Eurozone monetary trends strengthened further in July, suggesting that recent ECB policy easing is bearing fruit and will lead to an economic revival later in 2014, barring external “shocks”.
Six-month growth of real (i.e. inflation-adjusted) narrow money M1 has risen from 1.6% (not annualised) in April to 2.5% in July, a solid pace by historical standards. Real M3 expansion has recovered from 0.1% to 1.1% over the same period, the latter reading being the highest since late 2012, ahead of a return to economic growth in 2013 – see first chart.
Nominal money trends have firmed notably in the latest three months, partly reflecting the ECB’s June rate cut and the announcement effect of its targeted long-term refinancing operations (TLTROs), the first of which will be allotted on 18 September. M1 and M3 rose at annualised rates of 7.3% and 5.7% respectively between April and July.
Faster M3 growth has been driven by a further rise in the balance of payments surplus*, larger outflows from longer-term bank savings into deposits as a result of falling interest rates and a slower contraction of private sector credit.
The forecasting approach here emphasises M1 because of its closer link to spending intentions and historically superior leading indicator properties. The ECB publishes a country breakdown of overnight deposits, which comprise 83% of Eurozone M1. Six-month real overnight deposit growth is strong in Spain and – surprisingly – France, while remaining solid in Italy and Germany. Dutch weakness, however, has intensified – second chart.
In other news today, the net percentage of Eurozone consumers expecting prices to rise over the next 12 months slipped from +9% in July to +7% in August but remains broadly consistent with the ECB’s inflation target, based on history – third chart.
ECB President Draghi’s Jackson Hole speech signalled that further easing measures, including full QE, are under consideration but better monetary news and the forthcoming TLTRO suggest that a decision on action will be deferred until October at the earliest.
*Basic balance, i.e. current account plus direct / portfolio investment flows.
This post updates a comparison of the rise in the Dow Jones Industrials index from its March 2009 low with increases after six previous bear markets involving a peak-to-trough fall of about 50%. (The Dow declined by 54% between October 2007 and March 2009.) As explained below, the current level of the Dow is slightly above the top of the range spanned by these prior rises.
The six bear market troughs considered in this analysis occurred in November 1903, November 1907, December 1914, August 1921, April 1942 and December 1974. The Dow Industrials fell by between 45% and 52% into these lows. (The 1929-32 bear market was excluded because it involved a much larger decline, of 89%.) In each of the six cases, the trough of the bear market was rebased and shifted forwards in time to align with the March 2009 low. The subsequent rises were then traced out and an average calculated – see chart.
The current rise broadly tracked the “six-recovery average” until late 2011 but has since diverged positively, standing 39% higher as of yesterday’s close. The average remains below the current Dow level through end-2019.
The Dow is 4% above the top of the range spanned by the prior rises. The range top is defined by the “roaring twenties” increase from the August 1921 trough – black line in chart. The equivalent month to August 2014 was March 1927. If the Dow were to replicate its performance then, it would rise to 18,000 at end-2014 and 22,000 at end-2015 en route to a peak of 39,000 in January 2017, corresponding to September 1929.
As noted, the 1929-32 bear market wiped out 89% of the Dow’s peak value, returning it to the equivalent today of 4,000.
The historical analysis, therefore, suggests that the Dow will trade significantly below its current level at some point over the next five years. A further substantial rise first, however, cannot be ruled out.
The “monetarist” perspective here is that bear markets are normally triggered by money supply expansion falling short of the needs of the economy – such a shortfall crimps future activity and is associated with a withdrawal of liquidity from markets. Annual real narrow money growth moved well beneath industrial output expansion from late 1928, signalling a deteriorating liquidity backdrop. The real narrow money / industrial output growth gap remains positive currently, both in the US and globally.
An interesting feature of the August MPC minutes is that the “Money, credit, demand and output” section includes, for once, a discussion of monetary trends. This may reflect the influence of the Bank of England’s new chief economist, Andrew Haldane.
The discussion is relatively extensive and implies that monetary trends are consistent with continued strong economic growth, in line with the assessment here. In particular, it is suggested that households hold “excess” broad money balances that will be spent, while rapid expansion of corporate deposits supports optimism about business investment. There is also an indirect reference to narrow money buoyancy in an observation about households switching from time to sight deposits.
Mr Haldane was co-author of a 1995 Bank of England working paper Money as an Indicator, which found “strong and significant effects from narrow money through to nominal GDP and, in particular, prices”. As the paper noted, this matched a much earlier (1970) Bank study by Andrew Crockett, which concluded that “the money stock, narrowly defined (M1), seems to be positively related to subsequent changes in expenditure”.
If the above interpretation is correct, Mr Haldane will be placing significant weight on monetary trends and, if current strength continues, is likely to shift into the interest-rate-rise camp. (July monetary statistics are released on 1 September.)
Japanese monetary trends continue to suggest remarkably little impact from the country’s QE experiment.
Annual growth of broad money M3 stood at 2.1% when the Bank of Japan (BoJ) launched QE in October 2010; it was 2.5% in March 2013, when the programme was expanded significantly; it was 2.5% also in July this year.
As discussed in a post in June, the BoJ’s injection of money via its purchases of Japanese government bonds (JGBs) has been neutralised by an opposing shift by banks, who were expanding their lending to the government in 2010 but have been cutting it back more recently – see the “monetary counterparts” chart below. A key reason for this change is that QE has raised banks’ reserves at the BoJ, allowing them to reduce their JGB holdings while still meeting their liquidity targets. The BoJ and banks have, in effect, swapped JGBs and reserves, with no impact on the supply of money to households and firms.
There has been an additional drag on M3 growth recently from a reduction in banks’ net foreign asset position, following expansion in late 2012 and 2013. This, in turn, reflects the balance of payments basic balance moving from surplus to deficit – second chart. The main driver of this shift has been an increase in portfolio outflows, probably related to QE.
Japan’s experience supports the view here that QE has little impact on monetary trends under normal circumstances. Extending / expanding the BoJ’s bond-buying operation would be unlikely to make much difference. Banks’ outstanding lending to the government remains substantial – equivalent to 25% of M3 – and they would probably sell more JGBs to offset the additional reserves boost from higher BoJ purchases.
QE might have a larger monetary impact if the BoJ bought equities rather than bonds. Banks’ equity holdings are much smaller – less than 2% of M3. They would, however, still have an incentive to offload JGBs to counter reserves expansion. The BoJ could be constrained from switching QE away from bonds because of the smaller size of the equity market – the current ¥50 trillion annual pace of JGB buying is equivalent to 11% of stock market capitalisation.
Additional BoJ easing, in whatever form, could encourage further portfolio outflows, implying a negative external effect on money growth.
Rather than further monetary experimentation, Japan needs action on mooted “third arrow” structural reforms to boost supply-side economic performance. By enhancing confidence in medium-term prospects, such reforms could cause a rise in the velocity of circulation of the existing money stock while encouraging private sector credit growth – a firmer basis than QE for stronger M3 expansion.
Eurozone annual consumer price inflation fell further to 0.4% in July versus 0.7% in January and 1.6% in July 2013. This decline, however, is largely explained by lower energy and food costs. “Core” inflation, i.e. excluding energy, food, alcohol and tobacco, was 0.8% in July versus 0.7% in January and 1.1% in July last year – see first chart.
The modest reduction in core inflation over the past year, moreover, partly reflects a smaller boost from indirect tax rises. Tax rate changes contributed 0.2 percentage points (pp) to CPI inflation in July 2014, down from 0.4 pp a year earlier, according to Eurostat*.
A fall in inflation due to lower imported energy and food costs and smaller tax rises is positive, not negative, for demand and activity, ceteris paribus.
The stabilisation of core inflation since late 2013 is consistent with the “monetarist” rule that price developments echo money supply trends about two years earlier. Annual growth in narrow money M1 bottomed in mid-2011, though recovered significantly only after mid-2012 – second chart. The rule suggests that core inflation will firm through mid-2015. A prior large rise in M1 growth in 2008-09 preceded a faster rise in core prices in 2010-11.
Annual M1 expansion fell back from spring 2013. The ECB cut official rates in November and June and will offer additional liquidity via targeted longer-term repo operations (TLTROs) from next month. It also plans to buy asset-backed securities. Six-month growth in M1 (and M3) recovered between April and June. Launching large-scale QE would probably have limited additional impact on monetary trends, based on experience elsewhere**.
The ECB blundered in 2011, tightening policy when real money was contracting, thereby guaranteeing a recession. It corrected this mistake in 2012 and its current stance is reasonable, assuming a continuation of recent monetary trends.
*These estimates assume 100% pass-through.
**Japanese money growth, for example, is little changed from October 2010 and April 2013, when QE was introduced and expanded respectively – see previous post for more discussion.