The six-month rate of change of US broad money has recovered from negative territory in early 2023 to 3.9% annualised in December – close to an average of 4.2% over 2010-19, when economic performance was generally favourable.

Does this signal that the economy has adjusted to higher interest rates and monetary conditions are no longer particularly restrictive, in turn suggesting less need for Fed easing?

The analysis below of the “credit counterparts” to monetary expansion indicates that the recent revival has been driven by exceptionally large-scale purchases of Treasury bills by money market funds.

Such buying will fall back but its recent importance highlights a larger point. If the fiscal deficit remains at its current level (or rises further), and the Treasury chooses to fund a large proportion of the deficit by expanding the Treasury bill issue, the contribution of deficit financing to monetary growth is likely to be significant, even assuming no return to QE. In this scenario, a higher average level of interest rates may be necessary to constrain money growth to a pace – of perhaps 4-5% pa – compatible with trend economic expansion and on-target inflation.

On the suggestion that the recovery in money growth obviates the need for policy easing, a key point is that the effects of prior monetary restriction are still feeding through and may not be fully apparent for another year or more. Rate cuts are likely to be warranted to cushion near-term economic weakness and avert an inflation undershoot.

The numbers quoted above for US broad money expansion refer to the “M2+” measure calculated here, which adds large time deposits at commercial banks and institutional money funds to the official M2 aggregate. The inclusion of these items is important as they capture a significant proportion of money holdings of non-financial businesses and non-bank financial institutions. As previously discussed, US business money holdings have been rising rapidly in recent quarters, resulting in six-month momentum of M2+ diverging positively from that of M2 since late 2022, i.e. M2 is understating broad money growth at present.

Six-month broad money momentum has recovered by much more and to a higher level in the US than in the Eurozone and UK – see chart 1.

Chart 1

The credit counterparts analysis links changes in broad money to movements in other items on the monetary sector’s balance sheet, the US monetary sector being defined as the Fed, commercial banks and other depository institutions, and money funds. The following simple formulation is used for the analysis here:

Change in broad money = monetary financing of federal deficit + change in commercial banks’ loans and leases + other counterparts (residual)

Monetary financing of federal deficit = net purchases of Treasury securities by Fed, commercial banks and money funds – change in Treasury general account balance at Fed

The table shows the contribution of these items to the six-month change in M2+, not annualised, in December 2022 and December 2023.

The positive swing in six-month momentum between the two periods was driven by monetary deficit financing and, in particular, a huge change in money funds’ transactions in Treasuries, from selling in H2 2022 to exceptionally large-scale buying in H2 2023.

What caused this turnaround? Following the suspension of the debt ceiling in June 2023, the Treasury issued a net $1.21 trillion of Treasury bills in H2 2023, up from $170 billion in H2 2022 and the second-highest half-year amount ever (after H1 2020).

Money funds and commercial banks are natural buyers of Treasury bills because of the maturity structure of their liabilities. The market mechanism that induced them to increase demand was a rise in Treasury bill yields relative to other short-term rates, including the emergence of a premium over the Fed’s overnight reverse repo rate.

Money funds moved $1.1 trillion out of the Fed facility during H2 2023, buying an estimated $900 billion of Treasury securities and placing the remainder (and an additional amount) in the private repo market (with those funds probably also used to buy Treasuries, suggesting further indirect monetary financing).

Money funds’ Treasury buying is likely to slow dramatically in H1 2024, for two reasons. First, expansion of the Treasury bill issue will be scaled back to $200 billion (from $1.21 trillion in H2 2023), according to borrowing plans. Secondly, money funds’ balance in the Fed facility was down to $800 billion at end-2023 (from $2.3 trillion a year earlier), with a further decline in early 2024. The rate of Treasury bill purchases will plausibly slow as the balance approaches exhaustion.

It would, however, be misleading to suggest that purchases of Treasuries by money funds and banks face a constraint in terms of the availability of investible resources. The first-round effect of the fiscal deficit is to swell the broad money stock, i.e. it creates the liquidity necessary to absorb associated debt issuance. If new Treasuries are sold to non-banks, the monetary boost is reversed. If, alternatively, money-holders choose to retain their higher balances, banks and money funds have additional funds with which to buy Treasuries. The money creation due to the deficit then remains unsterilised.

How large a boost could this private form of monetary financing give to broad money growth over the medium term? The federal deficit was $1.78 trillion in calendar 2023, equivalent to 6.5% of GDP and 6.8% of the M2+ stock at end-2022. Suppose that 1) the deficit remains stable as a proportion of the money stock, 2) it is half-financed via Treasury bills and 3) money funds and banks take up half of the issued bills. Assuming no QE / QT and a stable Treasury balance at the Fed, monetary deficit financing would contribute 1.7 pp to annual M2+ growth.

For comparison, Treasury buying by money funds and banks contributed 0.6 pp to average annual growth of M2+ over 2010-19.

Suggested conclusions are: 1) prior monetary weakness will be the dominant influence on economic developments over the next few quarters; 2) the recovery in broad money growth is likely to stall in H1 2024; and 3) a persistent large fiscal deficit could cause funding indigestion and force a renewed increase in reliance on bill financing (or, in the extreme, a resumption of QE), in turn posing an upside risk to medium-term money growth and inflation.

US consumers have trounced the Europeans – again. US personal consumption rose by 9.7% between Q4 2019 and Q3 2023 versus a 0.5% increase in the Eurozone and a 1.6% fall in the UK – see chart 1.

Chart 1

The divergence probably widened in Q4, judging from retail sales. US sales rose solidly into year-end as Eurozone turnover flatlined (through November) and UK sales hit a new low – chart 2.

Chart 2

Faster growth of US real personal disposable income explains just over half of the US / Eurozone consumption divergence over Q4 2019-Q3 2023 and about one-third of the US / UK difference. The remainder reflects contrasting saving behaviour.

The US personal saving rate fell by 2.3 pp between Q4 2019 and Q3 2023 versus rises of 1.4 and 4.3 pp in the Eurozone and UK respectively – chart 3*.

Chart 3

What explains the willingness of US households to consume more out of their income than before the pandemic, both in absolute terms and relative to Europeans?

A “monetarist” view is that divergent saving behaviour is related to the magnitude of the boost to household money balances from pandemic-era monetary and fiscal stimulus.

The rise in the ratio of household broad money to disposable income from Q4 2019 was larger and peaked later in the US than in the Eurozone and UK – chart 4.

Chart 4

Households with “excess” money balances adjust by spending more on consumption or investment (housing), adding to non-monetary financial assets and / or reducing debt. The larger US excess has probably resulted in a bigger and more sustained boost to consumption than in Europe.

To the extent that monetary adjustment involves higher consumption, the saving rate will be lower than otherwise until the ratio of money balances to income is restored to an “equilibrium” level.

Judging how much of a consumption boost remains requires an estimate of “equilibrium”. As chart 4 shows, the ratio of household broad money to income is below its Q4 2019 level in the Eurozone but still higher in the US and, to a lesser extent, UK.

A superior approach, however, may be to compare money to income ratios with their pre-pandemic trends, since the ratios tend to rise over time as wealth grows faster than income.

On this basis, money demand may now be acting to restrain consumption in the Eurozone / UK, while US excess money balances are now modest and on course to be removed during 2024 – chart 5.

Chart 5

The US money to income ratio peaked in Q1 2022, a quarter ahead of the low in the saving rate. The saving rate had risen by 1 pp by Q3 2023 and may increase further as the excess money effect wanes.

*The headline measure of the US personal saving rate is calculated net of depreciation. A gross measure is used here to align with European convention.

China’s economic woes partly reflect restrictive monetary policy. The latest money numbers suggest still-deteriorating prospects and urgent need for a policy reversal. It is unclear whether such a pivot is under way. 

Two-quarter growth of nominal GDP (own seasonal adjustment) remained historically weak at 2.7% annualised in Q4, after 2.6% in Q3. Official real GDP numbers show a recovery in two-quarter growth from 3.6% annualised to 4.7%, so the implication is that GDP prices fell at a faster rate (1.9% annualised versus 1.0%) – see chart 1. 

Chart 1

The stabilisation of two-quarter nominal GDP growth in H2 2023 mirrors sideways movement of six-month narrow and broad money growth during H1. Money trends, however, weakened sharply during H2, suggesting a further slowdown in nominal / real GDP in H1 2024 – chart 2. 

Chart 2

Six-month narrow money momentum turned negative in late 2023 and is challenging the record low reached at end-2014. Weakness then rang policy alarm bells, contributing to an aggressive easing shift in 2015 that succeeded in reflating the economy and stocks. 

Monetary optimists note that broad money growth is above the level reached then and in the middle of its range in recent years. A widening narrow / broad money divergence, however, suggests a faster rate of decline of broad money velocity, plausibly related to structural weakness in real estate and lack of confidence in policy. 

Will the economy and markets be rescued by 2015-style easing? Developments in 2023 don’t inspire hope. The PBoC loosened policy during H1 but a new upswing in term money rates began soon after the appointment of new Governor Pan Gongsheng in July, with three-month SHIBOR closing 2023 at a 32-month high – chart 3. 

Chart 3

Another change under Governor Pan has been the suspension of publication of the PBoC’s informative quarterly surveys of entrepreneurs, consumers and bankers – the Q3 surveys were never released and Q4 results would normally have appeared by now. 

A possible interpretation is that the PBoC has switched to prioritising currency stability, managing rates higher to discourage capital outflows while passing the baton of economic support to fiscal policy (and withdrawing from providing information on economic developments). 

Foreign exchange reserves were boosted by valuation effects in late 2023 (weaker US dollar, rally in Treasuries) but settlements data suggest sustained intervention to support the currency during H2, consistent with a persistent sizeable forward discount on the offshore RMB – chart 4. 

Chart 4

Fiscal stimulus focused on government-directed investment is unlikely to be sufficient to reverse economic weakness without accompanying monetary accommodation to lift private sector confidence and broad money velocity. 

Are there any signs of the PBoC pivoting back to easing? One glimmer is that its lending to the banking system continued to expand rapidly in late 2023, which, together with a slower rise in government deposits at the PBoC, resulted in the second-largest quarterly rise in bank reserves on record – chart 5. 

Chart 5

The PBoC’s injections, however, may have been intended to moderate rather than reverse the rise in money rates. Three-month SHIBOR eased in early January but has stalled since – chart 3. Recent renewed US dollar strength may bolster the hard-liners.

The money and cycles forecasting approach suggested that global inflation would fall rapidly during 2023 but at the expense of significant economic weakness. The inflation forecast played out but activity proved more resilient than expected. What are the implications for the coming year? 

One school of thought is that economic resilience will limit further inflation progress, resulting in central banks disappointing end-2023 market expectations for rate cuts, with negative implications for growth prospects for late 2024 / 2025. 

A second scenario, favoured here, is that the economic impact of monetary tightening has been delayed rather than avoided, and a further inflation fall during H1 2024 will be accompanied by significant activity and labour market weakness, with corresponding underperformance of cyclical assets. 

The dominant market view, by contrast, is that further inflation progress will allow central banks to ease pre-emptively and sufficiently to avoid material near-term weakness and lay the foundation for economic acceleration into 2025. 

On the analysis here, the second scenario might warrant a two-thirds probability weighting versus one-sixth for the first and third. This assessment reflects several considerations. 

First, on inflation, developments continue to play out in line with the simplistic “monetarist” proposition of a two-year lead from money to prices. G7 annual broad money growth formed a double top between June 2020 and February 2021 – mid-point October 2020 – and declined rapidly thereafter. Annual CPI inflation peaked in October 2022, falling by 60% by November 2023 – chart 1. 

Chart 1

Broad money growth returned to its pre-pandemic average in mid-2022 and continued to decline into early 2023. The suggestion is that inflation rates will return to targets by H2 2024 with a subsequent undershoot and no sustained revival before mid-2025. 

Secondly, economic resilience in 2023 partly reflected post-pandemic demand / supply catch-up effects. On the demand side, an analytical mistake here was to downplay the supportive potential of an overhang of “excess” money balances following the 2020-21 monetary explosion. Globally, this excess stock has probably now been eliminated – chart 2. 

Chart 2

The moderate economic impact of monetary tightening to date, moreover, is consistent with historical experience. Major lows in G7 annual real narrow money momentum led lows in industrial output momentum by an average 12 months historically – chart 3. With a trough in the former reached as recently as August 2023, economic fall-out may not be fully apparent until H2 2024. 

Chart 3

The suggestion that economic downside is incomplete is supported by a revised assessment of cyclical influences. The previous hypothesis here was that the global stockbuilding cycle would bottom out in late 2023 and recover during 2024. Recent stockbuilding data, however, appear to signal that the cycle has extended, with a recovery pushed back until H2 2024. 

The assumption of a late 2023 trough was based on a previous low in Q2 2020 and the average historical cycle length of 3 1/3 years. This seemed on track at mid-2023: G7 stockbuilding had crossed below its long-run average in Q1, consistent with a trough-compatible level being reached in H2 – chart 4. The downswing, however, was interrupted in Q2 / Q3, with a further decline likely to be necessary to complete the cycle and form the basis for a recovery. 

Chart 4

A resumed drag from stockbuilding may be accompanied by a further slowdown or outright weakness in business investment, reflecting recent stagnation in real profits – chart 5. Capex is closely correlated with hiring decisions, so this also argues for a faster loosening of labour market conditions. 

Chart 5

Real narrow money momentum remains weaker in Europe than the US, suggesting continued economic underperformance and a more urgent need for policy relaxation – chart 6. Six-month rates of change are off the lows but need to rise significantly to warrant H2 recovery hopes. Globally, the US / European revivals have been partly offset by a further slowdown in China, suggesting still-weakening economic prospects. 

Chart 6

The frenetic rally of the final two months resulted in global equities delivering a strong return during 2023 despite the two “excess” money indicators tracked here* remaining negative throughout the year. The indicators, however, started flashing red around end-2021, since when the MSCI World index has slightly underperformed US dollar cash. 

Historically (i.e. since 1970), equities outperformed cash on average only when both indicators were positive, a condition unlikely to be met until mid-2024 at the earliest. 

The late 2023 rally was led by cyclical sectors as investors embraced a “soft landing” scenario. Non-tech cyclical sectors ended the year more than one standard deviation expensive relative to history versus defensive ex. energy sectors on a price / book basis – chart 7. Current prices appear to discount an early / strong PMI recovery, which the earlier discussion suggests is unlikely. 

Chart 7

Quality stocks outperformed during 2023, reversing a relative loss in 2022 and consistent with the historical tendency when “excess” money readings were negative. Earlier underperformance partly reflected an inverse correlation with Treasury yields, a relationship now suggesting further catch-up potential.

Contributing factors to the dramatic underperformance of Chinese stocks during 2023 include excessively optimistic post-reopening economic expectations at end-2022 and unexpectedly restrictive monetary / fiscal policies. MSCI China is at a record** valuation discount to the rest of EM – chart 8 – while monetary / economic weakness suggests an early policy pivot. 

Chart 8

A key issue for 2024 is the extent to which central bank policy easing will revive money growth. While inflation is expected to trend lower into early 2025, the cycles framework suggests another upswing later this decade – the 54-year Kondratyev price / inflation cycle last peaked in 1974. Aggressive Fed easing 54 years ago – in 1970 – pushed annual broad money growth into double-digits the following year, creating the conditions for the final Kondratyev ascent. Signs that a similar scenario is playing out would warrant adding to inflation hedges. 

*The differential between G7 plus E7 six-month real narrow money and industrial output momentum and the deviation of 12-month real narrow money momentum from a long-term moving average.

**Since June 2000. MSCI China included only B-shares through May 2000, when red chips and H-shares were added.

The MPC’s November inflation projections are ancient history. Price pressures have plunged in line with a simplistic monetarist forecast suggesting a return to target in Q2 2024 and an undershoot in H2. 

The simplistic forecast is based on the Friedmanite rule that inflation directionally follows money growth with an average lag of two years. This is converted to a numerical profile by assuming a one-for-one relationship of deviations in inflation and money growth from 2% and 4.5% respectively. 

Friedman emphasised the variability of the money growth / inflation lag but a two-year assumption has proved accurate in timing the inflation peak and subsequent decline – see chart 1. 

Chart 1

A post in July suggested that the six-month rate of increase in the CPI, seasonally adjusted, would fall to 2% annualised or lower around end-2023, reflecting a decline in six-month broad money growth to below 4.5% annualised in Q4 2021. The fall is ahead of schedule, with the six-month CPI increase at 1.6% in November. 

The simplistic forecast suggests that six-month inflation will fluctuate around the current level through mid-2024 before dropping further in H2 – chart 1. The implication is that the annual rate will return to target in Q2 and undershoot during H2. 

By contrast, the modal forecast for annual inflation in Q4 2024 in the November Monetary Policy Report was 3.1%, with the mean forecast (incorporating an upside risk assessment) at 3.4%. 

Broad money momentum remains negative, suggesting that an inflation revival is unlikely before mid-2025. 

Bottom-up considerations support the view that annual inflation will return to target by next spring, assuming no adverse shocks: 

• Annual inflation of food, alcohol and tobacco of 9.4% in November could fall to 3% by Q2. Annual producer output price inflation of food, beverages and tobacco is already down to 2.1%, while input prices of home-produced food are falling year-on-year. 

• The energy price cap will rise by 5% in January but Cornwall Insight currently projects a 14% cut in April. 

• Annual core goods inflation of 3.3% in November could fall to 1%. Core producer output prices are flatlining, while base effects are favourable through May. 

• Slowing food prices will feed through to catering services, with the historical sensitivity suggesting a fall in annual inflation from 7.8% in November to 4.5%. This would cut services inflation by 0.75 pp, based on the 23% weight of catering in the services basket. 

• The above two assumptions coupled with a 1 pp slowdown in the rest of the services basket would imply a 1.75 pp fall in annual core inflation by Q2 (5.1% in November). This would be sufficient to generate a 2% headline rate given the assumed food slowdown and a large year-on-year decline household energy bills.