ECB President Mario Draghi’s press conference statements always end by stressing the importance of “full and consistent implementation of the Stability and Growth Pact”. The words ring hollow because the ECB’s monetary largesse has encouraged governments to abandon fiscal consolidation.
The first chart shows the EU Commission’s estimates of the Eurozone structural or cyclically-adjusted budget balance, expressed as a percentage of GDP*. The structural deficit was cut by an average of 0.8 percentage points (pp) of GDP a year between 2010 and 2014. It widened, however, by 0.1 pp in 2015 and is projected to increase by a further 0.2 pp in 2016.
The rise in the deficit is at odds with revised guidelines on the implementation of the Stability and Growth Pact (SGP) published in January 2015. These guidelines link the required annual fiscal adjustment in a country to the level of GDP growth and size of the “output gap” (i.e. the deviation of GDP from potential). The Eurozone output gap was -1.8% in 2015 while GDP grew by more than potential, according to the EU Commission. Under these conditions, governments are required to strengthen the structural balance by 0.25-0.5 pp of GDP**.
The EU Commission expects GDP growth to exceed potential again in 2016, with the output gap narrowing to 1.1%. The recommended annual improvement in the structural balance under these conditions is at least 0.5 pp of GDP.
The rise in the structural deficit in 2015-16 would be larger but for a fall in debt interest costs caused mainly by the ECB’s policy actions. Eurozone debt interest is projected by the EU Commission to fall by 0.4 pp of GDP between 2014 and 2016 – second chart. Excluding interest, therefore, the structural balance is expected to deteriorate by 0.6 pp in 2015 and 2016 combined.
So governments have spent the interest windfall gifted to them by the ECB and engaged in additional fiscal loosening, despite Eurozone gross debt standing at 93.5% of GDP at end-2015 – far above the 60% maximum stipulated by the SGP.
The change in trend of the structural balance in 2015 coincided with the ECB launching QE. The ECB’s bond-buying removed any remaining market discipline on national fiscal policies. Financing costs for high-debt countries have plunged and governments have moved swiftly to reverse earlier consolidation. Excluding interest, structural deficits in Italy, Spain and Portugal are projected by the EU Commission to widen by 1.1, 1.3 and 1.8 pp of GDP respectively between 2014 and 2016.
The hypothetical Martian visitor would surely conclude that the ECB has engaged in monetary financing of peripheral governments, notwithstanding Mr Draghi’s casuistic protestations to the contrary.
The Draghi monetary striptease will become yet more daring this week. His actions are unlikely to stimulate the economy but will provide further titillation for debt-addicted Eurozone governments.
*The structural balance also adjusts for one-off and temporary measures.
**The recommendation is 0.25 or 0.5 pp depending on whether gross debt is below or above 60% of GDP.
Narrow money growth in the E7 large emerging economies rose further in January, suggesting improving economic and equity market prospects.
With January data available for six of the seven countries, the six-month change in real (i.e. consumer price-adjusted) narrow money* is estimated to have risen to more than 5%, or nearly 11% annualised, representing the fastest growth since October 2010 – see first chart. The six-month change turned negative in December 2014 ahead of economic weakness in 2015.
The pick-up in growth since mid-2015 reflects a combination of stronger nominal money expansion and a slowdown in inflation, with the former dominating.
By country, China has been the key driver but additional boosts have come from a resumption of real money growth in Russia and a slowdown in the rate of contraction in Brazil. Real money expansion remains strong in Korea (latest data point December) and respectable in other E7 countries, although has slowed notably in Mexico – second chart.
Key concerns for emerging market investors are that the US economy will either enter a recession in 2016 or reaccelerate strongly, prompting the Fed to press ahead with interest rate hikes. Current evidence suggests that a middle course of sub-par expansion is more likely.
A recession is not the main case scenario here because 1) US real narrow money has yet to contract, as it has before most prior recessions, and 2) consumer expectations are holding up, suggesting that consumption growth will continue to offset weakness in business spending. Expectations usually fall sharply at the onset of recessions – third chart. Energy price declines have provided important support recently, so an early, large oil price rebound would be concerning.
Strong economic reacceleration is deemed unlikely because 1) US narrow money trends remain weak and 2) the Kitchin inventory cycle is in a downswing. According to revised national accounts data released last week, the ratio of real non-farm inventories to sales of final goods and structures rose to an 18-quarter high at the end of 2015, with the deviation from the long-term downward trend the largest since the second quarter of 2009 – fourth chart. Assuming that final sales grow at a 2% annualised rate, and stockbuilding adjusts smoothly, a return to the long-term trend by end-2016 would imply a drag of 0.5-0.75 percentage points on GDP growth in the year to the fourth quarter.
Emerging market investors are also concerned about Chinese economic weakness. February purchasing managers’ survey headline numbers were modestly disappointing from the perspective of the optimistic view of Chinese near-term prospects here but upcoming “hard” data for January / February will be more important for assessing developments. There were some promising signs in the details of the surveys: for example, order backlogs in the official manufacturing survey rose to a four-month high while activity expectations improved sharply – fifth chart**.
*Narrow money = “true” M1 for China, M1 for other countries.
**Own seasonal adjustment applied to official data.
The consensus expects sluggish UK economic growth in 2016, reflecting global weakness, fiscal tightening and a small or large negative impact from the Brexit referendum – depending on its outcome. Strong money and credit trends suggest upside risk to this forecast.
UK GDP rose by 0.5% in the fourth quarter of 2015 versus an increase of 0.3% in the US and Eurozone and a 0.4% contraction in Japan. Monthly output numbers indicate positive carry-over into the first quarter. A strong rise in unfilled vacancies – a good coincident indicator – in the three months to January suggests a solid start to 2016.
The preferred broad and narrow monetary aggregates here are “non-financial” M4 and M1, comprising money holdings of households and private non-financial corporations (PNFCs). Financial sector money has less immediate relevance for economic prospects.
Non-financial M4 rose by 0.5% in January, pushing annual growth up to 5.8%, the fastest since June 2008. Non-financial M1 increased by 0.8%, lifting annual growth to a 13-month high of 7.8% – see first chart.
Annual non-financial M4 growth was depressed last year by households switching out of bank deposits into National Savings pensioner bonds before the May general election. This distortion is now unwinding as the one-year bonds mature and some cash flows back to the banking system – National Savings lost £150 million in January versus a £6.9 billion inflow a year earlier.
Annual growth in the Bank of England’s favoured broad aggregate, M4ex*, was lower at 4.0% in January, reflecting its inclusion of financial sector money, which contracted by 6.5% in the latest 12 months. Detailed data show significant falls in money holdings of insurance companies and pension funds, other fund managers and securities dealers recently. These declines may have negative implications for financial market prospects but are unlikely to signal any slowdown in household or corporate spending.
Credit trends, meanwhile, continue to strengthen. Annual growth of bank lending to households and PNFCs rose to 3.2% in January, the fastest since March 2009 – first chart. M4ex lending, which includes loans to financial corporations, rose by an annual 3.8%: the financial sector has stepped up its bank borrowing even as money holdings have been run down.
The lending pick-up was signalled by an earlier surge in arranged but undrawn credit facilities; growth in these has moderated but still suggests further lending acceleration – second chart.
The forecasting approach here places emphasis on the six-month rate of change of real (i.e. consumer price-adjusted) money. Major economic slowdowns or recessions have been preceded by sharp falls in six-month changes of real non-financial M1 and / or M4; both aggregates are giving a positive message currently – third chart.
*M4ex = M4 excluding money holdings of “intermediate other financial corporations”.
Eurozone January money and credit numbers were solid, signalling that the monetary backdrop remains growth-supportive and anti-deflationary. The ECB risks disrupting these conditions by pushing rates further into negative territory. Economic sluggishness reflects a combination of global weakness, heightened uncertainty and slow trend growth partly due to lack of reform. The ECB should stand pat unless money trends soften. If further easing turns out to be required, extending QE to bank bonds would be the best option.
The headline M3 and M1 aggregates bounced back from softness in December to rise by 0.7% and 1.0% respectively in January. Six-month growth rates were little changed at respectable rates of 2.3% (4.7% annualised) for M3 and 4.3% (8.8%) for M1 – see first chart.
Lending to households and non-financial corporations (NFCs) had contracted by 0.2% in December but more than made up the loss in January, rising 0.3%. Six-month growth ticked up to 0.6% (1.2% annualised).
These trends are stronger in real terms because energy price weakness has pushed the six-month change in consumer prices back into negative territory – first chart. The most reliable monetary leading indicator of the economy historically has been real non-financial M1*. Its six-month growth has moderated since early 2015 but remains solid, suggesting continued economic expansion – second chart. Real non-financial M1 has contracted before every recession since 1970 (at least – earlier data are patchy).
The ECB releases country data on deposits but not currency. Six-month growth of real M1 (overnight) deposits remains respectable in Germany / Italy and strong in Spain / France – third chart.
With little sign that recent economic softening is related to monetary conditions, the case for further policy easing is questionable. As previously discussed, a cut in the deposit rate to -0.4% or -0.5% risks being counterproductive by undermining banks’ ability and incentive to expand their balance sheets and reducing savers' income expectations, causing them to rein in spending. Policy-makers should recognise that a recovery in bank profitability is necessary to support credit creation and economic growth; extending the QE programme to bank bonds would be a good way of signalling this recognition.
*Non-financial M1 = currency and overnight deposits held by households and NFCs.
Monetary trends and leading indicators suggest that G7 economic growth will remain weak through the summer. The message for the E7* large emerging economies is more encouraging.
The first chart shows changes in G7 GDP and industrial output measured over two quarters / six months. Two-quarter GDP growth fell to an estimated 0.5% in the fourth quarter of 2015, or 1.1% at an annualised rate – the slowest since the second quarter of 2014. Industrial output, meanwhile, declined by 1.1% in the six months to December. Note that industrial output is significantly more volatile than GDP, so that a fall of at least 2% over six months would be needed to suggest GDP stagnation or contraction.
The second chart shows six-month changes in industrial output, real narrow money and a composite leading indicator based on OECD data. Real narrow money growth has slowed significantly since early 2015 but remains within its 2011-15 range. It would need to fall beneath this range to suggest a recession. Since the 1960s (at least – earlier data are patchy), every G7 recession has been preceded by a contraction of real narrow money.
The leading indicator, like industrial output, has fallen over the last six months but by less than the 2% GDP stagnation / recession “threshold”.
So both narrow money trends and the leading indicator are currently consistent with a continuation of recent sluggish GDP growth rather than a move into contraction.
The third chart shows the same three indicators for the E7 economies. The six-month change in E7 industrial output turned briefly negative in mid-2015 following a contraction of real narrow money in late 2014. Real money, however, reaccelerated strongly from spring 2015. Industrial output rose slightly in the six months to December and would be expected to pick up pace into the summer, based on the historical relationship.
The leading indicator is also giving a positive message, although has tended to be too optimistic in the recent past.
Divergent G7 / E7 narrow money trends mainly reflect opposite US / Chinese developments. From a monetary perspective, the main concern for global economic prospects is the weakness of US narrow money. The six-month change in real narrow money approached zero in October, recovered in late 2015 but has recently fallen back again – fourth chart**. The latest reading is still consistent with slow GDP expansion rather than a recession but further weakness would be troubling.
Elsewhere in the G7, real narrow money growth has fallen in Japan and, while currently still solid, is showing signs of tailing off in the Eurozone – January Eurozone data are released later this week. The seeming determination of the BoJ and ECB to push rates deeper into negative territory is discouraging for monetary prospects – see previous post.
In the E7, Chinese real narrow money growth is likely to cool from its recent supercharged pace but there is scope for recoveries in Russia and Brazil in response to interest rate / currency stabilisation – fifth chart. Six-month E7 real narrow money growth, therefore, may remain above the G7 level – sixth chart.
*E7 defined here as BRIC plus Korea, Mexico, Taiwan.
**February estimate in chart based on data for first week.