UK money trends remain consistent with inflation normalisation, implying that further MPC tightening will unnecessarily prolong and deepen the recession. 

The artificial boost to headline money numbers from cash-raising by LDI funds partially unwound in October – the Bank of England’s M4ex measure fell by 0.6% on the month after a 2.6% September jump. 

As usual, the focus here is on non-financial money measures, i.e. excluding volatile and uninformative financial sector holdings. The September surge in financial money was certainly no signal of future economic or inflation strength.

Annual growth of non-financial M4 was little changed at 3.4% in October, with the six-month annualised pace of increase lower at 2.7%. Annual non-financial M1 growth dropped to 2.6%, with the aggregate little changed in the latest six months – see chart 1. 

Chart 1

The latter weakness reflects households and non-financial firms switching out of sight into time deposits in response to higher term interest rates. The decision to lock away money is a negative economic signal, indicating weak near-term spending intentions. 

Broad money growth of 3-3.5% is unlikely to be sufficient to prevent inflation from falling below 2% over the medium term, unless potential economic expansion is even weaker than the generally assumed 1-1.5% pa. (This assumes no rise in velocity, which has exhibited a long-term downward trend, including during the 2010s.) 

Non-financial M4 is growing more slowly than the comparable Eurozone aggregate, non-financial M3, which rose by 4.8% in the year to October. 

The argument continues to be made that spending will be supported by the deployment of “excess” savings built up in 2020-21. The assessment of “excess” need to take into account inflation – fast price rises require more saving to maintain the real value of existing wealth. 

Real non-financial M4 has now crossed beneath its 2010-19 trend – chart 2. The suggestion is that money holdings are broadly in line with requirements given recent high inflation – there is no longer any buffer to cushion spending against an ongoing real money squeeze. 

Chart 2

A post last month argued that a pick-in Eurozone broad money M3 growth into September reflected temporary factors that would reverse. October numbers delivered the expected turnaround, with M3 falling by 0.4% on the month. Narrow money measures, meanwhile, lost further momentum, with Italian data particularly weak.

The summer pick-up in M3 growth had been discounted here for two reasons: the numbers had been boosted by rapid and probably unsustainable expansion of financial sector deposits; and the pick-up was inconsistent with the behaviour of the credit counterparts (bank lending to government and the private sector, net external lending etc), instead reflecting a statistical “residual”.

October numbers showed a large drop in financial M3 holdings, correcting earlier strength, while the credit counterparts residual turned negative.

The preferred money measures here exclude financial sector holdings, which correlate poorly with near-term economic performance. Six-month growth of non-financial M3 was stable in October at 5.2% annualised; growth of non-financial M1 slumped further to 2.1% annualised, the weakest since the 2011-12 Eurozone crisis / recession – see chart 1.

Chart 1

Real narrow money is contracting much faster than during that crisis: the six-month rate of decline reached a new record in data extending back to 1970 – chart 2.

Chart 2

Country data show particular weakness in Italy, reflecting both nominal contraction and a larger recent inflation spike than elsewhere – chart 3.

Chart 3

The previous post suggested that a lending slowdown would act as a drag on broad money growth. Bank loans to the private sector were unchanged on the month in October.

Cyclical sectors of European equity markets have recovered some relative performance recently, possibly reflecting a belief that a grim economic outlook was becoming less dire at the margin. A minor recovery in the expectations component of the German Ifo business survey might be viewed as supporting reduced pessimism – chart 4.

Chart 4

The level of Ifo expectations, however, remains historically weak and a further fall in Eurozone / German six-month real narrow momentum argues that economic stabilisation, let alone a recovery, remains distant – chart 5.

Chart 5

Nominal money trends and prospects suggest that monetary conditions are already restrictive, contrary to the ECB’s assessment*. Likely policy overtightening is another reason for fading the cyclical rally.

*See speech by Executive Board member Isabel Schnabel.

The major fiscal tightening announced by Chancellor Hunt in the Autumn Statement was motivated by a markedly more pessimistic OBR assessment of medium-term prospects for the economy and public finances. Even if its latest forecasts prove “correct”, revisions on this scale between six-monthly forecasting rounds are questionable and result in undesirable volatility in policy-making.

The economic outlook has deteriorated since the March Budget but the OBR’s fiscal assessment is based on the projected level of potential output four to five years ahead. This relies on assumptions about trends in productivity and labour supply and should be little affected by the prospect of a near-term recession.

The OBR has revised down its projection for potential output growth over the forecast horizon by a whopping 1.7 pp since March, mainly reflecting an assumed hit to productivity from energy prices staying high over the medium term. An associated loss of receipts accounts for almost a third of the £75 billion upward revision to borrowing in 2026-27 based on unchanged policies.

The OBR ignored the productivity implications of high energy prices in March on the grounds that it was unclear whether they would persist. The outlook is no less uncertain now yet the OBR has chosen to incorporate the full hit. A better approach would be to phase in adjustments over several forecasting rounds, varying the pace depending on energy price developments between rounds.

The most significant forecasting change since March was a substantial upward revision to the path of interest rates, with Bank rate and long-term (i.e. 20-year) gilt yields now averaging 4.4% and 4.0% respectively between 2023-24 and 2026-27, versus 1.5% for both previously. An increased debt interest bill accounts for £47 billion of the £75 billion boost to 2026-27 borrowing.

The interest rate assumptions are derived from market rates but they are clearly inconsistent with the OBR’s economic forecasts – particularly its projection that the annual change in consumer prices will turn negative in Q3 2024 and remain below zero for a further seven quarters.

The MPC’s latest forecasts show CPI inflation falling below target two to three years ahead if Bank rate remains at the current 3.0%*. An assumption of a 3.0% average for Bank rate is a more sensible basis for the medium-term fiscal forecast. If long-term gilt yields were also to average 3.0%, the interest bill in 2026-27 would be £21 billion lower than the OBR has projected, according to its debt interest ready reckoner. This is equivalent to three-quarters of the extra tax raised in 2026-27 from measures announced in the Autumn Statement.

A possible interpretation is that Chancellor Hunt has been bounced into unnecessary fiscal retrenchment by a combination of a questionable downgrade to the OBR’s productivity projection and its punctilious adherence to a forecasting convention – of using yield curve-derived interest rate assumptions – that made little sense in the context of recent stressed markets.

Chancellor Hunt, however, may have had an incentive to collude with the OBR’s doom-mongering, since it has allowed him to “kitchen sink” fiscal bad news in the reasonable hope that another OBR forecasting swing will open up space for him to reverse course and announce tax “cuts” before the next general election.

*CPI inflation falls below 2% in Q2 2024 in the MPC’s modal (i.e. central) forecast and in Q3 2025 in its mean forecast (which incorporates a risk bias to the upside).

A simple model of the Fed’s past behaviour suggests a shift in policy direction from tightening to easing in March 2023, assuming that the economy evolves in line with its forecasts.

The Fed could delay cutting rates for several months but the model suggests a strong likelihood of action by Q3.

The model is based on the following observations / judgements about the Fed’s historical behaviour:

• Policy direction alternates between tightening and easing and is rarely “on hold” for long.
  
  
• Fed officials aren’t guided by a “target” level of rates; rather, they continue to tighten or ease until incoming data prompt them to stop / reverse.
  
  
• The Fed places little weight on forecasts, focusing instead on recent trends in variables related to its mandate objectives.

The aim of the model is to estimate the probability that the Fed will tighten or ease in a particular month based on data available at the time of the decision. It does not attempt to predict the size of any move (although extreme probability readings suggest larger moves).

The model assesses the relative probability of tightening versus easing – “on hold” is excluded by design. As noted, periods of stable policy have been infrequent and usually short-lived historically. (The long period of Fed funds stability in the 2010s is misleading because the Fed was easing / tightening via QE and other “unconventional” policies during this period, as reflected in movements in “shadow” rates.)

To estimate the model, history was divided into alternating unbroken episodes of tightening and easing. This division was made judgementally based on the timing of peaks and troughs in official or shadow rates. Shaded areas in the chart below denote tightening episodes.

A decision was made to limit the model inputs to a small number of “obvious” variables, rather than cherry pick from a large data set to achieve maximum fit. The model, nevertheless, performs adequately, with the probability estimates consistent with policy direction in 88% of months (i.e. above 50% in tightening months and below 50% in easing months).

The key inputs are the levels and rates of change of core PCE inflation and the unemployment rate. The rate of change of the ISM manufacturing supplier deliveries index – an indicator of production bottlenecks – was also found to be significant.

The model assessment was that there was a 96% probability of tightening in November. This estimate incorporated a September number for core PCE inflation and October readings for the unemployment rate and ISM supplier deliveries.

The median forecast of FOMC participants in September was for core PCE inflation to average 3.1% in Q4 2023, versus 5.1% in September 2022. The unemployment rate was forecast at 4.4% in Q4 2023 versus 3.7% in October 2022. The probability projections in the chart assume straight-line movements in the two variables from their latest levels to the Q4 2023 forecasts. Additionally, the ISM supplier deliveries index is assumed to be stable at its October 2022 level.

The forecast probability of tightening falls to 74% in December, suggestive of a smaller rate hike of 50 or even 25 bp next month.

The first FOMC meeting in 2023 is on 31 January-1 February. The forecast tightening probability is little changed from its December level in January but falls further in February and moves below 50% in March – the 40% reading implies a 60% likelihood that the Fed will by then have shifted to an easing bias.

The implied easing probability increases further after March, exceeding 90% in September, suggesting a strong likelihood that the Fed will be cutting rates by then.

Alternative assumptions can be examined. If the unemployment rate were to rise to 4.4% in Q2 rather than Q4, the easing probability would reach 90% three months earlier, in June.

An unlikely worst case scenario is that core inflation and the unemployment rate remain at current levels. Interestingly, even in this scenario the tightening probability falls below 50% in April, fluctuating around the 50% level over the remainder of the year. (This reflects a downward pull from the rate of change terms, which offsets continued upward pressure from levels of core inflation and unemployment.)

The “monetarist” rule of thumb that broad money growth leads inflation by two years suggests a rapid fall in G7 CPI inflation in 2023 and an undershoot of targets by H2 2024.

Annual growth of the G7 broad money measure calculated here is likely to have fallen below 3% in October, based on US and Japanese data. The money stock appears to have stagnated in the latest three months, with a contraction in the US offsetting weak growth elsewhere*.

The monetarist rule worked perfectly in the early 1970s, when a surge in annual money growth to a peak in November 1972 was followed by a spike in annual CPI inflation to a high exactly two years later – see chart 1.

Chart 1

Inflation fell sharply from its 1974 peak, mirroring a big decline in money growth in 1973-74. The difference from now is that annual money growth bottomed above 10%, resulting in inflation stalling at a still-high level.

The money growth surge in 2020-21 was almost complete by June 2020 but a final peak was delayed until February 2021. Consistent with the two-year rule, CPI inflation spiked into June 2022, since moving sideways. It may or may not make a final peak but the rule suggests that a major decline will be delayed until after February 2023.

Broad money growth averaged 4.5% in the five years to end-2019. CPI inflation averaged 1.9% in the five years to end-2021 (i.e. allowing for the two-year lag). Money growth returned to the 2015-19 average in June 2022 (4.4%). The monetarist rule, therefore, suggests that inflation will be back below 2% by mid-2024 and will continue to move lower later in the year, reflecting the further decline in money growth since June.

How fast will inflation fall? A reasonable assumption is that its decline will mirror the rapid drop in money growth two years ago, consistent with the 1970s experience. An illustrative projection is shown in chart 2. Inflation, currently at 7.8% (October estimate), falls to 4% in July 2023 and below 3% by December.

Chart 2

Some monetarist economists expect inflation to be stickier in 2023. They argue that there is still a monetary “overhang” from the growth surge in 2020-21. Inflation, according to this view, will remain high into H2 2023 to “absorb” this excess. The impact of current monetary weakness will be delayed until 2024-25.

The assessment here is that the overhang is much reduced and its removal is consistent with the optimistic inflation projection shown in chart 2 as long as money trends remain as weak as currently, which is likely.

One measure of the monetary overhang is the deviation of the real broad money stock from its 2010-19 trend. This deviation peaked at 16% in May 2021 and has since narrowed to 6% as inflation has overtaken slowing nominal money growth – chart 3. 

Chart 3

The projection in chart 3 is based on the inflation profile in chart 2 and an assumption that broad money grows by 2% pa. The deviation of the real money stock from trend falls below 2% in H2 2023 and is eliminated by mid-2024.

Is the assumption of 2% money growth realistic? As noted, there has been no expansion in the latest three months.

As the chart shows, there was a larger deviation of real money from trend than currently at the end of the GFC in 2009. The adjustment back to trend was driven by nominal money weakness rather than high inflation – the money stock contracted by 1.9% between July 2009 and June 2010.

Bank lending has been supporting money growth but central bank loan officer surveys suggest a sharp slowdown ahead: October Fed survey results released this week echo weakness in earlier ECB and BoE surveys – chart 4.

Chart 4

Continued monetary stagnation – or worse – would confirm that G7 central banks, with the honourable exception of the BoJ, have overtightened policies, compounding their 2020-21 policy error.

G7 monetary gyrations may be contrasted with relative stability around trend in E7** real broad money – chart 5. EM central banks eased policies conventionally in 2020 and were swift to reverse course as economies rebounded and / or inflationary pressures emerged. This has been reflected in lower average inflation than in the G7 and a faster turnaround – chart 6.

Chart 5

Chart 6

*Money measures used: US M2+ (M2 plus large time deposits and institutional money funds), Japan M3, Eurozone non-financial M3, UK non-financial M4, Canada expanded M2+ (M2+ plus non-personal time deposits).

**E7 defined here as BRIC plus Korea, Mexico and Taiwan.

UK monetary statistics for September were heavily distorted by cash-raising by LDI funds to meet collateral requirements for derivative contracts. 

The headline M4ex broad money aggregate surged by £91 billion, equivalent to 2.7% after seasonal adjustment, between end-August and end-September. Money holdings of non-bank financial corporations* accounted for £71 billion of this increase. 

The long-standing practice here has been to focus on non-financial monetary aggregates, where available, because movements in financial sector money holdings can be erratic and usually have little bearing on near-term economic prospects. 

Non-financial M4, encompassing money holdings of households and private non-financial businesses, rose by £21 billion, or a seasonally adjusted 0.3%, in September. Annual growth eased to 3.5%, with the aggregate expanding at an annualised rate of 3.2% in the latest three months – see chart 1. 

Chart 1

The Bank publishes an industrial breakdown of sterling deposits at commercial banks. The LDI cash-raising is reflected in large monthly increases in deposits of insurance companies, pension funds, fund managers and securities dealers (LDI funds posted margin to dealers, with the dealers placing the funds with banks). This group added a combined £39 billion to sterling deposits in September. 

However, the rise in aggregate deposits of non-financial corporations, according to this table (C1.1), was £46 billion in September – far short of the £71 billion increase in their total M4 holdings (A2.2.3). This represents a record divergence – chart 2. 

Chart 2

The “missing” funds show up on the Bank’s balance sheet: private sector sterling deposits held at the Bank jumped by £28 billion in September (B2.2.1), also a record movement – chart 3. 

Chart 3

Securities dealers and clearing houses have accounts at the Bank, which they appear to have used to deposit a portion of the margin cash received from LDI funds. 

Note that this increase in deposits is not attributable to the Bank’s gilt-buying operation, which started on 28 September: the Bank’s holdings of public sector securities fell by £5 billion during September. 

Sterling cash-raising related to the LDI crisis may have totalled about £67 billion – the sum of the £39 billion increase in commercial bank deposits of insurance companies, pension funds, fund managers and dealers and the £28 billion placed at the Bank. 

LDI funds were also scrambling to raise foreign currency liquidity. The rise in foreign currency deposits of the same group of institutions rose by £25 billion in September. 

Not all the cash-raising represents sales of assets – LDI funds were also borrowing to meet margin requirements. Sterling bank lending to the same group rose by £16 billion in September, with foreign currency lending up by £18 billion. 

Was the Bank involved in facilitating the supply of liquidity to the funds, over and above its gilt-buying operation? It is unlikely to have played a direct role but banks may have borrowed from its discount window to onlend to LDI funds. 

This possibility is suggested by partial data on the Bank’s sterling liabilities and assets – it no longer publishes a full balance sheet on a timely basis. Identified sterling liabilities, including bank reserves and the sterling deposits referred to earlier, rose by £14 billion, while assets – including gilt holdings – fell by £6 billion. The implication is that unpublished items on the balance sheet resulted in the creation of £21 billion of identified sterling liabilities, with discount window lending a candidate explanation. 

*Excluding intermediaries such as central clearing counterparties.