Economic “optimists” argue that UK / US recessions will be avoided because households and firms have accumulated a “war chest” of excess monetary savings that will be deployed to support spending. The assessment here is that high inflation is rapidly eroding excess money balances while households / firms are unlikely to reduce precautionary savings against a backdrop of deteriorating economic / financial conditions.
Chart 1 is a recreation of one used to support the optimistic case. The suggestion is that UK households have amassed £170 billion of excess monetary savings, equivalent to 11% of annual disposable income.
A statistical issue here is the reliability of a measure of “trend” calculated over just two years.
More importantly, the demand to hold money depends on a host of influences, of which the most important is the price level. Any assessment of the magnitude of excess money balances should, at a minimum, take account of inflation.
Chart 2 recasts the analysis in real terms, while calculating “trend” over a 10-year period. The suggestion is that high inflation has already eroded a large proportion of the monetary excess, with the current deviation equivalent to 3% of disposable income.
Real money holdings were 2.7% above trend in April. Household M4 grew at a 4.2% annualised rate in the latest three months. If this pace were to be maintained, nominal money holdings would rise by 2.4% by Q4 2022. The Bank of England’s May forecast of CPI inflation of 10.2% in Q4, meanwhile, implies an increase in prices of 5.0% between April and then. These developments would result in real money holdings contracting by a further 2.5% by Q4. With “trend” increasing by 1.2% between April and Q4, the positive gap would be eliminated without any additional consumer spending.
Recent UK monetary trends are consistent with a medium-term return of inflation to target, implying that the Bank of England should hold policy even though current inflationary pressures will be slow to fade and the consensus will claim that it is “behind the curve”.
The alternative would be to exacerbate a severe squeeze on real money balances that – on the view here – already guarantees a GDP recession.
Satisfactory inflation performance in the five years before the pandemic was a consequence of low and reasonably stable money growth. Three-month expansion of the preferred broad aggregate here, non-financial M4*, averaged 4.4% annualised, mostly fluctuating between 2% and 7% – see chart 1.
The covid shock arguably warranted policy action to move money growth temporarily to the top of this range. Instead, the Bank’s grotesquely miscalibrated QE programme drove three-month growth to 31% annualised in May 2020. A subsequent sharp slowdown was followed by a rise to a second peak of 15% in January 2021 following an incomprehensible decision to extend QE in November 2020.
Three-month growth, however, has been back inside the pre-pandemic range since July last year – it was 4.2% annualised in April.
Monetary trends have yet to reflect fully recent policy tightening. The April-only numbers hint at further weakness: non-financial M4 rose by only 0.2% on the month, while non-financial M1 was flat.
The latest three-month increase of 4.2% annualised may overstate underlying growth because of retail investors switching out of mutual funds into bank and building society deposits in response to recent market losses. A broader savings measure including National Savings, foreign currency deposits and retail mutual funds grew by an estimated 2.9% annualised in the three months to April**.
A further rise in consumer price momentum, meanwhile, has intensified the squeeze on real money balances. Non-financial M4 and M1 fell by 3.4% and 3.3% (not annualised) respectively in the six months to April – chart 2.
Although three-month money growth has been running at a target-consistent pace for several quarters, the usual “long and variable lag” suggests that a normalisation of inflation may be delayed until late 2023 or 2024.
Economists were last week debating whether Chancellor Sunak’s latest cost of living support package would add to inflationary pressures. The net cost of £10 billion equates to only 0.4% of non-financial M4, i.e. the package won’t shift the dial on monetary trends and, by extension, inflation prospects even if fully financed via the banking system (unlikely).
*M4 holdings of the household sector and private non-financial corporations. **This assumes zero net purchases of retail mutual funds in April, following net sales in February and March.
March CPI numbers globally have mostly surprised on the upside (again) but monetary trends and other considerations continue to suggest significant relief in 2023-24.
G7 annual CPI inflation rose to 6.8%* in March, the fastest since 1982.
A post in September 2020 presented a “monetarist” forecast that G7 inflation would average 4-5% pa in 2021-22, i.e. between Q4 2020 and Q4 2022. Money growth in H2 2020 / 2021 was faster than assumed in the post and an outturn in the 5-5.5% range is now likely. (Annual CPI inflation was 4.9% in Q4 2021 and a retreat from the current level is likely over the remainder of 2022, partly reflecting commodity price base effects.)
The current inflation surge reflects a money growth surge in 2020 – G7 annual broad money growth* rose from 6.2% in February 2020 to 16.9% by June, eventually peaking at 17.3% in February 2021. This increase has now almost fully reversed, with annual growth estimated to have fallen below 7% in March – see chart 1.
Three-month annualised growth is down to about 4%, close to its average in the five years before the pandemic – chart 2.
Broad money growth has slowed by much more than after a comparable surge in the early 1970s. Annual money growth then bottomed above 10% before rebounding strongly, resulting in inflation remaining high and reaching a second peak in 1980.
Sustained broad money expansion of 4% would be consistent with inflation rates returning to target, though possibly not until 2024.
Will money growth stage a 1970s-style rebound? As previously discussed, this was triggered by monetary policy-makers abandoning restraint as economies weakened. Central bankers only recently shifted hawkishly and the hurdle for a policy U-turn is high.
The broad money slowdown partly reflects the winding down of QE, suggesting further weakness if QT plans are implemented. The proposed reduction of $95 billion per month in the Fed’s securities holdings is the equivalent of 0.35% of US broad money. The actual negative impact will be smaller because of various leakages, e.g. Fed disposals are likely to be partly absorbed by an increase in holdings of commercial banks (relative to a no QT scenario), implying a neutral effect on broad money. A reasonable assumption is a “multiplier” of 0.5, i.e. a drag on US broad money of 0.175% per month, or 2.1% over a year. This would cut 1.1 pp from G7 annual broad money growth.
With central bank actions on course to exert a negative impact, a rebound in money growth depends on “endogenous” strength in bank lending to the private sector. Monetary economists continue to debate this prospect. “Bulls” note a significant lending pick-up in recent months: G7 annual loan growth, adjusted for US PPP disbursements / forgiveness, was an estimated 6% in March, faster than in any month over 2009-2019. The suspicion here is that strength partly reflects the stockbuilding cycle, which is peaking, while recent yield rises will curb housing credit demand.
Central bank loan officer surveys are useful for gauging the outlook. The next Fed survey is due in early May but the ECB poll released last week signalled both a tightening of credit standards and weaker demand, suggesting that a recent pick-up in loan growth will reverse – chart 3.
The monetary forecast of 2023-24 inflation relief is supported by the assessment that the stockbuilding cycle is about to enter a 12-18 month downswing. The cycle is correlated with industrial commodity price momentum, which appears to have peaked – chart 4. Supply issues may constrain the downside but the wedge between G7 annual headline and core (i.e. ex. food and energy) inflation – currently 2.5 pp – is likely to narrow significantly in H2 2022 and may turn negative in 2023.
A “technical” factor promising CPI relief is a prospective reconvergence of consumer and producer prices of vehicles when supply constraints eventually ease. In the US, the CPI for motor vehicles would have to fall by 17% to eliminate a post-pandemic divergence with its PPI equivalent – chart 5. A PPI pick-up may bear part of the adjustment but the CPI vehicles index could plausibly decline by 10%, implying a 0.9% drag on headline CPI. A smaller but still meaningful effect is likely elsewhere.
*Own calculation using GDP weights.
Why did high inflation become entrenched in the 1970s?
The consensus view is that an initial inflation shock became embedded in expectations, resulting in inflationary price- and wage-setting behaviour.
The “monetarist” view is that the underlying driver was sustained high money growth, which played a key role in allowing inflation expectations to become dislodged.
A surge in G7 annual broad money growth to a peak in November 1972 was followed by a surge in annual CPI inflation to a peak two years later – see chart 1.
Broad money growth showed a similar surge to an initial peak in June 2020 and CPI inflation may top out in mid-2022. The ultimate peak in money growth was in February 2021, suggesting that inflation will remain high into 2023.
Monetary authorities responded to the 1973-74 inflation surge by tightening policy aggressively – see chart 2, which overlays a weighted average of G7 short-term interest rates. They had ignored the inflationary warning from money trends but displayed Volcker-esque zeal in attempting to correct their mistake.
Policy tightening resulted in a major monetary slowdown over 1973-75. With inflation continuing to surge, real money balances plunged and economies moved into recession.
The critical policy error occurred at this point. While money growth had fallen significantly, it remained high by historical standards and inconsistent with a full reversal of the inflation rise. Yet policy-makers performed another U-turn as recession unfolded, cutting interest rates as aggressively as they had raised them.
The result was that G7 broad money growth bottomed out above 10% in early 1975 and rebounded into 1976. Short rates were held at their lower level despite persistent high inflation and money growth remained above 10% until 1979.
What are the lessons for today?
While rate rises are only beginning, the view here is that there has already been a major “tightening” of policy in the form of the cessation of QE and shift to hawkish forward guidance. In the US, this is captured by a 210 bp rise in the Wu-Xia shadow fed funds rate between November and February. (The corresponding UK shadow rate has risen by an astonishing 10.2 pp since January 2021).
Consistent with this interpretation, annual broad money growth fell to an estimated 7.5% in February, with the three-month annualised rate of increase down to 5%.
With CPI momentum still rising, real money balances are now contracting and recession risk has risen. The real money squeeze, however, is mild compared with 1974-75.
On current trends, the monetary backdrop will soon be compatible with an eventual return of inflation to targets, although possibly not until 2024.
Central banks face opposing risks. If they raise rates in line with expectations, monetary trends could weaken further, causing unnecessary economic damage and a medium-term undershoot of inflation targets.
If they back off, however, money growth could stage a 1975-style rebound at a time when inflationary expectations are showing signs of becoming “unanchored”.
The judgment here is that the former risk is much greater.
A key point is that high money growth in the 1970s reflected underlying strength in private sector credit demand. The 1974-75 rate cuts, therefore, resulted in a big rebound in bank lending expansion, which underpinned inflationary money growth – chart 3.
The 2020 surge in money growth, by contrast, was entirely due to QE (more precisely, monetary financing of fiscal deficits). Bank lending expansion has risen recently but is nowhere near the levels reached in the 1970s, or even the noughties.
The upshot is that money growth is unlikely to rebound strongly if central banks back off from rate rises – assuming no return to QE.
Policy-makers should monitor monetary trends and adjust their stance accordingly – in a dovish direction if the recent slowdown extends or hawkishly in the unlikely event of a reacceleration. Astonishingly, they continue to deny any linkage between the 2020 money growth surge and current inflation problems. Such denial is a recipe for more bad decision-making and 1970s-style economic volatility.
Eurozone monetary trends were arguing against ECB policy tightening before the negative shock of Russia’s invasion of Ukraine.
Three-month growth of non-financial M3* – the preferred broad money aggregate here – slowed further to 4.2% annualised in January, the lowest since January 2020 and below a mean of 4.9% over 2015-19, when CPI inflation averaged 1.0% – see chart 1.
Current high inflation reflects excessive money growth in 2020-21 and supply side disruption. It is too late for an ECB response. Any second-round effects will swiftly burn out if money growth maintains its recent subdued pace.
The broad money slowdown has occurred despite ongoing QE, raising the prospect of outright weakness when it stops. The hope is that money growth will be supported by private credit expansion, which has strengthened recently – chart 1. The suspicion here is that corporate loan demand has been boosted by restocking and will fade as this slows.
Growth of narrow money (non-financial M1) has also normalised while high inflation has pushed the six-month rate of change in real terms marginally into negative territory – chart 2. Negative readings preceded every recession over 1970-2019, although there were several false signals (e.g. 1994-95) – chart 3.
The six-month rate of change of real narrow money deposits is now negative in Italy as well as Germany, with France still showing relative resilience – chart 4.
*M3 holdings of households and non-financial corporations.
Recent market weakness reflects an unfavourable monetary backdrop as well as negative geopolitical developments.
The monetarist view is that asset prices respond to imbalances between the supply of money and the demand to hold it. “Excess” money growth is associated with increased demand for financial assets and upward pressure on their prices, assuming no change in supply.
Excess money growth can’t be measured directly because the demand to hold money – based on current economic conditions and prices – is unobservable. Two proxy measures of global excess money are tracked here: the difference between six-month growth rates of real (i.e. CPI-deflated) narrow money and industrial output; and the deviation of 12-month real money growth from a slow moving average.
Historically, global equities outperformed cash significantly on average when both measures were positive but underperformed significantly when both were negative. Mixed signals were associated with a small return shortfall, i.e. no reward for assuming equity risk – see table 1.
A post in early January noted that the second measure had turned negative in October while the first appeared to have followed in November, based on partial data. This “double negative” signal was confirmed later in January.
A January estimate of global real narrow money is now available, along with a firm data point for December industrial output. Both excess money measures remain negative.
12-month growth of global real money is estimated to have fallen further below its moving average in January – chart 1. An early reconvergence seems unlikely – CPI inflation is probably peaking but a decline may be offset by a further slowdown in nominal money growth as large monthly increases a year ago drop out of the 12-month comparison.
Meanwhile, six-month real narrow money growth was little changed in January and below December industrial output growth – chart 2. Six-month output growth may stay at or above the December level through March: a temporary production catch-up is in progress as supply constraints ease, US output rose solidly in January and base effects are favourable (output fell between June and September 2021).
The excess money measures have also been correlated with sector relative performance historically, with double negative signals associated with strong outperformance of the defensive sectors basket (which includes energy) and underperformance of cyclicals, including tech (IT and communication services) – table 2.