“Euro area re-synching – part 1”

The key chart

The key message

Growth rates in euro area (EA) money supply and private sector credit continue to converge and re-align. This matters because the de-synchronisation of money and credit cycles over the past decade, which peaked during the COVID-19 pandemic, created major challenges for policy makers, banks and investors alike.

On a positive note, this reflects a combination of slowing (excess) money supply growth and rising demand for private sector credit. Recall that narrow money (M1), and within that overnight deposits, drove the expansion of broad money (M3) during the pandemic. The contribution of productive COCO-based lending is also increasing, led by a recovery in corporate credit. Importantly, COCO-based lending supports both production AND income formation.

That said, less-productive FIRE-based lending continues to be the more important driver of private sector credit in the EA, driven by resilient mortgage demand. FIRE-based lending, which accounts for more than half of the outstanding stock of credit, supports capital gains through higher asset prices but does not lead directly to income generation. This has negative implications for leverage, future growth, financial stability and income inequality.

In short, the message from the money sector here is broadly positive, albeit with the “hidden-risks” that are associated with higher levels of FIRE-based lending. In the second part of this analysis, I analyse money and credit trends in real terms to consider the implications here for the outlook for growth and business-cycle approaches to asset allocation. The conclusions here are less positive…

Euro area re-synching – part 1

Growth rates in EA money supply and private sector credit continue to converge and re-align (see key chart above). This matters because the de-synchronisation of these cycles over the past decade, which peaked during the COVID-19 pandemic, created major challenges for policy makers, banks and investors alike. The effectiveness of monetary policy, the dominant macro policy during this period, diminished dramatically as a result, and banks and investors had to deal with the consequences of excess liquidity for balance sheet management and the (mis-)pricing of both real and financial assets.

On a positive note, this reflects a combination of slowing (excess) money supply growth and rising demand for private sector credit (see chart above). Broad money (M3) growth has slowed from its January 2021 peak of 12.5% YoY to 6.0% YoY in April 2022. Growth in private sector credit has recovered from its May 2921 low of 2.7% YoY to 5.3% YoY, the highest nominal rate of growth since May 2020. The gap between the two growth rates (the green line in the chart above) has narrowed from 8ppt in January 2021 to 0.7ppt in April 2022, the narrowest gap since November 2018.

The contribution of productive COCO-based lending is also increasing (see chart above), led by a recovery in corporate credit. COCO-based lending, which includes lending to corporates (NFCs) and household (HH) consumer credit, contributed 1.9ppt towards to total PSC growth of 4.9% YoY in April 2022. This compares with only 0.4ppt to the total PSC growth of 3.0% in August 2021.

Note that COCO-based lending supports both production and income formation. Loans to NFCs are used to finance production, which leads to sales revenues, wages paid, profits realised and economic expansions. So while an increase in NFC debt will increase debt in the economy, it also increases the income required to finance it. Consumer debt also supports productive enterprise since it drives demand for goods and services, helping NFCs to generate sales, profits and wages. It differs from NFC debt to the extent that HHs take on an additional liability since the debt does not generate income.

That said, less-productive FIRE-based lending continues to be the more important driver of private sector credit (see chart above), driven by resilient mortgage demand (see also chart below).

FIRE-based lending, which accounts for more than half of the outstanding stock of credit, supports capital gains through higher asset prices but does not lead directly to income generation. Loans to NBFIs are used primarily to finance transactions in financial assets rather than to produce, sell or buy actual output. Such credit may lead to an increase in the price of financial assets but does not lead (directly) to income generation. Mortgage or real estate lending is used to finance transactions in pre-existing assets. It typically generates asset gains as opposed to income (at least directly). As noted in previous posts, the shift towards FIRE-based lending has negative implications for leverage, future growth, financial stability and income inequality.

In short, the message from the money sector here is broadly positive, albeit with the “hidden-risks” that are associated with higher levels of FIRE-based lending.

In the second part of this analysis, I analyse money and credit trends in real terms to consider the implications here for the outlook for growth and business-cycle approaches to asset allocation. The conclusions here are less positive…

Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.