US narrow money trends weakened further in December, strengthening the conviction here that the economy will lose momentum from around spring 2017, in turn casting doubt on the average expectation of Federal Open Market Committee (FOMC) participants for a 75 basis point rise in official rates during 2017.
Swings in real (i.e. consumer price inflation-adjusted) narrow money growth have consistently led fluctuations in GDP expansion in recent years (and over the longer term) – see chart. Current economic strength reflects a surge in six-month real money growth to a peak in August 2016. The loss of monetary momentum since then echoes a sharp slowdown over the summer / autumn of 2015, which preceded weak GDP outcomes in winter 2015 / spring 2016.
The final real money growth data point in the chart is a December estimate based on weekly monetary data through 26 December and an assumed 0.2% monthly rise in seasonally-adjusted consumer prices.
Monetary changes usually lead activity swings by between six and 12 months, with an average of nine months. The August 2016 peak in six-month real narrow money growth suggests that two-quarter GDP momentum will top out in the second quarter of 2017, plus or minus one quarter.
Any slowdown is expected here to be less pronounced than in late 2015 / early 2016 because 1) money trends are not as weak now as then and 2) the Kitchin stockbuilding cycle was entering a downswing phase in late 2015 but appears to have bottomed in 2016.
The obvious counter-argument to a slowdown forecast is that fiscal stimulus will boost growth in the second half of 2017 and 2018. The effects of fiscal policy, however, should be incorporated in narrow money trends: shifts in money demand are largely driven by changes in spending intentions of households and firms, which would strengthen in response to an effective fiscal stimulus. If the counter-argument is correct, that is, real money growth should rebound in early 2017. Even if it does, the recent pull-back suggests a softer patch for the economy around mid-2017.
UK monetary trends remained solid in the immediate aftermath of the Brexit vote but November numbers released today were weak, suggesting deteriorating economic prospects for mid-2017, allowing for an average nine-month lead from money to activity.
The preferred narrow and broad money measures here are non-financial M1 / M4, comprising holdings of households and private non-financial corporations (PNFCs). Both aggregates grew by only 0.1% in November – the weakest monthly changes since 2011-12.
Annual growth of non-financial M1 fell to 9.4% in November, a five-month low and down from a September peak of 10.2%. Annual non-financial M4 growth retreated to 5.7%, the lowest since December 2015, having reached 6.8% in September.
Economic growth prospects are related to real (i.e. inflation-adjusted) monetary trends. The first chart shows six-month rates of change of non-financial M1 / M4 deflated by consumer prices (seasonally adjusted). The nominal money slowdown has been compounded by accelerating consumer prices, which rose at a 1.9% annualised pace in the six months to November. Six-month real narrow money growth is at a 14-month low, with real broad money expansion the weakest since August 2014.
As the chart shows, faster real money growth in 2015 / early 2016 was reflected in a pick-up in two-quarter GDP momentum through the third quarter of 2016. Real money trends remained solid until autumn 2016, suggesting that economic strength will be sustained until spring 2017. The November numbers, however, hint at a sharp slowdown over the summer.
Monthly monetary statistics can be volatile so it is probably advisable to wait for December data before concluding that the economic outlook is darkening.
The recent fall in six-month real non-financial M1 growth reflects fading strength in the household component, which correctly signalled consumer spending resilience before and after the Brexit vote but now suggests rising caution – second chart. Corporate narrow money trends, by contrast, remain stable and solid, possibly indicating that Brexit worries have so far been neutralised by a better-than-expected economic environment.
The narrow money numbers have probably been slightly depressed recently by a switch of funds out of bank deposits into National Savings products – particularly instant-access income bonds, yielding a competitive 1.0%. National Savings inflows totalled £2.2 billion in November, equivalent to 0.2% of non-financial M1.
The Eurozone economy performed solidly in 2016. GDP rose by 1.7% in the year to the third quarter, equal to growth in the US and well above “potential” expansion estimated by the EU Commission at only 1.0% in 2016. Domestic demand increased by 1.9%. Available evidence suggests a similar pace of growth in the fourth quarter, while the OECD’s Eurozone leading indicator has strengthened.
GDP expansion was above potential in 2016 for the third successive year. Accordingly, the unemployment rate has fallen steadily from a 2013 peak of 12.1% to 9.8% in October 2016. The decline of 0.8 percentage points (pp) over the latest 12 months compares with drops of 0.4 pp in the US, 0.2 pp in Japan and 0.4 pp in the UK.
Monetary trends suggest that respectable growth will continue. Narrow and broad money rose strongly in November, reversing October softness. The preferred measure for economic forecasting purposes here is the six-month growth rate of real (i.e. consumer price inflation-adjusted) non-financial M1, comprising holdings of currency and overnight deposits by households and non-financial corporations. This rebounded to a four-month high in November and is robust by historical standards – see first chart.
Will the ECB’s decision to reduce QE securities purchases from €80 billion per month to €60 billion from April 2017 have a negative impact on monetary trends? Probably not. As previously discussed, the boost to broad money from QE has been more than offset an outflow of capital from the region – “excess” liquidity, in other words, appears to have been exported, pushing down the euro, rather than feeding through to stronger domestic demand. The view here is that solid economic performance reflects falling interest rates and an easing of fiscal austerity, with QE of little import.
The planned reduction in QE may curb excess liquidity creation and slow capital outflows, with the extent of any decline dependent partly on political developments. The current account surplus, meanwhile, remains strong – €344 billion in the 12 months to October, equivalent to 3.2% of GDP. Six-month real narrow money growth is higher in the Eurozone than in the US and Japan, though lower than in China – second chart. The Eurozone / US gap casts doubt on the consensus view that US relative economic strength will drive a further widening of interest rate differentials in favour of the US dollar during 2017.
Consensus pessimism about UK consumer spending prospects partly reflects the low level of the official household saving ratio measure. The accuracy of this measure, however, is questioned by other official data suggesting that saving has increased over the past year and is at a respectable level by historical standards.
The official measure of the household saving ratio fell further to 5.6% in the third quarter, the lowest since 2008 and well below an average of 8.4% over 1996-2015 (20 years). According to the consensus view, the ratio is unlikely to decline much further, so an expected inflation squeeze on real income growth in 2017 should result in a significant slowdown in consumer spending.
The official measure of the ratio is derived from the household income account, with saving defined as the difference between disposable income, adjusted for the change in pension entitlements, and consumer spending.
An alternative measure, however, can be calculated from the financial and capital accounts. This measure defines saving as new investment in financial or tangible assets minus borrowing. The two definitions of the ratio are theoretically equivalent but differ in practice because of measurement errors.
The first chart shows the two saving ratio measures plotted as four-quarter moving averages, to reduce quarterly volatility. The alternative measure based on the financial / capital accounts is usually higher than the official measure derived from the income account but the current divergence is unusually wide. In contrast to the official series, the alternative measure has risen strongly since the first half of 2015 and is close to its 20-year average – households, that is, have been adding to their net assets at a faster pace recently even while increasing consumer spending solidly.
The financial / capital account detail shows that the increase in the alternative saving ratio measure has been driven by stronger growth of household money holdings and faster accumulation of life insurance and annuity entitlements.
The Office for National Statistics prefers the income-based saving measure because it has greater confidence in the income account data. The recent rise in the alternative measure, however, accords with expectations that households would increase precautionary saving before and after the Brexit vote. The healthier financial position implied by the alternative measure, meanwhile, tallies with solid consumer spending growth. The rise suggested by the alternative measure is also supported by a recent fall in the net percentage of households planning to increase saving in the EU Commission monthly consumer survey: this percentage has been negatively correlated with the saving ratio historically (i.e. a higher current level of the ratio is usually associated with lower savings intentions) – see second chart.
If it is assumed that the alternative measure of the saving ratio is more accurate at present, the implication is that either consumer spending has been over-recorded or disposable income under-recorded in the income account. Supporting the latter possibility, a sizeable divergence has opened up recently between the net percentage of households reporting an improvement in their financial position over the past 12 months in the EU Commission survey and the annual rate of change of real disposable income – third chart.
If household saving has been higher than officially reported in recent quarters, saving of other sectors must have been correspondingly lower, since aggregate saving (including the financial surplus of the overseas sector) must equal aggregate investment. An examination of the financial accounts of other sectors suggests that the savings positions of the overseas sector and financial corporations are weaker than reported in the income accounts. According to the financial account data, for example, the overseas sector financial surplus (i.e. saving minus investment) was £71.9 billion in the year to the third quarter – significantly lower than the reported current account deficit of £93.4 billion.
UK GDP is on track to rise by about 0.4% in the fourth quarter, while the currently-reported 0.49% increase in the third quarter may be revised up slightly. Assuming a 0.9-1.0% gain across the two quarters, and no revisions to earlier data, GDP will rise by 2.1% for 2016 as a whole, versus 2.2% in 2015. Solid performance was predicted by monetary trends and growth would probably have been significantly stronger but for the Brexit referendum.
Services turnover numbers released yesterday suggest that output in the sector rose further in October, offsetting declines in industrial and construction activity. GDP is estimated here to have been 0.2% above its third-quarter level in October, while third-quarter expansion seems likely to be revised up by several basis points. If GDP were to rise by 0.15% per month in November and December – in line with estimated average growth between June and October – the increase for the fourth quarter as a whole would be 0.4%.
Such an outcome would be broadly consistent with simple tracking estimates based on vacancies and the CBI’s expected growth indicator – a composite business survey measure. Both the rate of change of vacancies and the CBI indicator have eased recently, with the latest readings suggesting quarterly GDP expansion of 0.31% and 0.50% respectively – see first and second charts.
GDP growth of 0.9-1.0% in the third and fourth quarters combined would compare with official / consensus forecasts of stagnation or recession after the Brexit referendum. Some Brexit supporters cite respectable GDP expansion as evidence that the referendum result has had little if any negative economic impact. An alternative view is that the economy would have expanded much more robustly in the absence of the vote.
Monetary analysis supports the latter view. Six-month growth of real non-financial M1 rose strongly between September 2015 and June 2016, suggesting that GDP would have accelerated in the second half of 2016 and into early 2017 in the absence of the Brexit vote shock, allowing for the usual six- to 12-month lead – third chart. The two-quarter increase in GDP reached 1.8% in the second quarter of 2014 after real non-financial M1 growth reached a similar level in the third quarter of 2013. Assuming that similar expansion was in prospect before the vote, a GDP rise of 0.9-1.0% during the second half of 2016 would imply a Brexit growth drag of as much as 0.75 percentage points (pp), or 1.5 pp at an annualised rate.