Euro at risk from distortionary ECB policy

Posted on Monday, December 11, 2017 at 03:20PM by Registered CommenterSimon Ward | CommentsPost a Comment

ECB monetary policy is grotesquely misaligned with economic conditions. Monetary laxity threatens to reverse a recent strengthening of the balance of payments basic balance, suggesting euro weakness.

GDP grew by 2.6% in the year to the third quarter, mainly reflecting strength in domestic final demand, which rose by 2.3% – see first chart. Such growth is well above “potential” economic expansion estimated by the OECD, IMF and EU Commission at 1.0%, 1.3% and 1.4% respectively in 2017.

Sustained solid growth of domestic final demand since 2014 – before the ECB embarked on QE – contrasts with an anaemic recovery in 2010-11 after the 2008-09 recession. ECB policy tightening in 2011 was clearly premature and resulted in another recession. This mistake was corrected in 2012-13 under incoming ECB President Draghi – narrow money growth surged, signalling the economic pick-up from 2014.

The subsequent move to negative rates combined with large-scale QE was not warranted by monetary trends and may have overinflated asset prices while laying the foundation for a medium-term inflation overshoot.

The annual increase in the GDP deflator, a broad measure of domestic prices, rose to 1.3% in the third quarter from 0.6% a year earlier – second chart. A similar pick-up in 2014-15 was aborted by pass-through of lower energy costs against the backdrop of a weak labour market. Input cost pressures are currently the strongest since 2011, according to the November purchasing managers’ survey, while labour market slack has fallen significantly since 2015 – third chart.

Annual nominal GDP growth moved up to 3.9% in the third quarter, the equal highest since 2008. Stable, strong narrow money growth suggests that nominal GDP will continue to expand robustly – fourth chart. Current growth, if sustained, would imply a rise in inflation to 2.5% or more over the medium term, assuming potential economic expansion of 1.0-1.4% per annum.

The rise in nominal GDP growth has opened up a record 3.2 percentage point gap with a debt-weighted average of Euroland 7-10 government bond yields, which have detached from economic reality because of negative rates and QE – fifth chart.

A post in January suggested that the euro, yen and renminbi would rise against the US dollar in 2017, reflecting a narrowing of balance of payments basic balance deficits. The basic balance is the sum of the current account balance and net direct and portfolio investment flows. The Euroland and Chinese basic balance deficits have indeed fallen, while Japan’s balance has moved into surplus.

According to monetary theory, the basic balance position is determined by the difference between domestic credit expansion (i.e. the growth of bank lending to the domestic public and private sectors) and growth in domestic residents’ demand to hold bank liabilities (i.e. broad money plus non-monetary liabilities such as bank bonds). Faster expansion of domestic credit than demand to hold bank liabilities creates “excess” liquidity that is, in effect, exported by running a basic balance deficit.

The earlier post suggested that Euroland domestic credit would slow in 2017 because of ECB QE tapering, while demand for bank liabilities would be boosted by faster nominal GDP expansion. These suggestions have played out – sixth chart. The narrower credit / liabilities growth gap “explains” the decline in the basic balance deficit – seventh chart.

Lower QE from January may result in a further reduction in credit expansion to governments but private lending growth may pick up in lagged response to current economic strength – ECB research found a 1-2 quarter average historical lag between GDP growth and real private loan expansion. The demand to hold broad money and bank bonds, meanwhile, may be depressed by the ECB’s commitment to maintain current negative rates at least through September 2018, despite rising inflation. The fall in the domestic credit / liabilities growth gap, therefore, may stall.

Relative credit / money demand trends may favour the US dollar rather than the euro in 2018. The planned reduction in the Fed’s balance sheet in 2018 is comparable in scale with the slowdown in ECB QE between 2017 and 2018, suggesting a similar drag on domestic credit expansion. US residents’ demand to hold broad money and other bank liabilities, however, may be boosted by rising nominal / real interest rates and repatriation of corporate foreign earnings due to tax reform.

Global money trends signalling economic growth peak

Posted on Tuesday, December 5, 2017 at 09:49AM by Registered CommenterSimon Ward | CommentsPost a Comment

The consensus view is that 2018 will be another year of strong and broadly-based global economic growth. Monetary trends and cycle analysis, by contrast, suggest that early robust momentum will fade as the year progresses.

As indicated by earlier partial data, global (i.e. G7 plus emerging E7) six-month real narrow money growth edged up in October after falling between June and September. Real money momentum turning points have led turning points in industrial output momentum by an average of nine months since 2005 – see first and second charts*. The June peak, therefore, suggests that six-month industrial output growth, which has moderated since the summer, will reach another peak around March 2018.

With global real narrow money growth still respectable in October, a post-March economic slowdown may initially be modest. Recent commodity price gains, however, may push up six-month consumer price inflation further, implying an increased drag on real money growth assuming stable nominal expansion – third chart. Nominal narrow money trends, meanwhile, could weaken if slowing QE leads to a reduction in risk appetite and broad money velocity – fourth chart.

The suggestion that economic momentum will peak by the end of the first quarter is consistent with the assessment here that the US / global stockbuilding cycle is approaching the end of its upswing phase. The cycle has an average duration of 13-14 quarters and probably bottomed in early 2016 – see previous post.

Upward pressure on unit labour cost growth and core inflation may be sustained well beyond an economic growth peak, reflecting stretched labour markets. The G7 unemployment rate fell further in October and is well below major lows reached in the 1990, 2000 and 2007 – fifth chart.

Headline inflation prospects may depend partly on Chinese policy developments. Narrow money trends are signalling a slowdown in house prices, industrial profits and producer prices into early 2018 – see previous post. The authorities may respond by partially reversing monetary and regulatory policy tightening in 2017, in which case global commodity prices may strengthen further despite peaking economic growth, with such strength sustaining upward pressure on G7 headline inflation and policy rates.

Put differently, Chinese policy tightening may have relieved pressure on G7 central banks in 2017; the reverse may be true in 2018.

The recent fall in global six-month real narrow money growth reflects declines in both the G7 and E7 but the G7 / E7 gap remains slightly positive, casting doubt on recommendations to be overweight emerging market equities – sixth chart.

The range of variation in six-month real narrow money growth across the major economies is unusually small: October growth was equal in the US, Japan, Euroland and China, with the UK only modestly lower – seventh chart. Among other developed economies, real money growth has weakened in Australia and to a lesser extent Canada but is strong in Switzerland – eighth chart.

*The series shown incorporate adjustments to exclude temporary large falls in Japanese industrial output in 2011 and Indian narrow money M1 in 2016 due respectively to the March 2011 Tohoku earthquake / tsunami and the November 2016 demonetisation programme. An average lead of nine months was also found in a longer-term (50 year) study of G7-only data.

Euroland / UK monetary update - messages unchanged

Posted on Wednesday, November 29, 2017 at 04:08PM by Registered CommenterSimon Ward | CommentsPost a Comment

Euroland monetary trends have cooled slightly, suggesting that GDP growth will moderate in the first half of 2018. UK trends have stabilised after weakness earlier in 2017, consistent with GDP growth continuing at around its recent pace.

As usual, the focus here is on non-financial monetary aggregates, i.e. covering holdings of households and non-financial businesses but excluding financial sector money, which is less relevant for assessing near-term economic prospects.

Six-month growth rates of Euroland non-financial M1 and non-financial M3 rebounded in October but are lower than in 2016 and the first half of 2017 – see first chart. Growth in real terms has been supported by a fall in six-month consumer price inflation but this is probably in the course of reversing – second chart.

Money trends, it should be emphasised, remain consistent with solid economic growth but activity data surprises may shift from positive to balanced / negative in early 2018.

Recent positive surprises have been focused on France. French economic acceleration was signalled by a strong pick-up in real M1 deposit growth in late 2016 / early 2017 but there was a set-back in October – third chart.

In the UK, six-month growth rates of non-financial M1 and non-financial M4 have moved sideways since the spring after falling in late 2016 / early 2017 – fourth chart. Growth in real terms has recovered slightly as six-month consumer price inflation has moderated – fifth chart.

Corporate money trends are of particular interest at present: a Brexit-related cut-back in investment or shift of activity overseas would be expected to be preceded by a slowdown or contraction in real M1 holdings of private non-financial corporations (PNFCs). Such holdings are still rising moderately, while household real M1 growth has recovered slightly, suggesting consumer spending resilience – sixth chart.

Some analysts may express alarm about a recent sharp fall in annual growth of the Bank of England’s M4ex broad money measure – from 7.3% in April to 4.2% in October. About half of this decline is attributable to a slowdown in financial sector money holdings, which is unlikely to be of economic significance. Household M4 growth, meanwhile, has been weakened by a portfolio shift out of bank and building society time deposits (including retail bonds) into investment funds and National Savings products. Retail sales of investment funds and inflows to National Savings totalled an estimated £54 billion in the 12 months to October, equivalent to 2.8% of M4ex, up from £16 billion, or 0.9%, in calendar 2016.

Santa Hammond throws caution to the wind

Posted on Wednesday, November 22, 2017 at 04:28PM by Registered CommenterSimon Ward | CommentsPost a Comment

The Chancellor belied his reputation as a fiscal conservative by announcing a sizeable easing relative to previous plans, allocating the extra cash across a range of supposedly populist measures.

Fiscal policy will be 1.2% of GDP looser in the run-up to Brexit: cyclically-adjusted borrowing is now projected to fall by 0.8% of GDP between 2017-18 and 2019-20 versus 2.0% in the March 2017 Budget.

The Treasury made room for this policy shift by reducing headroom in previous plans, employing accounting tricks – most notably, tweaking housing association regulations to move borrowing off balance sheet – and pushing out the ultimate objective of a balanced budget.

The Chancellor still meets his “fiscal mandate” of a cyclically-adjusted deficit of below 2% of GDP in 2020-21 but the new projection of 1.3% is up from 0.9% in March, implying little protection against Brexit or other risks crystallising.

The OBR downgraded its medium-term growth forecast as expected but is arguably still giving the Chancellor too easy a ride. It continues to assume a smooth Brexit with no negative demand impact on GDP and also ignores the strong possibility that the global economy will enter another downturn by 2020, as suggested by cyclical analysis.

In cash terms, the Budget “gives away” £9.9 billion in 2019-20, with the distribution apparently governed by political expediency rather than economic logic – so £1.1 billion is spent on encouraging fuel and alcohol consumption by freezing duties and £600 million on a further boost to housing demand via stamp duty relief for first-time buyers. The NHS receives an extra £1.9 billion while an additional £1.5 billion is allocated to “preparing for EU Exit”. A modest £300 million is spent on changes to Universal Credit.

There was little for business to cheer: an earlier switch from RPI to CPI uprating for business rates is welcome but the cost will be recouped by ending capital gains indexation, while the housing supply package was underwhelming.

The Chancellor has delivered the Budget apparently demanded by the Prime Minister – one suspects that no. 10 will take any credit while he will suffer the consequences if it flops.

Global money trends / stocks cycle turning less favourable

Posted on Monday, November 20, 2017 at 01:58PM by Registered CommenterSimon Ward | Comments2 Comments

Six-month growth of global real narrow money appears to have stabilised in October, following a decline between June and September – see first chart. The rise in real narrow money growth into June was the basis for an earlier forecast here that the global economy would reaccelerate in late 2017. The fall over July-September suggests that economic momentum will peak in early 2018 and moderate towards mid-year. Real narrow money growth remains respectable by historical standards, arguing against significant economic weakness within this time frame.

Strong current economic momentum is evidenced by positive data surprises – the Citigroup G10 activity surprise index recently reached its highest level since March – and a surge in upgrades of company earnings forecasts by equity analysts.

The estimated stabilisation of global six-month real narrow money growth in October reflected rises in the US and Japan offset by a further fall in China – second chart. The final estimate will depend importantly on Euroland data to be released on 28 November.

Global real narrow money growth fell significantly between August 2016 and February 2017, contributing to an expectation here that the economy would lose momentum in summer 2017. Economic surprises and earnings revisions turned negative, and G7 government bond yields fell, but GDP / industrial output data remained strong. Why was the monetary signal apparently less powerful on this occasion?

A hypothesis under consideration here is that the significance of changes in monetary trends for future economic activity depends partly on the status of the US / global stockbuilding cycle (the Kitchin cycle). Monetary slowdowns during the upswing phase of this cycle may have muted and / or delayed implications.

The stockbuilding cycle is usually described as having a duration of between three and five years. The judgement here is that cycle troughs occurred in 1995, 1998, 2001, 2005, 2009, 2012 and 2016. The contribution of the change in stockbuilding to the annual rate of change of G7 GDP bottomed in these years – third chart.

Global GDP / industrial output typically accelerates strongly in the year to 18 months after a stockbuilding cycle trough. Monetary slowdowns during this phase may be of less significance for economic prospects than at other times.

This hypothesis is consistent with similar experience after the prior stockbuilding cycle trough in 2012 – global real narrow money growth fell significantly in late 2012 / early 2013 but economic expansion remained strong into early 2014.

The corollary is that economic and market dangers, and the significance of monetary weakness, increase as the stockbuilding cycle matures.

On the dating here, troughs in the stockbuilding cycle since 1995 have been spaced on average 13.5 quarters apart*. Peaks can occur early or late in the cycle but an expectation of a roughly seven quarter spacing from the most recent trough is reasonable in the absence of other information. The judgement that a trough occurred in the first quarter of 2016, therefore, suggests that cycle momentum will start to fade in early 2018.

Major market disturbances in recent decades have usually occurred in the year to 18 months before a stockbuilding cycle trough. Downswings into troughs in 1995, 1998, 2001, 2009, 2012 and 2016 were associated respectively with the Tequila crisis, the Asian crisis / Russian default, the TMT bust, the global financial crisis, the Eurozone crisis and the OPEC / oil price bust. Market conditions remained benign in the run-up to the 2005 trough but this may have contributed to excessive risk-taking and credit expansion in the subsequent upswing.

Based on the average 13.5 quarter spacing since 1995, the next stockbuilding cycle trough could occur in mid-2019, suggesting that investors should batten down the hatches by mid-2018 at the latest – especially if global monetary trends continue to cool.

*Equivalent to 40 months, which equals the average periodicity of cycles in US / UK bank clearings and commodity prices documented by Joseph Kitchin in his original 1923 article.

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