UK money trends remain consistent with inflation normalisation, implying that further MPC tightening will unnecessarily prolong and deepen the recession. 

The artificial boost to headline money numbers from cash-raising by LDI funds partially unwound in October – the Bank of England’s M4ex measure fell by 0.6% on the month after a 2.6% September jump. 

As usual, the focus here is on non-financial money measures, i.e. excluding volatile and uninformative financial sector holdings. The September surge in financial money was certainly no signal of future economic or inflation strength.

Annual growth of non-financial M4 was little changed at 3.4% in October, with the six-month annualised pace of increase lower at 2.7%. Annual non-financial M1 growth dropped to 2.6%, with the aggregate little changed in the latest six months – see chart 1. 

Chart 1

The latter weakness reflects households and non-financial firms switching out of sight into time deposits in response to higher term interest rates. The decision to lock away money is a negative economic signal, indicating weak near-term spending intentions. 

Broad money growth of 3-3.5% is unlikely to be sufficient to prevent inflation from falling below 2% over the medium term, unless potential economic expansion is even weaker than the generally assumed 1-1.5% pa. (This assumes no rise in velocity, which has exhibited a long-term downward trend, including during the 2010s.) 

Non-financial M4 is growing more slowly than the comparable Eurozone aggregate, non-financial M3, which rose by 4.8% in the year to October. 

The argument continues to be made that spending will be supported by the deployment of “excess” savings built up in 2020-21. The assessment of “excess” need to take into account inflation – fast price rises require more saving to maintain the real value of existing wealth. 

Real non-financial M4 has now crossed beneath its 2010-19 trend – chart 2. The suggestion is that money holdings are broadly in line with requirements given recent high inflation – there is no longer any buffer to cushion spending against an ongoing real money squeeze. 

Chart 2

UK monetary statistics for September were heavily distorted by cash-raising by LDI funds to meet collateral requirements for derivative contracts. 

The headline M4ex broad money aggregate surged by £91 billion, equivalent to 2.7% after seasonal adjustment, between end-August and end-September. Money holdings of non-bank financial corporations* accounted for £71 billion of this increase. 

The long-standing practice here has been to focus on non-financial monetary aggregates, where available, because movements in financial sector money holdings can be erratic and usually have little bearing on near-term economic prospects. 

Non-financial M4, encompassing money holdings of households and private non-financial businesses, rose by £21 billion, or a seasonally adjusted 0.3%, in September. Annual growth eased to 3.5%, with the aggregate expanding at an annualised rate of 3.2% in the latest three months – see chart 1. 

Chart 1

The Bank publishes an industrial breakdown of sterling deposits at commercial banks. The LDI cash-raising is reflected in large monthly increases in deposits of insurance companies, pension funds, fund managers and securities dealers (LDI funds posted margin to dealers, with the dealers placing the funds with banks). This group added a combined £39 billion to sterling deposits in September. 

However, the rise in aggregate deposits of non-financial corporations, according to this table (C1.1), was £46 billion in September – far short of the £71 billion increase in their total M4 holdings (A2.2.3). This represents a record divergence – chart 2. 

Chart 2

The “missing” funds show up on the Bank’s balance sheet: private sector sterling deposits held at the Bank jumped by £28 billion in September (B2.2.1), also a record movement – chart 3. 

Chart 3

Securities dealers and clearing houses have accounts at the Bank, which they appear to have used to deposit a portion of the margin cash received from LDI funds. 

Note that this increase in deposits is not attributable to the Bank’s gilt-buying operation, which started on 28 September: the Bank’s holdings of public sector securities fell by £5 billion during September. 

Sterling cash-raising related to the LDI crisis may have totalled about £67 billion – the sum of the £39 billion increase in commercial bank deposits of insurance companies, pension funds, fund managers and dealers and the £28 billion placed at the Bank. 

LDI funds were also scrambling to raise foreign currency liquidity. The rise in foreign currency deposits of the same group of institutions rose by £25 billion in September. 

Not all the cash-raising represents sales of assets – LDI funds were also borrowing to meet margin requirements. Sterling bank lending to the same group rose by £16 billion in September, with foreign currency lending up by £18 billion. 

Was the Bank involved in facilitating the supply of liquidity to the funds, over and above its gilt-buying operation? It is unlikely to have played a direct role but banks may have borrowed from its discount window to onlend to LDI funds. 

This possibility is suggested by partial data on the Bank’s sterling liabilities and assets – it no longer publishes a full balance sheet on a timely basis. Identified sterling liabilities, including bank reserves and the sterling deposits referred to earlier, rose by £14 billion, while assets – including gilt holdings – fell by £6 billion. The implication is that unpublished items on the balance sheet resulted in the creation of £21 billion of identified sterling liabilities, with discount window lending a candidate explanation. 

*Excluding intermediaries such as central clearing counterparties.

Chinese money trends remain moderately favourable but the economy has been held back by covid disruption and now faces an export threat from global recession. Stocks, meanwhile, have been hit by a ramping up of the Biden administration’s war on Chinese tech along with President Xi’s take-over of economic policy-making, which investors have viewed as negative for longer-term growth prospects. “Excess” money has accumulated in the bond market and has the potential to flow into the economy and equities if the covid drag fades and policy-makers signal a continued commitment to private-led economic expansion. 

Six-month growth rates of nominal narrow and broad money have risen significantly over the past year, with the recovery reflected in a rebound in two-quarter nominal GDP expansion in Q3 despite further covid lockdowns – see chart 1. August / September numbers hint at a peak in money growth but continuing policy support, including directions to banks to expand lending, argues against a relapse – chart 2. 

Chart 1

Chart 2

The faster growth of money than GDP, and of broad money relative to narrow, indicates that the transmission of monetary stimulus is incomplete and “excess” money is currently trapped in the financial system. The key reason for the impaired transmission, of course, is the zero covid policy. With economic activity suppressed, excess money has flowed into the bond market, reflected in a fall in government yields despite the global surge and a tightening of onshore credit spreads – chart 3. 

Chart 3

The economy, nevertheless, has been less weak than many feared, as confirmed by the Q3 GDP number and September monthly activity data, showing a pick-up in industrial output and a stabilisation of new home sales – chart 4. A H1 fall in the interest rate on new mortgages and other easing measures are supporting housing market activity, with secondary sales reportedly growing strongly – chart 5. 

Chart 4

Chart 5

Retail sales remain weak but household money holdings are growing solidly, suggesting fire-power to lift spending if / when covid disruption eases – chart 6. 

Chart 6

Six-month growth of Chinese real narrow money contrasts with contractions in most major economies – chart 7. The level of growth, however, is modest by historical standards, suggesting moderate economic expansion at best: current growth, for example, has been consistent with a manufacturing PMI new orders index of about 50 – chart 8. 

Chart 7

Chart 8

Export weakness due to global recession could drag the PMI lower, as occurred during the GFC. The Chinese reading, however, would be expected to hold up relative to global PMI new orders, which may be heading to 40. 

The moderately positive message for economic prospects from real money trends is supported by a recent recovery in a composite leading indicator calculated here, which attempts to mirror the components of the OECD’s US leading indicator – chart 9. 

Chart 9

Recent dramatic tightening of UK credit conditions along with Bank of England plans for large-scale QT and a “significant” rate hike could tip current weak broad money growth over into contraction, in turn threatening a deflationary depression. 

To recap, the preferred broad measure here – non-financial M4, comprising sterling money holdings of households and private non-financial firms – grew at an annualised rate of just 0.8% in the three months to August. 

The Bank’s broad measure, M4ex, also includes money holdings of financial institutions, which may rise sharply in September / October, reflecting pension funds’ “dash for cash”. Any such strength is not expansionary / inflationary, increasing the importance of focusing on non-financial money measures. 

In real terms, non-financial M4 has retraced almost back to its pre-pandemic trend as the 2020-21 money surge has passed through to prices – see chart 1. There is no longer a monetary “excess” to support spending or sustain high inflation. 

Chart 1

Current monetary weakness will take time to be reflected in slower price momentum. Prices may continue to outpace nominal money expansion near term, sustaining the real-terms squeeze. 

How likely is it that nominal broad money will begin to contract? 

The “credit counterparts” analysis links movements in broad money to changes in four other components of the banking system’s balance sheet: lending to the public and private sectors, net overseas assets and non-deposit funding. 

Lending to the public sector includes QE / QT. The Bank plans to reduce its gilt holdings by £80 billion over the next 12 months, equivalent to 3.4% of non-financial M4. 

The monetary drag will be smaller to the extent that there is a compensating rise in commercial banks’ gilt holdings. Banks bought £13 billion of gilts in the year to August. Purchases reached a maximum 12-month rate of £50 billion in the wake of the GFC when banks were under strong regulatory pressure to boost their liquid assets. A plausible scenario is that banks will absorb between a third and a half of the QT supply, in which case lending to the public sector would have a contractionary impact on broad money of 1.7-2.2% over the next 12 months. 

Bank lending to the private sector has been supporting broad money growth recently: lending to households and private non-financial firms expanded at a 3.1% annualised rate in the three months to August. The Bank’s Q3 credit conditions survey, released yesterday, signals weakness ahead: future credit demand balances remained soft while availability plunged – chart 2. 

Chart 2

The survey closed on 16 September so does not capture the further surge in market rates and spreads in the wake of the mini-Budget. 

Residential mortgages account for 70% of the stock of lending to households and non-financial firms. The future demand and availability balances for secured credit to households last quarter were comparable with the lows reached at the depths of the GFC – before recent turmoil. Mortgage approvals could halve – chart 3.

Chart 3

Bank lending expansion, therefore, could plausibly grind to a halt, as it did in the wake of the GFC. The combined monetary impact of public and private sector lending would then become contractionary.

The other credit counterparts – banks’ net overseas assets and their non-deposit funding – are volatile and difficult to forecast but have had a combined contractionary impact over the last 12 months. The joint influence, however, tends to correlate inversely with lending to the private sector, so could become supportive as lending weakens. 

The “best case” scenario appears to be weak broad money expansion with a significant risk of contraction. 

The warranted policy response is to cancel QT and rate hikes. The Bank, instead, has boxed itself into a restrictive stance in a misguided effort to rebuild its shattered credibility and avoid a charge of “fiscal dominance”. 

The hope is that a government U-turn on the mini-Budget together with an easing of global interest rate pressures result in a reversal of recent market-driven credit tightening. A Bank policy shift is coming but may have to wait for evidence of sharply contracting economic activity.

UK monetary trends continue to argue against Bank of England policy tightening. 

Annual growth of non-financial M4 – comprising money holdings of households and private non-financial firms – was 3.7% in July, below a 4.4% average in the five years preceding the pandemic. The aggregate expanded at an annualised rate of only 2.0% in the latest three months – see chart 1. 

Chart 1

Growth of the Bank’s preferred broad money measure, M4ex, is higher, at 4.8% in the year to July and 4.9% annualised in the latest three months. This aggregate includes money holdings of financial companies, which have been rising strongly but are of little relevance for near-term demand prospects. 

Excessive money growth in 2020-21 boosted demand and “accommodated” price pressures due to various supply shocks, resulting in current high inflation. Is there still a monetary overhang from that period, warranting further policy tightening despite recent slow money growth? 

Expressed in real terms relative to consumer prices, non-financial M4 is almost back to its pre-pandemic trend – chart 2. The suggestion is that the monetary excess has already been largely “absorbed” by higher prices. 

Chart 2

In the absence of an overhang, the recent pace of money growth, if sustained, should be consistent with inflation returning to target within the two to three year horizon relevant for policy. Further tightening risks unnecessary economic pain and an eventual undershoot. 

Are the Truss government’s plans for large-scale fiscal loosening inflationary, warranting offsetting monetary policy action? 

Whether energy subsidies, tax cuts  etc. will prove inflationary depends on how they are financed. The banking system is likely to provide at least part of the funding, implying a first-round boost to broad money. 

A renewed rise in annual non-financial M4 growth to more than 6% would be inconsistent with medium-term inflation normalisation, requiring offsetting Bank action. 

Such a scenario, however, is far from guaranteed. Money growth was arguably on course to fall to a dangerously low level, reflecting planned Bank QT of £80 billion a year (equivalent to 3.4% of the current level of non-financial M4), a slowdown in mortgage lending and external outflows due to an expanded balance of payments deficit. 

A boost from monetary financing of fiscal loosening may offset such negative influences without pushing money growth significantly higher. 

A sensible approach, therefore, would be for the Bank to wait to assess the monetary consequences before deciding whether fiscal plans require a policy response. The current MPC membership, of course, has no understanding of or interest in monetary analysis. 

The Keynesian consensus view is that fiscal expansion necessarily implies a higher level of demand that the Bank cannot allow. The monetarist response is that, unless it leads to faster money growth, fiscal loosening will push up market interest rates and “crowd out” private spending. Surging gilt yields suggest that this scenario is already playing out. The Bank should avoid piling on the pain.

The assessment here a month ago was that Chinese monetary policy easing was gaining traction but that additional stimulus and a further recovery in narrow money momentum were required to adopt a positive view of economic prospects.

These conditions have been partially fulfilled: the PBoC has delivered additional easing and six-month narrow money growth picked up in July; however, a food-driven rise in CPI momentum held back real money expansion.

The news, on balance, warrants an upgrade to the assessment: economic momentum is judged likely to recover in late 2022 / H1 2023 barring further negative shocks.

This interpretation, of course, is at odds with deepening consensus gloom. According to the consensus, this week’s “surprise” rate cut was a panic response to worryingly weak July activity and credit data.

The PBoC, like other central banks, controls short-term money market rates by adjusting the supply of bank reserves relative to demand*. Money rates have fallen steeply since late July, signalling that the PBoC was stepping up easing – see chart 1. Rather than a panic move, the cut in official rates confirms a policy shift that began weeks ago.

Chart 1

Weaker-than-expected July activity numbers probably reflect payback for May / June gains boosted by catch-up effects following covid disruption. Seasonally-adjusted levels of key series remained comfortably above April lows – chart 2.

Chart 2

Talk of credit weakness is also exaggerated. The small rise in broad credit (total social financing) in July follows a larger-than-expected increase in June, with six-month growth the same as in April / May – chart 3.

Chart 3

The consensus view ignores better monetary data. Six-month broad money growth in July was stable at the highest level since August 2020. Narrow money growth rose further to its highest since January 2021.

The disappointment in July data, from the perspective here, was a pick-up in six-month CPI momentum, which dragged real money growth lower despite the nominal acceleration – chart 4.

Chart 4

CPI strength was driven by food (pork) prices with annual core inflation still low (0.8%) and PPI inflation falling. Earlier monetary weakness argues for a benign near-term inflation outlook and base effects suggest a decline in six-month CPI momentum in September / October.

*The supply of reserves reflects factors such as flows into / out of government accounts at the central bank and foreign exchange intervention as well as open market operations, changes in reserve requirements etc. Estimates of net supply based only on observable OMOs and other interventions are liable to be misleading whereas movements in money rates reflect the balance of all supply / demand influences.

Chinese monetary data for June confirm that policy easing is gaining traction but narrow money growth remains modest compared with previous reflationary episodes and a H2 economic recovery is likely to be dampened by weaker exports.

GDP fell by 2.6% between Q1 and Q2 but monthly activity data indicate a significant recovery from an April trough, with June exports and retail sales particularly strong – see chart 1.

Chart 1

Six-month growth rates of narrow and broad money, meanwhile, rose further in June, to 17- and 22-month highs respectively – chart 2.

Chart 2

Six-month growth of real narrow money has moved sideways, with faster nominal expansion matched by a rise in consumer price momentum. Nevertheless, positive and stable real money growth compares favourably with deepening contractions in the US, Europe and many emerging economies – chart 3.

Chart 3

What is driving faster money growth? The credit counterparts analysis of broad money shows major contributions from banks’ net lending to government, reflecting expansionary fiscal policy, and from unspecified items within non-monetary net liabilities. Growth of bank lending to other sectors bottomed last year but has yet to establish a rising trend – chart 4.

Chart 4

Six-month growth of broad money is close to levels reached in previous successful reflationary episodes since the GFC but narrow money growth remains well below the corresponding highs – chart 2. The judgement here is to place more weight on the less upbeat message from narrow money. The demand for broad money may have been boosted by risk aversion due to housing and equity market weakness, as well as the pandemic. Domestic credit expansion, like narrow money growth, is below previous reflationary highs – chart 4.