Last year’s US (and global) broad money surge is expected, on the “monetarist” view, to be reflected in a significant inflation rise over 2021-22. US broad money* growth, however, has normalised recently: six-month expansion has retreated from 41% at an annualised rate in July to 4.3% in January. Stabilisation at the current pace would suggest an eventual return of low inflation.

A key driver of the broad money slowdown has been a narrowing of the federal budget deficit after its H1 2020 blowout. The six-month rolling shortfall declined from $2.42 trn to $1.06 trn between July and January. Monetary deficit financing – net lending to the federal government by the Fed, commercial banks and money funds – has fallen accordingly.

President Biden’s stimulus package will drive another deficit surge and a reasonable base case scenario is that this will be associated with a rebound in monetary financing and broad money growth, with unfavourable implications for medium-term inflation prospects.

This monetary scenario, however, is not guaranteed.

Monetary financing by the Fed will rise substantially as the recent pace of Treasury purchases is maintained and the Treasury runs down its deposit balance at the Fed to finance the stimulus package and comply with the 2019 Bipartisan Budget Act. This could, however, be offset by reduced purchases, or even sales, by commercial banks and money funds, reflecting Treasury plans to reduce bill supply and a constraint on banks’ balance sheet expansion from the supplementary leverage ratio (SLR), assuming that this is not relaxed. The recent rise in Treasury yields could attract buying from “real money” domestic investors and foreigners, implying an increase in non-monetary financing of the deficit.

Higher yields could also dampen money growth via their impact on private sector credit demand. The jump in mortgage rates has already been reflected in a fall in mortgage applications for house purchase – chart 1. Growth of commercial banks’ lending book will continue to be dragged down by forgiveness of Payment Protection Program (PPP) loans: of the $521 bn of advances in 2020, only $169 bn had been forgiven as of 4 March.

Chart 1

The upshot is that broad money reacceleration is likely but not certain and there is no alternative to monitoring the incoming monetary data to judge whether another inflationary boost is in the pipeline.

It is, therefore, unfortunate that the Fed recently ended publication of weekly monetary data while pushing back the release of monthly figures to the fourth Tuesday of each month.

Timely monitoring of monetary trends, however, is still possible using alternative sources of weekly data for currency in circulation, commercial bank deposits and money funds. Chart 2 shows 26-week growth rates (not annualised) of broad money* and M2 up to the final week of Fed data (ending 1 February) along with growth of proxy measures calculated from the alternative sources. Broad money growth remains modest but has firmed since year-end ahead of the expected fiscal package boost. The extent of any further pick-up will be key for assessing medium-term inflation danger.

Chart 2

*”Broad money” refers to “M2+”, calculated as M2 plus large time deposits at commercial banks and institutional money funds.

UK broad and narrow money measures continue to surge, with growth now significantly above that in the Eurozone – a reversal of the norm in recent years. This suggests strong near-term prospects for domestic demand and support for UK equity prices but at the likely cost of a sizeable deterioration in the balance of payments combined with much higher inflation.

Annual growth of the preferred broad money measure here – non-financial M4, comprising money holdings of households and private non-financial corporations – rose further to 15.6% in January, the highest since 1989. Eurozone money growth on a comparable measure – non-financial M3 – was 12.5%.

Chart 1

Annual broad money growth remains strongest in the US but the UK has moved into the lead on a three-month comparison: UK annualised expansion of 14.9% over November-January compares with 7.8% in the US and 9.8% in the Eurozone – chart 2.

Chart 2

The Bank of England has suggested that household bank deposits have been boosted by a recent outflow from National Savings but this provides, at best, only a partial explanation of broad money strength. A wider aggregate including National Savings and foreign currency deposits grew by 11.4% annualised in the latest three months.

The National Savings effect, in any case, may have been offset by an outflow from bank deposits to purchase unit trusts and OEICs: inflows to retail funds totalled £14.5 billion in November / December, according to the Investment Association, compared with a £9.1 billion outflow from National Savings over the same two months.

Why has UK broad money growth strengthened relative to trends elsewhere? The UK has been running a larger fiscal deficit and funding this almost wholly through the banking system. “Monetary financing” – net lending to government by the Bank of England and other monetary financial institutions – totalled £261 billion in the 12 months to January, equivalent to 93% of public sector net borrowing of £279 billion.

Monetary financing contributed (in an accounting sense) 13.7 percentage points (pp) to annual non-financial M4 growth of 15.6% in January; the equivalent contribution to non-financial M3 growth in the Eurozone was 7.4 pp.

Broad money trends set the medium-term path for nominal demand, incomes and inflation but narrow money is a better guide to short-term economic prospects. Six-month growth of real narrow money (non-financial M1 deflated by consumer prices) has risen since November and is stronger than in other major economies  – chart 3.

Chart 3

Six-month real narrow money growth was consistently lower than in the Eurozone over 2017-19, a period during which UK GDP lagged Eurozone growth by 1.4 pp (i.e. measured between Q4 2016 and Q4 2019). UK equities returned 5.1% less than Eurozone equities in the three years to end-2019, with underperformance accelerating last year, according to MSCI US dollar indices. With Eurozone six-month real narrow money growth continuing to moderate, the current UK lead is the largest since 2002.

The rebound in six-month real money growth since November from an already strong level suggests a monetary boost to domestic demand and GDP momentum during H2 2021. This could interact with economic reopening to generate boom conditions by early 2022.

Chart 4

Domestic demand strength has been associated historically with rapid growth of imports and a worsening current account position. The impact could be magnified on this occasion by supply-side damage from the pandemic and a Brexit drag on exports. The CBI quarterly industrial trends survey asks manufacturers whether specified factors are acting to limit export orders. The Brexit effect is probably captured under “quota and import licence restrictions” and “political or economic conditions abroad”. The percentage citing the former is the highest since the 1980s, while the series for political / economic conditions abroad reached a record before the covid shock, rising further since. The percentage of firms expressing concern about price competitiveness, by contrast, is below the long-run historical average, though has increased as sterling has appreciated – chart 5.

Chart 5

Services exporters are expected to be harder hit than manufacturers because of the omission of services from the trade agreement with the EU.

Chart 6 shows that the current account position has tended to deteriorate following a rise in broad money growth relative to the medium-term trend (plotted inverted), although often with a significant lag. A comparable money growth surge in 1971-72 was associated with the current account moving from surplus in 1972 to a deficit of 3.9% of GDP in H1 1974. The starting position now is worse, with a deficit of 2.9% of GDP in Q3 2020.

Chart 6

A blowout in the current account deficit would suggest medium-term downward pressure on sterling. A strong economic rebound might be expected to provide near-term support for the currency but speculators are already long and worries about the inflationary implications of fiscal dominance of monetary policy could bring forward weakness. An indicator combining speculative futures positioning and bullish sentiment as measured by Consensus Inc. is at the top of its range in recent years, suggesting a pause in sterling’s rally, at least – chart 7.

Chart 7

A fall in sterling has been a standard feature of the transmission of rapid UK money growth into inflation. As previously discussed, annual broad money growth has led turning points in annual core CPI / RPI inflation by an average of 26-27 months since WW2. With money growth still rising in January 2021, core inflation may pick up into early 2023, at least.

Chart 8

Annual broad money growth will moderate as bumper monthly rises over March-May 2020 drop out of the calculation but fiscal / monetary plans suggest that it will remain high. The MPC decided at its November meeting to buy an additional £150 billion of gilts during 2021, equivalent to 6.9% of the stock of non-financial M4 at the start of the year. Fiscal financing needs may call forth more QE, with the OBR now expecting borrowing of £234 billion in 2021-22, up from £164 billion in November and equivalent to 10.3% of GDP – chart 9.

Chart 9

An article in November presented a “monetarist” forecast of a rise in UK annual CPI inflation to 3.2% in Q4 2021, far above the Bank of England’s central projection of 2.1% (reduced to 1.9% in February). News since then has been consistent with the assumptions underlying the forecast, which is maintained.

January inflation of 0.7% was slightly above the forecast for the month made in November.

Economists share the Bank’s relaxed view of prospects. The median Q4 projection in the Treasury’s latest survey of independent forecasters is 2.0%. Only one contributor expects an outturn above 3%*.

The assumptions underlying the forecast are set out below but the key differences from the Bank / consensus are 1) a larger rise in global commodity prices and associated stronger paths for energy / food inflation, 2) a more pessimistic assessment of current core trends, and 3) an expected increase in core inflation in response to last year’s broad money surge.

The commodity price view is on track, with the Brent oil price up by 40% since November and Ofgem hiking the energy price cap by 9% from April – above a 5% assumption in the November forecast. The FAO world food price index, meanwhile, rose by 7% between November and January, pushing annual growth up to 11%.

The preferred broad money measure here (i.e. non-financial M4, comprising money holdings of households and private non-financial corporations) continued to rise strongly in November / December, with annual growth now at a 31-year high of 14.2% – see chart 1.

Chart 1 

Previous research documented a leading relationship between broad money growth and core CPI / RPI inflation in post-WW2 data, with an average lead time at turning points of 26-27 months. The lead, however, varied widely and was affected particularly by exchange rate developments. A fall in money growth in the late 1990s, for example, was swiftly reflected in core inflation because of prior sterling strength. The lead was much longer after the GFC, when a large fall in the currency placed extended upward pressure on import prices.

Sterling’s effective rate has firmed 3% since November but is little changed from a year ago. A reasonable assumption, therefore, is that the lead time from money growth to core inflation will conform to historical average experience, implying a rising core rate through end-2022, at least.

An assessment of current core trends is complicated by the temporary VAT cut for hospitality and tourism. The assumption here is that one-third of this cut was reflected in prices, in which case core inflation (i.e. ex. energy, food, alcohol and tobacco) of 1.4% in January is understated by 0.7 percentage points (pp). The Bank of England and consensus assume that pass-through was much lower.

The forecast, accordingly, assumes a 0.6 pp boost to published core inflation when VAT for these industries is normalised – currently scheduled for April but possibly to be delayed**. The Bank / consensus view, by contrast, implies little impact. The VAT reversion is likely to coincide with excess demand for these services as the economy reopens, suggesting scope for providers to hike prices to protect current margins – the assumption of one-third pass-through could be too conservative.

Chart 2 shows projections for headline inflation, the published core measure and the policy-adjusted core series calculated here. These incorporate the same assumptions as in November, except for a small change in the Ofgem energy price cap.A rise in inflation for food, alcohol and tobacco to 2.0% in December 2021 (2010-19 average = 2.5%, January = 0.4%).

A return of vehicle fuel prices to their pre-covid level (unleaded petrol = £1.28 per litre).

A further 3% increase in the Ofgem energy price cap in October.

Monthly growth in core prices excluding tax effects of 2.25% at an annualised rate.

Chart 2

Note that the headline and published core rates will be artificially high in Q4 because of a reversal of the VAT effect. This distortion will end in April 2022, assuming that VAT is normalised in April 2021. Adjusted core inflation, however, is likely to have risen further by then, suggesting limited decline in headline / published core rates.

What could derail this forecast? A significant further rise in the exchange rate could push back an inflation pick-up but bullish positioning in sterling may already be extreme, judging from Consensus Inc. sentiment and US CFTC futures data – risks may now be skewed to the downside.

Inflation prospects beyond 2021-22 will depend on broad money developments this year. Monetary deficit financing has given as large a boost to broad money growth in the UK as in the US – chart 3. With little appetite for fiscal restraint***, and the Bank of England restored to its historical role of government financing arm, it is likely to remain a significant driver this year, suggesting low probability of money growth returning to its post-GFC average (i.e. over 2010-19) of 4.2%.

Chart 3

*Economic Perspectives (Peter Warburton).
**The impact is asymmetric because of changes in weights.
***The claim that low bond yields “make it a good time for governments to borrow” is misleading, because deficits are being financed by monetary expansion (and an implicit future inflation tax) rather than borrowing from savers: low yields would be unlikely to survive a switch to non-monetary financing.