A post last week noted that global six-month real narrow money growth had risen to its highest level since 2009, suggesting economic strength in late 2016 / early 2017. A reader expressed scepticism about this forecast on the grounds that zero / negative interest rates are putting downward pressure on the velocity of circulation of narrow money – strong money growth, therefore, may reflect liquidity preference and have no implication for future activity.

It is true that the low level of interest rates has reduced the opportunity cost of holding narrow money, and the average level of real narrow money growth has been higher relative to industrial output expansion in recent years than during the post-WW2 period as a whole. The monetarist forecasting relationship, however, is directional – it relies on changes in real money growth leading changes in economic growth. This relationship remains strong.

The chart below shows global six-month industrial output growth and real narrow money expansion adjusted for 1) a long-run downward trend in the rate of change of velocity and 2) the average nine-month lag between turning points in real money growth and output expansion. This adjusted real money growth measure exhibits a significant contemporaneous correlation with output expansion*.

The economy was expected to lose momentum in early 2016, reflecting a slowdown in real narrow money expansion between February and August 2015. Recent economic weakness, therefore, does not constitute evidence that the predictive power of narrow money is waning. The adjusted real money growth measure suggests that the six-month change in industrial output will recover strongly between May 2016 and January 2017 (the last available month given the applied nine-month lead).

Zero / negative interest rates are helping to sustain a post-GFC rising trend in the ratio of narrow to broad money. Significant short-term changes in real narrow money growth, however, are still likely mainly to reflect changes in spending intentions, with implications for future economic activity. Economists and policy-makers historically have found various reasons to dismiss the significance of monetary trends; they have usually been wrong to do so.

*Correlation coefficient = 0.62 over 1965-2015 (51 years).