Recent solid US economic and stock market performance was signalled by earlier monetary strength. Six-month growth of real narrow money, however, peaked in October and is estimated to have fallen sharply in February, based on weekly monetary data – see chart.

The earlier narrow money surge was partly but not completely explained by distortions due to regulatory changes, as described in a previous post. The recent slowdown may reflect an unwind of this regulatory effect. Six-month real growth is still healthy. This would argue for retaining a positive view of economic prospects.

An alternative possibility, however, is that the monetary slowdown is the consequence of QE2 stimulus fading – the expansion of the Fed's securities holdings stopped in June. “Operation twist and shout” – Fed purchases of longer-dated Treasuries financed by selling shorter-maturity bonds coupled with a campaign to talk down interest rate expectations – does not inject cash directly into the economy so is less powerful. The slowdown, on this view, signals deteriorating economic prospects.

The October peak in six-month real money growth suggests an April top in industrial output expansion, allowing for the typical six-month lead. The fall in the ISM manufacturing new orders index in February reported yesterday – which had been foreshadowed by other indicators – is consistent with such a scenario.

Optimistic economic commentary may be overemphasising lagging labour market indicators and underestimating the temporary positive effect of mild weather as well as leap year data distortions. It is early days but first-quarter GDP growth could be surprisingly weak. January real personal consumption was unchanged from the fourth-quarter average. Nominal capital goods shipments – a proxy for business equipment investment – fell by 1.6% on the same basis. Stockbuilding was 0.4% of GDP in the fourth quarter versus an average of 0.25% since 1995, suggesting a decline this quarter. Real government spending may fall for the sixth successive quarter. A rise in GDP, therefore, may depend on strength in construction investment and net exports – possible but not guaranteed.

The weakness of UK broad money growth in recent years misled most monetarist economists into underpredicting inflation. The view taken here, by contrast, was that this weakness would be more than offset by a rise in the velocity of circulation of money in response to negative real interest rates. The eroding real value of money, in other words, would result in households and firms wishing to hold less of it. The attempt to get rid of “excess” balances would cause money to circulate faster, with a given stock associated with a higher level of nominal GDP and prices.

An ex post measure of velocity is the ratio of nominal GDP to the broad money stock. (Broad money is defined here as M4 excluding holdings of “intermediate other financial corporations”, or M4ex. Figures before 1998 are estimated by linking to M4.) Velocity bottomed in the second quarter of 2009 and had risen by 6.4% by the fourth quarter of 2011. This represents the largest cumulative increase since the late 1970s, when real interest rates were similarly heavily negative – see chart.

The maximum rate of nominal GDP growth compatible with the 2% inflation target over the medium term is about 4% per annum, assuming 2% trend real economic expansion. The 6.4% rise in velocity over the last 10 quarters implies a 2.5% pa rate of increase. Assuming that velocity continues on its recent trend, therefore, inflation is likely to exceed 2% if broad money growth is more than 1.5% pa. Annual M4ex growth was 2.9% in January and has been above 2% in six of the last seven months. Accordingly, the view here is that inflation will continue to overshoot barring a “shock” that causes money demand to increase.

The ECB’s second three-year longer-term refinancing operation (LTRO) is similar in gross terms to the first but will have a significantly larger impact on net lending to the banking system and bank reserves, suggesting further liquidity support for markets.

The €529.5 billion lent in today’s three-year LTRO compares with €489.2 billion in the first such operation conducted on 21 December. Banks, however, repaid €275.1 billion of other “monetary policy” loans in the week of the December operation, resulting in a net increase of €214.1 billion.

This week, banks have repaid €218.9 billion of shorter-term loans, implying a net rise in monetary policy lending of €310.6 billion. Some banks previously borrowing under “emergency liquidity assistance” programmes, however, probably took advantage of looser collateral rules to switch into the cheaper three-year LTRO. The net increase in lending, therefore, should be less than €310.6 billion but still significantly higher than in December.

The rise of €214.1 billion in monetary policy lending in the week of the December operation was reflected in a €164.6 billion increase in banks’ current account and deposit facility balances at the ECB. Assuming the same percentage pass-through this week, these reserves may grow by about €240 billion from their level of €571 billion at the end of last week, a 42% gain. Such a rise would push G7 bank reserves well above their December record – see chart.

A provisional verdict based on today’s money supply numbers for January is that the Draghi bazooka has succeeded in stabilising bank balance sheets but has yet to lay the monetary foundation for an economic recovery. Peripheral monetary indicators, indeed, have deteriorated further, suggesting a faster contraction of economic activity.

The stabilising effect of the bazooka is evidenced by a €68 billion, or 0.7%, rise in broad money M3 in January, reversing falls in November and December. This reflected the sovereign carry trade: banks bought €52.3 billion of Eurozone government bonds, the most since October 2010 and up from €2.7 billion and €3.7 billion respectively in December and November – see first chart. (These numbers exclude the ECB’s purchases under the securities markets programme and are not seasonally adjusted.) As expected, the biggest buyers were Italian and Spanish banks, whose holdings rose by €28.4 billion and €24.4 billion respectively, presumably reflecting purchases of local debt.

The M3 rebound, however, was not mirrored by narrow money M1, which rose by only 0.1% last month following a 0.2% December decline. M1 is a better economic leading indicator than M3, probably because consumers and firms shift money into more liquid forms before increasing spending. The six-month rate of change of real M1 slipped further to -0.5% (not annualised) in January from -0.3% in December – second chart. This measure had turned positive between August and November last year, signalling less negative economic news in early 2012, allowing for the usual six-month lag; the recent decline implies deteriorating prospects for mid 2012.

M1 comprises currency in circulation and overnight deposits. The ECB publishes a country breakdown of deposits but not currency. A 1.0% (not annualised) fall in Eurozone real M1 deposits in the six months to January conceals a solid 2.2% rise in “core” economies (defined here as Austria, Belgium, France, Germany, Luxembourg and the Netherlands) offset by a 6.1% plunge in the “periphery” (i.e. Greece, Ireland, Italy, Portugal and Spain) – third chart. The latter represents a new low, suggesting that the rate of peripheral GDP contraction will accelerate in mid 2012.

The peripheral country decomposition, as expected, shows the largest decline in Greece (-12.9%, not annualised) but Ireland is now as weak as Portugal (-9.2% versus -9.0%), with Italy not far behind (-8.0%); Spain’s contraction, oddly, is milder (-1.5%) – fourth chart. In the former cases, these are depression-scale declines, although normal monetary relationships may be breaking down in the context of rising EMU dissolution risk.