US – CC&L Financial Group Ltd.

A cyclical forecasting framework implies that current economic events will contain echoes of developments at the same stage of previous cycles.

Similarities should be more pronounced at around 18- and particularly 54-year frequencies, corresponding to average lengths of the housing and Kondratyev inflation cycles respectively.

A previous post noted the similarity of Fed tightening episodes in 1967-69 and 2022-23. The Fed funds rate (month average) rose from peak to trough by 540 bp and 530 bp respectively, topping in August 1969 and August 2023, exactly 54 years later – see chart 1.

Chart 1

The US economy entered a recession at the end of 1969. GDP was recovering by Q2 1970 but suffered a second hit from a prolonged auto strike.

The Fed cut rates much more aggressively than recently but reversed course temporarily from early 1971 as the economy rebounded strongly and inflation remained high. The current Fed pause has occurred at the same cycle time.

Inflation fell sharply into 1972, mirroring a big slowdown in broad money growth two years earlier. The Fed resumed easing later in 1971, with the funds rate reaching an ultimate low in February 1972.

A possible scenario is that President Trump’s tariff shock triggers the recession “missing” from the current cycle, causing the Fed to ease aggressively later in 2025, with rates and inflation falling to lows in 2026 corresponding to those reached in 1972.

US disruption to global economic relations is itself is strongly reminiscent of policy developments 54 years ago. In August 1971, President Nixon shocked trading partners by suspending convertibility of the dollar into gold within the Bretton Woods system while imposing a 10% tariff on imports.

The backdrop was a US balance of payments deficit and an accelerating loss of gold from US reserves. According to a Federal Reserve history of the period, President Nixon blamed the deficit “on unfair trading practices and other countries’ unwillingness to share the military burden of the Cold War”. Sound familiar?

The “Nixon shock” triggered a crisis, with global policy-makers fearing that “international monetary relations would collapse amid the uncertainty about exchange rates, the imminent spread of protectionism, and the looming prospects of a serious recession”.

The crisis was resolved, at least temporarily, by the December 1971 Smithsonian Agreement, involving trading partners agreeing to revalue their currencies against the dollar in return for the removal of tariffs. “The net effect was roughly a 10.7 percent average devaluation of the dollar against the other key currencies … Foreign nations also agreed to comply with Nixon’s request to lessen existing trade restrictions and to assume a greater share of the military burden.”

Could a revaluation of currencies against the dollar be part of a “deal” to end the current crisis, once President Trump comes to recognise that the economic costs of his high tariff policy greatly exceed any benefits?

The Nixon shock occurred with the real trade-weighted value of the dollar at a similar premium to its long-run average to today. The shock accelerated a secular decline into and beyond the following housing cycle trough – chart 2.

Chart 2

The Fed’s economic forecasts are inconsistent with the suggestion of a 50 bp cut in rates by year-end, according to a model of its historical behaviour.

The model assesses the probability of the Fed being in tightening or easing mode in a particular month based on currently reported and lagged values of core PCE inflation, the unemployment rate and the ISM manufacturing delivery delays indicator. Despite the small number of inputs, the model does a satisfactory job of “explaining” the Fed’s past actions – see chart 1.

Chart 1

The model predicted that the Fed would hold in March with a slight tightening bias – the probability reading rose to just above the 0.5 neutral level, having previously been in the easing zone.

The FOMC median projections for core PCE inflation and the unemployment rate in Q4 2025 were raised to 2.8% and 4.4% respectively this month, from 2.5% and 4.3% in December. Assuming a smooth progression to these values, the model signals a greater chance of tightening than easing over the remainder of the year – chart 2.

Chart 2

The suggestion is that inflation and / or labour markets news will need to surprise significantly to the downside to warrant the 50 bp cut in rates by year-end implied by the median dot.

Chart 3 shows the model prediction in an alternative scenario in which the unemployment rate and core inflation move to 4.7% and 2.5% in Q4. The probability reading remains above 0.5 into the summer but falls back into the easing zone at end-Q3.

Chart 3

The Fed’s projection of a 4.4% unemployment rate in Q4 implies only a 0.17 pp rise relative to a recent (November) high. An indicator of labour market weakness from the Conference Board consumer survey rose further in March and is almost back to its January 2021 level, when the jobless rate excluding temporarily laid-off workers was more than 1 pp higher than now – chart 4.

Chart 4

The US economy and markets previously enjoyed a tailwind from an “excess” stock of money relative to prevailing levels of nominal spending and asset prices. A post in December argued that nominal economic growth and rising markets had eliminated this excess by mid-2024, with a small monetary shortfall opening up Q3. An updated analysis suggests that recent weakness in equities has been insufficient to restore a surplus.

To recap, the “quantity theory of wealth”, explained in posts in 2020, is a suggested modification of the traditional quantity theory recognising that (broad) money demand depends on (gross) wealth as well as income and proposing equal elasticities. Nominal income Y is replaced on the right-hand side of the equation of exchange MV = PY by a geometric mean of income and wealth.

Chart 1 applies the “theory” to US data since end-2014. Nominal GDP is used as the measure of income, with wealth defined as the sum of market values of public equities, debt securities (excluding Fed holdings) and the housing stock.

Chart 1

The combined income / wealth variable closely tracked moderate growth of broad money over 2015-19. Wealth rose faster than income, so traditionally-defined velocity fell. The velocity of the combined income / wealth measure was stable.

Policy easing following the covid shock resulted in possibly unprecedented monetary disequilibrium. Asset prices responded swiftly to the excess, causing wealth to overshoot broad money in 2021 before a sharp correction in 2022.

The combined income / wealth measure was still well below the level implied by broad money even before this set-back. Deployment of excess money fuelled a second surge in wealth from late 2022 while sustaining economic growth despite monetary policy tightening.

Asset price gains, goods / services inflation and real economic expansion resulted in the income / wealth measure finally catching up with broad money in mid-2024, with a small overshoot emerging in Q3. The velocity of the combined measure, in other words, had fully reversed its pandemic fall.

Asset stock numbers in the Q4 financial accounts released last week allow the calculation to be updated to end-2024. Broad money grew slightly faster than the combined income / wealth measure in Q4 but not by enough to close the end-Q3 gap.

Has the recent equity market correction pushed the combined measure back below the level implied by the money stock? Available information suggests not: ongoing growth in the stock of debt securities along with rising goods / services prices may have offset the decline in equities – unless the economy turns out to have contracted in Q1. Broad money, meanwhile, grew modestly in January, with a February number released next week.

The previous monetary excess imparted a positive skew to the economy / markets so its withdrawal suggests greater vulnerability to negative developments.

US / Eurozone January money numbers suggest that US policy chaos is damaging economic prospects.

The narrow money measures followed here – US M1A and Eurozone non-financial M1 – were unchanged and fell on the month respectively. Narrow money weakness can reflect reduced confidence and spending intentions.

US six-month real narrow money momentum fell between August and October, partially recovered into year-end but has now returned to the October level – see chart 1. The slowdown since August signalled recent softer economic data – see previous post.

Chart 1

A recovery in Eurozone six-month real narrow money momentum stalled in December / January but the gap with the US has narrowed significantly since August, suggesting better relative performance.

US narrow money momentum may weaken further. Policy chaos may cause spending to be deferred, reducing demand for transactions money.

The Fed has gone on hold with rates judged still to be in restrictive territory. The ECB has cut by more, is still in easing mode and may be closer to “neutral”.

A further consideration noted previously is that US narrow money growth has tended to rise into presidential elections but reverse shortly before or after the poll date – chart 2. (1984 and 2000 were notable exceptions.)

Chart 2

Sectoral numbers show that recent US money growth has been focused on the household and financial sectors, with business holdings falling.

A recent post noted that US six-month narrow money momentum fell back in September / October, casting doubt on post-election economic optimism. Sectoral money trends revealed in the Fed’s Q3 financial accounts give further grounds for caution.

Chart 1 compares the six-month rate of change of the monthly broad measure calculated here – M2+, which adds large time deposits at commercial banks and institutional money funds to the official M2 series – with the two-quarter change in a domestic money aggregate derived from the financial accounts. The series are closely correlated with end-Q3 readings similar.

Chart 1

An advantage of the financial accounts data set is that it allows a breakdown of broad / narrow money between the household, non-financial business and financial sectors. Broad money growth in the two quarters to end-Q3 was driven by households and financial firms, with business money falling – chart 2. The narrow money decomposition (not shown) mirrors this pattern.

Chart 2

Business money trends have exhibited a stronger and more consistent relationship with future economic activity than household / financial sector developments historically. Changes in business liquidity can influence decisions about investment and hiring, with employment consequences feeding through to household incomes and money holdings.

The approach here, therefore, is to interpret the signal from a given level of aggregate money growth as more positive – or less negative – when the business component is outperforming (and vice versa).

Chart 3 shows that real business money – on both broad and narrow definitions – is falling on a year-ago basis, suggesting that a slowdown in investment will continue in 2025.

Chart 3

The Q3 financial accounts numbers also support an earlier proposition here that asset prices and nominal GDP have – in combination – moved above levels implied by the current broad money stock, i.e. there is no longer an “excess” money tailwind for the economy and markets.

To recap, the “quantity theory of wealth” is a suggested modification of the traditional quantity theory recognising that (broad) money demand depends on wealth as well as income and proposing equal elasticities. Nominal income is replaced on the right-hand side of the equation of exchange MV = PY by a geometric mean of income and wealth.

Using Q4 2014 as a base, the measure of gross wealth used here – the market value of public equities, debt securities (excluding Fed holdings) and the housing stock – had risen by 107% as of end-Q3 versus a 64% increase in nominal GDP. Implied growth of 84% in the geometric average compares with an increase of 80% in broad money over the same period – chart 4.

Chart 4

Equity / house price gains, debt issuance / QT and expected respectable nominal GDP expansion suggest that the overshoot will have widened in Q4.

A pull-back in US narrow money momentum casts doubt on post-election economic optimism.

Six-month growth of M1A (comprising currency in circulation and demand deposits) eased to 5.7% annualised in October, down from an August peak of 10.0% – see chart 1.

Chart 1

Growth of the broad M2+ measure, by contrast, rose to 5.1% annualised, the fastest since March 2022. (M2+ adds large time deposits at commercial banks and institutional money funds to the official M2 measure.) Narrow money, however, has a better record of signalling turning points in economic momentum.

Six-month expansion of official M1 is weaker, at 2.9%. M1 is no longer a narrow money measure, following its redefinition in 2020 to include savings accounts.

A post in September expressed doubt that a pick-up in M1A growth would be sustained, partly because it had occurred before any rate cuts. In addition, the rise had been driven solely by the demand deposit component, with currency momentum unusually weak.

Six-month growth of currency has recovered but was still only 1.7% annualised in October – chart 1.

A further consideration, noted in a post last month, is that narrow money growth has tended to rise ahead of presidential elections but reverse shortly before or after the poll date – chart 2. (1984 and 2000 were notable exceptions.)

Chart 2

The pull-back to date has been modest but could become more serious, especially if the Fed delays further rate cuts.

Broad money growth, however, could be supported by increased monetary financing of the fiscal deficit, based on Treasury plans for higher bill issuance in Q4 and Q1 (given that these are mostly purchased by money funds and banks).

Narrow / broad money divergences can reflect shifts in confidence and spending intentions affecting broad money velocity. (Such shifts are associated with movements between low-velocity broad money components and high-velocity narrow money.) Relative narrow money strength into the summer was a positive signal for the economy; the reversal suggests fading prospects.

A pick-up in US narrow money momentum is a hopeful signal for 2025 but requires confirmation and does not preclude near-term economic deterioration.

The measure of narrow money tracked here (M1A, comprising currency in circulation and demand deposits) rose by 0.8% in August, pushing six-month annualised growth up to 10.5% – see chart 1.

Chart 1

The broad M2+ measure (which adds large time deposits at commercial banks and institutional money funds to the official M2 aggregate) also rose solidly in August, by 0.5%, but six-month growth remains subdued and within the recent range, at 3.5% annualised.

Six-month expansion of official M1 is weaker, at 2.1%. M1 is no longer a narrow money measure, following its redefinition in 2020 to include savings accounts.

Narrow money outperforms broad as a leading indicator of economic direction. The recent pick-up suggests that demand and activity will be gaining momentum by mid-2025. It does not, however, preclude – and may be consistent with – current economic deterioration.

Six-month narrow money momentum similarly recovered from negative to 10% annualised in September 2001 and September 2008. In both cases, the economy was within a recession that the NBER had yet to recognise.

Those narrow money rebounds may have partly reflected a rise in liquidity preference associated with an increase in saving, i.e. they may have been a signal of a reduction in current demand. They also, however, implied potential for future economic reacceleration when liquidity preference normalised and money balances were redeployed.

The 2001 / 2008 experiences were atypical: in earlier recessions, six-month narrow money growth rose strongly only at the end of – or after – the period of economic contraction.

A reasonable assessment, therefore, is that a pick-up in narrow money momentum is a neutral or negative signal for current economic momentum but positive for prospects six to 12 months ahead.

The current positive message is tempered by several considerations.

First, six-month momentum is likely to fall back in September / October because of negative base effects: narrow money rose by a whopping 3.1% (20.0% annualised) in March / April combined.

Secondly, the currency and demand deposit components of narrow money have been individually correlated with future activity historically but the recent pick-up has been solely due to the latter, with currency momentum unusually weak – chart 1.

Thirdly, the Fed funds target rate had been cut by 350 bp and 325 bp respectively by the time six-month narrow money momentum reached 10% annualised in 2001 and 2008. The Fed’s tardiness has increased the risk of a monetary relapse.