The forecasting approach in this journal places weight on the Friedmanite rule-of-thumb that changes in the real money supply lead demand and output by roughly six months. It is advisable to monitor the full range of money measures but narrow money, M1, has exhibited the most consistent relationship with the economic cycle historically.

The Friedmanite rule has worked well in recent years, albeit with a slightly longer lead than usual. The six-month rate of change of G7 real M1 turned negative in late 2007 ahead of the recession and bottomed in March 2008, 11 months before the six-month change in industrial output and nine months before that of the OECD G7 leading index, which is widely monitored by market participants. Real M1 expansion surged in late 2008 and early 2009, foreshadowing the strong recovery in G7 industrial activity over the last year – see first chart.

Monetary trends also signalled the current global industrial slowdown, with the six-month rise in G7 real M1 peaking as long ago as February 2009. The six-month increase in the OECD leading index reached a high eight months later in October 2009 with that of industrial output following in January 2010 – the same 11-month lag as at the cycle trough.

Importantly, however, the six-month change in real M1, while falling significantly, has remained positive in recent months, consistent with an economic slowdown rather than renewed contraction. It bottomed, moreover, in January 2010, picking up in May and, provisionally, June (the June estimate incorporates US and Japanese data only). Based on the lags at the prior two turning points, this suggests that the six-month change in the OECD leading index will bottom in September or October and that of industrial output in December.

Previous posts have explained that equities and other risk assets have, on average, performed better when real M1 has been growing more strongly than industrial output. The six-month change in real M1 crossed above that of the leading index in June, probably signalling a move above output expansion by late summer or early autumn. This could indicate an improving liquidity backdrop for markets later in 2010.

Monetary pessimists ignore M1 and emphasise recent contraction in G7 real broad money – second chart. The broad measure, however, failed to warn of the recession, continuing to grow strongly in late 2007 even as narrow money was weakening. The interpretation here is that the demand to hold broad money rose sharply as the financial crisis intensified but has been falling more recently, partly reflecting heavily-negative real deposit interest rates. Broad money, therefore, understated monetary tightness in late 2007 and is grossly overstating the degree of restriction now. Portfolio shifts are much less likely to have affected the demand for M1, which is more closely related to economic transactions.