The US economy has faced persistent fears of setbacks, but the recovery continues to move forward. Our proprietary liquidity indicator suggests that the economic cycle remains on solid ground and that GDP growth in 2016 will be faster than in 2015.
About the Liquidity Flows Indicator The Bureau of Economic Analysis (BEA) designed the liquidity flows indicator decades ago. The original series was based on the concept that changes in liquid balances lead to directional movements in nominal spending, with a lead time of six to nine months.
The original series consisted of the growth in broad money (adjusted for inflation), the growth in business and consumer credit, and the change in liquid assets.
Simply stated, the liquidity flows indicator captures all the ways spending might be financed: cash, credit or liquid assets. Financial markets have evolved since the series was initially constructed. As a result, some modifications were necessary. Over the lifespan of the series, one of the biggest developments was the birth of the mutual fund industry and the inclusion of dollar flows into bond and stock funds.
If the liquidity indicator had failed to capture these flows, it would have been missing a large and growing part of liquid balances, since mutual fund accounts are highly liquid assets and serve as very close substitutes for traditional bank accounts.
Working with statisticians at the BEA, we redesigned the series and revised the liquidity flows indicator, which has been one of our proprietary indicators for the past 25 years.
Recent Forecasting Record
To be fair, growth of the liquidity flows indicator has overstated real gross domestic product (GDP) growth for the past several years (Display 1).
Part of this overcalculation can be explained by the indicator’s direct link to trends in the private sector and lack of any link to the public sector; growth in credit and liquid balances captures the borrowing trends of nonfinancial corporate businesses and households and their liquid balances.
Over the past six years, average annual growth in the liquidity flows indicator was 3.3%, compared with 2.9% in private sector GDP. Overall real GDP growth of 2.1% came in well below trends in the private sector, because the public sector has contracted 1.3% per year since 2010.
1986 and 1998 Offer Clues for 2016
The liquidity flows indicator is sensitive to changes in interest rates, lending The US economy has faced persistent fears of setbacks, but the recovery continues to move forward. Our proprietary liquidity indicator suggests that the economic cycle remains on solid ground and that GDP growth in 2016 will be faster than in 2015. conditions and the inflation rate. Over the past several months, the sharp outflow from equity mutual funds, which are included as liquid assets, has held back the growth rate of the overall indicator, but haven’t altered the underlying trend.
Sharp declines in energy prices that lead to a sizable drop in headline inflation have given a big lift to liquidity flow growth over time. Two periods—1986 and 1998— highlight this relationship. In those years, a 40% to 50% decline in energy prices triggered a 1- to 1.5%-percentage point drop in headline consumer price inflation, lifting real liquid balances. A similar phenomenon occurred in 2015; oil prices fell by close to 50% and headline inflation dropped 1.5 percentage points from 2014.
The link between stronger growth in liquidity flows and faster spending growth isn’t immediate. In fact, stronger flows suggested faster economic growth in 1986, but there was a noticeable drop in overall GDP growth of about threequarters of a percentage point. But the rebound in liquidity flows ultimately did translate into higher spending, with real GDP growth rebounding strongly in 1987. The playbook for 1998 was different: growth remained strong in that year and the following year.
If yesterday’s playbook is still accurate, real GDP growth should rebound by at least one percentage point in 2016, up from 2.4% growth in 2015.
By Joseph G. Carson, US Economist and Director, Global Economic Research, AB
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