UK monetary trends are giving mixed signals for economic prospects. Broad money has picked up in both nominal and real terms, partly reflecting QE2, but narrow money remains weak. Narrow money would normally be accorded greater weight here but may have been depressed by a rise in term interest rates, resulting in funds shifting out of current accounts. Based on the broad money pick-up, the economy could surprise to the upside.
Broad money trends cannot be assessed by reference to the traditional M4 aggregate, which is artificially weak because of a fall in money holdings of “intermediate other financial corporations” – these corporations are essentially a conduit for interbank business, which is of little relevance to the economy. (Direct interbank business is excluded from money supply definitions). The preferred broad measure here is non-financial M4, comprising holdings of households and private non-financial companies. This rose by a solid 2.3%, or 4.6% annualised, in the six months to February.
Narrow money is best measured by M1, comprising cash in circulation and sight deposits. Unlike broad money, this remains weak, falling by 0.6% in the six months to February. This weakness, however, may be partly explained by banks’ bidding more aggressively for term funding, thereby encouraging households and firms to economise on current account balances. The average interest rate on household time deposits has risen from 2.54% to 2.77% over the last year.
The chart shows two-quarter or six-month changes in non-oil GDP and the two money measures, now expressed in real terms (i.e. deflated by seasonally-adjusted consumer prices). Real non-financial M4 rose by 0.6%, or 1.3% annualised, in the six months to February – the fastest since early 2009, just ahead of a spurt in growth. Real M1 is much weaker, showing a 2.2% decline. This is, however, better than a year ago, when real non-financial M4 was also contracting.
A provisional verdict is that monetary trends are signalling economic improvement but to an unknown extent – a revival in M1 would strengthen the case for optimism.