A key “monetarist” insight is that the supply of money can diverge from the money demand of households, corporations and financial institutions. “Excess” money will tend to flow into economies and markets, boosting activity and prices. Conversely, growth and asset values are at risk when money supply expansion falls short of demand.

Implementing the concept requires estimates of the growth rates of money supply and demand. The appropriate supply definition is a broad one, including currency, sight and time deposits, savings accounts and money market mutual funds. Money demand cannot be observed directly but under normal circumstances is likely to be related to the level of economic activity, which can be proxied by industrial production (available on a more frequent and timely basis than GDP).

As the chart shows, inflation-adjusted broad money growth in the Group of Seven (G7) major economies has been running well ahead of industrial output expansion in recent months but this has proved a poor guide to monetary conditions affecting economies and markets, for two reasons. First, the collapse of the “shadow” banking system has led to an enforced expansion of banks’ balance sheets, inflating published broad money numbers. (An adjusted measure – including US commercial paper – is shown in the chart but does not capture the full extent of such “reintermediation”.)

Secondly, money demand has probably been growing much faster than industrial production, as the financial crisis has prompted a flight into capital-certain liquid assets. Changes in the precautionary demand for cash are likely to be correlated with measures of investor risk aversion. These appeared to be moderating during the summer but have subsequently risen to new highs.

Given these uncertainties, narrow money M1 – comprising currency and instant-access deposits – is likely to be a better guide to monetary conditions currently than the broad money / output growth gap. Any “excess” money is likely to show up in M1 before being deployed in the economy or markets. As the chart shows, inflation-adjusted G7 M1 fell by 2% in the year to August – the largest annual contraction since 1981.

Empirical analysis indicates that changes in real M1 growth lead the economy by about six months and are roughly coincident with stock market movements. The recent slide therefore validates equity market weakness and signals a grim near-term economic outlook.

Data confirmation should be awaited but real M1 could be near a trough, reflecting three factors. First, US M1 has accelerated sharply in recent weeks. However, this appears to reflect a “safe-haven” shift out of money market mutual funds into demand deposits rather than a genuine improvement.

Secondly, M1 is inversely correlated with deposit interest rates so recent and prospective central bank easing will be supportive.

Thirdly, real trends will benefit from a big fall in headline inflation over coming months as energy and food price effects reverse dramatically.