also a significant reduction in loans to non-financial corporations. M3 declined by 0.5% in December following drops of 0.1% and 0.5% in November and October respectively.

The best monetary leading indicator of the economy is real narrow money M1. Worryingly, the six-month change in this measure returned to negative territory in December for the first time since June, suggesting falling output during the first half of 2012 – second chart. The hope – realistic but yet to be supported by the data – is that real M1 will revive in early 2012 in response to the ECB’s policy actions, setting the stage for an economic recovery late in the year.

The country breakdown of real M1 deposits continues to show respectable growth in the core offset by a slump in the periphery – third chart. The six-month core increase, indeed, rose to a 15-month high in December, reflecting strength in Germany and the Netherlands, with French real deposits flat. The peripheral change, by contrast, was -3.8%, or -7.4% annualised, with the smallest decline in Spain, followed by Italy, Ireland, Portugal and Greece – fourth chart.

The implied scenario of core economic resilience with deep recessions in the periphery suggests further trouble ahead, with the Bundesbank likely to veto additional aggressive ECB easing even as weak peripheral economies derail fiscal consolidation plans.

The US Conference Board has overhauled its leading indicator index, making changes to four of the 10 components. The new version has performed more weakly in recent years and over the last 12 months – see chart. It has recovered, however, from a low in September to reach a five-month high in December.

The revision is of questionable value. The Conference Board claims that the new index is a more accurate predictor of business cycles since 1990 but its earlier performance is inferior – as the chart shows, it failed to turn down before the 1960-61 recession, in contrast to its predecessor.

An important change is the replacement since 1990 of the real M2 money supply with a new “leading credit index”. This partly explains why the new index weakened last summer while the old version continued to rise. This weakness, however, appears to have been a false signal, based on recent solid US economic data. Had the new index been in operation, in other words, it would have encouraged dubious recession calls.

The view of this journal, of course, is that real money is a key forecasting tool and should be included in a composite leading index, although in most countries a narrow measure outperforms M2 and broader aggregates.

Recession-mongers will probably claim that the new index is consistent with their forecast since, despite the recent recovery, it has yet to regain the July 2011 peak. They can also argue, with some justification, that the index remains biased upwards by its inclusion of the 10-year Treasury yield / federal funds rate spread – the assumed positive implication of a steep yield curve is questionable when official interest rates are close to zero*. (The view here is that this bias is counterbalanced currently by a downward distortion from the omission of real money.)

* The economy entered a recession in 1937 with a similar Treasury yield curve to currently.

Global business surveys continue to surprise positively, the latest examples being the German Ifo and UK CBI manufacturing polls released today and yesterday’s Eurozone flash PMIs.

A cautionary note, however, is sounded by recent earnings revisions by equity analysts. The world revisions ratio (i.e. analyst upgrades minus downgrades as a proportion of the number of estimates) correlates with G7 PMI manufacturing new orders and fell back in January – see chart.

The suggestion is that the remaining PMIs released next week will break the run of favourable survey news. US ISM manufacturing new orders, in particular, could subside from an elevated December level.

The view here is that any such setback will prove temporary, based on continued solid global real money expansion and firmer leading indicators, discussed in prior posts.

The official first guess that GDP declined by 0.2% in the fourth quarter is within the margin of error of a flat economy. There may have been a small depressing effect on the number from a combination of mild weather, the public sector strike and one fewer working day in the quarter compared with the prior four years. (Mean temperatures in October, November and December were above long-term averages, contributing to lower electricity and gas consumption.)

GDP is estimated to have risen by only 0.9% in 2011 but there was a big drag effect from the North Sea – the onshore economy grew by 1.4%.

Business surveys and labour market indicators suggest marginally firmer activity as the quarter ended. The hope is that the economy will benefit from global lift and an abatement of the inflation squeeze on consumers and businesses as 2012 progresses. Inflation, however, may fall by less than the Bank and consensus expect – see post last week – while monetary trends have yet to show significant improvement (December numbers are released next week).

UK public sector net borrowing excluding the temporary effects of financial interventions (PSNB ex) remains on course to hit or undershoot the OBR’s November 2011 forecast of £127 billion (revised up from £122 billion in March) despite economic weakness.

December borrowing of £13.7 billion was down from £15.9 billion a year before and £1.2 billion below the consensus forecast, according to Reuters. There was, however, an upward revision of £1.3 billion to prior months in 2011-12.

PSNB ex was £124.8 billion in calendar 2011, implying that borrowing in the first quarter of 2012 must exceed the level a year earlier for the OBR forecast for 2011-12 not to be undershot.

PSNB ex was 8.3% of GDP in calendar 2011 versus an OBR forecast of 8.4% for 2011-12.

The view here remains that the fiscal position is better than implied by the PSNB ex measure since financial interventions are now generating a sizeable surplus, not all of which should be discounted – see previous post for more discussion. Total borrowing (i.e. net of this surplus) was £91.3 billion (6.0% of GDP) in calendar 2011, down from £122.5 billion in 2010 – an impressive 25% reduction.

Of the £33.5 billion positive impact of financial interventions last year, £19.6 billion represented the operating surplus of the public sector banks with a further £8.1 billion due to Bank of England net interest income from the Asset Purchase Facility (APF) and fees from the Special Liquidity Scheme (probably small). (The remaining £5.8 billion includes the surplus of the banks’ subsidiaries.) There is a strong case for the Treasury booking the Bank's net income from QE rather than allowing it to accumulate off-balance-sheet in the APF. This could be achieved by the APF paying the Treasury an annual dividend. Such a treatment would be equivalent to that adopted in the US, where the profit of the Federal Reserve, including its net income from QE, is distributed to the Treasury. The Fed has estimated that the distribution relating to 2011 will be $76.9 billion, up from $31.7 billion in 2008, with the increase mainly reflecting the expansion of its balance sheet due to asset purchases.

A post last April suggested that G7 consumer price inflation would peak in autumn 2011 and decline into 2012. Relief, however, was expected to be modest and temporary.

The forecast is on track, with annual inflation topping at 3.2% in September and down to an estimated 2.5% in December. A slowdown in commodity prices during 2011 points to a further decline in early 2012 – see first chart.

The forecast was based on the monetarist rule that money supply changes lead inflation by about two years. A smoothed measure of G7 narrow money growth rose between September 2007 and October 2009, correctly predicting the 2010-11 inflation upswing. It partially retraced this increase in 2010, reaching a trough in August, suggesting that inflation would decline from autumn 2011 to a low in summer 2012 – second chart.

The inflation slowdown has been factored into current market pricing. The smoothed money measure, however, has continued to trend higher from its August 2010 trough. The global monetary pick-up during 2011, discussed in numerous previous posts, should sustain this increase, with a possibility that the measure will surpass its 2009 high.

The monetarist rule, in other words, suggests that inflation will revive later in 2012 and into 2013, with a significant risk that it will exceed its 2011 peak next year. Recent firmer commodity prices could be early evidence of this scenario. Bond markets usually anticipate inflation, implying higher yields by the summer, although central bank manipulation may damp the move.