18th October 2015 by Simon Ward
Money supply analysis plays no role in policy formation under the current Monetary Policy Committee (MPC). Historically, policy-makers have run into trouble when they have ignored money and credit trends. Broad liquidity of households and non-financial firms is currently growing at the fastest rate since 2008. The velocity of circulation, meanwhile, has been stable in recent years, having fallen steadily during the 1990s and 2000s. If this stability persists, or velocity rises, liquidity growth at the current pace will cause inflation to overshoot the 2% target over the medium term.
It is clear from the Inflation Report and meeting minutes that the current MPC membership regards the behaviour of money and credit quantities as irrelevant for policy-making. The August rejig of the format of the Inflation Report involved the removal of the previous chapter on “Money and asset prices”. The word “money” did not appear in the August publication. It was similarly absent from the September minutes, except in the heading “Money, credit, demand and output”; the following section focused exclusively on GDP data and other activity news.
The further downgrading of the role of money supply analysis has coincided with a pick-up in broad liquidity growth. The quantity of M4 money and National Savings held by households and private non-financial corporations rose by 6.3% in the year to August, the fastest annual growth rate since June 2008 – see first chart*. It is important to include National Savings to capture a switch from bank deposits into NS pensioner bonds earlier this year: M4 holdings alone grew by an annual 5.3% in August. The pensioner bonds, and other NS products, are effectively “money” and would be included in M4 if they were issued by a bank rather than the government.
Historically, UK policy-makers have often ignored or explained away rises in money supply growth that were correctly signalling excessively loose policy. Annual growth of the above liquidity measure rose to nearly 9% in 2004, three years before the peak of the credit bubble and a subsequent sustained increase in inflation. Inflation Reports of the time – which did, at least, devote space to a discussion of monetary trends – suggested that strength was due to bank deposits being used as a savings vehicle following the equity bear market of the early 2000s. The signal, in any event, was ignored, with Bank rate cut in 2005, a change that served to sustain and increase monetary excess.
Chancellor Nigel Lawson, similarly, argued that the monetary aggregates were being distorted by financial liberalisation to justify suspending a target for broad money in 1985. Bank rate was cut in 1986-87 in response to temporarily weak price pressures, following which annual liquidity growth rose to over 15% in 1988, fuelling a housing market boom / bust and a surge in RPIX** inflation to a peak of 9.5% in 1990. Mr Lawson claimed that the monetary aggregates were “all over the place”; it was his policy, instead, that was in disarray.
Current liquidity growth of a little over 6% is far below prior extremes. The future inflation rate implied by a given growth rate, however, depends on the trend in the velocity of circulation – the value of national income supported by each pound of liquidity***. Velocity trended down in the late 1990s and 2000s, i.e. households and firms wanted to increase their liquidity holdings faster than national income – second chart. The decline over 1995-2009 averaged 2.1% per annum. Liquidity growth of 6% during this period, therefore, would have implied a rate of increase of income of about 4% per annum. Allowing for a trend rate of output expansion of about 2.5%, this would have been too low to achieve the 2% inflation target.
Velocity, however, recovered slightly after 2009 and has been broadly stable in recent years. One reason is that the interest rate on bank deposits has been much lower relative to inflation than in the past, reducing the attraction of money as a savings vehicle. If velocity were to continue to move sideways, sustained 6% liquidity growth would be reflected, in time, in an equal rate of increase of national income. This, in turn, would imply inflation of about 3.5%, assuming 2.5% trend output expansion.
The pick-up in liquidity growth argues for bringing forward an interest rate increase, despite current near-zero inflation. Suggestions that the next policy move should be to ease – or the first rate rise should be postponed until late 2016 or 2017 – are dangerous, recalling the 1986-87 and 2005 mistakes. There are two risks to raising rates now. First, the liquidity pick-up may turn out to be temporary; growth may subside back to the 2013-14 average of 4.75%, a level broadly consistent with the inflation target assuming stable velocity. Strengthening credit trends, however, suggest that faster liquidity expansion will be sustained. Bank lending to households and private non-financial corporations rose by 2.5% annualised in the six months to August, the largest such increase since November 2008. Leading indicators such as mortgage approvals and arranged but unused credit facilities are positive, while M&A activity may spur additional corporate borrowing. Liquidity growth has also been boosted recently by capital inflows from overseas, possibly partly reflecting spill-over from the ECB’s QE programme, which is scheduled to be sustained for another year.
The second risk is that recent velocity stability will give way to a renewed decline, implying that 6% liquidity growth is compatible with meeting the inflation target. This would mirror developments in the 1990s, when velocity stabilised for several years after the 1990-91 recession before resuming a downtrend later in the decade. This fall occurred, however, only after interest rates had been raised to well above the prevailing level of inflation, restoring the attraction of bank deposits as a savings vehicle. Governor Carney’s suggestion that the future norm for rates will be no higher than 2.5%, however, implies that real deposit rates will remain low or negative for the foreseeable future.
The current environment may bear greater similarity with the late 1960s / early 1970s, when a period of velocity stability gave way to a sustained rise, partly because interest rates failed to keep pace with an increase in inflation, resulting in savers wishing to reduce their money holdings. A velocity pick-up now would guarantee a future inflation overshoot.
Money supply analysis is rarely straightforward and analysts can reasonably disagree about the interpretation of current trends. The MPC should, at least, examine and explain the issues. The current mix of doctrinal aversion and lack of interest is a recipe for another policy mistake.
*The money / liquidity growth data in the chart refer to end-quarters, except for the final points, which are for August.
**RPIX = retail prices excluding mortgage interest.
***Velocity is calculated here as the ratio of GDP at market prices at an annualised rate to the stock of broad liquidity eight quarters previously. A lag is applied to allow for the delayed impact of monetary changes on output and prices.