Industrial output in the Group of Seven (G7) major economies recovered by 5% between March and September but was still down by 10% from a year before. G7 real money supply expansion, meanwhile, on narrow and broad measures is running at an annual 9% and 4% respectively – see first chart. The large gap between the rates of change of real money and output is a measure of the “excess” liquidity that has been pushing up stock markets, commodities and other “risky” assets.

On a six-month rather than annual basis, G7 output expansion has crossed above real money supply growth, implying that “excess” liquidity is no longer being created – second chart. The monetary backdrop for markets, therefore, is less favourable than in the spring but the huge money / output divergence of the prior six months should continue to buoy asset prices into early 2010. In other words, a “sell” signal awaits convergence of annual rather than six-month growth rates. Such a signal – annual output expansion rising above real money growth – occurred in 1987 and 1994, for example, and was associated with stock and bond market weakness respectively.

Real money growth – particularly narrow money M1 – leads output expansion by about six months. The annual rate of change of G7 real M1 reached a trough in August 2008 while the annual fall in industrial output bottomed in March 2009. Real M1 growth is likely to have peaked in September 2009, with a rise in headline inflation due to commodity price effects contributing to a significant slowdown into early 2010. This suggests that annual output expansion will reach a high next spring and fall back later in 2010.

G7 real broad money contracted in the six months to October. Previous posts have argued that this is unlikely to signal economic weakness because the demand for broad money has fallen in response to low interest rates and rising risk appetite. Put differently, broad money velocity is picking up after a plunge in late 2008 and early 2009. Real narrow money is a better guide to economic prospects – growth is slowing but remains solid by past standards, consistent with a moderation of output momentum within an ongoing economic recovery rather than a return to contraction later in 2010.