The predictive power of real M1 for real economic activity in the Euro area

ECB is of the few central banks which still looks at Money supply as an indicator of economic/price activity.

In this short research, Alberto Musso of ECB looks at power of real M1 on real economic activity in Euroarea. This graph shows real M1 follows the business cycle quite closely:

The leading and pro-cyclical properties of real M1 with respect to real GDP in the euro area remain a robust stylised fact. These properties, which can be found for the relationship between real narrow money and real economic activity in both levels and growth rates, have been documented in various publications for earlier time periods.[1] An illustration of such properties can be derived from a visual examination of monthly data from January 1970 to February 2019 for annual growth in real M1, which is defined as the nominal narrow money aggregate M1 deflated by the HICP. Specifically, it is notable that this growth rate went well into negative territory for prolonged periods just before (or in coincidence with) all historical euro area recessions, as dated by the CEPR Euro Area Business Cycle Dating Committee (see Chart A).

Chart A Real M1 annual growth and euro area recessions (annual percentage changes)

Real M1 growth is again moderating in 2019:

Turning to the current juncture, a formal econometric analysis based on probit models exploiting the predictive power of real M1 does not point to significant recessionary risks in the euro area for 2019 and early 2020. On the basis of data since 1970, the probability of a contraction in euro area real GDP derived from a probit model based on real M1 (lagged by 12 months) increased sharply before all previous euro area recessions (see Chart D), providing strong evidence of the usefulness of narrow money in predicting recessions in the euro area. Forecasts based on this model point to recession risks increasing slightly in 2019, from about 1% in January 2019 to between 5% and 7% in the second half of 2019 before falling to below 5% in February 2020, that is to say remaining very low (blue line). Controlling for the slope of the yield curve changes results only marginally (yellow line). Overall, the current level of real M1 growth is still comfortably above the zone that would be associated with risks of a recession in the near future.[4]

Chart D

Euro area recession probabilities based on probit models with lagged real M1



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