Global real narrow money continued to slow in July, suggesting dimming prospects for economic growth next spring, allowing for the usual lead.
Six-month growth of real (i.e. consumer price-adjusted) narrow money in the G7 and emerging E7 economies is back at its level in late 2014, having peaked in February – see first chart. While growth remains weaker in the E7 than the G7, the latter has been responsible for the recent decline – second chart.
Statistical research shows that real narrow money outperforms broad money and bank lending as a leading indicator of the economy, with an average lead time at turning points of nine months*. A rise in global real narrow money growth between August 2014 and February 2015 suggests that economic momentum will recover over the remainder of 2015. Industrial activity remained very weak through July – first chart – although the divergence between industry and a more resilient services sector is unusually large**. Manufacturing surveys for June and July hinted at an improvement in industrial prospects but August results were disappointing, possibly reflecting worries about a Chinese “hard landing” and associated market volatility.
The odds still favour a near-term pick-up in economic growth but the real money slowdown since February suggests that momentum will fade again in early 2016.
The global and G7 / E7 aggregates conceal considerable variation across countries. Within the G7, real narrow money growth is strong in the Eurozone and respectable in Japan / the UK but has fallen sharply in the US – third chart. In the E7, Korea and Mexico are leading growth while real money continues to contract in Russia and Brazil, in the latter case at a faster rate – fourth chart.
A further decline in global real narrow money growth would be concerning. Inflation developments, however, are likely to be supportive near term, with commodity prices signalling a temporary slowdown in the six-month consumer price rise – fifth chart.
Research shows that, in addition to real narrow money, the slope of the G7 yield curve – i.e. the difference between a weighted average 10-year government bond yield and a three-month money market rate – performs well as a leading indicator of the global economy. This suggests combining the two signals to create a superior forecasting indicator.
A simple method of combination is to add the yield curve slope to the six-month change in real narrow money. One rationale for such an adjustment is that the yield curve affects the relative attraction of money versus bonds. A steeply positive curve will tend to reduce the demand to hold money, meaning that a given level of real money growth has more positive economic implications than would otherwise be the case. Conversely, an inverted curve will encourage a shift from bonds into money; the observed level of real money growth, therefore, may be associated with lower future spending than under normal circumstances.
The final chart shows a forecasting indicator based on yield curve-adjusted real narrow money growth, with additional trend and scaling adjustments. The indicator is advanced by nine months, to reflect the average lead from real narrow money to the economy. An alternative indicator that excludes the yield curve is presented for comparison.
The current prediction is in line with the commentary above, i.e. a near-term recovery in global economic growth followed by another slowdown from early 2016. Comparing the two indicators, the yield curve adjustment makes a small but worthwhile difference to the historical performance, a conclusion confirmed by analysis of long-term data.
*Further details on request.
**For example, the difference between the new business / orders components of the US ISM non-manufacturing and manufacturing surveys is currently more than two standard deviations above its long-run average.
UK money trends continue to give a reassuring signal for economic prospects. Corporate liquidity, in particular, is rising rapidly, suggesting stronger business spending.
The preferred narrow and broad money measures here are “non-financial” M1 and M4, covering holdings of households and private non-financial corporations (PNFCs)*. Annual growth of non-financial M1 was 7.4% in July, up from 6.6% in June but well below a peak of 11.7% reached in 2013. Non-financial M4 growth rose to 5.0%, the fastest since December – see first chart.
Within M4, money holdings of PNFCs rose by 11.4% in the year to July, the largest annual increase since August 2007. Business liquidity is rising faster in the UK than in the US, Japan and Eurozone – second chart**.
By contrast, annual growth of household M4 holdings fell to 3.4% in July, the lowest since March 2012. The recent slowdown reflects a shift of funds out of bank and building society deposits into National Savings products in response to attractive interest rates – National Savings inflows were £21.8 billion in the year to July, up from £4.0 billion in the previous 12 months. The sum of household M4 and the stock of funds in National Savings rose by an annual 4.8% in July versus average growth of 4.0% over 2012-14 – third chart.
Business investment expanded by 5.0% in the year to the second quarter. Overall business spending, however, fell, because firms ran down stocks last quarter, having increased them a year before. Corporate money strength suggests that investment will continue to rise solidly while stocks will be rebuilt. GDP growth, in other words, should benefit from a rebound in business spending.
The fourth chart compares the two-quarter change in GDP, excluding volatile oil and gas production, with six-month changes in real*** non-financial M1, non-financial M4 and PNFC M4. The three measures turned down before the 2008-09 recession and the 2012 “double dip” scare. Growth of real non-financial M1 and corporate M4, meanwhile, rose strongly in 2012 ahead of the “surprise” 2013 GDP acceleration.
The recent modest decline in GDP growth followed a deceleration in real non-financial M1 and corporate M4 in 2014. Growth in the two measures, however, has stabilised and risen respectively since late 2014, suggesting a recovery in GDP expansion through early 2016.
*Fluctuations in money holdings of insurance companies, pension funds and other financial corporations are less relevant for assessing near-term economic prospects.
**Latest data July for UK and Eurozone, June for Japan and March for US (quarterly).
***Real = deflated by consumer prices, seasonally adjusted.
US inventories have risen to an elevated level relative to sales, suggesting that the 3-5 year Kitchin stockbuilding cycle is about to turn down. Together with slowing real narrow money expansion, this casts doubt on 2016 growth prospects.
A post in August 2014 argued that US economic fluctuations can be explained by the interaction of three cycles: the 3-5 year Kitchin stockbuilding cycle; the 7-11 year Juglar business investment cycle; and the 15-25 year Kuznets housebuilding cycle. Severe recessions, such as 2008-09 and 1974-75, occur when the three cycles reach a trough in the same year.
The post suggested that the Kitchin cycle last hit bottom in 2012. GDP grew by just 1.3% in the year to the fourth quarter of 2012, with economic weakness contributing to the Fed’s decision to launch QE3 in September. If this dating is correct, the cycle is scheduled to reach another low between 2015 and 2017.
A key indicator of the status of the Kitchin cycle is the ratio of inventories to final sales. The ratio typically moves significantly above its trend at cycle peaks, falling beneath it at troughs. It was above trend in the first and second quarters of 2015, with the deviation larger than at the last cycle peak in 2010 – see first chart.
A return of the ratio to trend requires a cut in the stock of inventories and / or a rise in final sales. With real money expansion slowing, final sales are unlikely to surge. Suppose that they grow by 2.5% over the coming year. The stock of inventories would then need to be held stable to return the ratio to sales to trend in 12 months’ time.
Inventories, however, were still rising fast in the second quarter – by the equivalent of 0.7% of GDP. A fall in the rate of change to zero, therefore, would imply a drag on GDP of this magnitude.
If the inventories to sales ratio were to fall beneath trend, as usually occurs at Kitchin cycle troughs, the implied drag would, of course, be larger.
As noted in the previous post, Kitchin cycle downturns, in isolation, are not usually associated with recessions. The Kuznets housebuilding cycle remains in an upswing. The Juglar business investment cycle is scheduled to reach another low between 2016 and 2020. Juglar downturns are almost always preceded by a profits squeeze. Economic profits* have stagnated over the past year but are not weak enough to suggest a fall in investment – second chart.
With prospects for business spending softening, personal consumption and housebuilding will need to make stronger contributions if GDP growth is to be sustained at its recent pace.
*Economic profits adjust for stock appreciation and over / underreporting of depreciation.
Eurozone money measures rose strongly again in July, reinforcing the positive view here of economic prospects. Narrow money is growing much faster than in the US, suggesting superior Eurozone economic performance over the next six to 12 months.
Broad money M3 and narrow money M1 rose by 0.8% and 1.2% respectively in July. Annual M3 growth was 5.3%, equal to a high reached in April, while M1 growth surged to 12.1% – the strongest since 2009.
The money measure with the best economic forecasting properties, according to ECB studies, is non-financial M1, comprising currency and overnight deposits held by households and non-financial corporations. Six-month growth in this measure has been running at about 5% since late 2014, with July at 5.2%, or 10.7% annualised – see first chart.
Growth in real terms (i.e. relative to consumer prices) has moderated since end-2014, reflecting a recovery in inflation. However, the current six-month increase of 4.3%, or 8.9% annualised, remains strong by historical standards, suggesting solid economic prospects. Six-month inflation, moreover, is likely to pull back near term on oil and exchange rate effects.
In addition to money supply strength, bank loans to the private sector, adjusted for sales and securitisation, rose by 0.3% in July, pushing annual growth up to 1.4% – the fastest since 2011. Unlike money, credit is a coincident or lagging indicator of the economy. With narrow money trends signalling solid economic growth, lending should pick up further.
US real narrow money M1 rose by 2.1%, or 4.2% annualised, in the six months to July*. The recent gap between Eurozone real non-financial M1 growth and US real M1 growth is the largest since early 2010. GDP grew faster in the Eurozone than the US over the subsequent year**.
The ECB publishes a country breakdown of overnight deposits but not currency. Among the big four, six-month growth of real deposits is strongest in France and Spain, with Italy lagging – second chart. Consistent with the positive French signal, Insee business surveys for August were upbeat, with composite climate indicators for services and industry at their highest since 2011.
The outflow of deposits from Greek banks slowed to €1.7 billion in July after €8.1 billion in June but, surprisingly, the overnight component rebounded, reducing the six-month decline in real deposits sharply – third chart. Growth remains strong in Ireland but fell back in Portugal after a spike last month.
*US non-financial M1 is available only quarterly and with a lag – the latest datapoint is for end-March.
**GDP rose by 2.8% and 1.9% respectively in the year to the first quarter of 2011.
UK household spending is as extended relative to income as in the late 1980s and mid 2000s, ahead of the 1990-91 and 2008-09 recessions. Those earlier episodes were associated with rapid and unsustainable credit growth; current spending excess, by contrast, is the mirror of record-low accumulation of financial assets. A normalisation of financial investment behaviour threatens MPC and OBR central forecasts that GDP growth will be sustained at about 2.5% per annum over the next three to five years.
The suggestion that household finances are weak runs counter to recent commentary noting stronger nominal and real wage growth and a significant decline in the debt / income ratio from its 2009 peak. Spending, however, has accelerated along with income, while lower gearing has been achieved mainly by paring asset accumulation.
The difference between income and spending is equal to “net lending” in the capital account of the national accounts. Household sector net lending was negative by £5.4 billion, or 1.7% of available income (resources), in the first quarter of 2015. In data extending back to 1987, deficits were previously recorded only in 1988, 1999 and over 2004-08 – see first chart.
The weakness of household finances in the late 1980s and mid 2000s was transmitted to spending as interest rates subsequently rose. Rates, by contrast, fell in 1999, while the trend in net lending – as measured by a four-quarter moving sum – did not fall as far as in the other episodes. Growth slowed in the early 2000s but remained respectable. With interest rates likely to rise soon, and net lending in persistent deficit, current conditions bear a closer resemblance to the late 1980s and mid 2000s.
Household net lending should be distinguished from “saving”, which is the difference between income and consumption. Saving, in other words, includes household spending on investment goods – mainly housing. The saving ratio – saving as percentage of income – was 4.9% in the first quarter of 2015. Subtracting investment net of capital transfers of 6.6% of income generates the net lending deficit of 1.7% of income. The saving ratio is low by historical standards – it was below the current level in only three quarters in data extending back to 1963.
While net lending is similar now to the late 1980s and mid 2000s, borrowing / saving behaviour is very different. The net lending position in the capital account is mirrored in the financial account by the difference between gross lending or financial investment (“net acquisition of financial assets”) and borrowing (“net acquisition of financial liabilities”). This alternative financial account measure is not exactly equal to net lending in the capital account because of a statistical discrepancy, which is usually positive – second chart. Assuming that the capital account is more accurate, this implies that the financial account either overstates financial investment or understates borrowing.
The weakness of net lending in the late 1980s and mid 2000s, and to a lesser extent 1999, reflected strong borrowing, which peaked at 16.1% and 17.1% of income respectively in the former two cases (four-quarter moving sum) – third chart. Despite a recent recovery, borrowing currently remains historically very subdued, at 3.4% of income.
Weak net lending today is explained, instead, by low financial asset accumulation – currently only 4.0% of income versus a pre-crisis average (1987-2007) of 16.1%.
Households have slashed their asset accumulation probably for two main reasons, both related to monetary policy. First, low interest rates have reduced the demand for bank deposits and other money-like assets. This has been reflected in monetary data showing a persistent withdrawal of funds from household time deposits – the outflow totalled £23 billion in the 12 months to June.
Secondly, super-loose monetary policy has inflated the valuations of existing equity and bond holdings, allowing households to scale back their acquisition of new assets while maintaining a rise in wealth – fourth chart. Asset price inflation, in other words, has temporarily reduced the need for financial saving.
Household spending turned down in the late 1980s and mid 2000s as rising interest rates and other developments triggered a normalisation of borrowing behaviour. The risk now is that households will reduce spending to return asset accumulation to a more normal historical level.
Such a scenario would probably involve a rise in interest rates but could occur simply as a result of asset price inflation slowing. With smaller price gains, households would need to raise their acquisition of assets to maintain growth in financial wealth. (This is analogous to the “credit impulse” idea that spending is related to the rate of change of borrowing rather than its level.)
To summarise, it is likely that households will wish to return their financial asset accumulation / net lending to a more normal historical level at some point over the next few years. Barring a substantial rise in income, this would require spending restraint, with negative implications for economic growth.
Could the adjustment be achieved solely via income expansion? This would require a rise in spending relative to income in other sectors of the economy. The equality of aggregate spending and income implies the following identity for the net lending positions of the various sectors:
Household + corporate + government + rest of world = 0
Since the net lending position of the rest of the world is, to a close approximation, the mirror-image of the current account balance, this is equivalent to:
Household + corporate + government = current account
A rise in household net lending would require the corporate / government positions to deteriorate and / or the current account to improve. The Chancellor’s plans, of course, involve eliminating the government deficit. An income-driven recovery in household net lending, therefore, would depend on big rise in corporate spending relative to income and / or a surge in net overseas earnings.
Corporate net lending has moved from a large surplus after the 2008-09 recession to a modest deficit – fifth chart. Scarred by the crisis, and uncertain about the financial / economic impact of monetary policy normalisation, firms may be reluctant to allow a significantly larger shortfall.
The current account position may improve as the recent puzzling weakness of net investment earnings reverses but there is little reason to expect significantly stronger export performance, with the most dynamic sector – financial services – now hobbled by overregulation.
The prospective combined change in the corporate and rest of world positions, in other words, is unlikely to be sufficient to accommodate both government deficit reduction and a pain-free recovery in household net lending.