Annual consumer price inflation fell unexpectedly to 0.9% in October and could undershoot the Bank of England’s 1.25% forecast for the fourth quarter. Sadly, this does not warrant any change to the view that inflation will rise sharply in 2017, probably exceeding 3% during the course of the year. Currency and commodity price effects are still a significant net drag on inflation currently but should deliver a major boost in early 2017. Strong monetary growth and a tight labour market, meanwhile, suggest that upward pressure on inflation will be sustained over the medium term.
“Core” CPI inflation – excluding energy, food, alcohol and tobacco – declined to 1.2% in October, a five-month low, with significant downward contributions from clothing (reversing a September boost), games and toys, student tuition fees and hotels. Changes in core inflation in recent years have been positively correlated with swings in the rate of change of manufactured import prices, lagged by a year – see first chart. The annual import price change reached a low of -5% in November 2015 but had rebounded to 5% by September 2016, with a double-digit gain likely by early 2017, based on the current level of sterling. This suggests a rising trend in core inflation from end-2016 through late 2017, at least.
Headline CPI inflation is still below the core rate currently because of negative and neutral contributions respectively from food and energy prices. With sterling commodity prices, however, currently 40% above their level at the start of 2016, the headline / core gap will soon turn positive and may reach 1-2 percentage points later in 2017 – second chart.
Faster headline price rises are more likely to feed back into higher wage demands now than when inflation spiked in 2008 and 2011, because the labour market is much tighter than then. The percentage of CBI industrial firms reporting a shortage of skilled labour rose to its highest since 1989 in October – third chart. EU free movement will no longer act as an automatic safety valve to prevent labour market overheating.
The monetary backdrop, in addition, is more inflationary. Annual growth of broad money, as measured by non-financial M4, fell sharply during the 2008 inflation spike and was below 2% in 2011; it rose to 6.8% in September 2016, an eight-year high – fourth chart. Broad money velocity fell by 1.1% per annum (pa) on average over the five years to mid-2016. If this rate of decline were to continue, sustained money growth of 6.8% pa would imply nominal GDP expansion of more than 5.5% pa, in turn suggesting 3% plus inflation, assuming a potential output rise of no more than 2.5% pa.
Global monetary trends have been giving a reflationary message since early 2016. The US election results appear to have acted as a trigger for sceptical investors to adjust their portfolios in this direction. This adjustment probably has further to run.
Annual growth of global (i.e. G7 plus emerging E7) narrow money bottomed in mid-2015 and has vaulted higher since early 2016, with a September reading of 11.6% the equal highest (with August / September 2011) since 2009. Large movements in narrow money growth lead swings in nominal GDP expansion, which appears to have bottomed in the fourth quarter of 2015 – see first chart. The recent upswing in narrow money growth is the largest since 2008-09.
The positive narrow money signal has been confirmed by an upswing in a non-monetary global leading indicator derived from the OECD’s country leading indicators. Six-month growth of this measure rose further in September, according to data released this week – second chart.
An additional reason for the positive economic view here is an assessment that the three- to five-year US Kitchin stockbuilding cycle is at or close to a trough. Stocks were little changed in the third quarter and their ratio to final sales has fallen significantly – third chart. The upswing out of the last US Kitchin cycle trough in 2012 was associated with strong global equity markets, outperformance of “cyclical” stocks relative to “defensives”, and rising longer-term government bond yields.
The increase in yields in 2013 contributed to underperformance of emerging market assets, reflecting a vicious circle of capital outflows, tighter domestic monetary conditions and economic weakness. The E7 grouping, however, is leading the current growth upswing and narrow money trends are much stronger than in 2013, both in absolute terms and relative to the G7 – fourth chart. Another contrast is that commodity prices were soft in 2013 but are now strengthening, implying an income gain for some emerging economies.
Some commentary has suggested that rising US long-term yields and associated US dollar strength are squeezing global liquidity, threatening economic prospects. A steepening yield curve, however, normally signals an improving economic outlook and is particularly noteworthy when accompanied by strong monetary expansion. The slope of the yield curve is a component of several of the OECD’s country leading indicators, including the US, Japan and Germany. The recent steepening, therefore, may sustain the upswing in the global leading indicator tracked here.
The ratio of the MSCI World cyclical sectors index to the counterpart defensive sectors index has risen by 16% from a low reached in early July after the Brexit referendum, a larger gain than during the last global economic acceleration in 2012-13 – fifth chart. The fall into the July low, however, arguably partly reflected a false assessment of the implications of the UK vote, while the global growth / inflation outlook is judged here to be stronger now than in 2012-13. The cyclical / defensive relative rose by 45% during the 2009-11 economic upswing.
Global monetary growth remained strong in September, suggesting that the current upswing in economic momentum will be sustained through mid-2017 (at least), based on the historical average nine-month lead from money to output.
Annual growth of narrow money in the G7 major economies and seven large emerging economies (the “E7”) rose to 11.7% in September, the fastest since 2009 (slightly exceeding a 2011 peak of 11.6%). Broad money growth firmed to 7.5%, the fastest since 2013 – see first chart.
The forecasting approach here emphasises the six-month growth rate of real (i.e. consumer price-adjusted) narrow money. This edged down in September from August’s seven-year high, reflecting both a decline in nominal expansion and higher inflation. There was a similar downtick in six-month real broad money growth – second chart.
The third and fourth charts show adjusted real narrow money growth measures. The red line applies the historical average nine-month lead from real money to output and also adjusts for a long-run downward trend in the rate of change of narrow money velocity. The green line additionally incorporates the slope of the G7 government yield curve, which has also performed impressively as a leading indicator historically (but may be less reliable now because of central bank manipulation of bond markets). As the fourth chart shows, current G7 plus E7 industrial output growth is broadly in line with the “forecasts”, which are signalling a further pick-up in momentum through spring 2017.
The small decline in G7 plus E7 six-month real narrow money growth in September reflected a fall in the G7 component, which is nonetheless much stronger than a year ago. E7 real money growth, by contrast, rose to a new six-year high – fifth chart.
Six-month real narrow money growth rates are similar across the major developed economies. Japan remains at the top, consistent with recent equity market outperformance, with the UK in the middle, arguing against the consensus view that UK GDP growth will be below the G7 average in 2017 – sixth chart.
In the E7, Indian real narrow money growth has surged to match Chinese buoyancy. Brazilian weakness is abating but a renewed contraction in Russia suggests that recovery hopes will be disappointed – seventh chart.
The UK economic outlook was uncertain in the wake of the Brexit vote. The provisional assessment here was that the economy would slow significantly but that official / consensus forecasts of stagnation or recession would be proved wrong. This assessment, however, was subject to revision depending on post-referendum monetary trends.
Three months on, it appears that the provisional assessment was unduly conservative. Monetary trends have remained strong since the referendum and suggest rising nominal GDP growth with stable real-terms expansion.
The preferred narrow and broad monetary aggregates here are non-financial M1 and M4, covering money held by households and private non-financial firms. M1 comprises notes / coin and sterling sight deposits; M4 also includes sterling time deposits, money funds, repos and short-term bank securities. These measures grew at annualised rates of 10.5% and 7.8% respectively between end-June, just after the referendum, and end-September. The Bank of England’s M4ex broad money aggregate expanded at a 10.0% rate over the same period, boosted by rapid growth of deposits held by insurance companies / pension funds, unit / investment trusts, other fund managers and securities dealers – movements in such deposits, however, contain little information about near-term economic prospects (hence the preference here for non-financial money measures).
12-month growth rates of non-financial M1, non-financial M4 and M4ex were 10.2%, 6.8% and 7.7% respectively in September. The two broader aggregates are rising at their fastest pace since 2008. Non-financial M1 growth exceeded 10% between May 2013 and June 2014, ahead of several quarters of strong nominal and real economic expansion.
The 12-month growth rates have been trending higher since early / mid 2015. Swings in non-financial M1 growth have consistently led those in nominal GDP expansion in recent years – see first chart. Annual nominal GDP growth rose between the third quarter of 2015 and the second quarter of 2016, and is likely to have increased further last quarter, based on last week’s preliminary real GDP estimate. (A first estimate of nominal GDP for the third quarter will be released on 25 November.) Monetary acceleration suggests that the pick-up will extend into spring 2017, at least.
Faster nominal GDP growth is likely to be driven by higher inflation, with output expansion broadly stable. The second chart shows two-quarter / six-month changes in real GDP and the money measures deflated by consumer prices. Growth of real non-financial M1 / M4 remains strong but has moderated slightly, reflecting a recovery in consumer price momentum. GDP may continue to rise at its recent pace of 2-2.5% annualised through next spring. The consensus forecast of 1.0% growth in all of 2017 (October Treasury survey, revised up from 0.7% in September) looks much too low.
Eurozone monetary trends remain positive but are no longer strengthening, suggesting stable GDP growth at around its recent pace of 0.4% per quarter, i.e. 1.5-1.75% annualised. This is above most estimates of potential, implying a continued decline in unemployment. Economic prospects may be improving in Spain / Italy relative to France / Germany, based on country narrow money data.
Annual growth of Eurozone-wide M3 was 5.0% in September and has moved sideways since early 2015. Annual M1 growth, however, has fallen from a peak of 11.8% in July 2015 to 8.5% in September. The combination of stable M3 expansion with slowing M1 has led some commentators to suggest that economic growth prospects have deteriorated at the margin.
The M3 and M1 numbers, however, have been pulled down by a sharp slowdown and recent small contraction in financial institutions’ deposits, possibly reflecting further reductions in interest rates – such deposits contain little information about near-term economic prospects. Annual growth of non-financial M1 – comprising holdings of households and non-financial corporations (NFCs) – was stronger than that of M1 in September, at 9.1%, and has slowed by less. Non-financial M3 growth, meanwhile, rose to 5.6% last month, its fastest since 2008 – see first chart.
Economic growth prospects depend on real rather than nominal monetary trends. Six-month growth rates of non-financial M1 and M3, deflated by consumer prices, have moderated recently but remain solid by recent and longer-term standards – second chart. The slowdown would need to extend significantly further to suggest weakening prospects, on the judgement here.
The decline in real narrow money growth has been focused on France and, to a lesser extent, Germany, with Spanish and Italian trends remaining upbeat, based on country data on overnight deposits – third chart. This may signal improving relative economic and equity market prospects for Spain / Italy, and deteriorating reelection prospects for President Hollande.