The gap between the net-of-tax dividend yield on equities for a basic rate taxpayer and the net interest rate on a competitive bank / building society savings account stood at 1.90% in July compared with an average negative difference of 1.99% between 1954 and 2012 (i.e. 59 years). The gap was higher in only one quarter over this period – the first quarter of 2009, which marked the low of the 2008-09 equity bear market.

The wide gap reflects super-low interest rates rather than attractive equity prices – the net dividend yield is close to its long-run average. The higher income available on shares, nevertheless, could prompt a “great rotation” out of cash into equities, underpinning prices in the short run but exposing small savers to a medium-term risk of capital loss. Such a portfolio shift would imply that broad money supply expansion of as little as 4% per annum could be inflationary.

The chart shows the dividend yield on equities on an as-published basis and net of basic rate tax. The published yield refers to actual dividends paid since 1998; basic rate taxpayers are not liable for tax on such dividends* so the published and net yields are the same. Before 1998, the published yield was calculated on a gross basis, i.e. including a tax credit that was reclaimable by tax-exempt investors; the net yield applies the basic or standard rate of (dividend) income tax to this gross measure. The yield data refer to the FTSE all-share index from 1963 and the FT30 index for earlier years.

The deposit rate series links together interest rate data for bank / building society savings products that were competitive historically. The rate used in recent years is the average quoted rate on two-year fixed-rate bonds, sourced from the Bank of England. This series begins in 2009; the effective rate on one- to two-year household time deposits is used between 2004 and this date. Earlier figures refer to the average or recommended building society ordinary share rate.

The net dividend yield / deposit rate gap was positive in only 21 out of 216 quarters between 1954 and 2007, before the 2008-09 financial crisis. The gap of 1.90% in July compares with a record difference of 2.46% in the first quarter of 2009. Unlike now, equities were then cheap in absolute as well as relative terms.

Recent gap widening, of course, reflects a collapse in savings rates since summer 2012, due mainly to ECB and Bank of England interventions to reduce bank funding costs. The interest rate on two-year fixed-rate bonds, for example, fell from 3.17% to 1.80% between July 2012 and July 2013.

High deposit interest rates relative to inflation and yields on other assets contributed to a sustained rise in the ratio of the broad money supply to nominal GDP in the decades preceding the 2008-09 financial crisis. The velocity of circulation of money, in other words, fell steadily.

Recent unappealing savings rates have arrested this trend. The ratio of broad money, M4ex, to nominal GDP, for example, was unchanged between the fourth quarter of 2009 and the first quarter of 2013. With savings rates continuing to sink, the “equilibrium” M4ex / GDP ratio may embark on a sustained decline, as it did in the 1970s when real interest rates were last significantly negative.

On an optimistic view that the economy can sustain trend real growth of 2.5% over the medium term, nominal GDP expansion of 4.5% per annum is consistent with achievement of the 2% inflation target. If the M4ex / GDP ratio is stable, this implies target-consistent broad money growth of 4.5%. If the ratio declines, as seems likely, even this rate of increase will generate an inflation overshoot.

*More precisely, a tax credit of 10% offsets the 10% dividend income tax rate for such taxpayers.