The Bank of Japan (BoJ) today boosted its target for asset purchases by the end of 2013 by another ¥10 trillion to ¥76 trillion. It now plans to buy securities worth the equivalent of 7.6% of GDP in 2013 – slightly larger than the 7.3% of US GDP implied by the Fed’s announced purchases of $85 billion per month, assuming that this run-rate is sustained throughout the year.

A further substantial expansion of the programme is widely expected during the first half of 2013, although the timing will depend on the willingness of BoJ Governor Shirakawa to “co-operate” with the new government before his retirement in April.

The chart shows the implications of the new plans for bank reserves, assuming that forthcoming purchases are unsterilised and other influences net to zero*. Reserves are on course to rise to ¥80.5 trillion by the end of 2013, equivalent to 17.1% of GDP. On the same assumptions, US reserves will amount to 16.0% of GDP if QE3 is sustained at $85 billion per month.

The BoJ’s planned actions, in other words, are already on a scale suggesting a significant impact on markets and the economy. As previously discussed, however, their effectiveness would be enhanced by lengthening the maturity of securities purchases – longer-term bonds are more likely to be held outside the banking sector, in which case buying by the central bank results in a direct boost to the broad money supply in addition to a rise in bank reserves**.

*This is reasonable but uncertain. Other changes on the BoJ’s balance sheet have partly offset the reserves impact of asset purchases to date – reserves have risen by ¥28.0 trillion since October 2010 versus securities buying of ¥39.2 trillion. Another BoJ easing initiative – the “fund-provisioning measure to stimulate bank lending” – could result in additional reserves creation.

**The BoJ currently limits buying of government securities, which account for ¥68.5 trillion of the ¥76 trillion asset purchases target, to Treasury bills and JGBs with a remaining maturity of less than three years.

A simple forecasting rule-of-thumb based on the money supply and share prices – a rule that correctly predicted that 2012 would be disappointing – suggests that 2013 will be the best year for the economy since (at least) 2006, when GDP climbed 2.6%.

The forecasting rule assesses growth prospects for the coming calendar year based on whether end-year levels of real (i.e. inflation-adjusted) money supply growth and share prices are higher or lower than 12 months earlier. Real money growth is measured by the annual rate of change of the broad M4ex measure deflated by the retail prices index (RPI). Share prices are measured by the domestically-orientated FT30 index, again deflated by the December RPI.

Annual GDP growth averaged 2.4% in the 47 calendar years from 1966 to 2012. The forecasting rule gave a “double-positive” signal in 16 of these years (i.e. both real money growth and share prices at the end of the prior year were higher than 12 months before). GDP growth in these years averaged 4.1%.

There were, by contrast, 11 years when the forecasting rule gave a “double-negative” signal. Growth in these years averaged just 0.5%. In the remaining 21 cases where the money supply and share prices gave conflicting signals GDP expansion averaged 2.1%.

As noted, the forecasting rule warned that the economy would perform poorly in 2012 – the December 2011 real level of the FT30 index was down by a whopping 20% from a year earlier, while the annual change in real M4ex was -3.4% versus -2.2% in December 2010. The currently-estimated* 0.2% GDP decline in 2012 is below the 0.5% growth average for double-negative years but the result was affected by a fall in oil and gas production, which subtracted about 0.3%.

The rule has also worked reasonably well in other recent years. A previous double-negative signal was given at the end of 2008, ahead of a 4.0% GDP slump in 2009. The money supply and share prices gave conflicting signals for 2010 and 2011: GDP growth was 1.8% and 0.9% respectively in the two years, or 2.0% and 1.5% excluding oil and gas.

What is the message for 2013? The FT30 index at the time of writing (17 December) was 19.9% higher than in December 2011, implying a real gain of 16% allowing for expected December RPI inflation of about 3%. The annual rate of change of real M4ex, meanwhile, was 0.9% in October versus -3.4% at end-2011. The rule, therefore, will give a double-positive signal barring a year-end stock market crash or implausible monetary relapse.

It is, of course, possible to accept the rule’s implication that 2013 will surprise favourably without believing that growth will equal the 4.1% average for double-positive years! The last double-positive signal was for 2006, which delivered GDP expansion of 2.6% – the minimum following such a signal. Assuming that potential growth has fallen since the 2000s, a “good” year might now involve a GDP rise of little more than 2%.

How could a positive growth surprise be generated? Possible drivers include:

• Consumer spending. Spending is no higher than in 2006, suggesting pent-up demand. The real income backdrop has improved, despite weak wages, reflecting higher employment and lower inflation. The saving ratio is stable at close to its long-run average. Debt has fallen from a peak of 175% of disposable income to 146%, its level in 2004, while market gains have lifted financial wealth. Increased mortgage availability, partly due to the funding for lending scheme, should boost the housing market in 2013.

• Exports. Recent global economic weakness was signalled by a dive in real money growth in early 2012 but monetary trends have recovered since the spring, suggesting stronger export markets in early 2013, allowing for the typical six-month lead. Sterling remains competitive, with the percentage of CBI industrial firms citing prices as a constraint on exports well below the long-run average.

• Investment in plant and machinery. Business investment grew respectably in 2012 and could accelerate in 2013 as consumer / export pick-ups boost animal spirits. Corporate finances remain healthy, money holdings are rising, surveys indicate that spare capacity is limited and the temporary increase in the annual investment allowance announced in the Autumn Statement will be helpful at the margin.

• Construction. Falling construction output lopped an estimated 0.6% from GDP in 2012 but orders – a leading indicator – have stabilised since late 2011, suggesting a neutral impact in 2013.

An additional reason for optimism is Mark Carney’s appointment as Bank of England Governor. Mr Carney may be a brilliant policy-maker but his career management skills are even more impressive; his decision to accept the role must reflect a judgement that UK economic performance in his coming five-year term will be considerably better than the dismal record under his predecessor.
 
*Estimate from the Treasury’s monthly survey of economic forecasters.

David Smith’s Sunday Times column discusses the drag on GDP from falling North Sea oil and gas production. Such production fell by 35.6% between the second quarter of 2009 – the recession trough – and the third quarter of 2012. With the sector accounting for 2.0% of the economy in 2009, this decline subtracted 0.7 percentage points from gross value added (GVA)*. Put differently, GVA has risen by 3.7% since the trough but GVA excluding oil and gas extraction (“non-oil GVA”) has climbed 4.5%.

The fall in North Sea production, of course, pre-dated the recession. Output peaked in the first quarter of 2000 and had declined by 47.1% by the second quarter of 2009.
 
The North Sea effect is neglected in unflattering comparisons of recent GDP / GVA performance with previous recessions / recoveries, when oil and gas production was stable or rising. The chart overlays the path of non-oil GVA in the late 1970s / early 1980s on the current cycle, aligning the two pre-recession peaks**. The peak-to-trough falls are identical – 6.3% – and the current recovery was tracking the early 1980s upswing until the third quarter of 2011. Over the subsequent year, however, non-oil GVA has risen by just 0.2% versus 4.0% at the corresponding point in the early 1980s (i.e. between the fourth quarters of 1982 and 1983).

The reasons for this shortfall, of course, are hotly debated. The explanation offered here is a combination of GVA mismeasurement (i.e. recent numbers will be revised up, though possibly not for many years), an inflation squeeze on real money in 2011 and weaker Eurozone export markets. The Keynesian claim that fiscal austerity bears responsibility is at odds with the timing of underperformance  – the fall in cyclically-adjusted net borrowing was similar in 2010-11 and 2011-12, according to the Office for Budget Responsibility (i.e. 1.5% and 1.4% of GDP respectively).

Economic prospects are judged here to have improved significantly as a result of recent stronger real money expansion and an incipient global upswing. The level of non-oil GVA may remain below the early 1980s path (at least pending data revisions) but the growth rate may reconverge. This suggests a 2.0% rise in non-oil GVA between the fourth quarters of 2012 and 2013 (i.e. equal to the gain between the first quarters of 1984 and 1985).

*GVA is the output / income measure of domestic product and excludes indirect taxes and subsidies.
**The 1970s / 1980s path is based on an earlier data vintage. Statistics calculated on the current basis are due for release in early 2013.