Chinese monetary trends continue to suggest moderate economic expansion and limited “excess” liquidity to fuel asset price bubbles. The monetary backdrop, in other words, is consistent with policy goals.

Six-month real M1 expansion, the favoured indicator here, rose sharply from 3.6%* in December to 6.8% in January – see first chart. The increase, however, is likely mainly to reflect the timing of the Chinese New Year – M1 expands temporarily around the holiday, which can have a positive or negative impact on end-January data depending on its date. The timing this year is similar to 2010 and 2008 – New Year falls on 10 February versus 14 February and 7 February respectively. Six-month real M1 expansion rose in January in both years but fell back significantly in February. A similar pattern is likely this year.

Six-month real M2 and credit expansion – as measured by bank loans and the wider “total social financing” aggregate – are shown in the second chart. Real M2 growth has been broadly stable recently while bank loan expansion has slipped to a 15-month low. Both are modestly below their averages over the last 15 years. Real social financing, by contrast, is relatively strong, reflecting fund-raising outside the banking system in the form of corporate bonds / bills and entrusted / trust loans. The view here is that such borrowing has little positive economic implication because it is not associated with money creation.

The gap between six-month real money and industrial output expansion is a gauge of “excess” liquidity available to push up asset prices. For both M1 and M2, this is currently positive but small, suggesting limited fuel for property or stock market strength.

*Seasonally adjusted, not annualised.

The UK recession probability indicator followed here continues to signal a stronger economy in 2013. The estimated probability of another activity dip has fallen significantly over the last 12 months and currently stands at below 1% – the lowest since 2003 and a level historically associated with solid GDP expansion.

The model uses currently-available information on a range of monetary and financial indicators to assess the probability of the economy being in recession three quarters ahead, with a recession defined here as an annual fall in GDP (i.e. a stricter requirement than the commonly-used formulation of two consecutive quarterly declines). It correctly signalled that 2012 would be a poor year – the estimated likelihood rose to 47% at end-2011, a level suggestive of economic stagnation rather than outright recession. According to provisional figures released last month, GDP was unchanged in 2012 although the onshore economy grew by 0.2%. The chart shows the historical performance* of the indicator, with the reading at each date referring to the probability of a GDP decline three quarters later.

The recent fall in the indicator reflects a combination of a decline in interbank interest rates, faster real money supply growth, narrower credit spreads, stock market strength and exchange rate weakness. The indicator has been at 1% or below in 58 of 184 quarters since 1966, i.e. 32% of the time. The median annual rise in GDP three quarters after such a reading was 4.0%. Slower trend growth and fiscal / external headwinds imply much weaker prospects now but GDP expansion in 2013 may nonetheless exceed the consensus projection of 1.0% by a significant margin.

*In-sample estimates from model fitted to data up to Q1 2012.

Judging from some excited commentary, incoming Bank of England Governor Mark Carney will sweep away what remains of the inflation-targeting framework and embark on dramatic new easing designed to boost growth, cheered on by the Chancellor and with the rest of the MPC bending to his will. Mr Carney will, presumably, clarify his intentions at his Treasury select committee appearance tomorrow but such speculation may be poorly grounded, for three reasons.

First, Mr Carney’s record at the Bank of Canada cannot be described as dovish. Inflation has averaged less than 2% (1.8%) during his term as Governor and he has given no quarter to manufacturers complaining about a punishingly-high exchange rate. The Bank of Canada rejected the “low for long” mantra of the Federal Reserve and Bank of England in the wake of the financial crisis, raising the overnight target rate between May and September 2010 from 0.25% to 1.0%, a level at which it remains today.

Secondly, while Mr Carney discussed nominal GDP level targeting in speeches last year, the suggestion was that this should be employed only as a temporary measure in exceptional circumstances when inflation has undershot the target. The latter condition, of course, does not apply in the UK, where the consumer prices index is currently 7.4% above a level implied if inflation had averaged 2% since the target was switched to the CPI at end-2003.

Thirdly, Mr Carney remains strongly wedded to “flexible inflation targeting”, at least as practised in Canada, under normal economic circumstances. The success of this approach, however, hinges on longer-term inflation expectations remaining anchored to the target. Given the UK’s recent poor inflation track record, there is a high risk that a switch to a nominal GDP level objective, even if billed as temporary, would boost such expectations, a shift that could prove costly to reverse when economic conditions normalise.

Recent evidence, indeed, suggests that the inflation anchor is slipping. The median five-year-ahead inflation expectation in the Bank of England’s quarterly inflation attitudes survey rose to 3.6% in November 2012, the equal highest (with May 2012) since the relevant question was included in the survey in February 2009. Meanwhile, implied retail prices index (RPI) inflation in five years’ time derived from a comparison of conventional and index-linked gilt yields has climbed to 3.2%, the highest since May 2010 and above the long-run average of 2.9% – see chart. (A recent surge in implied inflation mainly reflects the decision by the National Statistician to retain the existing methodology for calculating the RPI, against expectations of a switch to formulae used in the CPI, which would have lowered RPI inflation significantly. This decision, however, cannot explain why the current level is high relative to history.)

Central bank liquidity operations are judged here to be an influence on market prospects and have turned temporarily negative – bank reserves at the Fed, ECB and BoJ combined recently reached their lowest level for 11 months, reflecting the impact of banks repaying ECB loans.

The chart shows G3 reserves in total and broken out, together with projections. For the US and Japan, the latter are based on reserves levels at end-2012 and current plans* for securities purchases, which are assumed to be unsterilised. For the Eurozone, the projection takes account of the €140.6 billion repayment to date of three-year LTRO1 lending and assumes a similar paydown of LTRO2 at end-February.

As the chart shows, US bank reserves are rising in line with the projection but Japanese reserves are currently lagging – this shortfall is probably temporary, although the BoJ may have partially sterilised QE to temper downward pressure on the yen. The expansionary impact of US / Japanese QE, however, has been more than offset by Eurozone banks repaying ECB lending, a trend that began in earnest last summer but has accelerated with the opportunity to pay back the two three-year LTRO loans.

The further LTRO2 repayment should prevent a rise in G3 reserves until March despite ongoing US / Japanese QE. An upward trend should resume thereafter, with G3 reserves projected to reach another record in May.

*US QE is assumed to be suspended in mid-2013 as the economy improves.

Previous posts have compared the rally in the Dow Jones Industrials index from its March 2009 low with recoveries following six previous bear markets involving a peak-to-trough fall of about 50%. (The Dow declined by 54% between October 2007 and March 2009.) As explained below, the current recovery looks extended relative to history, suggesting, at the least, a pause for breath.

The six bear market troughs considered in this analysis occurred in November 1903, November 1907, December 1914, August 1921, April 1942 and December 1974. The Dow Industrials fell by between 45% and 52% into these lows. (The 1929-32 bear market was excluded because it involved a much larger decline, of 89%.) In each of the six cases, the trough of the bear market was rebased and shifted forwards in time to match the March 2009 low. The subsequent recovery paths were then traced out and an average calculated – see first chart.

This “six-recovery average” proved to be a good guide to the underlying trend in US stocks over the two-and-a-half years following the 2009 trough. Since late 2011, however, the Dow has diverged positively from the average and is currently near the top of the range spanned by the historical recoveries.

Relative to the prior bear market trough, the Dow was higher at the corresponding stage of the recovery in two of the six cases – the rallies from the August 1921 and April 1942 lows. These recoveries are highlighted in pink in the second and third charts respectively.

In the former case, the equivalent month to February 2013 was September 1925. If the Dow were to replicate its performance then, it would rise rapidly into mid-year before correcting back to the current level. Strength would then resume, with the index exceeding the mid-year peak by the end of 2013 – second chart.

In the second case, the equivalent month to February 2013 was May 1946. This comparison is more bearish, suggesting an imminent peak and sharp fall into the summer – third chart.

To summarise, the current level of the Dow is above its implied year-end level in five of the six historical recoveries. In the single exception, a further near-term advance was completely retraced before the bull market resumed.

A common response when this comparison is presented is that a stronger recovery path is warranted currently because of unprecedented monetary policy stimulus. This stimulus, however, may already be reflected in market valuation, which is higher than at the corresponding points historically.