The ECB badly mishandled its communications strategy in the run-up to today’s meeting, with comments from President Draghi and leaks about 20 different easing measures being under consideration encouraging market expectations of much more aggressive action than the announced 10 basis point cut in the deposit rate and six-month extension of QE at an unchanged pace. The suspicion is that Mr Draghi overplayed his hand and ran into stiff German-led opposition based on doubts about the economic case for further easing and objections to an income transfer from core to peripheral banks implied by a larger cut in the deposit rate. With headline inflation set to rebound, surveys signalling solid GDP growth and M3 expansion above the ECB’s “reference value”, markets may conclude that the window for further action has closed, putting a floor under the euro, especially with Fed Chair Yellen remaining resolutely non-committal about a second US rate rise.
Global real narrow money* has been growing solidly in recent months, with strength in the Eurozone and China offsetting weakness in the US. Reflecting these trends, previous posts have suggested that:
1) Global economic growth would recover in late 2015 / early 2016.
2) The recovery would be driven by Europe / Asia, with US growth moderate at best.
3) This rotation would be welcomed by equity market investors, with stronger non-US growth supporting earnings expectations and a sluggish US tempering worries about the pace of Fed tightening.
Is this scenario panning out?
On 1), available data suggest that the six-month rate of change of global industrial output recovered further in October – see first chart. As noted on Monday, Korean companies are usually sensitive to changes in the global environment and have become significantly more optimistic, according to the latest Federation of Korean Industries survey. The Markit / J P Morgan global manufacturing purchasing managers’ index (PMI), however, was little changed in November.
On 2), the November manufacturing PMIs for Japan and the Eurozone were upbeat, while US results surprised negatively. The Chinese official and Markit / Caixin surveys, however, remained weak.
On 3), investors are sceptical that non-US growth can take up the baton if the US slows. Weaker US news, therefore, is producing a mixed market reaction, with earnings concerns offsetting the implied reduction in Fed tightening risk.
To summarise, the evidence to date partially supports the suggested scenario but more convincing signs of non-US economic improvement are needed – particularly better news from China.
When might this occur? Analysis of G7 data extending back to the 1960s indicates that real narrow money leads industrial output by nine months on average. This rule-of-thumb signalled, to within one month, the end of the 2008-09 recession: the six-month change in G7 real narrow money surged from August 2008, while the six-month industrial output change recovered strongly from April 2009 (i.e. eight months later).
Six-month growth of Chinese real narrow money rose significantly after March 2015, so the nine-month rule-of-thumb suggests a pick-up in industrial output momentum from end-2015. Allowing for reporting lags, therefore, Chinese economic news may show a convincing improvement in February / March 2016.
Risks to the suggested scenario include 1) the Chinese narrow money surge is a false positive signal and 2) the US economy is entering a period of weakness, rather than slowing modestly. The former possibility was considered in a previous post and judged to be unlikely. US weakness is a greater risk: in addition to slowing real narrow money expansion, the stocks cycle is turning down while corporate finances have deteriorated, questioning prospects for business investment and hiring. The monetary evidence, however, is currently flashing amber rather than red, with signs of improvement in weekly data for November – second chart**.
*Global = G7 plus emerging E7. Narrow money = currency in circulation plus demand / overnight deposits. Real = deflated by consumer prices.
**The final US data point is an estimate for November; other series are up to October.
Key UK money and credit measures continued to grow solidly in October, sending a positive message for economic prospects and supporting the case for an early rate rise.
The Bank of England’s broad money measure, M4ex, rose by 0.4% in October, pushing annual growth up to 4.5%, the fastest since January – see first chart.
The rate of increase of M4ex has been restrained recently by 1) a fall in financial sector deposits, which probably has little relevance for economic prospects, and 2) a switch of household deposits into National Savings (NS), which are not included in M4ex. A better guide to the availability of liquidity to finance private sector spending is the sum of M4 money held by households and private non-financial corporations (PNFCs) – i.e. “non-financial M4” – and outstanding NS. This increased by 0.6% in October, pushing annual growth up to 6.4%, the fastest since May 2008 – first chart.
The velocity of circulation of this measure has been broadly stable in recent years – see previous post. If velocity were to continue to move sideways, sustained 6% plus growth would be reflected, in time, in an equal rate of increase of national income. This, in turn, would imply inflation of 3.5% plus, assuming 2.5% trend output expansion. The MPC is unconcerned about, or oblivious to, this risk, judging from recent communications*.
The rise in broad money growth has been concentrated in the corporate sector, with annual growth of PNFC M4 rising to 12.7% in October, the fastest since June 2007.
Narrow money continues to expand more strongly than the broader aggregates. Non-financial M1 (i.e. currency in circulation and sight deposits of households and PNFCs) rose by 0.9% in October, lifting annual growth to 7.4%. This is, however, well down from a peak of 12.0% reached in October 2013.
Credit expansion is gathering pace, with the annual increase in M4ex lending up to 3.3% in October, the fastest since April 2009. Non-financial lending growth (i.e. to households and PNFCs) is lower, at 2.6%, although such lending has risen more strongly recently – at an annualised rate of 3.8% in the latest three months.
Of the various measures, real (i.e. inflation-adjusted) non-financial M1 has the best record as a leading indicator of the economy, accelerating before rises in GDP growth and contracting before recessions – second chart. Its six-month rate of increase has been little changed over the past year, consistent with GDP continuing to expand by about 2.5% per annum. Recent stronger broad money growth, however, suggests upside risk to this forecast.
*The word “money” did not appear in either the November or August Inflation Reports.
The Korean economy is often a bellwether of global trends, reflecting its openness* and wide-ranging industrial activities spanning electronic equipment, vehicles and capital goods. The Federation of Korean Industries (FKI) expected business conditions indicator rose sharply in November, with strength focused on manufacturing, particularly exports. This suggests that global trade and industrial output are regaining momentum, in line with a forecast based on monetary trends – see chart.
China is Korea’s largest export market, accounting for 26% of shipments in 2014 (versus 11% for the US). The rise in Korean optimism may indicate that Chinese demand is beginning to respond to monetary / fiscal policy easing.
*Exports of goods and services = 51% of GDP in 2014.
Whatever happened to the ECB’s “monetary pillar”? Annual growth of broad money M3 rose to 5.3% in October, comfortably above the central bank's 4.5% “reference value” – the rate “deemed to be compatible with price stability over the medium term”. Yet ECB President Draghi seems determined to push through a further easing of monetary policy at next week’s Governing Council meeting.
Bank lending growth remains subdued but ECB research shows that money leads credit rather than vice versa. October lending figures were encouraging, with loans to households and non-financial corporations (NFCs), adjusted for sales and securitisation, rising by 0.3% on the month, pushing annual growth up to 1.0%, the fastest since January 2012 – see first chart.
The monetary measure with the most impressive leading indicator properties, according to ECB research, is non-financial M1, comprising currency in circulation and overnight deposits of households and NFCs. This continues to rise strongly, with a 1.1% October gain pushing annual growth up to 10.9%, close to a recent 11.0% peak reached in July.
ECB doves argue that additional action is required because headline inflation remains close to zero, GDP growth fell back last quarter and external downside risks have risen, reflecting China’s slowdown. These reasons are unconvincing.
Commodity price weakness has obscured a significant pick-up in core inflation: the ECB’s seasonally-adjusted consumer price index excluding food and energy rose at a 1.4% annualised rate in the six months to October versus 0.8% in the prior half-year – second chart.
GDP expansion of 0.3% in the third quarter, down from 0.4% in the second, may well be revised up when a figure for fast-growing Ireland is incorporated. Even 0.3%, however, is above the IMF’s estimate of trend growth of 1.0% a year*, or 0.25% per quarter.
Downside China risk, meanwhile, was at a maximum a year ago when real narrow money was contracting. With money now surging and fiscal policy in overdrive, a positive surprise is more likely.