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.

Recent US economic weakness was predicted by a significant slowdown in real narrow money in late 2011 / early 2012 – see March post. Some series have been notably soft – gross domestic income (an alternative GDP gauge) rose by only 0.1% in the second quarter, the household survey jobs measure has been stagnant since early 2012, non-defence capital goods orders fell sharply in June and July, while industrial output tumbled 1.2% in August (of which 0.3% is attributed to the impact of Hurricane Isaac).

Such news has given fresh hope to stale bears such as the Economic Cycle Research Institute (ECRI), which claims that further weakness in upcoming reports together with downward revisions to earlier data will cause the National Bureau of Economic Research (NBER) cycle-dating committee to pronounce that a recession began around mid-year. (This would, however, invalidate ECRI’s September 2011 call that a recession was then imminent.)

While not impossible, such a development is judged here to be unlikely. Real narrow money slowed but never contracted, as it did before 10 of the 11 NBER-defined recessions since World War 2 – see previous post. Its six-month growth rate, moreover, bottomed in May and moved up over June-August – see first chart. Allowing for the normal half-year lead, this suggests that industrial output momentum will trough in November and recover into 2013.

Such a scenario would imply an upturn in the key ISM manufacturing new orders index from a bottom reached over August-October. An improvement is suggested by a sharp recovery in equity analysts’ earnings revisions in September: the “revisions ratio”, i.e. net forecast upgrades as a proportion of the number of earnings estimates, correlates with ISM new orders – second chart.

With real money growth already reviving, last week’s launch of QE3 was unjustified on monetary / economic grounds – except perhaps as a pre-emptive strike against the (unlikely) scenario that Congress fails to mitigate planned fiscal tightening after the November elections. It may even prove counterproductive – additional liquidity may boost commodity prices and inflation, thereby neutralising or outweighing the real impact of any further pick-up in nominal money expansion resulting from the action.

Recent strength in US – and global – stock prices can be partly attributed to investors correctly anticipating last week’s Fed decision to restart QE (i.e. balance sheet expansion financed by reserves creation, as opposed to duration extension of the existing balance sheet under “operation twist”). A key issue, therefore, is the extent to which the “good news” has already been discounted.

US stocks have loosely correlated with the monetary base – now dominated by bank reserves – since the Fed launched QE1 in late 2008. The chart compares the Dow Industrials index with the level implied by contemporaneous bank reserves, based on a simple regression run on data since the start of 2009. The regression “predicts” that a $100 billion injection of reserves is associated with a 440 point rise in the Dow. Yesterday’s Dow close of 13,553 was 1,300 points above the level implied by the regression, based on average bank reserves in the week to last Wednesday. This suggests that the market is discounting an increase in reserves of $292 billion as a result of QE3 (i.e. 1,300 divided by 440/100).

The Fed last week committed to buying $40 billion per month of agency mortgage-backed securities until the labour market improves “substantially” while promising further action if this objective is not achieved. Assuming that purchases are fully financed by reserves creation, a $40 billion per month pace of buying would take more than seven months to achieve the $292 billion reserves boost suggested by the current level of the Dow, based on the regression.

On this simplistic analysis, therefore, investors betting on further significant Dow strength may be implicitly assuming that either the Fed will accelerate its bond-buying in late 2012 / early 2013 or continue the $40 billion per month pace beyond next spring.

Good news: the combined trade balance of Greece, Ireland, Italy, Portugal and Spain moved further into surplus in July – see first chart.

Bad news: the improvement reflected a further decline in imports, probably related to slumping domestic demand, rather than a pick-up in exports – second chart.

Still, exports have held up despite a global slowdown and domestic credit constraints, while cost competitiveness is improving, promising a future gain in market share at home and abroad.