The ECB has signalled a likely rate rise in April but there is a much stronger case for monetary policy tightening in the US.

Real narrow money, M1, rose by 3% (not annualised) in the US in the six months to January versus a 1% contraction in Euroland – see first chart. M1 comprises currency and checkable / overnight deposits and is usually a better leading indicator of the economy than broader measures. The current divergence suggests that US growth will remain strong during 2011 while the Eurozone is about to slow sharply.

US M1 buoyancy cannot be attributed simply to QE2. Growth started to pick up last spring well before the Federal Reserve signalled another round of securities purchases. M1 does not include bank reserves at the Fed, which have risen 30% since QE2 started.

The US M1 pick-up has fed through to stronger economic expansion, an improving labour market and rising capacity pressures. Core inflation, meanwhile, is bottoming. A leading indicator of monetary policy based on changes in unemployment and core inflation and the ISM manufacturing supply bottlenecks measure has moved into the tightening zone for the first time since 2007 – second chart. (Caveat: the current Fed may behave differently.)

Central banks rarely commence policy tightening when narrow money is weak (whether or not they monitor it). The ECB's hawkishness recalls Bank of Japan rate rises in 2000 and 2006, which occurred against a backdrop of slowing (not contracting) real M1 and were subsequently reversed as the economy turned down. (In defence of the BoJ, economic weakness mainly reflected global rather than domestic developments.)

Note that M1 often slows after the first increase in interest rates, as money-holders switch out of demand deposits into higher-yielding time deposits and savings accounts. Such a portfolio shift may have limited implications for economic growth so M1 weakness may coexist with further rate rises (e.g. the US in the mid 2000s).