The forecasting approach employed here relies on the “monetarist” rules that:
1) The real or inflation-adjusted money supply predicts economic activity about six months in advance.
2) The nominal money supply influences prices / inflation with a longer and more variable lead-time of about two years.
These rules have worked better historically using a narrow money measure (i.e. a variant of M1, comprising currency in circulation and sight deposits), although broader aggregates should also be monitored for confirmation.
From this perspective, the current recession / deflation scare in markets stems from:
a) Slower global real narrow money growth since late 2011 – now being reflected in a loss of economic momentum.
b) Slower nominal money growth between the second half of 2009 and the second half of 2010 – reflected in a fall in inflation since autumn 2011.
As discussed in a post last week, the first rule suggests that the global economy will continue to slow at least through October, although real money has yet to signal a recession.
The second rule, more controversially, suggests that the current disinflationary trend will reverse in late 2012. A smoothed measure of G7 nominal money growth bottomed in September 2010 and rose strongly in 2011, consistent with G7 consumer price inflation troughing in autumn 2012 and picking up into 2013 – see chart.
The current recession / deflation scare is likely to result in additional central bank policy easing that may provide further fuel for an inflation upswing in 2013-14.
Such a scenario, needless to say, is at odds with the consensus and would be associated with a significant rebound in yields on Treasuries and other “safe-haven” government bonds later in 2012*. The gold price would probably rise sooner – confidence in the forecast would be strengthened by an extension of the recent rally.
*Speculators’ long position in US Treasury futures has risen further to a level exceeded on only six occasions over the last 10 years, all close to at least short-term lows in yields.