UK money supply trends continue to suggest an improving economy and no case for more QE.

Annual growth of non-financial M4 (i.e. broad money held by households and non-financial companies) rose to 5.0% in November, the highest since August 2008. The pick-up has been concentrated in liquid forms of money more likely to be associated with future transactions: non-financial M1 grew by an annual 5.8% in November and Divisia by 7.0%*– see chart.

5% broad money expansion is probably too high to be compatible with the 2% inflation target over the medium term, at least on current policy settings. Negative real interest rates on bank deposits depress the demand to hold money and boost the velocity of circulation (i.e. the ratio of nominal GDP to the money stock). Broad money velocity has risen by an average 1.2% per annum from a trough reached in the second quarter of 2009. Extrapolating this trend, 5% money growth, if sustained, suggests nominal GDP expansion of more than 6%. Even assuming, optimistically, that output could rise by 3% per annum, this would entail inflation of 3% plus.

The suspension of QE may cause money growth to moderate but a major slowdown is not expected here – earlier stimulus should have positive lagged effects while the funding for lending scheme should partially substitute for QE by lowering lending rates and stimulating credit demand, and encouraging banks to reduce their non-deposit funding.

*M1 comprises physical cash and sight deposits while Divisia combines broad money components using liquidity weights based on interest rates.