The fundamentalist wing of the monetarist school will be concerned by December money supply data, showing growth of only 1.1% in adjusted M4 (i.e. excluding holdings of non-bank financial intermediaries) over the last year and a small contraction over the latest three months. This weakness, however, is unlikely to signal an economic relapse because the demand to hold money has fallen in response to negative real interest rates and reviving confidence. Put differently, slow M4 expansion is being offset by a pick-up in the velocity of circulation, following a collapse before and during the financial crisis.
Key points:
The sectoral breakdown shows that weakness in adjusted M4 has been concentrated in the financial sector, with money holdings of insurance companies, pension funds and other investment managers down significantly since late 2008. This is likely to reflect a voluntary reduction in cash as institutions have become more confident about market prospects.
Non-financial M4 – i.e. money holdings of households and private non-financial corporations – rose by 2.6% in the year to December and at the same annualised rate over the latest three months.
The demand to hold money of households, like that of institutions, has been depressed by paltry yields and a revival of risk appetite. Household M4 rose by £23 billion during 2009 but retail inflows to unit trusts and OEICs are likely to have exceeded £25 billion (IMA figures for December are released tomorrow), up from just £4 billion in 2008.
Lower demand by institutions and households has allowed non-financial corporations to boost their liquidity despite slow aggregate money supply expansion. Corporate M4 rose by 4.2% in the year to December and by 6.2% annualised over the last three months. The liquidity ratio – sterling and foreign currency money holdings divided by bank borrowing – stabilised in December but has recovered significantly from its late 2008 low.
Broad money fundamentalists neglect a recent pick-up in narrow money M1 (notes and coin plus sight deposits), which rose an annual 7.2% in December. An increase in M1 relative to M4 is consistent with a recovery in velocity, with people shifting funds from savings accounts and time deposits into instant-access accounts in anticipation of increasing spending on goods and services or assets. M1 gave better warning of the recession than M4.
Bank rate is currently 1.9 percentage points below the annual increase in retail prices – the largest negative divergence since 1980. The shortfall will widen significantly further by the spring. The last sustained period of negative real rates, in the 1970s, was associated with a trend increase in M4 velocity – by 4.7% per annum on average over 1974-79. If velocity is embarking on another trend rise, slow broad money growth offers limited reassurance that inflation will return to target over the medium term.
