Many have argued recently that UK interest rates should be cut, despite the recent acceleration in price inflation, because money supply growth is collapsing. We think this
view is based on an incorrect reading of recent M4 data.
UK money supply growth still too fast
Many have argued recently that UK interest rates should be cut, despite the recent acceleration in price inflation, because money supply growth is collapsing. We think this view is based on an incorrect reading of recent M4 data. It is true that M4 growth is decelerating but it still remains higher than is consistent with a withdrawal of monetary stimulus from the economy. It is well above its long run average and so still consistent with accelerating price inflation. It thus seems extremely odd for ardent followers of money supply as a guide to policy to be arguing for cuts in interest rates at a time that price inflation is actually accelerating and money supply growth is still above the pace necessary solely to ‘fund’ economic activity. Cutting interest rates to help induce faster growth would make sense but would be inconsistent with using it to keep inflation low and stable and with a belief that, in the long run, there is no
trade off between growth and inflation and that “inflation is always and everywhere a monetary phenomenon.”
UK money supply growth is decelerating sharply…
It is clear that money supply growth is slowing sharply in the UK. From a peak of 14% in the year to May 2007, growth in UK broad money, M4, fell to a low of 10% in May this year before accelerating to 11% on provisional figures for June. Of course, the last 12 months covers the credit crisis and suggests that, thus far, the solvency issues and lack of liquidity in banking markets and massive marking down of financial assets has not led to an outright fall in M4. But chart a shows that it has just taken its growth back to 2006 rates, which at the time were considered as too fast and incompatible with stable economic growth and so inflationary. M4 lending has also not fallen back much from its peak and is not signalling that there is a shortage of liquidity in the economy as a whole.
However, in spite of the June acceleration in M4, there has been a deceleration of 2.5 percentage points over the past year and it is even more observable if one takes a closer look at the breakdown of M4 holdings, chart b. The details of M4 holdings – or deposits – shows that growth for financial institutions, excluding banks and building societies, has decelerated but not collapsed, which might have been expected had there been widespread bankruptcy in the sector resulting from pressures created by the credit crisis. Meanwhile, households M4 deposit growth has remained steady.
So the fall in total UK M4 growth from the peak of 14% last year to the current 11.5% seems mainly down to a sharp fall in growth of M4 holdings by the industrial and commercial sector. This rate has dropped dramatically, from over 15% last year to slightly negative in May, implying that industrial and commercial companies withdrew deposits from the M4 banking sector that month. It may be that one of the reasons for the sharp rise in M4 in June is that some of this reversed. (However, we will not know if this is indeed the case until the full breakdown of June’s M4 data are released in early August). But it is one clear sign of the credit crisis which has shut down capital markets, so companies cannot easily issue bonds or rollover debt or are unhappy with the deposit rates being offered relative to lending rates. They may also be facing greater cash flow concerns reflecting weaker trading conditions. However, chart c shows that companies are still utilising bank loans, despite a widening of spreads and reduced loan availability. Indeed, looking at the flow of lending one sees few signs of a household credit crunch, with slower growth in mortgage lending being partly offset by a rise in consumer credit.