Global economic momentum is reviving, consistent with a forecast based on monetary trends, which continue to give a reassuring message.
The monetary measure used for forecasting here is the six-month change in global real narrow money, with “global” defined as the G7 plus seven large emerging economies (the “E7”). Statistical testing shows that this leads the six-month change in industrial output by nine months on average. Turning points in industrial output growth, meanwhile, usually coincide with those in GDP growth.
Real narrow money growth strengthened around end-2014, suggesting a pick-up in industrial output momentum during the second half of 2015. Output has been weaker than expected but the six-month change bottomed in June and appears to have returned to positive territory in September, judging from partial data – see first chart. GDP has been more resilient than industrial output this year, reflecting services strength.
Real narrow money growth moderated over the spring and early summer but has bounced back in August / September, offering reassurance that the global economy will perform respectably in the first half of 2016 – first chart.
The view that the global economy is lifting is supported by news this week, including stronger Japanese / Taiwanese exports in September and upbeat October “flash” PMIs for the Eurozone and Japan. The October Chinese MNI business survey was also stronger.
The rise in global real narrow money growth in August / September mainly reflects a surge in China, discussed in several recent posts, most recently on Monday. With China accounting for about half of the E7, this surge has resulted in real money growth in the E7 crossing above that in the G7 – second chart.
In addition to the re-emergence of a positive gap with the G7, the available September data suggest that E7 six-month real money growth has risen above the 4% level historically associated with emerging market equities outperforming developed markets – see previous post.
Today’s batch of Chinese economic data contains grist for both optimists and pessimists. Bears will focus on a further slide in annual nominal GDP growth to 6.2% in the third quarter – below a 6.5% trough reached during the 2008-09 downturn. Real GDP growth was maintained at a solid 6.9% only via an annual fall in prices, as measured by the GDP deflator.
Bulls, however, can point to improvements in monthly data to argue that stimulus efforts are starting to bear fruit. Six-month growth of industrial output and real retail sales rose further in September – see first chart. Housing floorspace started registered its first year-on-year gain this year. The annual change in auto sales also returned to positive territory. Government spending, meanwhile, rose 27% from September 2014.
These positive signs are consistent with a recovery in real narrow money growth since early 2015. The PBOC released additional monetary data for September today, allowing calculation of the “true M1” measure followed here. Six-month growth of real (i.e. CPI-adjusted) true M1 surged to its highest level since 2010, suggesting a further acceleration in industrial output and other activity measures into early 2016 – first chart.
Recent intervention to support the renminbi, meanwhile, may have been larger than current market estimates. Foreign exchange reserves were earlier reported to have fallen by $180 billion during the third quarter but this figure mixes valuation effects with transactions. The transactions element is separated out in the balance of payments accounts but these have yet to be released for the third quarter. The transactions series, however, correlates closely with the change in financial institutions' “position for forex purchase”, which fell by 1.73 trillion yuan, or $275 billion, last quarter – second chart. The monthly decline in the forex purchase position, moreover, was larger in September than August, casting doubt on the suggestion from the reserves data that intervention slowed last month.
Money supply analysis plays no role in policy formation under the current Monetary Policy Committee (MPC). Historically, policy-makers have run into trouble when they have ignored money and credit trends. Broad liquidity of households and non-financial firms is currently growing at the fastest rate since 2008. The velocity of circulation, meanwhile, has been stable in recent years, having fallen steadily during the 1990s and 2000s. If this stability persists, or velocity rises, liquidity growth at the current pace will cause inflation to overshoot the 2% target over the medium term.
It is clear from the Inflation Report and meeting minutes that the current MPC membership regards the behaviour of money and credit quantities as irrelevant for policy-making. The August rejig of the format of the Inflation Report involved the removal of the previous chapter on “Money and asset prices”. The word “money” did not appear in the August publication. It was similarly absent from the September minutes, except in the heading “Money, credit, demand and output”; the following section focused exclusively on GDP data and other activity news.
The further downgrading of the role of money supply analysis has coincided with a pick-up in broad liquidity growth. The quantity of M4 money and National Savings held by households and private non-financial corporations rose by 6.3% in the year to August, the fastest annual growth rate since June 2008 – see first chart*. It is important to include National Savings to capture a switch from bank deposits into NS pensioner bonds earlier this year: M4 holdings alone grew by an annual 5.3% in August. The pensioner bonds, and other NS products, are effectively “money” and would be included in M4 if they were issued by a bank rather than the government.
Historically, UK policy-makers have often ignored or explained away rises in money supply growth that were correctly signalling excessively loose policy. Annual growth of the above liquidity measure rose to nearly 9% in 2004, three years before the peak of the credit bubble and a subsequent sustained increase in inflation. Inflation Reports of the time – which did, at least, devote space to a discussion of monetary trends – suggested that strength was due to bank deposits being used as a savings vehicle following the equity bear market of the early 2000s. The signal, in any event, was ignored, with Bank rate cut in 2005, a change that served to sustain and increase monetary excess.
Chancellor Nigel Lawson, similarly, argued that the monetary aggregates were being distorted by financial liberalisation to justify suspending a target for broad money in 1985. Bank rate was cut in 1986-87 in response to temporarily weak price pressures, following which annual liquidity growth rose to over 15% in 1988, fuelling a housing market boom / bust and a surge in RPIX** inflation to a peak of 9.5% in 1990. Mr Lawson claimed that the monetary aggregates were “all over the place”; it was his policy, instead, that was in disarray.
Current liquidity growth of a little over 6% is far below prior extremes. The future inflation rate implied by a given growth rate, however, depends on the trend in the velocity of circulation – the value of national income supported by each pound of liquidity***. Velocity trended down in the late 1990s and 2000s, i.e. households and firms wanted to increase their liquidity holdings faster than national income – second chart. The decline over 1995-2009 averaged 2.1% per annum. Liquidity growth of 6% during this period, therefore, would have implied a rate of increase of income of about 4% per annum. Allowing for a trend rate of output expansion of about 2.5%, this would have been too low to achieve the 2% inflation target.
Velocity, however, recovered slightly after 2009 and has been broadly stable in recent years. One reason is that the interest rate on bank deposits has been much lower relative to inflation than in the past, reducing the attraction of money as a savings vehicle. If velocity were to continue to move sideways, sustained 6% liquidity growth would be reflected, in time, in an equal rate of increase of national income. This, in turn, would imply inflation of about 3.5%, assuming 2.5% trend output expansion.
The pick-up in liquidity growth argues for bringing forward an interest rate increase, despite current near-zero inflation. Suggestions that the next policy move should be to ease – or the first rate rise should be postponed until late 2016 or 2017 – are dangerous, recalling the 1986-87 and 2005 mistakes. There are two risks to raising rates now. First, the liquidity pick-up may turn out to be temporary; growth may subside back to the 2013-14 average of 4.75%, a level broadly consistent with the inflation target assuming stable velocity. Strengthening credit trends, however, suggest that faster liquidity expansion will be sustained. Bank lending to households and private non-financial corporations rose by 2.5% annualised in the six months to August, the largest such increase since November 2008. Leading indicators such as mortgage approvals and arranged but unused credit facilities are positive, while M&A activity may spur additional corporate borrowing. Liquidity growth has also been boosted recently by capital inflows from overseas, possibly partly reflecting spill-over from the ECB’s QE programme, which is scheduled to be sustained for another year.
The second risk is that recent velocity stability will give way to a renewed decline, implying that 6% liquidity growth is compatible with meeting the inflation target. This would mirror developments in the 1990s, when velocity stabilised for several years after the 1990-91 recession before resuming a downtrend later in the decade. This fall occurred, however, only after interest rates had been raised to well above the prevailing level of inflation, restoring the attraction of bank deposits as a savings vehicle. Governor Carney’s suggestion that the future norm for rates will be no higher than 2.5%, however, implies that real deposit rates will remain low or negative for the foreseeable future.
The current environment may bear greater similarity with the late 1960s / early 1970s, when a period of velocity stability gave way to a sustained rise, partly because interest rates failed to keep pace with an increase in inflation, resulting in savers wishing to reduce their money holdings. A velocity pick-up now would guarantee a future inflation overshoot.
Money supply analysis is rarely straightforward and analysts can reasonably disagree about the interpretation of current trends. The MPC should, at least, examine and explain the issues. The current mix of doctrinal aversion and lack of interest is a recipe for another policy mistake.
*The money / liquidity growth data in the chart refer to end-quarters, except for the final points, which are for August.
**RPIX = retail prices excluding mortgage interest.
***Velocity is calculated here as the ratio of GDP at market prices at an annualised rate to the stock of broad liquidity eight quarters previously. A lag is applied to allow for the delayed impact of monetary changes on output and prices.
Chinese money and credit numbers for September indicate that economic prospects continue to improve. Brazilian numbers give the opposite message.
Two features, in particular, of the Chinese data warrant increased optimism. First, annual growth in narrow money M1 rose further to 11.4%, the fastest since April 2013 – see first chart. Secondly, growth in the total stock of financing to non-financial enterprises and households held steady at 12.5%, up from a recent low of 11.9% in June. The recent stabilisation / reversal in financing growth suggests that the “credit impulse” is turning positive, undermining a key strand of the bearish case.
The preferred Chinese money measure here is “true” M1, which adds household demand deposits to the official M1 aggregate. A September number for demand deposits is not yet available, but a further rise in annual true M1 growth is highly likely, based on the official M1 number.
By contrast, the annual change in Brazilian M1 dived deeper into negative territory in September, reaching -6.2%, considerably worse than a -3.5% low during the 2008-09 recession. Inflation, moreover, is much higher now than then: real (i.e. consumer price-deflated) M1 contracted by 14.3% in the latest 12 months.
Growth in the broader M3 measure, meanwhile, has fallen sharply, while bank lending continues to decelerate – the credit impulse is certainly still negative in Brazil.
The consensus view seems to be that the Chinese authorities should ease monetary policy further, while their Brazilian counterparts must maintain high rates until inflation subsides. Money trends argue the opposite. The Chinese M1 surge is evidence that policy is already sufficiently, and possibly excessively, stimulative. The monetary carnage in Brazil, by contrast, signals that inflation will collapse as soon as the exchange rate stabilises. An immediate rate cut is warranted and could trigger a currency rally, by stemming capital outflows associated with fear of a prolonged economic slump.
Equity markets weakened during the third quarter amid investor concerns about the impact of expected Federal Reserve policy tightening and slower growth in China and other emerging economies. Our monetary analysis suggests that the Chinese economy will regain momentum in late 2015 / early 2016, while US growth will remain moderate, allowing the Fed to proceed cautiously with rate rises. Such a scenario would probably be favourable for markets.
The equity swoon was not, in our view, due to any negative shift in current liquidity conditions. Global real (i.e. inflation-adjusted) money growth is solid by historical standards and well above economic output expansion, implying “excess” liquidity – see first chart*. Central bank policies, meanwhile, remain expansionary, with QE programmes proceeding in Japan and the Eurozone, and China and India cutting official rates and reserve requirements last quarter.
Rather than tighter liquidity, we attribute market weakness to a rise in investor risk aversion due to Fed / EM concerns and a series of negative “shocks”, including another Greek “crisis” in July, a change in China’s exchange rate policy in August and the Volkswagen emissions cheating scandal in September. Investors are now overly pessimistic about economic and earnings prospects, in our view.
China is key to the outlook. Industrial output growth slowed sharply in early 2015 and remained below-par over the summer. This weakness had been signalled by a contraction of our preferred real money measure in late 2014 – second chart**. This measure, however, has rebounded since early 2015, indicating that People’s Bank of China (PBOC) policy easing has more than offset a liquidity drain from foreign exchange intervention to support the renminbi. Fiscal policy is also turning expansionary, having been unintentionally harsh in early 2015. Economic news, therefore, should improve in late 2015 / early 2016.
Pessimists counter that the slump in Chinese stock prices will depress consumption, while exports will remain weak unless the exchange rate is allowed to fall significantly. Stocks, however, are not widely owned and consumer confidence has risen over the summer, partly reflecting a reviving housing market. Chinese exports, meanwhile, are outperforming, arguing against claims that the currency is overvalued: a 5.5% fall in US dollar terms in the year to August compares with a double-digit decline in global trade. The change to the fixing mechanism in August appears to have been made in order to satisfy conditions for the renminbi to be added to the basket of currencies forming the IMF’s special drawing right (SDR), rather than to open the door to a large depreciation.
Consensus pessimism about China contrasts with optimism about US economic prospects and associated worries that the Fed will be forced to tighten monetary policy significantly. US real money growth, however, has fallen sharply since early 2015 and is now below the pace in other G7 countries, suggesting that economic expansion will slow in late 2015 / early 2016 – third chart. The Fed is still likely to raise interest rates in response to a gradually tightening labour market but the risk of a series of closely-spaced increases has receded.
Opposite US / Chinese money trends have contributed to a convergence of real money growth between the G7 and an “E7” grouping of seven large emerging economies – fourth chart. Historical evidence suggests that the sign of the E7 / G7 real money growth gap is relevant for assessing whether EM equities will outperform developed markets: for example, EM stocks outperformed when the gap was last significantly positive in 2010-11 but have lagged since it turned negative in 2011. An increase in EM exposure may be warranted if the current small positive gap is sustained or widens further.
Within developed markets, real money growth is strong in Sweden, Australia and the Eurozone and weak in Switzerland as well as the US, with Canada, the UK and Japan mid-range – fifth chart. Economic and equity market prospects may be better in the former group. Within the Eurozone, real money growth is notably robust in France and is slightly higher in the “core” than the “periphery”***.
In emerging markets, real money growth is strong in Korea and Mexico, and solid in China, Taiwan and India; the pace of contraction has slowed sharply in Russia but remains alarming in Brazil, probably reflecting very high real interest rates – sixth chart. Favourable monetary trends in most EM economies support the view that consensus pessimism is overblown.
*”Global” = G7 developed countries and seven large emerging economies (“E7”). Narrow money = currency in circulation plus demand deposits and close substitutes. Broad money = narrow money plus time deposits, notice accounts, repos and bank securities. Precise definitions vary by country. Narrow money has been more reliable than broad money for forecasting purposes historically and is consequently emphasised in the analysis here.
**True M1 = currency in circulation plus demand deposits of corporations, government organisations and households.
***”Core” = Germany, France, Netherlands, Belgium, Austria, Luxembourg; “periphery” = Italy, Spain, Ireland, Portugal, Greece.