The acceleration phase is over but monetary trends suggest that UK economic growth will remain solid through summer 2014.

The forecasting approach here focuses on the six-month rate of change of real narrow money, as measured by non-financial M1 deflated by consumer prices. This turned positive in late 2011, about six months before the economy began to show signs of life – see chart. Real money expansion continued to rise strongly during 2012, peaking in early 2013, since when it has eased slightly. GDP growth, accordingly, stabilised in late 2013 and may run at a slightly lower but still strong pace during the first half of 2014.

Current official data show GDP rising at a 3.0% annualised rate during the second half of 2014 (i.e. between the second and fourth quarters) but this is likely to be revised up, possibly to 3.5-4.0% – see Tuesday’s post. Based on the minor slowdown in real money expansion, GDP growth could run at about 3% during the first half of 2014. Weak productivity trends suggest that potential output is rising by less than 2% per annum, so 3% actual expansion would imply significant additional pressure on supply capacity, with attendant inflationary risks.

The message from narrow money is supported by the broader M4 measure. Real non-financial M4 growth also picked up in 2011-12, stabilising since early 2013. The current level remains low by recent historical standards but has been sufficient to support rapid economic expansion because the velocity of circulation has risen, as negative real interest rates have reduced the savings demand to hold money.

To repeat, the fundamental drivers of economic resurgence have been a reversal of the 2010-11 inflation spike and falling bank funding costs since mid-2012 due to Eurozone financial stabilisation and the funding for lending scheme. Falling inflation has lifted real money growth while lower deposit interest rates have encouraged consumers and firms to spend monetary savings, reflected in the switch from M4 into M1 and rising M4 velocity.

Faster economic growth is not, in other words, due to QE, reduced fiscal drag or a credit-driven consumer splurge. The latter hypothesis is particularly fanciful – lending to individuals rose by just 1.3% in the 12 months to December, implying that the household debt to income ratio continues its trend decline. The “creditist” argument that no economic improvement was possible without a prior pick-up in bank lending has been comprehensively demolished by recent events yet commentators continue to pore over credit tea leaves while ignoring the money supply.

Eurozone monetary trends are judged here to be consistent with a continued economic recovery during the first half of 2014. December numbers, however, were mildly disappointing – further weakness in January would suggest slower growth later in 2014.
 
The headline money / credit measures continue to diverge, allowing entrenched bears and bulls to cite “evidence” in favour of their respective positions. In real terms (i.e. adjusted for consumer prices), broad money M3 was unchanged in the six months to December, while lending to the private sector was down by 1.6% (not annualised). Narrow money M1*, however, rose by a respectable 2.4%.

The statistical evidence is that real M1 significantly outperforms M3 as a leading indicator, while credit lags the cycle. Real M1, indeed, has a flawless forecasting record over the last decade, clearly signalling well in advance the 2008 recession, 2009-10 rebound, 2011-12 “EMU crisis” relapse and current recovery. M3 missed the former two while lending has had little relationship (even lagging) with short-term economic fluctuations – see first chart.

ECB research confirms that the signal from M1 can be improved slightly by stripping out financial sector holdings, which are volatile and of little consequence for short-run economic prospects. Real non-financial M1 rose by 3.2% in the six months to December versus 2.4% for headline M1. Its growth has been broadly stable since spring 2013 at a level historically consistent with moderate economic expansion – second chart.

While the six-month increase remains healthy, real non-financial M1 fell in December alone. This could be an early signal of a second-half economic slowdown, although monthly numbers are often volatile around year-end.

Further insight is provided by country-level narrow money trends**. Real growth in the core and peripheral groupings*** was similar in the six months to December, suggesting no major divergence in economic prospects – third chart. Among the large economies, narrow money trends are solid in Germany and Spain, with France and Italy lagging and renewed Dutch weakness hinting that recent economic improvement in that country will prove temporary – fourth chart.

*M1 comprises notes / coin and overnight deposits.
**Country data are available for overnight deposits but not notes / coin.
***Core = Austria, Belgium, France, Germany, Luxembourg, Netherlands; periphery = Greece, Ireland, Italy, Portugal, Spain.

GDP is provisionally estimated to have grown by 0.7% in the fourth quarter of 2013 and by 1.9% for the year as a whole. These numbers are likely to be revised higher. Quarterly GDP changes between the fourth quarter of 2012 and the second quarter of 2013 have already been raised by 0.2 percentage points per quarter. If current third and fourth quarter numbers – 0.8% and 0.7% respectively – are increased by the same amount, 2013 growth will rise to 2.0%.

Excluding North Sea oil and gas production, GDP expansion last year was 2.0% and will probably be raised to about 2.25% later in 2014 as revisions come through.

GDP in the fourth quarter was still 1.3% below peak, reached in the first quarter of 2008. The non-North Sea shortfall is smaller, however, at 0.3%. Monthly output data and official estimates indicate that GDP in December was 0.4% above the quarterly average – see chart. This, in turn, implies that the non-North Sea measure regained its peak level at end-2013, even before allowing for revisions.

A post in early December suggested that equities were at risk from a deteriorating liquidity backdrop. This warning was premature – global stocks reached a new post-recession high at end-2013 – but a sharp decline over the last week has pushed the MSCI World index to the bottom of its range since mid-October – see first chart.

The focus here is on the gap between global* six-month real (i.e. inflation-adjusted) money supply expansion and industrial output growth. This was mostly positive and large over 2011-13, suggesting the availability of “excess” liquidity to power asset price inflation. Stronger economic growth coupled with a minor slowdown in real money expansion, however, resulted in the gap closing in November 2013 – second chart.

Liquidity concerns have been partially alleviated by December monetary data, suggesting a rebound in global real money expansion**. Industrial output probably accelerated further last month but the real money / output growth gap may have remained close to zero. The liquidity backdrop, in other words, is currently neutral rather than negative.

The estimated December rise in global real money expansion partly reflects recoveries in China and India, which lifted the emerging E7 component – third chart. Current financial pressures could reverse the E7 pick-up but the suggestion is that emerging economies in aggregate will perform respectably through mid-2014, at least.

*G7 plus emerging E7.
**The final result will depend importantly on Eurozone data released tomorrow.