27th March 2015 by Simon Ward
Posts here from the summer onwards argued that faster Eurozone monetary growth, particularly of the narrow M1 measure, was signalling notably better economic performance in early 2015. The monetary signal was starkly at odds with consensus gloom, including recession warnings from the IMF and others, but has been vindicated by recent data. The Citigroup Eurozone economic surprise index has been strongly positive since early February, while the composite PMI output index rose to a 46-month high in March, according to this week’s flash data.
The earlier posts noted that narrow money growth was particularly strong in Spain, where the central bank now estimates that GDP will rise by 0.8% in the current quarter, following a 0.7% fourth-quarter gain.
The positive trends in M1 and the broader M3 measure continued in February, with media reports of the data containing numerous quotes from commentators about the bullish implications for economic prospects. Where were these experts six months ago?
M1 and M3 rose by 0.9% and 0.6% respectively in February alone. Six-month M1 growth increased to 5.7%, or 11.8% annualised – the highest since November 2009; the corresponding M3 measure was 2.5%, or 5.0% annualised – see first chart.
One reason for the change in the consensus interpretation of the data is that private sector credit is now expanding. Adjusted for sales and securitisations, bank loans to the private sector grew by 0.5%, or 2.2% annualised, in the latest three months. As noted with monotonous regularity in previous posts, the historical evidence for the Eurozone and elsewhere shows that money tends to lead the economy while credit is coincident or lagging. The credit pick-up, nevertheless, is significant because it confirms the positive message from other coincident data and will support broad money growth going forward.
The second chart shows the drivers of six-month M3 growth, based on the ECB’s monetary counterparts analysis. As well as the turnaround in private sector credit, M3 expansion has been pushed higher by bank buying of government securities, encouraged by the ECB’s TLTROs, and a switch in bank funding from bonds and other longer-term liabilities to deposits, reflecting lower interest rates. By contrast, growth in banks’ net external assets, which was a major supportive factor in 2013-14, has slowed sharply. With the current account surplus remaining high, this implies that Eurozone non-banks have been exporting capital – the ECB’s monetary boost, in other words, has partly spilled abroad.
A key issue is whether QE leads to further monetary acceleration. The assessment here is that QE programmes had limited impact on broad money trends in the US, UK and Japan. Annual growth in Japanese M3, for example, was 2.9% in February versus 2.5% in March 2013, just before newly-installed Bank of Japan Governor Kuroda launched his monetary blitz. The small impact of these programmes is judged to be for two reasons. First, central bank purchases of government securities were partly offset by sales (or reduced buying) by banks, whose demand for liquid securities fell as QE expanded their reserves. The effect on broad money depends on the combined transactions of the central bank and banks. Secondly, the payment of interest on reserves meant that banks were content to “hoard” their increased balances rather than use them to expand their assets. Asset expansion would not have reduced the total amount of reserves but would have increased their velocity of circulation.
Eurozone QE is also likely to involve offsetting transactions by banks; they appear, indeed, to have started already, with banks selling €25 billion of government securities in February, following the ECB’s QE announcement on 22 January. The second-round effect of higher reserves on bank balance sheets, however, could be larger than in the US, UK and Japan because banks are penalised for holding excess balances via the negative (-0.2%) deposit rate. The expansion of reserves, in other words, is less likely to be fully offset by a fall in their velocity.
Current Eurozone money supply trends signal that monetary conditions are already sufficiently, and possibly excessively, loose. A further acceleration in response to QE would suggest that the ECB will be forced to call time on the programme well before the indicated September 2016 termination date.