Widely-ignored UK money supply measures predicted the current economic pick-up and suggest that growth will remain robust at least through the first quarter of 2014.
The “best” monetary measures for forecasting purposes are “non-financial” M1 and M4, i.e. excluding holdings of non-bank financial corporations*. Narrow money M1 comprises physical cash and sight deposits while the broader M4 aggregate adds time deposits and cash ISAs. M1 is a measure of money held for transactions purposes so tends to perform better as a leading indicator of the economy.
Annual growth in non-financial M1 and M4 rose substantially during 2012, clearly signalling a pick-up in economic expansion in 2013, allowing for a typical lead time of six months or so from monetary changes to demand and activity – see chart. M1 growth has continued to climb in recent months, with August’s reading of 11.0% the strongest since August 2004, before an economic boom**. M4 expansion, by contrast, has moderated to 4.8% from a peak of 5.6% in April, although remains higher than in any month between October 2008 and July 2012.
The M4 slowdown is currently of little concern because 1) it has been modest, 2) there has been no confirmation from M1 and 3) further analysis reveals that non-financial corporations have increased their foreign currency deposits significantly recently – such deposits are excluded from M4 but are probably relevant for assessing corporate liquidity and spending prospects***.
Consensus neglect of monetary signals partly reflects an obsession with bank credit. Credit has a much looser relationship than money with economic activity and tends, if anything, to lag the cycle. Annual non-financial M4 lending growth edged into positive territory in August for the first time since November 2011, consistent with a lagged response of credit demand to economic improvement – see chart. This pick-up should continue: arranged but unused sterling credit facilities – a leading indicator of lending – rose by an annual 1.5% in August, the fastest since February 2008.
The “monetarist” rule is that money supply changes affect economic activity in the short run but filter through to prices after about two years. The downside of recent monetary trends is that the current decline in inflation is likely to reverse from early 2014 in lagged response to the rise in money growth during 2012. The MPC may face a “crunch point” next spring as unemployment nears 7%, the housing market overheats and inflationary clouds darken.
*That is, comprising holdings of households and private non-financial corporations. The non-financial measures are not produced by the Bank of England but can be calculated from published data.
**Gross value added excluding oil and gas rose by 5.3% in the year to the fourth quarter of 2005.
***A wider aggregate including foreign currency deposits rose by an annual 5.6% in August.
