A widely-held view is that the covid-19 shock has been the trigger for a “late cycle” global economy to enter an overdue and probably sustained period of weakness, to be reflected in a trend rise in unemployment and widening output gaps.

This view is encapsulated by the latest IMF forecasts of a 4.9% fall in global GDP in 2020 followed by a rise of only 5.4% in 2021, implying that the level of GDP next year will be barely higher than in 2019 and about 6.5% lower than projected in January.

The cycle analysis here yields an opposite conclusion: rather than acting as a catalyst for a new period of cyclical weakness, the virus shock has magnified but probably marks the end of a pre-existing downswing dating back to early 2018. Key cycles are now shifting from acting as a headwind to providing a tailwind to global economic momentum.

The cycles methodology followed here is based on the “European” approach, which recognises independent cycles in the components of (investment) demand, rather than the dominant but misleading “American” approach, which asserts the notion of a single, all-encompassing “business” cycle*.

The European approach identifies three main cycles: a stockbuilding or inventory cycle ranging between 3 and 5 years in length (i.e. measured from low to low), a business investment cycle of 7 to 11 years and a longer-term housing cycle averaging 18 years.

Why no consumer spending cycle? Consumption is a derivative of the above cycles. It is influenced by employment trends, which echo the business investment cycle. Consumption booms typically occur during the late upswing phase of the housing cycle, reflecting house price-driven wealth effects and strong mortgage credit growth / home equity withdrawal.

The first chart shows suggested dates of stockbuilding cycle lows, based on the contribution of stockbuilding to G7 annual GDP growth. The pre-covid view here was that the cycle had bottomed in Q4 2019. The shock appears to have shifted the low to Q1 2020. The negative GDP impact last quarter was larger than at many previous cycle lows and, at 4 years, the current cycle is already longer than a 3.4 year average.

A business survey inventories indicator shown in the second chart correlates closely with the GDP growth contribution and supports the view that the bottom is in.

Suggested dates of business investment cycle lows are given in the third chart, showing annual growth of G7 non-housing fixed capital spending. With the previous trough in Q2 2009, the maximum 11 year length of this cycle implies that Q2 2020 is the latest possible date for the current cycle low.

The annual investment fall was insufficiently large to mark a cycle low in Q1 but will be more pronounced in Q2. A Q2 trough is supported by a business survey capex indicator, which bottomed in April, rebounding significantly in May with a further increase indicated for June, based on partial data – fourth chart.

A counterargument is that investment is unlikely to bottom before profits. The lead time of profits at troughs historically, however, was often only one quarter. Profits weakened more than investment in Q1 and it is possible that their annual change bottomed in that quarter.

Business money trends are consistent with an investment trough having been reached. The fifth chart shows the relationship for the US, which has the longest business money data history, but the recent surge is echoed elsewhere.

A common misperception is that a business investment cycle recovery requires a rebound in “animal spirits”. This usually occurs later in the upswing. Replacement capital spending plays an important role in the initial revival: such spending is postponed during the downswing, creating a reservoir of pent-up demand that is released as economic conditions stabilise.

*Wesley C. Mitchell, the pioneer of the American approach, defined business cycles as fluctuations in overall economic activity varying in duration “from more than one year to ten or twelve years”. The wide range is a consequence of inappropriately aggregating component cycles, which has the effect of discarding valuable forecasting information based on their individual periodicities. One consequence is that the research agenda of Mitchell et al. focused on the development of leading indicators for forecasting.

Annual growth of US broad money, on the M2+ definition* used here, rose further to 25.7% in May, the fastest since 1943 and more than 20 percentage points higher than a year earlier.

The economist consensus is that the monetary surge will not result in a rise in inflation because of an offsetting fall in velocity**. The required 20% plunge, however, would be unprecedented – about double, for example, the decline in 2008 at the height of the GFC.

The view here is that an inflation pick-up will be avoided only if the monetary surge is rapidly reversed. A return of growth to its prior level is insufficient – the level of the money stock needs to contract significantly.

Such a scenario should not be dismissed out of hand. Broad money contracted by 5.2% between May 2009 and June 2010 during the initial economic and market recovery after the GFC. That weakness, however, partly reflected commercial banks restructuring their balance sheets to meet official demands for an increase in capital ratios, while a larger decline would be required now because of the monetary overhang.

Two other scenarios should be considered. Annual broad money growth is almost certainly peaking. Suppose that it returns to its year-ago level of 5.1% in 12 months’ time. Allowing for a rough two-year lead from money to prices, this would suggest a temporary inflation rise to a peak in 2022 followed by a return to around the 2010s average.

An alternative scenario, favoured here, is that broad money growth will remain elevated by recent standards, meaning high single digits, at least, compared with a 10-year average (to 2019) of 3.9%. This would suggest a structural shift higher, or secular rise, in inflation.

What are the probabilities of the above three monetary scenarios? A starting point for an assessment is an analysis of the causes of the recent surge.

Unlike other central banks, the Fed does not provide a counterparts breakdown linking changes in broad money to other elements of the monetary system balance sheet. The table cobbles together available information.

Several points are notable. First, the Fed’s securities purchases made the largest contribution to the rise in money growth over the past 12 months but much of the impact was offset by an increase in the Treasury’s balance at the Fed. The latter has had the effect of deferring part of the monetary boost from QE until the Treasury disburses the funds.

Secondly, purchases of government securities by commercial banks and money market funds, surprisingly, made the second largest contribution. This buying can be viewed in two ways. Market weakness in Q1 caused investors to switch into cash. Institutional money funds, in particular, experienced large inflows and invested excess liquidity in Treasury bills.

An alternative explanation is that banks and money funds – along with the Fed – are the buyers of last resort of Treasuries and agencies. There has been record issuance of both – $3.29 trillion of marketable Treasury securities in the 12 months to May and $505 billion of agency securities in the 12 months to March. With the household sector and foreign investors selling Treasuries / agencies, banks and money funds have been required to increase holdings despite record Fed absorption.

Thirdly, banks’ commercial and industrial (C&I) lending rose significantly but broad money growth would be above 20% even without this boost. Much of the lending was associated with the Paycheck Protection Program (PPP), which stood at $510 billion at end-May compared with a 12-month increase in C&I loans of $703 billion.

The contribution to the rise in money growth of the other counterparts, derived as a residual, was similar to that of C&I lending. This may partly reflect banking system lending to foreign entities to relieve a shortage of US dollars, including Fed lending via central bank liquidity swaps, which stood at $448 billion at end-May.

The figures for May 2021 in the right-hand column of the table represent speculative projections based on the following considerations.

The Fed’s contribution to broad money growth is likely to be much smaller but still significant over the coming 12 months. The June policy statement committed the Fed to increase its holdings of Treasuries and agencies at least at the current pace, i.e. $80 billion and $40 billion per month respectively. The projection assumes that purchases continue at this rate through December, implying totals of $560 billion of Treasuries and $280 billion of agencies.

The Treasury’s balance at the Fed stood at $1.33 trillion in late May and has since climbed further to more than $1.6 trillion. The projection assumes a fall to $500 billion in May 2021, still well above "normal" (it averaged $300 billion in 2019). The current high balance partly reflects pre-funding of PPP loan forgiveness, the bulk of which is likely to occur during H2 2020.

The net monetary impact of PPP loan forgiveness, assumed here to cover most of the program, will be neutral because the Treasury pay-out will be offset by a fall in commercial banks’ C&I lending – banks will, in effect, swap loans for reserves at the Fed. With excess reserves already high, this is unlikely to result in additional lending.

System-wide bank lending to firms, however, could be boosted by the Fed’s Main Street Lending Program (MSLP) and its Primary and Secondary Corporate Credit Facilities (CCFs), involving purchases of corporate bonds. The MSLP and CCFs have size limits of $650 billion and $750 billion respectively and will run until end-September. MSLP take-up and Fed CCF buying are uncertain: the table assumes a combined $500 billion, balancing the suggested fall in C&I loans.

Another entry subject to significant uncertainty is commercial bank and money market fund transactions in Treasuries and agencies. Economic and market normalisation might be expected to reverse recent inflows to banks and money funds, resulting in them selling securities. Treasury issuance, however, will remain high, possibly requiring additional absorption. Based on the CBO forecast of federal deficits of $3.7 trillion and $2.1 trillion respectively in fiscal years 2020 and 2021, the earlier assumption of Fed Treasury purchases of $560 billion in the year to May 2021 implies central bank coverage of perhaps only one-quarter of Treasury funding needs.

The residual counterparts are assumed to undershoot their contribution in the year to May 2019 to compensate for an overshoot over the past 12 months.

The projections, in combination, suggest broad money growth of about 10% in the 12 months to May 2021, consistent with the medium-term inflationary scenario outlined earlier. The individual assumptions can certainly be questioned, although the intention was to be conservative. The main takeaway from this exercise, however, is the difficulty of generating a forecast of monetary contraction to reverse the recent surge and support consensus inflation complacency.

*M2+ = M2 + large time deposits at commercial banks + institutional money funds. M2+ is the broadest available monthly measure. The old M3 measure, discontinued in 2006, also included repos and Eurodollar deposits – the Fed no longer releases monthly data on these.
**Conventional velocity, i.e. the ratio of nominal GDP to money, rather than “true” velocity, as defined in the quantity theory of wealth.