Aim
To anticipate the direction of economies and markets using a disciplined approach combining monetary and cycle analysis.
Philosophy
The forecasting approach combines the “monetarist” insight that trends in monetary aggregates are informative about economic and market prospects with the “Keynesian” insight that economic fluctuations are driven primarily by swings in investment.
Directional focus
The aim is to anticipate the timing of turning points in economic momentum, since these are often associated with changes in market trends. Numerical forecasts for levels of GDP growth, inflation etc. are of limited value to investors and business planners.
Monetary analysis
Turning points in (real) money growth lead turning points in economic growth, usually by between six and 12 months. Money growth in excess of the rate required to support economic expansion is associated with increased demand for financial assets and upward pressure on their prices (“money moves markets”).
Cycle analysis
Economic fluctuations reflect interlocking cycles in different components of investment. The length of each cycle is related to the lifespan of the associated investment good. The current status of the cycles suggests timings of future windows of economic strength and weakness.
Complementary
Monetary and cycle aspects provide independent information. The monetary signals confirm or qualify the longer-term cycle analysis, serving to narrow down timings. Forecast confidence is higher when the two aspects agree.
Empirical basis
The forecasting “rule” that money leads the economy by six to 12 months is supported by G7 data since the 1960s and the Friedman and Schwarz studies of much longer-run US and UK data. Cycles in different investment components can be traced back centuries.
Narrow vs broad money
Both are important. Narrow money – currency in circulation and demand / overnight deposits – is better for signalling turning points in short-term economic momentum. Broad money – which also includes time deposits, savings accounts and money funds – drives medium-term trends in nominal incomes and wealth.
Money demand vs supply
Narrow money is demand determined. The broad money stock, by contrast, can temporarily diverge from desired holdings of households and firms. Such divergences lead to changes in economic activity and prices – including asset prices – to restore “equilibrium”.
Money and central banks
The stock of broad money is determined by the banking system “credit counterparts – lending to the private / public sectors, net foreign assets and net non-monetary liabilities, including capital and reserves. Central bank policies influence these counterparts but there is no direct control.
“European” cycle analysis
The analysis follows the pre-WW2 “European” approach recognising the existence of several different cycles. The dominant “American” approach of Mitchell and Burns asserts a single “business” cycle of widely varying length and is of limited use for forecasting.
“American” cycle undercounting
Cycle lows are associated with below-trend growth or recessions. The American approach, reflected in the “official” US business cycle chronology maintained by the National Bureau of Economic Research, recognises only lows associated with recessions. This results in an undercounting of cycles.
Markets are European
Markets reflect all cycle upswings / downswings, not only those associated with recessions. The economist Paul Samuelson joked that “the stock market has predicted nine of the last five recessions”. The four additional market declines reflected non-recessionary cycle downswings.
Quantity theory of money
The traditional quantity theory implies equal growth of the (broad) money stock and nominal economic activity over the long run. In practice, money has grown faster, i.e. the velocity of circulation has trended down, though not at a constant rate.
“Quantity theory of wealth” (QTOW)
Desired money holdings depend on wealth as well as nominal incomes. Broad money has grown in line with a combined income / wealth measure over the long run. The downward trend in traditionally defined velocity is explained by a rising wealth to income ratio. Falling velocity is bullish!
Applied QTOW
A positive (negative) deviation of the broad money stock from the predicted level suggests upward (downward) pressure on nominal incomes and / or wealth over the long run. Cycles influence how adjustment is split between economic activity, goods / services prices and asset prices.
Target economic variable: industrial output
Industrial output is monthly, timely and less prone to revision than GDP. Momentum turning points in industrial output and GDP coincide. Equity market earnings are better correlated with industrial output than GDP, which includes government “output” and other non-market activities.
Leading indicators
Leading indicator indices, such as those constructed by the OECD, are a useful additional tool but have a shorter lead time than money – between three and six months – and are prone to revision, particularly when their construction depends on detrending component series.
Purchasing managers’ surveys
Purchasing managers’ indices are of limited use for forecasting. They provide timely confirmation of momentum turning points but rarely lead.
Money vs credit
Turning points in money growth lead turning points in economic growth. Turning points in bank lending growth – particularly lending to companies – usually lag. Companies are forced to borrow in the early stages of a downswing as profits weaken and inventories accumulate.
Money vs “credit impulse”
The credit impulse is the rate of change of lending growth. Using the second derivative of lending generates a leading relationship with turning points in economic growth (first derivative) but there are more false signals than for real money growth and the lead time varies widely.