UK money numbers continued to show absolute and relative strength in February, suggesting a coming domestic demand boom with unfavourable balance of payments and inflation consequences.

Charts 1 and 2 compare six-month growth rates of real narrow and broad money across economies. The UK tops both rankings, with recent monetary reacceleration contrasting with ongoing slowdowns elsewhere (although US growth is turning up again as stimulus payments enter bank accounts).

Chart 1

Chart 2

The preferred UK broad money measure here – non-financial M4, comprising money holdings of households and private non-financial corporations (PNFCs) – grew by 16.0% in nominal terms in the year to February. The comparable Eurozone measure – non-financial M3 – rose by 12.5%. Annualised growth rates in the latest three months were 14.4% and 9.5% respectively.

The Bank of England’s M4ex broad money measure grew by a slightly lower 15.2% in the year to February, with its annualised rate of increase slowing to 9.7% in the latest three months. M4ex also includes money holdings of financial institutions, which have fallen over the last three months* but are of limited significance for near-term demand prospects.

UK broad money strength reflects the large fiscal deficit and its entire financing by money creation, i.e. net sterling lending to the government by the banking system, including the Bank of England – chart 3**.

Chart 3

In 1985 then Chancellor Nigel Lawson introduced the “full funding” rule, which required deficits (and any increase in foreign exchange reserves) to be financed by net debt sales to the UK non-bank private and overseas sectors, implying no public sector contribution to broad money growth. According to this concept there has been zero funding over the last 12 months – domestic and overseas “savers” made no contribution to financing the deficit, which has been mirrored pound-for-pound by an increase in the broad money stock.

In terms of the “credit counterparts” arithmetic, monetary financing accounted for 15.4 percentage points (pp) of the 16.0% growth of non-financial M4 in the year to February. A positive contribution of 3.6 pp from sterling lending to households and PNFCs was offset by a 3.1 pp drag from other counterparts*** – chart 4.

Chart 4

The chart shows that official money creation made an even larger contribution in 2009-10, reflecting the Bank of England’s post-GFC QE programme. This was, however, needed to offset private money destruction as banks attempted to meet regulatory demands to boost their capital ratios rapidly by contracting their lending and shedding other assets. The net result was low broad money growth and inflation. There is no actual or potential monetary shortage to counteract now, and hence no monetary justification for QE on the current scale.

Broad money growth would have been even faster but for a diversion of liquidity into sterling bank deposits of overseas residents – monetary aggregates include deposits of domestic residents only. Overseas deposits grew by £49 bn in the year to February, equivalent to 2.6% of non-financial M4. The recent rise is the largest since before the GFC, when liquidation of the overhang of foreign balances triggered a sharp fall in sterling – chart 5.

Chart 5

Strong domestic demand prospects typically imply upward pressure on the exchange rate as expectations for monetary policy adjust. With central banks now committed to prolonged interest rate suppression, this linkage has been broken. Instead, the prospect of unchecked demand strength suggests a bigger current account deterioration and falling real rates as inflation accelerates. Central banks may be rehabilitating the monetary theory of exchange rate determination, according to which a rise in the relative supply of a currency (in this case sterling) results in depreciation.

The consensus appears complacent about balance of payments risks: the average current account deficit forecast in the Treasury’s monthly survey is £80 bn in 2021 and £84 bn in 2022, essentially unchanged from £74 bn in 2020 (£79 bn excluding trade in precious metals). The view here remains that a major blow-out is possible, based on the historical relationship with broad money growth – chart 6 – and a Brexit hit to the UK’s global export share.

Chart 6

*Due to reductions in sterling bank deposits of fund managers, insurance companies and securities dealers.
**The deficit definition referred to here is public sector net borrowing excluding public sector banks (PSNB ex). The public sector net cash requirement (PSNCR) includes financial transactions and was larger than PSNB ex in the 12 months to February (£330 bn vs £286 bn), mainly reflecting Bank of England lending schemes and the student loan programme. Monetary financing accounted for 90% of the PSNCR over this period.
***Net sterling lending to UK financial institutions plus net overseas and foreign currency lending minus capital and other net non-deposit liabilities.

Global six-month real narrow money growth is estimated to have fallen further in February, based on monetary data covering 70% of the G7 plus E7 aggregate calculated here. The decline from a July 2020 peak suggests a slowdown in industrial momentum extending through Q3 2021.

Turning points in six-month real narrow money growth have led turning points in the global manufacturing PMI new orders index by 6-7 months on average historically. The July money growth peak, therefore, suggested a new orders peak in January-February. The current high point of the orders index is November 2020 but this may have been surpassed in March. These are details: the key point is that the index appears to be reaching a peak on schedule, with money trends suggesting a significant relapse by end-Q3.

Chart 1

Cooler consumer goods demand is consistent with a coming industrial slowdown. Global retail sales fell between October and January, with early data suggesting another decline in February – chart 2.

Chart 2

Industrial output growth appears to have been sustained by a continued recovery in investment goods demand and – probably more importantly – a rebuilding of depleted inventories. Restocking, however, will have been accelerated by softer consumer goods demand and the associated output boost may be peaking.

A key point, often neglected, is that the level of industrial output is related to the rate of change of inventories. These are probably still lower than desired and restocking should continue. A slowdown in the rate of increase, however, is sufficient to exert a negative impact on the level of output.

A normalisation of US six-month real narrow money growth has been a key driver of the slowdown in the global measure, although smaller declines have occurred elsewhere – chart 3. US money growth should rebound strongly in March / April as the Treasury transfers cash to households from its account at the Fed (i.e. helicopter money).

Chart 3

A US rebound could drive a pick-up in global six-month real narrow money growth, signalling industrial reacceleration in late 2021 / H1 2022. This isn’t guaranteed, however: a further inflation rise will drag on real money growth near term, while nominal money trends elsewhere may continue to cool.

Analysis of US narrow money trends has been complicated by banks reclassifying some savings accounts as transactions accounts following a Fed decision to lift restrictions on the former. This artificially boosted the old M1 measure in 2020, particularly later in the year, when its six-month growth rate rebounded strongly – chart 4. The numbers used here attempt to correct for this distortion but the suggestion of a significant slowdown was disputed by some readers.

The debate has now been resolved by the recently released Q4 financial accounts – these contain M1 flow data adjusted for reclassifications and other discontinuities. The fall in six-month growth of the break-adjusted M1 series during H2 2020 was similar to that of the corrected measure calculated here.

Chart 4

A global industrial slowdown in Q2 / Q3 may not be reflected in GDP data because of services reopening. The latter, indeed, could contribute to industrial softening as consumer demand switches back from goods to services. The judgement here is that industrial trends are a better guide to underlying economic momentum and a more important driver of markets, partly reflecting a stronger correlation with equity market earnings.

A simple rule for switching between global equities and US dollar cash discussed in previous posts holds cash when six-month growth of global real narrow money is below that of industrial output. A negative cross-over occurred in October 2020 and – allowing for data publication lags – resulted in the switching rule recommending a move to cash at end-2020.

Real money growth was below industrial output growth in January and early indications are that this remained the case in February – chart 5. The rule, therefore, will continue to recommend cash in April and, probably, May. The rule is currently about 4% offside since the end-December switch. Such a drawdown is not unusual and compares with a 32% gain when the rule was in equities between end-April and end-December 2020.

Chart 5

Chinese money trends have been signalling an economic slowdown in H1 2021. This appears to be playing out but the PBoC has kept policy tight and narrow money growth has fallen further in early 2021. A Chinese slowdown could derail current global reflation optimism.

Covid base effects are distorting year-on-year growth rates of coincident economic indicators so a two-year comparison is more informative. Retail sales and fixed asset investment slowed sharply in January / February but industrial output gained further momentum – see chart 1.

Chart 1

Output strength is probably explained by additional working days due to covid travel restrictions that shortened workers’ holidays and reduced factory idling – this suggests payback in March / April. The NBS PMI manufacturing new orders index peaked in November and fell to its lowest since June last month.

An economic slowdown had been signalled by money trends: six-month growth rates of narrow and broad money peaked over May-July 2020 at modest historical levels, moving lower during H2 – chart 2.

Chart 2

Six-month broad money growth stabilised in early 2021 but is below the post-GFC average, while narrow money growth has fallen further. Sectoral detail shows weaker expansion of both household and enterprise narrow money holdings, consistent with the joint slowdown in retail sales and private investment.

China has retained its bottom place in a ranking of six-month real narrow money growth across major economies despite falls elsewhere – chart 3.

Chart 3

The expectation here had been that the PBoC would respond to early economic slowdown signs by partially reversing its H2 2020 policy tightening. Instead, it withdrew liquidity before the holiday to protest an easing of money market rates in December / January. Three-month SHIBOR has backed up to 2.7%, almost double its low in April / May 2020.

The suggestion that monetary policy is restrictive is supported by a flat yield curve – chart 4 – and weak core inflation: consumer prices ex. food and energy were unchanged in February from a year before.

Chart 4

China led last year's economic recovery and the expectation here has been that a Chinese slowdown would presage a loss of global industrial momentum into Q3 2020. Assuming that this scenario plays out, a key question is whether new US fiscal stimulus will drive a growth rebound during H2. This will hinge on the extent to which another deficit blowout in Q2 / Q3 is reflected in US money trends. Growth of the weekly broad money series calculated here has firmed slightly – chart 5 – and a significant pick-up is likely in late March / April as households receive stimulus payments.

Chart 5

Last year’s US (and global) broad money surge is expected, on the “monetarist” view, to be reflected in a significant inflation rise over 2021-22. US broad money* growth, however, has normalised recently: six-month expansion has retreated from 41% at an annualised rate in July to 4.3% in January. Stabilisation at the current pace would suggest an eventual return of low inflation.

A key driver of the broad money slowdown has been a narrowing of the federal budget deficit after its H1 2020 blowout. The six-month rolling shortfall declined from $2.42 trn to $1.06 trn between July and January. Monetary deficit financing – net lending to the federal government by the Fed, commercial banks and money funds – has fallen accordingly.

President Biden’s stimulus package will drive another deficit surge and a reasonable base case scenario is that this will be associated with a rebound in monetary financing and broad money growth, with unfavourable implications for medium-term inflation prospects.

This monetary scenario, however, is not guaranteed.

Monetary financing by the Fed will rise substantially as the recent pace of Treasury purchases is maintained and the Treasury runs down its deposit balance at the Fed to finance the stimulus package and comply with the 2019 Bipartisan Budget Act. This could, however, be offset by reduced purchases, or even sales, by commercial banks and money funds, reflecting Treasury plans to reduce bill supply and a constraint on banks’ balance sheet expansion from the supplementary leverage ratio (SLR), assuming that this is not relaxed. The recent rise in Treasury yields could attract buying from “real money” domestic investors and foreigners, implying an increase in non-monetary financing of the deficit.

Higher yields could also dampen money growth via their impact on private sector credit demand. The jump in mortgage rates has already been reflected in a fall in mortgage applications for house purchase – chart 1. Growth of commercial banks’ lending book will continue to be dragged down by forgiveness of Payment Protection Program (PPP) loans: of the $521 bn of advances in 2020, only $169 bn had been forgiven as of 4 March.

Chart 1

The upshot is that broad money reacceleration is likely but not certain and there is no alternative to monitoring the incoming monetary data to judge whether another inflationary boost is in the pipeline.

It is, therefore, unfortunate that the Fed recently ended publication of weekly monetary data while pushing back the release of monthly figures to the fourth Tuesday of each month.

Timely monitoring of monetary trends, however, is still possible using alternative sources of weekly data for currency in circulation, commercial bank deposits and money funds. Chart 2 shows 26-week growth rates (not annualised) of broad money* and M2 up to the final week of Fed data (ending 1 February) along with growth of proxy measures calculated from the alternative sources. Broad money growth remains modest but has firmed since year-end ahead of the expected fiscal package boost. The extent of any further pick-up will be key for assessing medium-term inflation danger.

Chart 2

*”Broad money” refers to “M2+”, calculated as M2 plus large time deposits at commercial banks and institutional money funds.

UK broad and narrow money measures continue to surge, with growth now significantly above that in the Eurozone – a reversal of the norm in recent years. This suggests strong near-term prospects for domestic demand and support for UK equity prices but at the likely cost of a sizeable deterioration in the balance of payments combined with much higher inflation.

Annual growth of the preferred broad money measure here – non-financial M4, comprising money holdings of households and private non-financial corporations – rose further to 15.6% in January, the highest since 1989. Eurozone money growth on a comparable measure – non-financial M3 – was 12.5%.

Chart 1

Annual broad money growth remains strongest in the US but the UK has moved into the lead on a three-month comparison: UK annualised expansion of 14.9% over November-January compares with 7.8% in the US and 9.8% in the Eurozone – chart 2.

Chart 2

The Bank of England has suggested that household bank deposits have been boosted by a recent outflow from National Savings but this provides, at best, only a partial explanation of broad money strength. A wider aggregate including National Savings and foreign currency deposits grew by 11.4% annualised in the latest three months.

The National Savings effect, in any case, may have been offset by an outflow from bank deposits to purchase unit trusts and OEICs: inflows to retail funds totalled £14.5 billion in November / December, according to the Investment Association, compared with a £9.1 billion outflow from National Savings over the same two months.

Why has UK broad money growth strengthened relative to trends elsewhere? The UK has been running a larger fiscal deficit and funding this almost wholly through the banking system. “Monetary financing” – net lending to government by the Bank of England and other monetary financial institutions – totalled £261 billion in the 12 months to January, equivalent to 93% of public sector net borrowing of £279 billion.

Monetary financing contributed (in an accounting sense) 13.7 percentage points (pp) to annual non-financial M4 growth of 15.6% in January; the equivalent contribution to non-financial M3 growth in the Eurozone was 7.4 pp.

Broad money trends set the medium-term path for nominal demand, incomes and inflation but narrow money is a better guide to short-term economic prospects. Six-month growth of real narrow money (non-financial M1 deflated by consumer prices) has risen since November and is stronger than in other major economies  – chart 3.
 
Chart 3

Six-month real narrow money growth was consistently lower than in the Eurozone over 2017-19, a period during which UK GDP lagged Eurozone growth by 1.4 pp (i.e. measured between Q4 2016 and Q4 2019). UK equities returned 5.1% less than Eurozone equities in the three years to end-2019, with underperformance accelerating last year, according to MSCI US dollar indices. With Eurozone six-month real narrow money growth continuing to moderate, the current UK lead is the largest since 2002.

The rebound in six-month real money growth since November from an already strong level suggests a monetary boost to domestic demand and GDP momentum during H2 2021. This could interact with economic reopening to generate boom conditions by early 2022.

Chart 4

Domestic demand strength has been associated historically with rapid growth of imports and a worsening current account position. The impact could be magnified on this occasion by supply-side damage from the pandemic and a Brexit drag on exports. The CBI quarterly industrial trends survey asks manufacturers whether specified factors are acting to limit export orders. The Brexit effect is probably captured under “quota and import licence restrictions” and “political or economic conditions abroad”. The percentage citing the former is the highest since the 1980s, while the series for political / economic conditions abroad reached a record before the covid shock, rising further since. The percentage of firms expressing concern about price competitiveness, by contrast, is below the long-run historical average, though has increased as sterling has appreciated – chart 5.

Chart 5

Services exporters are expected to be harder hit than manufacturers because of the omission of services from the trade agreement with the EU.

Chart 6 shows that the current account position has tended to deteriorate following a rise in broad money growth relative to the medium-term trend (plotted inverted), although often with a significant lag. A comparable money growth surge in 1971-72 was associated with the current account moving from surplus in 1972 to a deficit of 3.9% of GDP in H1 1974. The starting position now is worse, with a deficit of 2.9% of GDP in Q3 2020.

Chart 6

A blowout in the current account deficit would suggest medium-term downward pressure on sterling. A strong economic rebound might be expected to provide near-term support for the currency but speculators are already long and worries about the inflationary implications of fiscal dominance of monetary policy could bring forward weakness. An indicator combining speculative futures positioning and bullish sentiment as measured by Consensus Inc. is at the top of its range in recent years, suggesting a pause in sterling’s rally, at least – chart 7.

Chart 7

A fall in sterling has been a standard feature of the transmission of rapid UK money growth into inflation. As previously discussed, annual broad money growth has led turning points in annual core CPI / RPI inflation by an average of 26-27 months since WW2. With money growth still rising in January 2021, core inflation may pick up into early 2023, at least.

Chart 8

Annual broad money growth will moderate as bumper monthly rises over March-May 2020 drop out of the calculation but fiscal / monetary plans suggest that it will remain high. The MPC decided at its November meeting to buy an additional £150 billion of gilts during 2021, equivalent to 6.9% of the stock of non-financial M4 at the start of the year. Fiscal financing needs may call forth more QE, with the OBR now expecting borrowing of £234 billion in 2021-22, up from £164 billion in November and equivalent to 10.3% of GDP – chart 9.

Chart 9