The Bank of England's favoured broad money measure – M4 excluding money holdings of "intermediate other financial corporations" (i.e. companies classified as non-banks that act as a conduit for interbank business) – contracted by 0.7% in October following a 0.8% September decline. This suggests a serious monetary deficiency that threatens to abort an economic recovery.

On closer examination, however, these falls are entirely explained by a large drop in M4 held by other financial corporations (OFCs) not classified as "intermediate". By contrast, the combined money holdings of households and non-financial corporations – i.e. M4 excluding all OFCs – rose by 0.3% and 0.2% respectively in September and October, with annual growth reaching an eight-month high of 2.9%. This suggests that liquidity created by official gilt-buying is filtering down to "end-users" responsible for spending decisions.

The large fall in money holdings of "non-intermediate" OFCs, moreover, appears to be an artefact of the Bank of England's seasonal adjustment procedure. This grouping includes insurance companies and pension funds, investment and unit trusts, other fund managers and securities dealers. M4 holdings contracted by a seasonally-adjusted £29 billion, or 9%, in September and October (see Bankstats table A2.2.3, T6, column 4). Yet non-seasonally-adjusted figures show a decline of only £5 billion (derived by summing changes for the listed industries in table C1.1, T95-96). The £24 billion discrepancy accounts for the entire decline in M4 excluding intermediate OFCs in September and October.

An alternative approach is to use the non-seasonally-adjusted money holdings of "non-intermediate" OFCs when calculating the M4 measure. This is defensible on two grounds: it is unclear why these holdings should exhibit a seasonal pattern and there is insufficient history to estimate reliable monthly seasonal factors. On this basis, M4 excluding intermediate OFCs rose by 0.3% in October after a 0.2% September drop. While still weak, this is probably consistent with economic growth since the demand to hold broad money has been depressed by low deposit rates and reviving risk appetite.

Other features of the October monetary data support optimism about economic prospects. Narrow money M1 has accelerated strongly, rising at a 16% annualised rate over the last three months – see chart. Meanwhile, there were further rises in October in the corporate liquidity ratio (i.e. non-financial companies' sterling and foreign currency money holdings divided by their bank borrowing) and mortgage approvals for house purchase, to their highest levels since September 2007 and March 2008 respectively. 

The Bank of England this week revealed that it provided covert “emergency liquidity assistance” (ELA) to RBS and HBOS between 1 October 2008 and 16 January 2009, with the combined loan peaking at £61.6 billion on 17 October 2008. Why were analysts unable to uncover this operation from the Bank’s weekly balance sheet, the “Bank return”?

The RBS / HBOS loans, like the earlier Northern Rock facility, were probably recorded under “other assets” on the Bank return. “Other assets” were on a declining path from early 2008, reflecting the repayment and eventual transfer to the Treasury of the Rock loan. They surged, however, after Lehman’s failure, rising from a low of £21 billion on 10 September 2008 to a peak of £170 billion on 22 October. It now appears that about £60 billion of this increase was due to the RBS / HBOS loans.

The problem for analysts at the time was that “other assets” were simultaneously being boosted by US dollar repo operations, involving the Bank borrowing from the Federal Reserve under a swap arrangement and lending on to banks short of dollar funding. These operations began on 18 September 2008 and rose to a peak around the same time as the RBS / HBOS loans.

While it was possible to track the Bank’s dollar lending to the market, the swap facility could, in theory, have involved the Bank holding additional dollar cash in a reserve account at the Fed. This would also have been included within “other assets”. So although the dollar loans were smaller than the rise in “other assets”, it would have been a leap to conclude that the Bank was engaging in additional covert lending.

The hypothesis that the surge in “other assets” was due to the swap arrangement was seemingly supported by a similar change in “other liabilities” on the Bank return – these would have included the borrowing from the Fed and rose from £16 billion to £158 billion between 10 September and 22 October 2008. In fact, part of this increase was probably also connected with the RBS / HBOS support. In particular, “other liabilities” may have included a loan from the Treasury / Debt Management Office (DMO) to the Bank to finance the ELA operation, with the DMO funding the loan via debt sales.

“Other assets” stood at £192 billion last week (18 November) but now include a loan of £180 billion (19 November) to the asset purchase facility (APF). In other words, without the APF “other assets” would have fallen back to £12 billion – the level in early September 2007, just before Northern Rock imploded.

The recent recession and current revival in world industrial output bear a close resemblance to the deep 1974-75 contraction and subsequent recovery. This comparison suggests an ongoing economic upswing during 2010 but with growth momentum slowing as the year progresses.

A weighted average of industrial output in the Group of Seven (G7) major economies and seven large emerging economies (the “E7”) fell by 14% between February 2008 and February 2009 but had recovered by 7% by September – see earlier post for more details. The decline is similar to a 12% drop in G7 industrial output between May 1974 and May 1975 – the previous biggest post-war recession. It is reasonable to use G7 output as a proxy for world industrial activity in the 1970s, when emerging economies were much less significant.

Seven months after the May 1975 trough G7 industrial output had recovered by 5% versus the 7% rise in G7 plus E7 production between February and September this year. The first chart overlays the 1970s G7 path on current G7 plus E7 data, aligning troughs and rebasing the G7 series to equal G7 plus E7 output at the start of 2003. The comparison suggests that the recovery will be sustained during 2010 but  momentum will slow progressively from the spring into 2011. Output could regain its February 2008 peak level in October next year.

The downshift in momentum is clearer in rate of change data shown in the second chart. The implied slowdown in annual growth from a high to be reached in February 2010 is consistent with a recent peak and likely deceleration in G7 annual real narrow money supply expansion, which leads output by about six months – see previous post. Stock markets and other “risky” assets would probably anticipate slower economic growth later in 2010, suggesting a set-back early next year, although possibly after a significant further near-term gain. As the prior post explained, the liquidity backdrop may also turn less favourable for markets in early 2010.

Industrial output in the Group of Seven (G7) major economies recovered by 5% between March and September but was still down by 10% from a year before. G7 real money supply expansion, meanwhile, on narrow and broad measures is running at an annual 9% and 4% respectively – see first chart. The large gap between the rates of change of real money and output is a measure of the “excess” liquidity that has been pushing up stock markets, commodities and other “risky” assets.

On a six-month rather than annual basis, G7 output expansion has crossed above real money supply growth, implying that “excess” liquidity is no longer being created – second chart. The monetary backdrop for markets, therefore, is less favourable than in the spring but the huge money / output divergence of the prior six months should continue to buoy asset prices into early 2010. In other words, a “sell” signal awaits convergence of annual rather than six-month growth rates. Such a signal – annual output expansion rising above real money growth – occurred in 1987 and 1994, for example, and was associated with stock and bond market weakness respectively.

Real money growth – particularly narrow money M1 – leads output expansion by about six months. The annual rate of change of G7 real M1 reached a trough in August 2008 while the annual fall in industrial output bottomed in March 2009. Real M1 growth is likely to have peaked in September 2009, with a rise in headline inflation due to commodity price effects contributing to a significant slowdown into early 2010. This suggests that annual output expansion will reach a high next spring and fall back later in 2010.

G7 real broad money contracted in the six months to October. Previous posts have argued that this is unlikely to signal economic weakness because the demand for broad money has fallen in response to low interest rates and rising risk appetite. Put differently, broad money velocity is picking up after a plunge in late 2008 and early 2009. Real narrow money is a better guide to economic prospects – growth is slowing but remains solid by past standards, consistent with a moderation of output momentum within an ongoing economic recovery rather than a return to contraction later in 2010.

Today's solid retail sales numbers (+0.4% in October with upward revisions to prior months) were foreshadowed by a pick-up in "retail M4" – notes and coin in circulation plus bank and building society retail deposits. Annual growth in this measure rose further to 6.1% last month, the highest since June last year – see first chart.

Meanwhile, mortgage approvals for house purchase by large UK banks continued to recover last month – second chart. The current rate of approvals is consistent with industry-wide net mortgage lending rising to about £3 billion per month in early 2010 from an average of only £600 million in the second and third quarters.

By contrast, public borrowing figures for October were disappointing, with the deficit after seasonal adjustment reaching another new record – third chart. Nevertheless, there is still a chance that the full-year shortfall will be within the £175 billion Budget forecast – this implies a seasonally-adjusted deficit of £17 billion per month over the remainder of 2009-10 versus an average of £13.5 billion in the last three months.

A big decline in pay growth since early 2008 is often cited as a reason for expecting lower inflation. This fall, however, largely reflects cuts in bonuses and working time rather than a slowdown in hourly wages.

The official average earnings index measures pay per worker and is separable into regular and bonus elements. The chart shows annual growth in total and regular earnings together with an adjusted regular pay measure taking into account changes in average weekly hours.

Headline earnings growth has fallen from an annual 4.0% in the first quarter of 2008 to 1.2% in the third quarter of this year with the bulk of the decline due to a slowdown in regular pay expansion from 3.8% to 1.8%. This latter reduction, in turn, mainly reflects a cut in average working time from 32.2 to 31.5 hours per week since last year's first quarter.

Regular hourly pay growth, by contrast, has slowed only marginally, from an annual 3.5% in the first quarter of 2008 to 3.4% by this year's third quarter.

Firms may base pricing decisions on trends in hourly pay rather than earnings per worker. This is because reductions in bonuses and working hours are usually associated with lower output so do not result in a fall in unit labour costs.

The limited response of hourly pay growth to labour market weakness may partly explain recent core inflation resilience, although this mainly reflects the impact of sterling depreciation and pass-through of global commodity price rises.