Eurozone narrow money trends continue to suggest an economic recovery in which peripheral countries will participate later in 2013.

Eurozone-wide narrow money M1 rose by 1.0% in May and has increased by 3.6% (not annualised) over the last six months. Adjusted for inflation, six-month growth was 3.3% in May – above an average since 1995 of 2.6%.

The broad M3 measure is expanding more sluggishly – by 0.3% in May and 0.9% over the last six months – while private-sector credit continues to contract. M1, however, is a more reliable leading indicator of the economy than M3, while credit tends to lag the cycle. M1 similarly diverged positively from M3 and credit in 2009, correctly signalling an economic recovery – see first chart.

The M1 pick-up is interpreted here as a sign of returning confidence – households and firms are increasing their holdings of transactions money in preparation for higher spending.

The ECB publishes a country breakdown of overnight deposits, which dominate M1. The six-month change in real deposits in the periphery (i.e. Italy, Spain, Greece, Portugal and Ireland) was negative over 2010-12 but has recovered strongly this year, converging with growth in the core – second chart.

Among the major countries, the six-month change in real deposits recovered sharply in France in May but turned negative in the Netherlands – third chart. Italy partially reversed an earlier large gain while Spain edged higher; recent growth in both cases is the best since early 2010. Germany slowed but remains strong.

Revised national accounts figures show that there was no “double dip” in late 2011 / early 2012 but the output / inflation trade-off in recent years has been even more unfavourable than previously thought – news that should give pause to advocates of further monetary stimulus.
 
Key points:

• GDP is now estimated to have flatlined in the first quarter of 2012 after a 0.1% fall in the fourth quarter of 2011 – previous numbers showed a 0.1% decline in both quarters.

• The onshore economy avoided contraction over this period – the GDP decline in late 2011 was entirely due to lower North Sea production.

• GDP in the first quarter of 2013 was 3.9% lower than the pre-recession peak reached in the first quarter of 2008 – much worse than a previously-estimated 2.6% shortfall.

• The wider gap mainly reflects a larger fall in GDP during the 2008-09 recession – 7.2% versus 6.3%. The recovery in output from the 2009 trough is only slightly weaker than before – 3.5% versus 3.9%.

• The deeper recession, however, has been counterbalanced by an upward revision to inflation, leaving growth in current-price GDP between 2008 and today little changed. The supply-side performance of the economy, in other words, looks even more dismal.

• Revisions to recent quarterly data were minor and do not alter the optimistic prognosis here – the current estimate of a 0.8% rise in GDP in the second quarter will be refined in light of April services output to be released tomorrow and May numbers for industry and construction due on 9 and 12 July respectively.

The Bank of England formally ended QE in November 2012. The MPC, however, has acquiesced in a form of “stealth QE” by failing to sterilise the monetary impact of the transfers of net coupon income from the Bank’s Asset Purchase Facility (APF) to the Treasury, announced by the Chancellor in his Autumn Statement. This stealth injection is estimated to have been £23 billion in the first half and will rise to about £47 billion by the end of 2013-14.

Conventional QE involves the Bank creating central bank reserves to pay for purchases of gilts from the market. This results in 1) expansion of the Bank’s balance sheet, 2) expansion of the monetary base (i.e. physical cash plus reserves) and 3) a rise in sterling bank deposits as the accounts of those selling gilts to the Bank are credited.

In the stealth operation, the Bank makes a transfer from its retained profit account to the Treasury’s account with the Bank. The Treasury then runs down the balance in this account to finance the budget deficit, thereby injecting liquidity into the economy. The end-result is a rise in both the monetary base and sterling bank deposits; these higher deposits are the mirror-image of lower official gilt sales due to the transfer. The only difference from conventional QE is that the size of the Bank’s balance sheet is unchanged but this is of no economic significance.

The Bank transferred £11.3 billion to the Treasury during the first quarter of 2013 and is on course to pay a further £11.7 billion in the second quarter*, giving a first-half total of £23 billion. The transfers will “taper” to about £8 billion per quarter over the coming three quarters (i.e. to end-March 2014)**. They will fall further in 2014-15 – to about £3 billion per quarter if Bank rate remains at 0.5% and the stock of asset purchases is held at £375 billion.

The MPC’s acquiescence in the stealth operation has left it open to the charge of allowing the Treasury to drive a change in monetary policy. The view here is that, following the Autumn Statement announcement, the Committee should have redefined its QE target as the stock of asset purchases plus cumulative transfers from the APF to the Treasury. A formal vote should then have been conducted on whether to raise this target or to sterilise the monetary impact of the transfers, by selling gilts of equal value. Such action would have made clear that the MPC is solely responsible for setting monetary conditions, thereby discouraging any future attempts to encroach on its independence.

*Assuming a monthly payment of £3.9 billion in June, the same as in April and May.
**The Treasury’s schedule implies a total payment of about £36 billion in 2012-13, comprising a transfer of £23.8 billion accumulated up to end-March 2012 and income in 2013-14, estimated here at £12 billion.

The chart compares the recent rise in China’s one-month repo rate – a representative market interest rate – with movements over May-August in the last three years. There is a seasonal tendency for liquidity to tighten during June, with the repo rate peaking in the final week of the month before easing back to a “normal” level by mid-July.

The liquidity shortage this year has, clearly, been much more severe. This could, as some commentators suggest, reflect a balance of payments deficit caused by an outflow of “hot” money. More likely, the authorities have allowed seasonal tightening to develop into a squeeze in order to send a warning signal to banks to curb off-balance-sheet credit expansion, which continues to fuel property speculation. (Another view is that banks are increasingly worried about the creditworthiness of their counterparties but this would not explain rising rates on secured repo lending.)

The seasonal pattern suggests that the one-month rate will start to fall this week, with a larger decline next week. Today’s reversal may mark the start of this process. Economic and market prospects depend importantly on where the rate settles in mid-July. The bias here is to expect a large fall, on the view that the authorities remain in control and will not allow a sustained tightening of monetary conditions given sluggish growth and little inflationary pressure outside housing.