Weak money supply growth argues for continued stimulus
Mon, Jan 25 2010, 12:26 GMT
by Lloyds TSB Financial Markets Economic Research Team
A notable feature of the global economic downturn over the past two years has been the marked weakening in money supply growth. Despite unprecedented policy stimulus, the deposits held by the private sector and the amount of bank borrowing undertaken have both slowed sharply. Since peaking at 9.6% in early 2008, OECD annual broad money supply growth has almost halved to 5.4%. As chart a shows, broad money supply in the US, euro zone and UK have all posted sharp slowdowns over the past year, with the annual growth of broad money (M3) in the euro zone recently dipping into negative territory for the first time ever.
The desire of monetary financial institutions to repair their balance sheets has led to a decline in the supply of credit, while uncertainty over the economic outlook has weakened demand for loans. The fall in both the supply of, and demand for, credit has contributed to a decline in the money multiplier - how quickly financial intermediaries convert deposits into new lending - and the velocity of money – how many times money is spent in the economy. These declines, in turn, have exacerbated the fall in both money supply and nominal spending growth.
That said, there is no clear hard and fast shortterm relationship between the money supply and nominal gdp growth. As chart b shows, there was a clear breakdown in the link between UK broad money growth (M4) and nominal gdp from the early to mid-1990s. The breakdown in this relationship, which was also evident in other countries, was largely due to the increased instability of the velocity of money. This was partly related to the growth of debit card transactions and also to changes in the structure of financial intermediation, notably the growth of off-balance sheet vehicles and the increase in capital market funding. The impact of these changes has been to weaken the link between traditional forms of credit growth and nominal spending.
As a result, the importance central banks attach to money supply developments in setting monetary policy has declined since the 1980s. Nonetheless, the relationship may be inexact, but money supply trends can still impart useful information about the prospects for an economy. For example, the contraction in the euro zone money supply strongly suggests that nominal gdp growth across the region is likely to remain weak for some time.
More generally, with the world’s central banks having embarked on an unprecedented loosening of monetary policy, money supply is once again being monitored for signs of whether the policy stimulus is working. This is particularly the case in the UK, where the Bank of England has gone a step further than most other central banks by injecting around £200bn into the economy through the purchase of financial assets (mostly gilts) from the private sector. These purchases have been financed through the creation of central bank reserves (the so-called policy of Quantitative Easing).
The Bank of England hoped that these purchases would achieve two aims: (i) boost financial asset prices, both gilts, equities and corporate bonds, and thus boost financial and economic confidence; and (ii) by raising the aggregate amount of deposits and reserves held in the banking system, encourage an increase in bank lending, thus raising money supply growth and, with a lag, nominal spending.
So far, evidence of the success of this policy has been mixed. While Quantitative Easing appears to have boosted financial asset prices – equities have risen sharply and corporate bond spreads have narrowed – traditional credit growth and nominal gdp growth have fallen further. As chart b shows, both the headline annual rates of broad money (M4) and nominal gdp growth have continued to drop sharply over the past year.
The detail of the money supply data shows an even weaker prognosis. Transfers between banks and intermediate ‘other financial companies’ have grown substantially over the past ten years. These flows, which are captured within the OFCs component of M4, impart little information about trends in nominal spending. To get a better picture of underlying trends, the Bank of England is now publishing a measure of M4 which excludes intermediate OFCs. As chart c shows, on this measure, annual M4 growth has dropped from over 10% to less than 3% over the past two years, while M4 lending (ex OFCs) has fallen from a peak of over 14% to just 0.1%.
The weakness of money supply growth is partly being driven by the desire of both households and companies to pay down their loans. Over the past year, the amount of outstanding borrowing from banks and building societies by households and private non-financial companies (PNFCs) has declined by 0.8% and 2.4%, respectively (i.e. debt has been repaid).
The rate of borrowing for house purchase has slowed markedly, while consumers have reduced their unsecured balances. Faced with historically high levels of indebtedness and a weak labour market, this process of balance sheet repair in the household sector is likely to continue.
In the corporate sector, the picture is more complicated. While PNFCs have paid down bank debt over the past year, thus reducing M4, the volume of bond and equity issuance has picked up markedly (see chart d). Indeed, it appears that larger companies are actively using the proceeds of capital market financing to reduce their outstanding bank loans.
With households and companies likely to continue repairing their balance sheets, the prospect of a meaningful recovery in money supply growth in the UK and other developed economies remains remote. Although there is no automatic link between money supply and nominal GDP, a recovery in money growth (towards a more normal range of around 5-7%) is likely to be viewed by policy makers as an important objective as they seek to put nominal gdp growth on a firmer footing. Indeed, until measures of money supply start to turn higher, speculation of a reversal, or even a suspension, of policy stimulus in the UK, US or euro zone may well be premature.
