UK monetary growth remains broadly stable, suggesting continued solid economic expansion and rising domestic inflation.

The broad and narrow monetary aggregates judged here to be most informative for forecasting purposes are M4 and M1 excluding financial sector deposits*. Annual growth in the M4 measure was 4.9% in October, equal to the average over the past two and a half years. Annual growth in non-financial M1 was significantly stronger, at 9.0%, though has fallen from a peak of 12.0% in October 2013.

Previous posts argued that broad money growth of more than about 4% per annum (pa) is inconsistent with achievement of the 2% inflation target over the medium term, unless interest rates rise significantly. This is because the velocity of circulation of broad money is increasing as households and firms economise on money balances in response to negative real deposit interest rates. Measured velocity** has risen by 0.5% pa since the recession ended in the second quarter of 2009. This compares with a fall of 2.9% pa in the prior 10 years, when real interest rates were significantly positive – see chart.

Current broad money growth of about 5% pa coupled with a velocity increase of 0.5% suggests nominal economic expansion of about 5.5%. Trend real economic growth is unlikely to be more than 2.5% pa, so nominal expansion of 5.5% implies an eventual rise in inflation to about 3%.

The forecast increase in nominal expansion is well advanced: annual growth in nominal gross value added (GVA) rose to 5.3% in the third quarter of 2014, a post-recession high, according to preliminary data. This was split between a 2.9% increase in output and domestically-generated inflation of 2.3%, as measured by the GVA deflator – see previous post. With the economy now operating near capacity, the output growth / inflation split is likely to become less favourable.

*Financial sector deposits are volatile and contain less information about near-term economic prospects.
**Nominal gross value added divided by non-financial M4 six quarters earlier. The six-quarter lag is a compromise based on the Friedmanite rule that money leads activity by about two quarters and inflation by about two years.