Eurozone monetary trends and leading indicators continue to strengthen, suggesting a significant pick-up in economic growth in the first half of 2015, barring external shocks.

Both narrow and broad money have surged since the ECB imposed a negative interest rate on excess reserves in June. Narrow money M1 rose by 9.8% annualised in the four months to October, with the broader M3 measure up by 4.6%.

Real or inflation-adjusted monetary trends anticipate changes in economic activity about six months ahead, according to the monetarist rule.  Six-month growth of real M1 and M3 is the highest since October 2012 and March 2009 respectively – see first chart.

Pessimists will focus on a continued contraction of private sector credit. Money leads the cycle while credit usually lags or detaches. There was a similar money / credit divergence in the UK in late 2012. The monetary signal was correct: economic growth surprised positively in 2013.

The encouraging message from monetary trends is confirmed by the longer leading indicator*, which bottomed in May and rose further in October – second chart. The indicator typically leads turning points in six-month industrial output momentum by 4-5 months, suggesting that an economic pick-up is already under way.

Narrow money is growing solidly in all four major economies, with Spain strongest and Germany lagging slightly – third chart.

*The indicator uses the same components as the OECD’s Eurozone leading indicator but is designed to give earlier warning of growth turning points. It is calculated independently, allowing an estimate for a particular month to be produced by the end of the following month.
  

A post last week drew attention to a pick-up in world trade, as measured by the volume index compiled by the Netherlands CPB research institute. The CPB yesterday reported a strong 1.9% monthly rise in its index in September. Six-month growth climbed to 4.2%, or 8.5% annualised – the highest since January 2011.

The CPB notes that the September increase was broadly-based, with “import and export volume growth accelerating in most advanced and emerging regional blocks (sic), the main exception being the United States”.

Global industrial output has lagged the pick-up in trade but six-month growth in the CPB's production measure rebounded in September after a weak August, to its highest since April – see chart. The expectation here remains for output to accelerate further into early 2015, consistent with solid real money expansion during the first half of 2014 and more recent strength in leading indicators.

GDP price statistics in today’s revised third-quarter report confirm that domestically-generated inflation has risen since early 2014, in line with an earlier pick-up in monetary growth. The annual increase in the deflator for “gross value added at basic prices” – a measure of prices of domestically-produced goods and services – was 2.3% last quarter, up from 1.3% in the first quarter and the highest since the third quarter of 2012.

GDP price statistics, admittedly, are often revised significantly. The 2.3% third-quarter figure, however, is consistent with analysis in a previous post suggesting that consumer price inflation would now be 2.0-2.5% rather than 1.3% in the absence of falls in global commodity prices and sterling appreciation.

In an October speech, MPC member Kristin Forbes suggested using two variants of the GVA / GDP deflator to assess domestically-generated inflation: the GVA deflator excluding government and the GDP deflator excluding exports. The former measures private sector domestic inflation while the latter focuses on domestic production sold in the UK. The annual rises in the two measures in the third quarter were 2.2% and 4.1% respectively – see chart.

Meanwhile, annual inflation of services producer prices – another measure cited by Dr Forbes – rose to 1.5% in the third quarter from 0.8% in the first quarter and 1.3% in the second.

The monetarist rule of thumb is that inflation follows monetary growth with a variable lag averaging about two years. Annual expansion of the broad non-financial M4 money measure peaked in May 2013, slowing only modestly since, suggesting that underlying inflation will continue to firm into mid-2015.

ECB President Mario Draghi last week expressed pessimism about near-term Eurozone economic prospects, citing a weak November “flash” purchasing managers’ survey. The survey, he said, “suggests a stronger recovery is unlikely in the coming months, with new orders falling for the first time since July 2013”.

President Draghi’s comment refers to the Markit Economics “composite” PMI survey covering services and manufacturing. This survey, in fact, is hugely overrated as a forecasting tool. Historically, even the new orders component has been, at best, a coincident indicator of the cycle.

The last Eurozone recession, for example, ended in the first quarter of 2013, with GDP growing by 0.3% in the second quarter. The PMI composite new orders index, however, remained below the “break-even” 50 level until mid-2013.

This year, the composite PMI has been misleadingly strong until recently. Based on the July survey, Markit Economics estimated that Eurozone GDP had grown by 0.4% in the second quarter while German GDP was on course for a 0.7-0.8% third-quarter rise. The outturns were 0.1% and 0.1% respectively. The PMI has now reset lower in line with actual economic results.

The November fall in the composite new orders measure reflected weakness in the services component. Manufacturing new orders are judged here to be a better coincident indicator of the cycle and have been stable since September. The longer leading indicator suggests a coming rise – see chart. Today’s German Ifo survey for November, showing the first increase in manufacturing expectations for seven months, is an encouraging sign.

UK experience demonstrates the perils of using the services PMI as a forecasting guide. The survey suggested that the economy was heading into a “triple-dip” recession in early 2013: the new business component fell below 50 in November and December 2012, prompting Markit Economics to opine that “activity may continue to fall in the new year”. GDP rose by 0.5% in the first quarter of 2013.

President Draghi, of course, will be aware of these issues. He may or may not believe that “a stronger recovery is unlikely in the coming months” but it suits his purpose to draw attention to PMI weakness to make the case for further monetary policy easing. An ECB leadership bent on further stimulus when monetary trends are improving and the economic cycle is turning up suggests a benign backdrop for equities.