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 continues to choose 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 measure. 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 refunding 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 5.2% annualised increase in the headline expenditure-based measure of US GDP in Q3 partly represents payback for earlier weakness. GDP has risen at a modest 1.7% annualised pace since end-2021, well below average expansion of 2.5% in the five years preceding the pandemic (i.e. to end-2019).

The alternative income-based measure of GDP – gross domestic income – paints a much more miserable picture. GDI grew by 1.7% annualised in Q3 alone and by only 0.4% in the seven quarters since end-2021 – see chart 1.

Chart 1

It has been suggested that the GDP / GDI divergence is capturing an increased reliance on borrowing and / or savings depletion to finance spending. This is incorrect: GDP and GDI measure the same concept and the divergence reflects a rising statistical discrepancy, with GDP 2.6% higher than GDI in Q3.

The higher level of GDP does not imply that the GDI measure is less inclusive or accurate. Research by Jeremy Nalewaik, then a Fed economist, found that early GDI estimates were a better gauge of cyclical fluctuations and predicted the direction of future revisions to GDP.

If the national accounts evidence suggests lacklustre performance at best, what explains the consensus perception of US economic “strength”?

The answer seems to be unusually rapid growth of payroll employment. Payrolls rose at a 2.8% annualised rate between Q4 2021 and Q3, significantly outpacing GDP expansion of 1.7%.

Payrolls strength is judged here to reflect a normalisation of the relationship with the level of GDP, following an undershoot of trend during the pandemic – chart 2. This adjustment appears complete, implying that payrolls will lag GDP going forward (the slope of the trend line implies an annualised growth shortfall of 1.0%).

Chart 2

The GDP / GDI contrast is particularly stark over the latest four quarters, during which GDP grew by 3.0% but GDI contracted by 0.2%.

The table below shows the contributions of GDI components to its change over the past year. With real wage income growing solidly, GDI contraction was attributable to falls in real operating profits of corporations and other private enterprises.

 

Is national accounts profits weakness consistent with company earnings data? GDI operating profits are gross of depreciation, interest and taxes and exclude foreign earnings, so adjustments are necessary to align with S&P 500 earnings. Chart 3 compares nominal data for S&P 500 aggregate operating earnings and an equivalent national accounts-based measure for corporations excluding the Fed. S&P earnings grew more slowly in the year to Q3, so there is no suggestion of a negative discrepancy in the national accounts numbers.

Chart 3

Real operating profits are a leading indicator of business investment so the contraction in recent quarters suggests a capex downturn ahead – chart 4.

Chart 4