The suggestion from media and economists’ commentary is that the current UK economic boomlet has appeared “out of the blue” and was essentially unpredictable. Not so. A return to robust growth was signalled by an acceleration of real (i.e. inflation-adjusted) broad and narrow money during 2012 and early 2013. This contributed to a December forecast here that the economy would expand by about 2% on an annual average basis in 2013, implying a significantly larger rise during the course of the year (i.e. between the fourth quarters of 2012 and 2013).

The “best” signal was given by narrow money M1, comprising physical cash and sight deposits – monetary components more likely to be related to future economic transactions. Six-month growth in real non-financial M1* reached 5.1% at an annualised rate by December 2012 and rose further to 10.3% in April 2013 – the highest since August 2004, ahead of very strong economic expansion**.

As noted in a post last week, real M1 growth has slowed slightly since the spring, suggesting that economic momentum will moderate – while remaining solid – in early 2014.

M1 was the favoured monetary aggregate of the late Sir Alan Walters, chief economic adviser to Mrs Thatcher, but is now widely ignored – the author of this journal is unaware of any other private-sector economist who bothers even to monitor its behaviour. The strong rise in M1 growth in 2012 and early 2013 was certainly noticed by monetary economists at the Bank of England but they seem to have either underplayed its significance or else been overruled during the forecasting process.

“Monetarist” analysis remains deeply unfashionable so renewed interest in M1 is unlikely, despite its recent forecasting success – good news for anyone seeking to use monetary signals to gain an edge on the consensus.

*M1 held by households and private non-financial firms.
**Gross value added excluding oil and gas rose by 5.4% in the year to the fourth quarter of 2005.

Popular mythology is that the recent economic pick-up has been consumer-driven and reflects an unwelcome return to debt-financed spending. This is wrong.

Consumer spending accounted for only 0.4 percentage points (pp) of the 1.0% rise in GDP between the fourth quarter of 2012 and the second quarter of 2013, according to current official data. Net exports were a much bigger positive, adding 0.9 pp, while fixed investment contributed 0.25 pp. The GDP rise was limited to 1.0% because increased demand was met partly from inventories – positive for second-half production prospects.

Total household financial debt has fallen from a peak of 170% of disposable income in the first quarter of 2008 to 144% in the first quarter of 2013 – see first chart. It is true that the debt to income ratio rose between the fourth and first quarters but this reflected a temporary drop in income due to a shifting of bonus payments from 2012-13 to 2013-14 to take advantage of the cut in the top income tax rate. The first quarter increase, in other words, probably reversed last quarter.

The debt to income ratio is likely to decline further during the second half. Borrowing from banks – which accounts for three-quarters of the stock of debt – rose at an annualised rate of only 0.9% in the three months to July. Average weekly regular earnings and employment increased by 2.7% and 0.9% annualised respectively in the latest three months, consistent with income expansion of about 4%.

Credit demand is picking up but leading indicators such as mortgage approvals do not currently suggest that debt growth will rise above 4-5%. The debt to income ratio, in other words, may stabilise in early 2014 but a rise is not yet being signalled.

A judgement about whether debt is supportable must take account of servicing costs and the value of tangible and financial wealth. Interest payments were only 5.6% of income in the first quarter of 2013, a new low in data extending back to 1987 – first chart. The interest burden would remain below its post-1987 average of 8.7% even if the average interest rate on debt rose by 2 percentage points.

The ratio of debt to wealth, meanwhile, is likely to fall below its post-1987 average of 17.4% in 2013, taking into account house and share price rises through mid-year – second chart. It is commonly argued that both are significantly overvalued but this is not supported by income yield analysis – the dividend yield on equities and the rental yield on housing* are not low by historical standards.

Concern that stronger growth has been achieved via a deterioration in consumer finances may partly reflect a sharp fall in the saving ratio in the first quarter but – like the rise in the debt to income ratio discussed above – this was due to bonus shifting into the second quarter. The ratio, in other words, is likely to have returned to around its fourth-quarter level of 5.9% in the second quarter. The latter is close to a post-1987 average of 6.1% – third chart.

*See previous post.

Previous posts (e.g. here) have discussed a “monetarist” investment strategy involving holding either global equities or US dollar cash depending on whether annual growth of G7 real narrow money is above or below that of industrial output*. The rationale for the strategy is that faster expansion of real money than output may signal that liquidity supply has run ahead of demand – such an excess may prompt additional buying of equities and other assets.

Slower growth of real money than output, by contrast, may indicate that liquidity supply is insufficient to support current economic activity – individuals and firms may then sell assets in an attempt to raise cash, pushing down prices.

The strategy performs well in an historical backtest: the excess return compared with buying and holding equities averaged 3.6% per annum over 1970-2012 – see first chart. These results are based on currently-available data but annual real money and industrial output growth could have been calculated in real time and subsequent data revisions would probably have made little difference to the timing of cross-over signals.

The last “buy” signal for equities occurred at end-September 2011, since when global stocks have outperformed cash by 40%.

The gap between the annual growth rates of G7 real narrow money and output remains large but has narrowed recently, reflecting both stronger economic activity and slower monetary expansion – second chart.

The still-wide gap, moreover, is mostly due to developments in late 2012 / early 2013: output has grown by only slightly less than real money in the latest six months – third chart.

The current pick-up in the global economy suggests that the six-month increases will cross by the autumn, barring unexpected monetary reacceleration. This, in turn, could presage convergence of annual growth rates around end-2013.

The monetarist approach, in other words, is still giving a positive message for equity markets currently but suggests that conditions will become less favourable in 2014.

*A six-month lag is applied before buying equities after a positive cross-over.

The “MPC-ometer” model followed here suggests that the Monetary Policy Committee would be inclining towards tightening policy if it were responding to economic and financial developments in the same way as in the past. Specifically, the model reading for September is consistent with a majority decision for no change but with three MPC members dissenting in favour of a quarter-point Bank rate hike.

The MPC-ometer is designed to forecast the “average interest rate vote” of MPC members based on a small number of economic and financial inputs relevant for assessing the outlook for growth and inflation. Estimated in 2006, the model proved useful for predicting interest rate changes in the late 2000s; it also signalled the expansions of QE in 2011 and 2012*.

The model reading was -9 basis points (bp) in May, consistent with the MPC’s easing bias at the time – three members voted to expand QE every month between February and June. It returned to positive territory in August, however, and stands at  +8 bp currently, suggesting three votes for a 25 bp Bank rate rise and six votes for no change.

The recent turnaround mainly reflects components of the model measuring economic strength but there has also been a small deterioration in future inflation indicators.

The model may have been rendered obsolete by the new forward guidance framework. The MPC, however, has claimed that the framework is intended to make explicit its existing “reaction function” rather than signalling any weakening of its (supposed) commitment to the inflation target. The model’s hawkish shift suggests that several members – not just Mr Weale – will be uncomfortable with the Committee’s current stance.

*The model was modified in 2009 to incorporate QE, with the relevant parameter implying that £75 billion of gilt-buying is the policy equivalent of a quarter-point rate cut.