Where are the inflationary pressures in the Eurozone's monetary development?

Much has been written about the inflationary pressures the lengthening of the central bank's balance sheets would create. I have stated on various occasions (see for instance Is inflation just around the corner? Part II) that I do not see that this will ultimately be followed by inflation rates moving higher significantly on a sustainable basis (barring the ups and downs in headline inflation rates due to the high volatility of commodity prices, most notably oil). On a cyclical view the spare capacity is just too high to suggest that corporates have any meaningful level of pricing power (in the same way employees have only very limited capability to demand higher wages at present). But on a more medium term view, also the lengthening of the central banks' balance sheet does not need to be followed up by higher inflation rates. I previously stated that narrow money aggregates are rising but broad credit aggregates are not as banks are unable/unwilling to lend and borrowers unwilling to borrow. In turn, the velocity of money decelerates and essentially we remain in a state where there are too many goods and not too much money.

With respect to the ECB's balance sheet, my former colleague Christoph Rieger provided me with the following chart:

Source: ECB, Federal Reserve, BoE

It shows the development of the size of the balance sheet together with a trend for the ECB since mid 2007, i.e. long before the height of the financial crisis. Christoph suggests that the additional lengthening of the ECB's balance sheet following the bankruptcy of Lehman Brothers compared to a theoretical "normal" course of action - while still significant - is not as substantial as is generally believed with a key reason behind the growth of the ECB's balance sheet over the past years was the growth in currency in circulation as the chart below shows.

Currency in circulation has been growing strongly ever since 2002

Source: ECB

Furthermore, if we look at the development of the monetary aggregates M1 to M3 there are also some interesting features worth highlighting. As a reminder: M1 is the sum of currency in circulation and overnight deposits; M2 is the sum of M1, deposits with an agreed maturity of up to two years and deposits redeemable at notice of up to three months; and M3 is the sum of M2, repurchase agreements, money market fund shares/units and debt securities up to two years.

The first chart below shows the development of the annual rate of growth of M1 vs. the ECB repo rate (inverted). As one would expect, there is a strong co-movement between the two data series. In an environment where the ECB cuts rates, the growth rate of M1 increases - an accommodative monetary policy environment - and vice versa.

Lower repo rate = higher M1 growth rate

Source: ECB

The next chart shows the annual growth rate of M1 together with the annual growth rate in M3. Here the link is not as close but generally, when the growth rate in M1 increases, M3 growth tends to accelerate as well. However since late 2005 there is a big discrepancy. When the ECB started to rise rates in late 2005, M1 growth started to fall until it reached bottom in the summer of 2008 (just when the ECB hiked for the last time) and has been moving sharply higher since to 12.2% in July. On the other side, growth in M3 peaked in late 2007 and has been on a downward moving path ever since and reached a level of 3% in July this year.

Significant discrepancy between growth in M1 and M3

Source: ECB

Now, M1 is a part of M2 and M2 is a part of M3. Therefore, if M1 is increasing (because currency in circulation and onvernight deposits have been growing), then this boosts directly the level of M2 and M3. However, as the chart below shows, the remaining parts of M2 and of M3 have not been growing at all, rather they are shrinking!

Only M1 is growing, the exclusive parts of M2 and M3 are shrinking

Source: ECB

The exclusive part of M3 (i.e. the one which is included in M3 but not in M1 and in M2) fell by 7% yoy in July, just shy of the record -7.1% reached in March 1994. Even more dramatic is the fall in M2. M2-M1 has never fallen since the data is available (that is since 1981). After having continued to grow, in July this year for the first time ever annual growth in M2-M1 turned negative with a rate of -2.6%!
The combination of falling M3-M2 and even more so M2-M1 coupled with a limited addittional balance sheet lengthening by the ECB vs. a "normal" course of action add further weight to the argument that even medium-term inflation pressures in the Eurozone appear very limited as the money being created by the central bank does not find its way into the broader economy.