Today’s upward revision to UK GDP growth in the second quarter from 0.6% to 0.7% had been suggested by earlier construction and industrial data – see previous post. Unrounded, the increase is now 0.72% rather than 0.62%, with a marginal upgrade to services growth also contributing.

Adjusting for distortions from North Sea oil and gas production, additional bank holidays and the Olympics, growth last quarter was the strongest since the second quarter of 2011 – see chart.

Contrary to popular assertion, the growth pick-up is “balanced”: consumer spending rose by a modest 0.4% last quarter but investment increased by 1.7% while net exports contributed 0.38 percentage points to the GDP rise.

Consumption expansion, moreover, was based on increased income rather than borrowing, which remains historically subdued. Employee compensation jumped by 2.4% in the second quarter, or an inflation-adjusted 1.9%, reflecting a shifting of bonus payments to take advantage of the cut in the top rate of income tax from April. This suggests that the decline in the household saving ratio in the first quarter, to 4.2% from 5.9% in the fourth quarter, reversed last quarter – an official figure will be released next month.

Today’s upward revision should contribute to a further rise in the consensus GDP growth forecast for 2013 – still only 1.1%, according to the Treasury’s August survey. Posts since late 2012 have suggested that the economy will expand by about 2% this year. This is still a reasonable expectation for non-oil GDP, incorporating likely further upward revisions and solid second-half expansion. Headline growth, however, may be held back by further weakness in North Sea production during the second half: the industry now expects a full-year output fall of between 9% and 22%, implying a GDP drag of 0.2-0.4 percentage points.

UK CPI inflation hit a 2013 high of 2.9% in June before subsiding to 2.8% in July. Posts earlier this year suggested that inflation would rise well above 3% in mid-2013. What went wrong?

The forecast miss is attributable, in roughly equal measure, to two factors: motor fuel costs and “core” inflation. Unleaded petrol was assumed to rise above £1.45 per litre by mid-year; it averaged £1.36 in July, according to the AA. The incorrect motor fuel assumption explains 0.25 percentage points of the inflation forecast error.

Core inflation, meanwhile, has eased slightly since end-2012 rather than being stable, as was expected. Stripping out energy and unprocessed food, CPI inflation was 2.3% in July versus 2.6% in December 2012.

Lower-than-expected core inflation has prompted a review, described below, of the relationship with monetary trends. It turns out that the core decline was predictable and may extend slightly further in the short term. Core inflation, however, is expected to turn up in late 2013 and trend higher through 2014 / early 2015. A new forecast for CPI inflation is presented incorporating this trend and assumptions about energy and food prices.

The monetarist rule-of-thumb is that changes in money supply growth affect demand / activity after about six months and inflation with a longer and more variable lag averaging about two years. There is strong empirical support for the first part of this proposition but the relationship between money supply trends and inflation is often obscured by “exogenous” factors, including indirect tax changes, movements in imported commodity prices and shifts in the exchange rate (i.e. shifts unrelated to monetary conditions).

In the recent UK context, it is important to base any analysis on a measure of core inflation that, as well as excluding energy and food commodities, strips out the impact of the changes in VAT in December 2008, January 2010 and January 2011 and the hike in undergraduate tuition fees from October 2012. Such a measure is shown in the first chart below; it has behaved quite differently from headline CPI inflation.

Core inflation trended higher from the mid 2000s, reaching a peak of 2.9% in March 2009 – point A in the chart. It fell in the wake of the 2008-09 recession, bottoming at 1.9% in June 2011 – point B. A short-lived but significant rebound then occurred, to a peak of 2.9% in March 2012 – point C.  Core inflation has since fallen back, reaching a low of 1.9% in April 2013, with July at 2.0%.

As the chart shows, these two up-down waves in core inflation were preceded by similar movements in money supply growth, as measured by the broad aggregate non-financial M4 (i.e. comprising holdings of households and private non-financial corporations). The lead times, moreover, at the three turning points (i.e. A, B and C) are consistent with the two-year average of the monetarist rule-of-thumb – 22, 25 and 24 months respectively.

The relationship between the magnitudes of movements in money growth and core inflation, however, has been loose. In particular, inflation rose by more in the late 2000s and fell by less over 2009-11 than suggested by the preceding swings in monetary expansion. This probably reflects the inflationary impact of the large decline in the exchange rate over 2007-08, an effect that took several years to play out.

In other words, a core inflation measure that additionally stripped out the impact of the 2007-08 depreciation, to the extent that this reflected non-monetary influences, would probably show a close relationship with prior money supply growth in magnitude as well as direction. Estimating such a measure, however, is difficult. The exchange rate influence, in any case, has diminished recently – the effective rate has been broadly stable since 2009.

As an aside, the above results stand when a narrow money measure is used instead of non-financial M4; narrow money growth has also exhibited two up-down waves since the mid 2000s, with similar turning point dates.

The second chart shows a forecast for core inflation based on the uncovered relationship. Money growth has trended higher from a trough reached in August 2011 – point D. Core inflation is projected to increase from a corresponding trough to be reached in October 2013, implying a 26 month lag. This trough is expected to occur at 1.9%, equal to the April 2013 low.


Money growth has stabilised since February 2013 but it is premature to declare that another peak has been reached. The forecast, therefore, assumes that core inflation will trend higher until mid-2015, stabilising in the second half of that year.

A key uncertainty, of course, is how much core inflation will rise in response to the increase in money growth since 2011 (i.e. upwave D-E). The forecast assumes, conservatively, that the core rate will rise to 2.8%, just below its prior peak of 2.9% at C, despite a much larger increase in monetary expansion recently than in the previous upwave (i.e. B-C). It allows, in other words, for a restraining influence on core inflation from non-monetary factors, such as a revival in productivity growth or a recovery in the exchange rate.

The third chart shows a forecast for headline CPI inflation based on the above core projection and the following additional assumptions:

• Domestic electricity and gas prices rise by 5% per annum, in line with the MPC’s projection in the latest Inflation Report. A 2.5% increase is incorporated this winter.

• Motor fuel prices rise by an underlying 2.5% per annum, on top of which duty is raised by 2 pence per litre in 2014 and 2015.

• Unprocessed food price inflation moderates from 5.8% currently to 2.5% by mid-2014, stabilising at this level thereafter.

• VAT rates are unchanged.

• The boost to CPI inflation from undergraduate tuition fees remains at 0.3 percentage points until October 2015, when it falls to zero.

The headline CPI rate is projected to return to 2.9% in August before drifting down to a low of 2.5% in early 2014, reflecting a temporary slowdown in energy inflation. It then rebounds to 3.1-3.2% in the second half of next year, remaining at this level for most of 2015.


The final chart compares this profile with the MPC’s mean projection assuming unchanged policy. Inflation undershoots the MPC’s forecast modestly in late 2013 / early 2014 but rises to cross it in the middle of 2014, with the divergence widening progressively through autumn 2015 as the MPC projection falls away.

The monetarist forecast implies a “knockout” of the MPC’s forward guidance, since CPI inflation 18 to 24 months ahead (i.e. in the first half of 2015) is projected to be 3.1%, well above the 2.5% threshold.

The measure of global real money supply expansion followed here slowed further in July, based on data for countries with a weighting of about 60% in the aggregate. The measure peaked in April / May. Allowing for the usual half-year lead, this suggests that economic momentum will top out in October / November and begin to fade at end-2013.

Specifically, six-month growth in real narrow money in the G7 and emerging E7 economies fell from 3.8% (not annualised) in May to 2.8% in June and an estimated 2.4% in July. The latter, if confirmed, would be the slowest since July 2012 – see first chart.

The scenario of a late 2013 economic slowdown has yet to be confirmed by a longer-term leading indicator derived from the OECD’s country leading indices – see previous post. This indicator, which has led by an average of five months at recent turning points, rose further in June, consistent with solid economic expansion through November. A July reading will be available on 9 September.

The second chart decomposes real money growth into nominal monetary expansion and inflation. A rebound in inflation has contributed significantly to the recent real money slowdown, although nominal growth has also eased.

The inflation drag on real money may stabilise. The third chart compares six-month changes in consumer and commodity prices. Commodities have driven the major fluctuations in CPI inflation in recent years. Inflation undershot the relationship in early 2013 but has since reconnected with the "prediction". Absent a large move in commodity prices, the suggestion is that inflation will plateau.

The fourth chart shows real money growth for countries that have released July data. The further decline in the global measure was driven by a sharp fall in China; as discussed in a recent post, this may partly reflect temporary factors but is nonetheless disappointing. The final July global reading will depend importantly on Eurozone data scheduled for release on 28 August.

The approach here will be to await leading indicator confirmation of the monetary signal before turning more cautious on global economic and equity market prospects. Despite the recent slowdown, real money growth remains above industrial output expansion, suggesting still-supportive liquidity conditions – bear markets usually begin only after the real money / output growth gap has turned negative.