Money supply growth − is it signalling bad news or good?
Tue, Dec 16 2008, 06:53 GMT
by Trevor Williams
With the release of the latest UK monetary statistics this week, the spotlight should shine on what has been happening to money supply since the credit crisis broke in the summer of 2007. If the economic slowdown is going to be exacerbated by the credit crisis, then this is where the bad news should be evident. On the surface, there does not appear to be a problem at all with credit growth. UK money supply expanded by 15.3% in the year to October 2008, up from a rise of 12.4% in December 2007 and 10.1% in May this year. But this aggregate figure is very misleading. If the activities of other financial institutions (OFIs) are excluded, a completely different profile is revealed. On this adjusted basis, money supply rose by just 3.5% in the year to October 2008, down from 8.9% in December 2007 and 6.6% in May, see chart a.
Adjusting for transactions amongst financial firms shows money supply is falling at an alarming rate…
But why leave out OFIs? The answer is that this sector contains the specialist financial companies that were most active in creating the credit instruments that lie at the heart of the current global financial market crisis. Many are now being wound up, are hoarding cash to meet obligations, and receiving loans from parent companies or from selling assets in order do so. In October, bank lending to OFIs rose by 42.8% on the year before, and M4 deposits by them were up by 44.1% in the same period. These flows, and the behaviour driving them, is distorting, at the aggregate level, the overall picture of what is happening to lending and deposit flows by households and companies in the UK. The trend in real 'inflation adjusted' M4, shown in chart c, is bad news for the economy.
M4 money supply deposit growth and lending growth are weakening dramatically, reflecting, of course, tougher credit standards, wider spreads and less credit demand as households cut back on spending and companies cut investment and costs, see chart b. In October, annual bank deposit growth by households was 6% up from a year earlier, but down from an 8.8% increase at end-December 2007 and from 8.9% growth as recently as May. For companies, the fall-off in deposits has been even sharper, with deposit growth moving from an annual rise of 9.8% at the end of 2007, to a fall of 5.2% in October, see chart b. With these sorts of data now becoming the norm, it is no wonder that retail sales growth has fallen sharply and that company investment spending is being cut aggressively and hence that unemployment is now rising sharply.
…with deposits by the company sector falling for the first time since the 1980s and household deposits down sharply from a year ago, despite policy loosening…
Chart b illustrates the extent that money supply trends have turned down alarmingly for the non-financial corporate sector in the UK. This further explains the need to adjust the headline M4 money supply total by excluding the transactions taking place in the OFI sector in order to understand what money supply trends really mean for the economy. Companies are dipping into deposits, down by 5.2% in the year to October, to survive as lending growth weakens. Households are not in such a dire position, but they too are seeing weaker M4 lending growth as mortgage markets weaken sharply. However, lending growth roughly matches deposit growth, implying more balance than in the corporate sector.
…all of which points to the severity of the pressures on these sectors, which will lead to a fall in UK economic growth of 2% or so in 2009 and a muted recovery in 2010
There are two main economic effects at the macro level that falling growth in the adjusted M4 measure imply. The first is sharply lower near term price inflation. Chart d illustrates this clearly, with substantially less money in the system how can there be rising price inflation? This means that there is scope for Bank rate to fall to even lower levels than the current 2%, as the inflationary backdrop remains very weak. The data do not yet however suggest that the UK is on the verge of persistent price deflation - or falling prices year in year out - though retail price inflation could be negative next year due to cuts in VAT and official interest rates. The other implication, as shown in the final chart, is that UK economic growth could fall as low as it did in the 1990s recession. This implies a fall in gdp next year of 2.3% and only a weak recovery in 2010, of around 1%
Unfortunately, looking at the recent purchasing managers' indices (services, construction, manufacturing), retail sales, surveys of business and consumer sentiment and unemployment, they seem to confirm the depth of economic slowdown that the monetary data are suggesting. But official policy has responded aggressively in this downturn and quite quickly, with interest rates likely to be cut further below 2% in early 2009 and significant fiscal easing already in place. The one bit of good news is that this does imply that the recession should not be on the scale of the 1980s or the 1970s but does look on course to match the 1990s downturn.
