UK inflation: Easter effect obscures strong upswing

Posted on Tuesday, April 11, 2017 at 02:37PM by Registered CommenterSimon Ward | CommentsPost a Comment

UK annual consumer price (CPI) inflation was stable at 2.3% in March but remains on course to move above 3% in the second half of 2017, implying a significant overshoot of the Monetary Policy Committee’s central forecast (showing inflation of 2.6% and 2.7% in the third and fourth quarters respectively).

CPI inflation was suppressed by a 23% year-on-year fall in air fares due the later timing of the Easter holiday this year compared with 2016. This effect subtracted 0.2 percentage points from the headline rate but will reverse in April.

The forecast of a move above 3% is based on “core” inflation – defined here as the annual CPI increase excluding energy, food, alcohol, tobacco and education, and adjusted for VAT changes – rising to about 2.5% by late 2017 and the headline / core gap climbing to more than 1 percentage point. The air fares effect resulted in the core rate retreating from 1.9% in February to 1.7% in March – see first chart. Seasonally-adjusted core prices, however, rose at a 2.5% annualised rate in latest three months from the prior three, consistent with the forecast – second chart.



The headline / core gap, meanwhile, increased to 0.6 percentage points in March, the highest since 2013, and the lagged relationship with sterling commodity prices suggests that it will peak well above 1 percentage point later in 2017 and remain elevated into 2018, unless commodity prices weaken or the exchange rate rallies significantly – third chart.


A post last month argued that inflation is rising in lagged response to a significant increase in monetary expansion between 2011 and late 2016. The fall in the exchange rate has been part of the “transmission mechanism” from loose money to faster price rises, rather than being a primary driver. The historical evidence is that money growth peaks lead core inflation peaks by between two and three years. Assuming that annual broad money growth topped out last autumn*, the suggestion is that inflation will remain under upward pressure through late 2018, at least.

*Annual growth of non-financial M4 peaked at 6.8% in September 2016, falling to 5.4% in February 2017 – see previous post.

A "monetarist" perspective on current equity markets

Posted on Monday, April 10, 2017 at 03:05PM by Registered CommenterSimon Ward | CommentsPost a Comment

Global economic growth remained robust in early 2017 but monetary trends and leading indicators suggest that strength will fade from the spring. Central banks may continue to withdraw policy stimulus despite slower economic momentum because of late-cycle inflationary pressures. Lower real money growth implies a less favourable liquidity backdrop for markets, while earnings may fall short of expectations as the global economy cools.

On our calculations, GDP in the G7 major economies and seven large emerging economies (the “E7”) rose at a 2.8% annualised pace in the fourth quarter of 2016 after a 3.2% third-quarter gain. Average growth of 3.0% over the second half was the fastest since the second half of 2014. Business surveys signal continued strength in early 2017: J P Morgan’s global all-industry purchasing managers’ output index rose further between the fourth and first quarters.

Global economic acceleration was predicted by monetary trends. Our key global forecasting indicator is the six-month growth rate of real (i.e. inflation-adjusted) narrow money in the G7 plus E7 economies. Narrow money comprises currency in circulation and demand deposits – forms of money most closely related to economic transactions. Turning points in this indicator have consistently led turning points in G7 plus E7 industrial output growth over the past 50+ years, typically by between six and 12 months.

Real narrow money growth peaked in August 2016 at its fastest pace since 2009, suggesting that economic momentum would rise into spring 2017, allowing for an average nine-month lead. The subsequent monetary slowdown was exaggerated by India’s “demonetisation” programme, which resulted in narrow money M1 plunging by 30% between October and December. We have attempted to adjust for this distortion by recalculating our real money growth measure holding Indian M1 stable at its pre-demonetisation level. The adjusted measure fell sharply in late 2016 / early 2017, reaching an 18-month low in February – see first chart. Four-fifths of the decline in the measure since August 2016 has reflected weaker nominal narrow money expansion, with the remaining one-fifth due to higher inflation.


Our forecasting process seeks confirmation of monetary signals from a non-monetary composite leading indicator for the G7 plus E7 economies, derived from OECD country leading indicator data. This indicator combines a wide range of economic and financial series that have led activity fluctuations historically. Its average lead time at turning points is shorter than for real narrow money – typically four to five months. Six-month growth of the indicator plateaued in February, while one-month growth fell for a second month – second chart. This behaviour is consistent with the suggested scenario of global economic momentum slowing from a spring peak.


Real narrow money growth has fallen by varying amounts across the major economies. Weakness has been most pronounced in the US, suggesting that GDP expansion will fall short of Federal Reserve and consensus expectations – third chart. The UK has also slowed sharply recently. Growth, by contrast, is holding up in Euroland and Japan, and remains high in China. Brazil and Russia are bucking the trend, with real money growth reviving as inflation falls and policy eases.


With monetary trends giving mixed signals across countries, our base-case scenario is for a moderate global economic slowdown rather than significant weakness. This would be consistent with our economic cycle analysis, which suggests that the US / global stockbuilding and business investment cycles will remain in upswings through 2017. Such a scenario, however, requires our global adjusted real narrow money growth measure to stabilise or recover from its current position near the bottom of its post-crisis range – first chart.

Early- or mid-cycle economic slowdowns usually generate a swift central bank response and are associated with falling government bond yields and commodity price weakness. Late-cycle slowdowns, by contrast, are often accompanied by a rise in inflation due to tight labour markets, capacity constraints and productivity slippage, delaying policy relief and yield declines. The G7 unemployment rate is lower than at the peaks of the last two economic cycles – fourth chart. Upward pressure on wage growth and core inflation may keep central banks on a tightening tack despite softer economic data, with negative implications for equities.


Our analysis of data since 1970 indicates that major equity market declines have usually been preceded by one or more of the following conditions: 1) G7 annual real narrow money growth falling below 3%; 2) real money growth falling below industrial output expansion; 3) real money growth falling by 3 percentage points or more within six months. Conditions 1) and 2) are unlikely to be triggered soon but real money growth has declined from a peak of 8.6% in October 2016 to 6.5% in February; a further fall to 5.5% or lower by April, therefore, would meet condition 3) and warrant shifting to a defensive investment stance.

Relative real narrow money trends argue for overweighting emerging versus developed markets, and EAFE markets versus the US. E7 real money growth, adjusted for India’s demonetisation, remains above the G7 level, a condition associated with emerging markets outperforming on average historically – fifth chart. A sustained shortfall of US real money growth relative to other developed economies, meanwhile, would be reminiscent of the mid 2000s, when EAFE stocks outpaced the US market, partly reflecting a weakening US dollar.


Our previous quarterly commentary questioned consensus bullishness on the dollar on the grounds that a record capital outflow from Euroland, Japan and China had boosted the US currency in 2016 but was likely to slow in 2017. Recent data are consistent with this hypothesis and the reversal in capital flows may extend if US economic growth weakens relative to the rest of the world, as suggested by monetary trends. A recovery in the renminbi is possible in response to a rise in Chinese / US interest rate differentials in the first quarter and as Chinese policy shifts towards promoting a firmer exchange rate to defuse trade tensions with the US administration.

UK data wrap: positive current account surprise

Posted on Friday, March 31, 2017 at 02:14PM by Registered CommenterSimon Ward | CommentsPost a Comment

UK monthly sectoral output numbers suggest that quarterly GDP growth will slow to 0.4-0.5% in the first quarter from 0.7% in the fourth quarter. GDP price data, meanwhile, confirm a pick-up in domestic inflationary pressures, with the annual rise in the GDP deflator unrevised at 2.8% in the fourth quarter. The current account deficit fell sharply last quarter, reflecting stronger trade performance in both goods and services and a further fall in net income paid abroad.

Highlights of today’s batch of data releases include:

  • GDP fell by 0.2% between December and January to stand 0.3% above the fourth-quarter level. The decline spanned sectors, with services, industrial and construction output down by 0.1%, 0.4% and 0.4% respectively. The soft start to the quarter suggests downside risk to the Bank of England staff “nowcast” of 0.6% growth in the first quarter at the time of the March MPC meeting.

  • Services output growth in the third and fourth quarters was revised down slightly, resulting in a reduction in third-quarter GDP expansion from 0.6% to 0.5% with fourth-quarter growth unchanged at 0.7% rather than revised up (as earlier data had suggested).

  • The 2.8% annual rise in the GDP deflator in the fourth quarter was the strongest since 2008. The gross value added deflator – which excludes indirect taxes and subsidies – was up by 2.6%. Measured from the income side, employee compensation per unit of output rose by 2.3%, while the unit contribution of profits, rents and other income was up 3.1%. These numbers confirm that the current inflation pick-up has a significant domestic element.

  • The official measure of the household saving ratio fell to 5.2% in 2016 and 3.3% in the fourth quarter, a record low in data extending back to 1963. An alternative measure of the saving ratio derived from the financial / capital accounts remains significantly higher than the official series, giving a more favourable impression of consumer finances, but also declined last year – see first chart below and previous post for more details.

  • The current account deficit fell from 5.3% of GDP in the third quarter to 2.4% in the fourth, reflecting a smaller trade shortfall in goods and services and a further decline in the income deficit to the lowest since 2013 – second chart. The services trade surplus matched a previous record 5.4% of GDP last quarter as exports – particularly to non-EU countries – continued to grow robustly. The recent decline in the income deficit has been driven by a strong recovery in foreign direct investment earnings probably mainly due to the translation effect of sterling weakness and higher oil prices / profits – fourth-quarter earnings were up by 64% from a year earlier.

  • The combination of solid output expansion, accelerating domestic prices and a big decline in net income paid abroad resulted in gross national income surging by 7.4% in the year to the fourth quarter, the strongest annual increase since 2000 – third chart.




UK real money squeeze suggesting late 2017 weakness

Posted on Wednesday, March 29, 2017 at 01:36PM by Registered CommenterSimon Ward | CommentsPost a Comment

UK narrow and broad money trends have weakened since the autumn, with rising inflation acting as a further drag on real-terms expansion. Allowing for the usual six to 12 month lag, this suggests that the economy will expand respectably through mid-2017 but slow sharply in the second half.

UK money trends are diverging negatively from those in the Eurozone. As noted in Monday’s post, annual growth of Eurozone narrow and broad money – as measured by non-financial* M1 and non-financial M3 – rose to 10.0% and 5.8% respectively in February, representing 16-month and eight-year highs. In the UK, by contrast, annual non-financial M1 growth peaked at 10.2% in September 2016 and fell to 8.6% in February, an 11-month low. Broad money growth – as measured by non-financial M4 – declined from 6.8% to 5.4% over the same period. The change of trend suggests that the recent pick-up in nominal GDP expansion will tail off and reverse later in 2017 – see first chart.


Shorter-term money trends signal a likely further decline in annual expansion. Non-financial M1 rose by 3.5%, or 7.2% at an annualised rate, in the six months to February, with non-financial M4 up by 2.0%, or 4.0% annualised. With consumer prices accelerating, six-month real growth of the two measures is the lowest since 2012 and 2011 respectively – second and third charts.



Why has money growth slowed? The demand to hold narrow money is influenced importantly by spending intentions, explaining why it leads the economy. Households and firms may be scaling back spending plans in response to Brexit uncertainty and rising prices / costs, with these negatives outweighing favourable global economic conditions. Real M1 holdings of households and private non-financial corporations (PNFCs) have slowed similarly, suggesting weaker prospects for both consumer spending and business investment – fourth chart.


Broad money fluctuations are viewed here as being driven by supply-side influences such as credit trends and balance of payments flows in the short run, with demand adjusting to supply further out. The recent slowdown appears to reflect a moderation of lending growth – second chart – and a rise in banks’ non-deposit funding. To the extent that the September-February QE programme had any positive impact, it was more than offset by other factors.

The MPC is now in a stagflationary bind of its own making. The failure to act to check rising money growth in 2015-16 suggests upward pressure on inflation through late 2018, at least – see previous post. Belated policy action, however, will be presentationally and politically difficult against the backdrop of a second-half economic slowdown suggested by real money trends.  A possible scenario is that the MPC will make a token reversal of its ill-advised August rate cut later in 2017 while relying on the Brexit excuse to deflect blame for poor inflation / growth outcomes and avoid a more significant policy adjustment.

*Non-financial = held by households and non-financial corporations (i.e. excludes financial sector money).

Eurozone money trends arguing for earlier ECB exit

Posted on Monday, March 27, 2017 at 04:24PM by Registered CommenterSimon Ward | CommentsPost a Comment

Eurozone narrow and broad money growth remains strong, suggesting a stable, solid economic outlook and rising pressure on the ECB to accelerate its “exit strategy”.

The narrow aggregate non-financial M1 – comprising currency in circulation and overnight deposits of households and non-financial corporations (NFCs) – has the strongest correlation with future GDP growth, according to ECB research. Annual growth of this measure was 10.0% in February, the fastest since 2015. The recent pick-up suggests that nominal GDP expansion will rise through 2017 – see first chart.


The broader non-financial M3 aggregate has also accelerated, with annual growth of 5.8% in January / February the fastest since 2009 – first chart.

The headline M1 and M3 measures include money holdings of financial corporations but these are volatile and contain little information about near-term spending prospects. Analysts focusing on the headline measures are at risk of underestimating future economic growth, as financial sector money has been falling – M1 grew by an annual 8.4% in February (versus 10.0% for non-financial M1) and M3 by 4.7% (versus 5.8% for non-financial M3) – second chart.


The third chart shows the two-quarter change in GDP and six-month changes in real (i.e. consumer price-deflated) non-financial M1 and its household / NFC deposit components. Real non-financial M1 growth has moderated since mid-2016 but remains solid by historical standards. The recent slowdown has been entirely due to a pick-up in consumer price inflation – nominal money growth has remained buoyant. Both household and NFC real deposits are rising strongly, suggesting solid prospects for consumer spending and business investment.


Some monetary economists attribute favourable monetary and economic trends to the ECB’s QE programme. The bulk of the rise in non-financial M1 growth, however, occurred over 2012-14 before QE started in March 2015. GDP expansion had also strengthened significantly before the QE launch – two-quarter GDP growth, indeed, peaked at 1.25% (2.5% annualised) in the first quarter of 2015. ECB interest rate cuts and lending to the banking system, and the slow repair of bank balance sheets, have probably been the key drivers of strengthening money trends.

Six-month real non-financial M1 growth is close to its average since 2013, a period during which GDP expanded by 1.7% per annum (i.e. between the fourth quarters of 2013 and 2016). The Eurozone unemployment rate fell by 0.8 percentage points per annum between end-2013 and end-2016. Current monetary trends, therefore, suggest GDP growth of about 1.75% during 2017 and a fall in the jobless rate from 9.6% at end-2016 to below 9% at end-2017. This would be close to the OECD’s estimate of the “NAIRU” (non-accelerating-inflation rate of unemployment) – fourth chart.


Such a scenario suggests rising pressure on the ECB to accelerate its “exit strategy”. In the US, the FOMC halted QE in October 2014 when the unemployment rate was 0.5 percentage points above the mid-point of the Committee’s "central tendency" range for the long-run equilibrium rate (i.e. 5.9% versus 5.35%). It began hiking rates in December 2015 as the jobless rate converged with this mid-point (by then reduced to 4.9%). If the ECB were to behave similarly, it might end QE in summer 2017 and raise rates at the start of 2018. It might, however, choose to reverse the order and lift rates first, on the view that an abrupt end to QE would risk undermining peripheral bond markets.