Today we have seen the preliminary release of M4 money supply (so-called ‘ broad money’), and it could potentially be a very important piece of economic data. December saw a 1.1% drop in the money supply, the largest monthly fall since records began in 1982. Expectations were for a 1% increase. Year-on-year, expectations were for an 8.9% increase, but this came in at a meagre 6.4%. M4 money supply includes cash in circulation, retail deposits and wholesale deposits at banks and building societies and certificates of deposit.
M4 became a key piece of economic data post the economic crash, since it’s a primary concern of monetary policy decision makers if the supply of money ceases and contracts. Trust and credit disintegrate, and monetary policy becomes utterly ineffective. Ultimately, this can lead to drastic deflation post a financial crash, which in a heavily indebted economy, can spell disaster (see here for a blog from early 2008 on the importance of money supply). One of the key motivations behind the Bank of England’s decision to implement exceptional monetary policy measures, and in particular Quantitative Easing, was to prevent such a collapse in the supply of money, and so to prevent serious disinflation or deflation. As Mervyn King said in his speech earlier this week, “the unprecedented actions of the Monetary Policy Committee to inject £200bn directly into the economy…have averted a potentially disasterous monetary squeeze” (full text available here).
Mike wrote earlier this week about the rising inflation numbers in the UK. And whilst we feel that most of the cause of this spike was due to base effects, policymakers are likely to find it incredibly difficult to justify a further round of printing money through QE (as Anthony mentioned last month here). Following the higher than expected inflation numbers, there is now a very strong consensus that there will be no QE extension next month, although there is a considerably weaker consensus around whether we could see more QE in the future.
The final M4 figure will be released on 1st February, when we’ll get an idea of the breakdown and therefore why the M4 figure was so weak. In addition, it’s worth highlighting that the Bank of England prefers to strip out the deposits of ‘intermediate other financial corporations’, which excludes things like counterparties and SPVs. Nevertheless, today’s release is still alarming, because it suggests that QE’s efficacy as a tool to increase the supply of money is perhaps not what we thought it was.
It is also potentially alarming that there is less money supply chasing the same number of goods and services, and yet inflation is still quickly rising. It’s not our core view, but there’s a risk that inflation could be more persistent than first thought, ie imagine what will happen to inflation if or when the money supply starts rising quickly again. This number will also be a concern to policy makers because it suggests an emergence of a monetary policy dilemma : the higher inflation number suggested that QE had served an important part of its purpose, the avoidance of deflation. But concomitantly, now, it appears that it has had less impact than expected on the supply of broad money – the money supply data would argue for an increase in monetary policy stimulus.
So which one of the two measures will policymakers give primacy to in February? Our belief is that the members of the MPC will still struggle to justify an increase in QE with inflation where it is now, but this M4 figure has just presented them with a much harder decision. Mervyn King also spoke of this lack of clarity in his speech;
The headline in the Racing Post of 29 December said it all: “Quantitativeasing Maintains Perfect Record”. Its Newbury correspondent reported that “Quantitativeasing started as a red-hot favourite and had little trouble maintaining his unbeaten record. Ridden with plenty of confidence his task was made easier when Tail of the Bank came to grief at the second last. His trainer said ‘I was delighted with the way he went through that testing ground’”. Rather like the MPC, the owners of Quantitativeasing, winner of all three of his races in 2009, have yet to decide how many outings he will have in 2010. They are waiting for race conditions to become clearer.
We do appear to be living in a two-tier world. One part of this world (banks and investors) is awash with cash as a result of £200 billion of QE, and some of this cash for gilts is being invested in other, higher risk assets, which is bringing significant asset price appreciation and, perhaps, inflation. The other part of this world, the real economy, is in a very different position, and today’s money supply data suggests that the cash that has been given to banks and investors is not permeating down into new loans and new credit to the real economy. Worryingly, at some point these two worlds will have to come back into line.