Henderson: US narrow money growth moderating, warranting Fed caution

The Fed hiked by 25 basis points in December 2015 and guided markets to prepare for four further quarter-point moves during 2016. Its hawkishness was in conflict with narrow money trends: six-month growth of real M1A* had fallen to a five-year low in October 2015, signalling that the economy would be weak over the winter and during the first half of 2016 – see chart. GDP growth averaged just 1.0% annualised in the fourth, first and second quarters. The Fed was forced to backtrack.

The second mistake was its failure to resume rate-hiking in summer 2016. Real narrow money growth had rebounded strongly from late 2015, suggesting a return to above-trend GDP expansion in late 2016 / early 2017. GDP rose at a 2.9% annualised pace in the third quarter, with similar growth expected in the current quarter (the Atlanta Fed’s “nowcast” model projects 3.6%). A summer hike would have put the Fed slightly “ahead of the curve” and might have prevented or tempered the recent sharp rise in inflation expectations and Treasury yields.

Fed Chair Yellen’s comments yesterday suggest that the central bank has turned hawkish again. Markets now discount a 91% probability of a December hike and a greater-than-50% likelihood of at least one further quarter-point increase by June 2017, according to the CME.

In contrast to late 2015 and summer 2016, narrow money trends do not argue strongly that the Fed is on the wrong track. Six-month growth of real narrow money has fallen back since August but remained respectable in October, suggesting solid economic expansion through spring 2017, at least. A further slowdown, however, would be concerning. Investors should monitor monetary trends and ignore Fed communications to assess policy prospects for later in 2017.