A post last week suggested that 4% UK broad money growth was sufficient to support a solid economic recovery because the velocity of circulation may be rising. Expressed differently, the demand to hold money may be declining as cash hoarding related to last year’s crisis reverses

One sign of declining money demand is a recent pick-up in mutual fund inflows. Net retail sales of unit trusts and OEICs totalled £14.0 billion in the first seven months of 2009, up from £3.9 billion in all of 2008, according to the Investment Management Association. Sales are on course to reach about £24 billion for the full year, well above the prior annual record of £17.7 billion in 2000.

If a £20 billion rise in mutual fund buying between 2008 and 2009 reflects a reduced demand for money, money supply numbers will understate the growth in cash available to finance economic recovery by £20 billion this year. This is equivalent to 1.3% of the MPC’s favoured broad money measure, M4 excluding cash holdings of “intermediate other financial corporations”.

As the earlier post noted, some monetarist economists argue that QE should be expanded further until broad money growth reaches 6% per annum or higher. With money demand likely to be rising by significantly less than 6% pa, however, this would risk creating excess liquidity, leading to new asset market bubbles and – further ahead – another pick-up in inflation.

Today's Financial Times Lex column contains an interesting article arguing that US corporate profit margins are far above their long-run average and should "return to the mean relatively quickly", implying significant risk to current consensus earnings estimates. The article states that corporate profits before depreciation, tax and interest amounted to about 35% of corporate output in the second quarter compared with an average since 1947 of 29%.

On closer inspection, however, the margins measure used appears somewhat odd, in that pre-depreciation profits are compared with net corporate output, i.e. after deducting depreciation. That is, there seems to be an inconsistency in the treatment of depreciation between the numerator and denominator of the ratio.

Two consistently-defined measures of profit margins are 1) profits before depreciation, tax and interest as a percentage of gross corporate output, i.e. before deducting depreciation, and 2) and profits before tax and interest as a percentage of net output. These gross and net measures are shown in the first chart. The gross measure behaves similarly to the series used in the FT article but net margins are currently much less extreme relative to history – 19.4% in the second quarter versus an average since 1950 of 18.1%.

The widening gap between the two measures reflects a trend increase in depreciation as a proportion of output, related to a rising economy-wide capital-output ratio and a shortening average life-span of capital goods. If gross margins were to mean revert, as Lex thinks likely, net margins would fall to the bottom of their historical range.

Economic theory suggests that the income share of capital-owners should be stable over the long run but this refers to their rewards after compensation for the erosion in value of assets due to depreciation. This argues for using net rather than gross margins.

The FT analysis focuses on domestic profits, ignoring the 25% share of total profits accounted for by foreign earnings. The second chart compares total profits net of taxes and adjusted for inflation with a log-linear trend. This suggests that profits were 8% below trend in the second quarter after a 10% first-quarter shortfall – similar to the 13% deviation at the bottom of the last recession.

The slope of the trend-line implies real profits growth of about 3.5% per annum. Assuming 2% inflation, nominal trend profits will be about 18% above the second-quarter actual level by the end of 2010. Consensus hopes of a significant earnings recovery next year are therefore not irrational, providing a near-term economic pick-up can be sustained.

UK broad money – as measured by M4 excluding money holdings of "intermediate other financial corporations" – probably needs to grow by 6-7% per annum over the long run to be consistent with sustainable economic growth and the 2% inflation target. This assumes a decline in the velocity of circulation of about 2% pa, in line with the trend over 1992-2004, when CPI inflation averaged close to 2%. (Trend growth of 2.5% plus 2% inflation and a 2% velocity decline implies a required 6.5% pa increase in broad money.)

In late 2008 annual broad money growth was below 4% and falling. A post in February therefore argued that the MPC needed to buy assets from the domestic non-bank private sector on a scale sufficient to deliver a five percentage point monetary boost. This was estimated to require purchases of at least £125 billion. The following month the MPC announced a purchase programme of up to £150 billion; this was expanded to £175 billion at last month's meeting.

Broad money has accelerated as a result of this initiative but by less than expected, with a 4.9% annualised increase in the first seven months of the year. Many monetarist economists argue that, unless coming figures improve sharply, the MPC should expand asset purchases further in November and continue buying until money growth reaches at least 6%. (See, for example, the minutes of the last Sunday Times Shadow MPC meeting, available on David Smith's blog.)

While faster growth is likely to be required over the long run, however, there are reasons for thinking that the recent modest pace of monetary expansion is consistent with a solid recovery in 2010 and does not pose a downside risk to the inflation target. On this view, the MPC should be cautious about expanding asset purchases any further, particularly given uncertainty about the lagged effects of buying to date.

The first point is that slow money growth in 2008-09 is partly just pay-back for excessive strength in earlier years. The annual increase averaged 10% over the three years 2005-07, implying a cumulative deviation from a 6.5% long-run norm of 10-11 percentage points. This has been partly absorbed by a cumulative inflation overshoot of about 3 percentage points but there remains an excess of 7-8 percentage points available to finance future economic growth. If this excess were to be eliminated by the end of 2010, broad money growth over 2008-10 would need to be about 2.5 percentage points below the 6.5% pa norm, i.e. about 4%. Recent trends are broadly consistent with this scenario.

Expressing the same point in a different way, the decline in velocity has averaged 4.5% pa since the end of 2004, much larger than the prior 2% trend. The fall last year may have reflected households and companies hoarding cash because of extreme uncertainty about financial and economic prospects. With interest rates at record lows and markets reviving, this velocity slump may now be reversing, in which case 4-5% money growth is more than sufficient to support a strong recovery and on-target inflation.

A prior post on recent US monetary trends suggested that a recovery in broad money velocity ought to be associated with a shift of funds out of savings accounts into cash and transactions deposits, implying a pick-up in narrow money relative to the broader measure. Consistent with this suggestion, notes and coin in circulation rose by 7.6% annualised over January-August, above the 4.9% growth rate of broad money up to July. Historically, "non-interest bearing M1" – comprising cash and sight deposits with no advertised interest rate – has also conveyed useful information. This measure is not officially recognised but can be calculated from published Bank of England data: annual growth was 23% in July – see first chart. (Note that this does not reflect banks cutting the interest rate on some sight deposits to zero, since the "non-interest bearing" definition covers accounts with no ability to pay interest, not those with a current zero rate.)

Monetarist arguments for a further expansion of asset purchases also cite the small scale of the recovery to date in the corporate liquidity ratio – private non-financial firms' M4 money holdings divided by their sterling bank borrowing. A wider definition including foreign currency deposits and borrowing has shown a larger pick-up – see chart in previous post – but either version of the ratio is still well below the long-run average. However, a sectoral analysis suggests that deficient liquidity is concentrated in the real estate and construction sectors, while some industries (e.g. manufacturing) have ample cash. The aggregate ratio excluding real estate and construction is in the middle of its historical range – second chart. This supports hopes of an early recovery in business spending (outside the real estate sector) and is also easier to reconcile with national accounts data showing a record corporate sector financial surplus (i.e. undistributed income minus capital spending).

Economists expect no change in Bank rate or QE tomorrow but rumours abound of a change in arrangements for paying interest on cash reserves held at the Bank of England. Banks currently receive Bank rate on all reserves; critics claim this encourages hoarding of cash.

As explained in a prior post, a blanket abolition of interest on reserves would push overnight rates well below Bank rate. One of the objectives of the Bank of England's money market operating procedures is to keep the two in line. Suspending this objective would undermine the anchor role of Bank rate in current monetary arrangements.

Since interest abolition and a consequent fall in overnight rates would be an effective easing of monetary policy, the decision would need to be taken by the full MPC rather than Bank staffers. If the MPC judges such an easing to be necessary, it is difficult to understand why it would not simply cut Bank rate itself, or indeed why it did not do so last month.

While interest abolition seems unlikely, at least without an accompanying cut in Bank rate, the Bank could conceivably introduce measures to penalise individual banks holding larger-than-average reserves balances, e.g. balances above a certain percentage of sterling assets could receive no interest or attract a charge. The macroeconomic implications of such a change, however, would be negligible.

The OECD's forecast that UK GDP will contract by a further 0.25% in the third quarter looks even more suspect following today's industrial output release for July, showing a 0.6% rise from June to a level 0.7% above the second-quarter average.

Services output for July will be published on 30 September but the June number was already slightly above the second-quarter average. Even assuming no rise in July (at odds with more upbeat recent business surveys), the monthly GDP estimate described in previous posts will be 0.2% above the second-quarter level – see chart.

The significance accorded by media commentators to OECD and IMF forecasts remains a mystery. Both were later even than the consensus of economists to recognise last year's developing recession. Neither predicted the emerging strength of the current recovery, reflected in a V-shaped rebound in industrial output in emerging economies and this week's upbeat G7 manufacturing surveys.

Both are political bodies and thereby constrained from issuing forecasts implying criticism of member governments' policies. The IMF's warnings of financial and economic doom since late 2008 have not been unrelated to its demands for additional funding.

Both organisations have been unaccountably, and so far wrongly, negative on the UK's relative economic performance, predicting late last year that Britain would suffer the largest annual decline in GDP among the major economies in 2009. Even based on the OECD's latest forecast that UK GDP will continue to contract during the second half while the US and Euroland recover, the calendar 2009 fall of 4.7% will be smaller than in Germany (4.8%), Italy (5.2%) and Japan (5.6%).

The projected further UK decline, however, is implausible. June data on services and industrial output already suggest a marginal GDP rise in the third quarter. Recent purchasing managers' surveys are consistent with expansion and stronger than their Eurozone counterparts. Broad money trends are also more favourable in the UK: the 4.9% annualised rise in adjusted M4 between January and July compares with growth of just 0.3% in Eurozone M3.

The OECD bases its UK pessimism partly on the larger role of the financial sector in the economy. Yet the last CBI financial services survey signals that the big recovery in markets since the spring is already contributing to a revival in business volumes, suggesting a positive GDP impact going forward – see chart.

The GDP rises in Germany and France in the second quarter partly reflected temporary "cash for clunkers" effects and pay-back for earlier extreme German weakness. Germany may continue to outperform other EMU members as global trade revives but Euroland as a whole is likely to lag the UK in the coming recovery.