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The monetarist rule is that the (real) money supply leads economic activity by between six months and a year. This rule has worked well in recent years: G7 real narrow money contracted in late 2007 before the recession but surged in late 2008 ahead of the economic recovery from spring 2009.

G7 real money expansion fell back temporarily around the end of 2009 but rebounded to a peak last summer. This pick-up has been reflected in a strong global economy in early 2011. Real money, however, has continued to slow in recent months. Based on the monetarist rule, therefore, global growth should lose momentum from the spring.

Other evidence is starting to confirm this scenario. The chart shows the six-month growth rate of combined industrial output in the G7 and emerging “E7” economies together with a forecasting indicator based on the OECD’s country leading indices, which incorporate a wide range of economic and financial inputs. The indicator usually leads turning points in output expansion by between three and seven months and has fallen since December, suggesting a growth peak between March and July.

In contrast to late 2007, real money expansion and the leading indicator remain positive – they are not signalling major economic weakness, let alone the dreaded “double dip”. Directional changes in the indicator, however, tend to be sustained so a further decline is likely over coming months, in turn implying that the economic slowdown will extend into late 2011.

Importantly, the fall in G7 real money growth has been due to rising inflation rather than a slowdown in nominal monetary expansion. It does not, in other words, reflect any tightening of policy by the G7 central banks. Without policy restraint, inflationary pressures are likely to remain elevated. The outlook, therefore, is for slower economic growth but limited relief on inflation – an unappealing “stagflationary” prospect for markets.

Construction output bounced back strongly in February after weather-related weakness in December and January but the sector is still likely to act as a significant drag on the first-quarter GDP estimate released later this month. There should, however, be a corresponding boost to the second quarter.

Construction accounts for 6% of GDP. Output is estimated to have risen by a seasonally-adjusted 8% in February from an upwardly-revised January level but was still 9% below the fourth-quarter average and 14% lower than in November, before the snow struck. It seems reasonable to assume that the November level will be regained in March or April – construction new orders rose by 18% between the third and fourth quarters and surveys suggest that weakness was temporary. Assuming a March return and stable output thereafter, construction would subtract 0.4 percentage points from GDP growth in the first quarter while adding 0.8 points in the second.

The rest of the economy may grow by about 0.75% in the first quarter, assuming modest further gains in services output in February and March and a reversal of the February decline in industrial production. The construction effect would then imply GDP growth of 0.3-0.4%. This shortfall would be offset in the second quarter. If non-construction output rose by a further 0.5%, GDP expansion would increase to 1.3%, based on the above assumptions.

The Monetary Policy Committee kept Bank rate unchanged at 0.5% despite evidence that the medium-term inflation outlook has deteriorated since the February Inflation Report.

That Report itself signalled a need for policy tightening, forecasting above-target inflation of 2.5% in two years’ time if interest rates were held at 0.5%. The alternative projection based on market interest rate expectations was in line with the target but assumed that Bank rate would average 0.7% during the second quarter, implying a quarter-point increase in April or May.

Since February, actual inflation has again overshot the Bank’s projection while commodity prices are now stronger and sterling weaker than assumed in the Report. The Bank’s first-quarter inflation attitudes survey showed a rise in medium- as well as short-term inflationary expectations and wage settlements have moved up to an average 2.6% in the three months to February, versus 1.5% a year ago, according to Incomes Data Services.

Economic news has been mixed but not obviously softer than implied by the February forecast. First-quarter GDP could be held back by carry-over weakness in construction output following December’s bad weather but construction orders and surveys suggest a strong rebound (February output is released tomorrow). Services activity has recovered solidly in early 2011 while private-sector labour demand continues to firm, judging from hiring intentions and online vacancies.

The news since February, therefore, argues for a further upward revision to the Bank’s inflation forecast, which was already barely consistent with the target. The MPC’s continued inaction is, at least to this author, baffling. The Bank, it seems, is prioritising supporting growth and assuming that this objective can be traded off against higher inflation. Such an approach is both misguided and in conflict with its inflation-targeting remit.

The Japanese stock market has underperformed the World index by 16% year-to-date, incorporating currency moves, according to MSCI – see first chart. Continental Europe has been the best performer closely followed by Canada, in both cases partly reflecting currency strength.

Unless they hedged, investors who rushed to add to Japan in the immediate aftermath of the earthquake have been hit by a sharp fall in the yen, following G7 “concerted” intervention (apparently involving minimal use of foreign official funds) and a large injection of liquidity by the Bank of Japan – second chart. Bank reserves at the central bank surged from ¥14.7 trillion on 10 March, the day before the earthquake, to ¥36.5 trillion on 25 March.

This liquidity boost, however, has taken the form of an increase in net lending to the banking system rather than Federal Reserve-style QE. The Bank of Japan has raised its asset purchase programme by only ¥5 trillion, with buying to be spread over more than a year, implying a monthly rate of about ¥400 billion or $5 billion – the Fed, by comparison, is expanding its securities portfolio by $15-20 billion per week.

The Bank may be reserving its ammunition but the statement issued after today’s policy meeting does not suggest imminent radical action. The recent liquidity injection, therefore, is likely to reverse as conditions normalise and banks’ emergency demand for funds falls back. This process may be under way, with bank reserves down by ¥3.9 trillion from their peak, and may lend support to the yen and, by extension, relative Japanese equity performance.

The “MPC-ometer” predicted an average interest rate vote of +14 basis points in March, up from +8 bp in February and just above the +12.5 bp threshold suggesting a rate increase – see previous post. In the event, the average vote was unchanged at +8 bp (counting Adam Posen’s QE2 proposal as equivalent to a 25 bp rate cut).

The March minutes reveal that wavering members were concerned about economic weakness and unconvinced that inflationary expectations were becoming detached from the target. More recent news on these issues has been mostly hawkish.

Services and industrial output – accounting for 93% of GDP – rose strongly in January to stand 0.7% above the fourth-quarter level. The services recovery is more than a temporary bounceback, judging from upbeat business surveys – not just today’s PMI but also the EU Commission business / consumer services survey released last week and yesterday’s CBI financial services poll. GDP was held back in January by a further fall in construction output but this reflects carry-over from December’s bad weather disruption and should be reversed.

On inflation, the Barclays survey reported a further rise in both short- and longer-term inflationary expectations in the first quarter, confirming the Bank of England’s own poll (to which the MPC had early access at its March meeting). CPI and RPI figures again exceeded the consensus forecast in February, business survey pricing plans remain strong while pay settlements averaged 2.6% in the three months to February, up from 1.5% a year before, according to research firm Incomes Data Services.  

Policy shifts abroad could be a key factor tipping the MPC towards tightening. As of yesterday, sterling’s effective rate had fallen by 1.9% from the starting level assumed in the February Inflation Report, partly as a result of the ECB signalling an interest rate increase despite seemingly lesser inflation difficulties than in the UK. Recent strong US economic news could result in the Federal Reserve also shifting tack, risking a further slide in the pound with attendant inflationary implications if the MPC continues to stand pat.

The MPC-ometer has moved further in a hawkish direction this month, predicting an average interest rate vote of +16 bp, consistent with six members favouring an increase (assuming that Andrew Sentance continues to vote for 50 bp while Adam Posen maintains his dovish dissent). It must be admitted, however, that MPC communications have not suggested an imminent change in the current stalemate while proximity to the Budget may incline some members towards further delay.

Household real disposable income fell by 0.8% in 2010 but real wealth gained an estimated 2% to stand only 6% below its 2007 high. A rising wealth to income ratio should maintain downward pressure on the saving ratio, supporting consumer spending.

Household net financial wealth – the market value of financial assets minus debt – grew by 10.1% between end-2009 and end-2010, according to National Statistics figures published last week. This reflected a capital gain on equities and corporate bonds held within life assurance and pension schemes, supplemented by additional saving.

Total wealth includes housing. Official 2010 figures on housing wealth have yet to be released but the Department of Communities and Local Government house price index – a key input – rose by 3.7% in the year to December. Assuming the same increase in the value of the housing stock, total wealth grew by 6% or a real 2%.

This 2% rise follows a 9% gain during 2009, implying that real wealth has retraced two-thirds of its 15% decline during 2008 – see first chart. The ratio of wealth to annual disposable income was an estimated 7.0 at the end of 2010, a level bettered in only two previous years (i.e. 2006 and 2007). The wealth to income ratio is inversely correlated with the saving ratio so the rebound supports expectations that a further fall in the latter will insulate consumer spending from income weakness this year – second chart.

The consensus view that housing remains significantly overvalued reflects the high level of the house price to average earnings ratio. A national accounts version of this metric is the value of the housing stock divided by aggregate household disposable income. This stood at 4.31 at the end of 2010, 52% above the average of 2.84 since 1965 – see first chart.

The “equilibrium” level of prices relative to earnings, however, has trended higher over time as rising demand – due to an expanding population, a fall in average household size and the tendency to spend more on accommodation as income increases – has clashed with inelastic supply. The housing stock / aggregate income ratio at the end of 2010 stood 5% below a log-linear regression line – first chart.

A superior valuation metric is the ratio of prices to rents or its inverse, the rental yield. Rents already incorporate fundamental influences on housing demand and supply. People need to live somewhere – the choice is between buying your own home or renting, not between spending money on housing or retaining income for other purposes.

A national accounts version of the rental yield is the sum of actual and owner-occupied imputed rents divided by the value of the housing stock. This finished 2010 at 3.56% – almost exactly in line with its average since 1965, of 3.57%.

The yield reached a low of 2.77% in September 2007, consistent with house prices being overvalued by 29% (the percentage deviation of 3.57 from 2.77). This excess, however, has been eliminated by a combination of a 5% fall in prices – according to the Department of Communities and Local Government index – and a 24% rise in rents.

The statement that housing is not expensive does not, of course, preclude a fall in prices to an undervalued level, for example if a shock to household income resulted in forced selling. Displaced owner-occupiers, however, would add to the demand for rented accommodation. Any downside for prices from current levels is likely to be temporary and limited as long as rents continue to increase solidly.

A weighted average of services and industrial output rose by 1.2% in January, more than offsetting December’s 0.8% weather-driven fall – see first chart. The January level of output was equal to September’s recovery high and 0.7% above the fourth-quarter average.

Overall GDP, however, was depressed by a surprise further 9% fall in construction output in January following a 16% December plunge. GDP is estimated to have increased by only 0.6% after a 1.8% fall in December to stand 0.5% below its fourth-quarter average – first chart

Fortunately, construction weakness probably reflects carry-over from December’s bad weather disruption and output should recover strongly over coming months. Consistent with this view, construction orders, which lead output and softened in the middle of 2010, rebounded to a new recovery high in the fourth quarter – second chart.

The EU Commission’s UK business surveys for March are encouraging, showing significant rises in confidence across the services, industrial and retail sectors, in the former two cases to new recovery highs. Employment expectations, in particular, strengthened impressively, confirming an improvement in labour demand signalled by rising online job vacancies – see third chart and previous post.

Gilt yields have been suppressed by strong demand from banks and building societies, which bought a further £7.7 billion in February following £10.5 billion in January, according to monetary statistics released today. Purchases totalled £29.6 billion between November and February, more than in the first 10 months of 2010 and equivalent to 84% of net gilt issuance – see chart.

Banks are buying gilts partly under regulatory pressure but also because private sector demand for bank loans remains weak. Any revival in credit demand would probably slow the rate of purchases and put upward pressure on gilt yields. For the moment, banks are effectively delivering the QE2 stimulus sought by MPC arch-dove Adam Posen.

Increased bank demand for gilts has offset a recent slowdown in overseas buying, which was boosted last year by capital flight from peripheral Eurozone economies. Foreign investors purchased £3.5 billion of gilts in February and £13.2 billion in the last four months, down from £67.6 billion between January and October 2010. The Portugese debt crisis should support overseas gilt demand near term.

Other features of today’s monetary and revised GDP data include:

• The Bank of England’s favoured broad money measure, M4 excluding money holdings of “intermediate other financial corporations”, fell by 0.5% in February, causing three-month growth to slump to 0.5% annualised from 3.2% in January. The February decline, however, was the result of money-holders switching into foreign currency deposits (not included in M4ex), possibly in anticipation of sterling weakness. Foreign currency deposits, excluding holdings of intermediate OFCs, rose by £11.8 billion in February, equivalent to 0.8% of M4ex.

• Ignoring the foreign currency distortion, M4ex rose by 2.2% annualised in the six months to February, up from 1.6% in the prior six months. While growth remains sluggish, it is probably more than sufficient to finance trend economic expansion and 2% inflation given a rise in the velocity of circulation. Nominal domestic demand grew by 6.2% in the year to the fourth quarter despite M4ex expansion of only 1.8%. The Bank of England has recently acknowledged arguments for expecting velocity to continue to increase (see a box in the February Inflation Report and an article in the latest Quarterly Bulletin), implying that an acceptable M4ex growth rate may now be well below the minimum 5% previously suggested.

• M4ex growth of 2.2% annualised in the six months to February compares favourably with Eurozone M3 expansion of 0.6% over the same period.

• With the decline in GDP in the fourth quarter revised back to 0.5% from 0.6%, the Office for National Statistics now estimates that underlying output (i.e. excluding the impact of December’s bad weather disruption) was “broadly flat” versus last month’s assessment of a “slight fall”. Based on labour market and survey data, further upgrades are likely. Note that GDP growth in the fourth quarter of 2009 has been revised up from an originally-reported 0.1% to 0.4%.



Global monetary developments are signalling a prospective slowdown in economic growth and less favourable liquidity conditions for markets. The recovery in the Dow Industrials index since March 2009 continues to display a remarkable resemblance to the rally following the 1906-07 “bankers’ panic” bear market, a comparison also suggesting a need for caution.

Six-month growth of G7 real narrow money has slowed progressively from a peak in July, reaching an 11-month low in February – see first chart. The money supply usually leads economic activity by between six months and a year. The last trough in six-month real money growth in January 2010 preceded a low in six-month industrial output expansion 10 months later, in November. Assuming the same lead-time from the recent peak, industrial output should begin to slow from April. Business surveys should soon start to signal this shift.

In addition to the money supply leading economic activity, the gap between real money growth and industrial output expansion is a gauge of “excess” liquidity available to flow into markets and push up prices. Global equities, on average, have underperformed cash when real narrow money has risen more slowly than industrial output. Six-month real money growth crossed beneath output expansion in December, with the gap since widening.

Previous posts have compared the recovery in the Dow Industrials index since March 2009 with an average of rises following six prior bear markets when equities fell by about 50%. The Dow stood 6% above this “six-bear average” at Friday’s close while the average falls by 8% by the end of 2011 – second chart.

As discussed in a post in June last year, the recovery in the Dow since March 2009 bears the strongest resemblance to the rebound after the January 1906-November 1907 decline. Like the 2007-09 fall, the 1906-07 bear market was associated with a credit bust and financial panic. Both crises climaxed with the failure of a major institution – the Knickerbocker Trust Company in October 1907, Lehman Brothers in September 2008 – and a subsequent decisive rescue effort (co-ordinated by J P Morgan in 1907, before the institution of the Federal Reserve).

The 20% plus rise in the Dow suggested in the June 2010 post on the basis of this comparison has now occurred. US stocks entered another bear phase at the corresponding stage of the post-1907 recovery. A repeat performance would involve an imminent 14% correction in the Dow and a 20% fall by year-end – second chart.

Weakness on this scale is unlikely barring a major shock but less bullish economic news, slower growth in real money than output and the approaching end of QE2 suggest that equities and other risk assets face increasing headwinds.