Why did UK economic growth take off from late 2012? Economists interviewed recently by the Financial Times variously cited QE, housing market stimulus measures and a spontaneous revival in confidence. These explanations are unconvincing. QE2 started much earlier – October 2011 – and seems to have had a limited impact on monetary trends. The Help to Buy guarantee scheme, meanwhile, came into effect well after the growth pick-up. Confidence did revive from late 2012 but why?

Two factors are judged here to have been key for the economic reversal. First, inflation fell sharply between 2011 and 2012, moving below the rate of broad money expansion. The “real balance effect” – the impact of changes in real money holdings on spending intentions – turned from negative to positive.

Secondly, banks’ wholesale funding costs declined from mid-2012, reflecting improved Eurozone financial conditions and the funding for lending scheme, resulting in a large reduction in retail deposit rates in late 2012 and early 2013. This fall encouraged households and firms to spend more of their monetary savings – the velocity of circulation of broad money, in other words, rose.  

The stimulatory effect of lower deposit rates on the economy was signalled by a strong pick-up in narrow money from mid-2012 as funds were shifted from time deposits (“savings money”) to sight deposits (“spending money”).

A representative interest rate on longer-term time deposits has fallen by 1.6 percentage points (pp) since mid-2012 – see chart. This is equivalent to half of the decline between 2007 and 2009, when the MPC cut Bank rate by a total 5.25 pp.

A correct explanation of why growth rebounded is important for assessing current economic prospects and appropriate policy. If QE2 was the key factor, economic momentum should already be fading, since the programme was ended long ago*. The housing stimulus explanation, meanwhile, suggests that the onus is on the government to abolish Help to Buy, rather than on the MPC to raise interest rates. The view that confidence drives economic shifts would also warrant caution about tightening monetary policy, since current “animal spirits” may be fragile.

The “monetarist” explanation offered above, by contrast, suggests that growth will remain strong and may be insensitive to a rise in interest rates. Real broad money expansion is stable and bank deposit rates have fallen further since end-2013. With banks funding comfortably, deposit rates may rise by much less than any increase in Bank rate. Just as earlier Bank rate cuts failed to stimulate the economy because the “transmission mechanism” was broken, a small rise may be ineffective in slowing the economy now that the monetary plumbing has been repaired.

*November 2012.