The G7 longer leading indicator calculated here rose again in October, providing further support for the expected scenario of a revival of global growth into early 2015.
The leading indicator is designed to predict turning points in the six-month change in industrial output. It bottomed in May, trod water over the summer and increased sharply in September / October – see first chart. The six-month output change has recovered from a low in August and should continue to rise through early 2015, at least.
Importantly, the G7 industrial pick-up is expected to reflect growth recoveries in Japan and Eurozone countries (i.e. Germany, France and Italy) rather than US acceleration. The Eurozone longer leading indicator rose again in October, confirming the recent positive message from monetary trends and signalling an early improvement in business surveys – see previous post and second chart.
In Japan, production projections from the METI survey suggest that the six-month industrial output change – still negative in October – will rise to about 4% (not annualised) by year-end. The output recovery follows a solid rebound in retail sales – third chart.
Previous posts (e.g. here) described a simple investment rule for switching between global equities and cash based on the G7 longer leading indicator. The rule prefers equities or cash depending on whether the leading indicator is above or below its long-run average. The indicator is now marginally above the average, suggesting benign conditions for equities. (The alternative rule based on G7 “excess” money growth continues to favour equities.)
UK monetary growth remains broadly stable, suggesting continued solid economic expansion and rising domestic inflation.
The broad and narrow monetary aggregates judged here to be most informative for forecasting purposes are M4 and M1 excluding financial sector deposits*. Annual growth in the M4 measure was 4.9% in October, equal to the average over the past two and a half years. Annual growth in non-financial M1 was significantly stronger, at 9.0%, though has fallen from a peak of 12.0% in October 2013.
Previous posts argued that broad money growth of more than about 4% per annum (pa) is inconsistent with achievement of the 2% inflation target over the medium term, unless interest rates rise significantly. This is because the velocity of circulation of broad money is increasing as households and firms economise on money balances in response to negative real deposit interest rates. Measured velocity** has risen by 0.5% pa since the recession ended in the second quarter of 2009. This compares with a fall of 2.9% pa in the prior 10 years, when real interest rates were significantly positive – see chart.
Current broad money growth of about 5% pa coupled with a velocity increase of 0.5% suggests nominal economic expansion of about 5.5%. Trend real economic growth is unlikely to be more than 2.5% pa, so nominal expansion of 5.5% implies an eventual rise in inflation to about 3%.
The forecast increase in nominal expansion is well advanced: annual growth in nominal gross value added (GVA) rose to 5.3% in the third quarter of 2014, a post-recession high, according to preliminary data. This was split between a 2.9% increase in output and domestically-generated inflation of 2.3%, as measured by the GVA deflator – see previous post. With the economy now operating near capacity, the output growth / inflation split is likely to become less favourable.
*Financial sector deposits are volatile and contain less information about near-term economic prospects.
**Nominal gross value added divided by non-financial M4 six quarters earlier. The six-quarter lag is a compromise based on the Friedmanite rule that money leads activity by about two quarters and inflation by about two years.
Eurozone monetary trends and leading indicators continue to strengthen, suggesting a significant pick-up in economic growth in the first half of 2015, barring external shocks.
Both narrow and broad money have surged since the ECB imposed a negative interest rate on excess reserves in June. Narrow money M1 rose by 9.8% annualised in the four months to October, with the broader M3 measure up by 4.6%.
Real or inflation-adjusted monetary trends anticipate changes in economic activity about six months ahead, according to the monetarist rule. Six-month growth of real M1 and M3 is the highest since October 2012 and March 2009 respectively – see first chart.
Pessimists will focus on a continued contraction of private sector credit. Money leads the cycle while credit usually lags or detaches. There was a similar money / credit divergence in the UK in late 2012. The monetary signal was correct: economic growth surprised positively in 2013.
The encouraging message from monetary trends is confirmed by the longer leading indicator*, which bottomed in May and rose further in October – second chart. The indicator typically leads turning points in six-month industrial output momentum by 4-5 months, suggesting that an economic pick-up is already under way.
Narrow money is growing solidly in all four major economies, with Spain strongest and Germany lagging slightly – third chart.
*The indicator uses the same components as the OECD’s Eurozone leading indicator but is designed to give earlier warning of growth turning points. It is calculated independently, allowing an estimate for a particular month to be produced by the end of the following month.
A post last week drew attention to a pick-up in world trade, as measured by the volume index compiled by the Netherlands CPB research institute. The CPB yesterday reported a strong 1.9% monthly rise in its index in September. Six-month growth climbed to 4.2%, or 8.5% annualised – the highest since January 2011.
The CPB notes that the September increase was broadly-based, with “import and export volume growth accelerating in most advanced and emerging regional blocks (sic), the main exception being the United States”.
Global industrial output has lagged the pick-up in trade but six-month growth in the CPB's production measure rebounded in September after a weak August, to its highest since April – see chart. The expectation here remains for output to accelerate further into early 2015, consistent with solid real money expansion during the first half of 2014 and more recent strength in leading indicators.
GDP price statistics in today’s revised third-quarter report confirm that domestically-generated inflation has risen since early 2014, in line with an earlier pick-up in monetary growth. The annual increase in the deflator for “gross value added at basic prices” – a measure of prices of domestically-produced goods and services – was 2.3% last quarter, up from 1.3% in the first quarter and the highest since the third quarter of 2012.
GDP price statistics, admittedly, are often revised significantly. The 2.3% third-quarter figure, however, is consistent with analysis in a previous post suggesting that consumer price inflation would now be 2.0-2.5% rather than 1.3% in the absence of falls in global commodity prices and sterling appreciation.
In an October speech, MPC member Kristin Forbes suggested using two variants of the GVA / GDP deflator to assess domestically-generated inflation: the GVA deflator excluding government and the GDP deflator excluding exports. The former measures private sector domestic inflation while the latter focuses on domestic production sold in the UK. The annual rises in the two measures in the third quarter were 2.2% and 4.1% respectively – see chart.
Meanwhile, annual inflation of services producer prices – another measure cited by Dr Forbes – rose to 1.5% in the third quarter from 0.8% in the first quarter and 1.3% in the second.
The monetarist rule of thumb is that inflation follows monetary growth with a variable lag averaging about two years. Annual expansion of the broad non-financial M4 money measure peaked in May 2013, slowing only modestly since, suggesting that underlying inflation will continue to firm into mid-2015.