Monetary developments in the Eurozone will soon call for higher rates

Today's release of the Eurozone M3 data came in slightly below-consensus at a yoy rate of 1.7% (and a 3m mav of 1.6%). Clearly such low numbers are not compatible with my expectations of a potential ECB rate hike around June this year (assuming that a broadened EFSF solution can be agreed upon in March)? Not so fast. For one, the 3m M3 moving average rate has been rising, suggesting that yoy growth will pick up soon also. More importantly, I have long been of the opinion that growth in M3-M1 is more important than in M3. This is because M1 is roughly around half the size of M3 and M1 has been extremely heavily influenced by ECB action. As the ECB started to dramatically lengthen its balance sheet, M1 growth increased significantly, helping to stabilise M3. Effectively, this was the ECB pushing on a string. However, now that this effect is past, yoy M1 growth has dropped from 14% in Aug09 to below 5% in Dec10. Clearly as M1 is stalling, this keeps the growth of M3 in check as well. But to gauge whether inflationary pressures are starting to build in the economy, the difference between M3 and M1 seems more important as here the central bank has less of a direct influence and changes should be influenced much more by developments in the real economy. Additionally, the growth in M3-M1 seems to be related more closely to the path of the ECB repo rate than the growth in M3 as the chart below suggests. And this growth in M3-M1 has recovered strongly over the past months, from -10.5% yoy in Dec09 to -0.4% yoy in Dec10.

Growth in M3-M1 suggests that the ultra-low repo rate might not be warranted much longer anymore

Source: ECB, ResearchAhead

The ECB engaged in its first rate hiking cycle in November 1999. At that time, yoy growth in M3 was still falling (reaching a low point in March 2001, just when the repo rate topped out. On the other side, M3-M1 growth whad just moved into positive territory. In its seconed rate hiking cycle which started in December 2005, the M3-M1 growth rate was also below 1%! The recovery in M3-M1 is a good sign for the economy, however, it suggests that the ultra-low policy ratge of 1% will not be warranted much longer. As a result, monetary developments do not stand in the way of an early ECB rate hike.

For Germany, the current monetary environment is not only very accommodative, it is even getting easier. Yesterday, the German Bundesbank published its January bank lending survey. The key take aways were that German banks continued to ease lending standards towards German customers (corporates and households). German banks stopped tightening credit standards for coroporate customers in Q2 2010 and started easing in Q3 2010. Demand for credit by corporates continued to increase strongly, this time mainly due to increased investment plans. But also households are increasing their credit demands related to house purchases. This supports my notion that besides the drop in realised real yields - amid ongoing low nominal yields but rising inflation - also credit availability is improving which both means that the monetary environment in Germany is indeed becoming ever more accomodative. As a result, especially the domestic German economy should become stronger over time and German growth less dependent on growing export demand.

Overall, this is an environment where from a monetary policy perspective, the following actions would be necessary:
a) A broadened mandate for a larger EFSF gives it the power to engage in peripheral bond buying, which will lead to a less restrictive monetary policy environment in the periphery.
b) The ECB slowly hikes the repo rate which will lead to a less accommodative monetary policy environment in the core
c) The ECB continues to provide ample liquidity for the banking system.



Finally, some Friday fun stuff: