Euroland coincident indicators remain strong but monetary trends suggest that economic growth will moderate in 2018.

The consensus interpretation of September monetary data, released yesterday, is likely to be upbeat. Annual growth rates of broad money M3 and narrow money M1 rose slightly, to 5.1% and 9.7% respectively, with the latter representing a 17-month high.

The forecasting approach here, however, focuses on non-financial monetary aggregates, i.e. excluding holdings of non-bank financial institutions – such holdings are less relevant for assessing near-term prospects for spending on goods and services. Headline M3 / M1 expansion has been supported in 2017 by a recovery in financial sector money growth following weakness in 2016. Annual growth of non-financial M3 has fallen from 6.1% in March to 5.0% in September, with non-financial M1 expansion retreating from 10.1% to 9.2% over the same period – see first chart.

The year-over-year figures, moreover, conceal a sharper decline in six-month growth rates. Non-financial M3 rose by 1.7% or 3.4 annualised in the six months to September, with non-financial M1 up 3.4% or 7.0% annualised; these increases are the smallest over six months since 2014 – second chart.

With six-month consumer price inflation recovering from a decline in the first half of 2017, six-month growth of the non-financial money measures expressed in real terms is also the lowest since 2014 – third chart.

Real money growth remains respectable by longer-term historical standards, suggesting a modest loss of economic momentum rather than weakness. Any slowdown, however, could surprise a consensus relying on continued loose ECB policy – confirmed by yesterday’s news of a nine-months-plus extension of QE – to sustain a strong economy.

Why are money trends cooling despite ECB support and gradual banking-system healing? One probable driver is rising bond yields – average 7-10 year government yields in July 2017 were 60 basis points higher than in July 2016, representing the largest year-on-year rise since 2011. The fall in yields in response to yesterday’s ECB news may prove short-lived against a backdrop of rising US yields and a weakening euro.

ECB research found that real non-financial M1 has outperformed other money / credit aggregates as a leading indicator of the economy, with real M1 holdings of non-financial corporations displaying a stronger correlation with future GDP expansion than those of households. Six-month growth of real corporate M1 deposits was above that of household deposits in September but has fallen sharply since June – fourth chart.

The country M1 deposit breakdown, meanwhile, hints at economic damage from Spanish political turmoil: six-month growth of real M1 deposits in September was the lowest since 2014. A rise in Italian growth, by contrast, suggests improving relative economic prospects – fifth chart.

Slowing QE may put downward pressure on the velocity of circulation of broad money in 2018, with negative implications for the economy and risk markets.

The 12-month rolling total of purchases of government and agency securities by the Fed, BoJ, ECB and Bank of England peaked at nearly $1.7 trillion in April 2017 and is projected to halve by mid-2018 – see first chart*.

Previous falls in the 12-month rolling total from peaks in December 2009, June 2011 and March 2014 were followed by significant declines in world equities starting 16, nine and 14 months later respectively – first chart.

Some monetarist economists claim that QE fluctuations have affected the economy and markets by changing the growth rate of broad money M3. The evidence does not support this claim. The initial burst of QE in 2009-10 was associated with a recovery in G7 M3 growth in 2010-11 but subsequent rounds appear to have had little impact – second chart.

QE, instead, may have mainly affected confidence / risk appetite and the velocity of circulation, rather than money growth directly. The annual rate of change of a monthly measure of broad money velocity, i.e. the product of industrial output and consumer prices divided by M3, rose after each of the three big QE surges – third chart.

The prospective QE slowdown, therefore, suggests renewed downward pressure on velocity in 2018. Unless broad money growth rises to compensate, this would imply lower nominal economic expansion and, probably, weaker markets.

Broad money trends are currently stable: G7 annual M3 growth is lower than a year ago but within its post-2012 range – second chart.

The forecasting approach here emphasises narrow rather than broad money. The demand to hold narrow money is closely related to spending intentions, so narrow money trends should reflect shifts in confidence / risk appetite and associated changes in broad money velocity. Global real narrow money growth has moderated recently, suggesting slower economic expansion in 2018 than 2017 – see previous post.

*The projection is based on Fed QE reversal plans, open-ended BoJ purchases of ¥5 trillion per month (i.e. close to the average over the 12 months to September), a final round of ECB QE of €25 billion per month over January-September 2018 and no purchases / sales by the Bank of England. Transactions in corporate securities are excluded.