FT columnists are developing a penchant for misusing UK monetary statistics.

Last week, Sir Samuel Brittan claimed that “nominal money supply has been allowed to fall by 10% since September 2010”. No conventionally-defined aggregate has displayed such weakness. The Bank of England’s favoured broad money measure, M4ex, rose by 1.8% between September 2010 and August 2011.

Sir Samuel may, possibly, be referring to cash held in banks’ reserves accounts at the Bank of England, which have fallen from £144 billion on 29 September 2010 to £126 billion as of Wednesday this week, a 12% decline. Reserves, however, are a component of the monetary base and not a measure of the “money supply”, which refers to monetary assets held by non-banks. The £18 billion fall, moreover, needs to be placed in the context of a £109 billion rise over the prior two years.

This morning, Martin Wolf argues for more QE or, preferably, “helicopter money” – fiscal expansion financed by borrowing from the Bank of England – partly on the grounds that the M4 broad money measure shrank by 1.1% in the year to July 2011. (August figures were released yesterday, showing a 0.6% annual fall.) Mr Wolf seems unaware that the Bank and independent monetary analysts long ago shifted focus to M4ex, which excludes deposits held by financial intermediaries largely transacting interbank business. Interbank deposits, by definition, are excluded from the “money supply”.

As noted yesterday, a broader liquidity measure incorporating foreign-currency deposits and public-sector money substitutes grew by 4.5% in the year to August, up from 0.9% a year before – hardly suggestive of an intensifying monetary squeeze.

The well-connected FT, however, is likely to be reflective of official thinking so the pro-QE line supports the expectation here that the MPC will launch QE2 next week. With only the PMI inputs yet to be released, the “MPC-ometer” continues to suggest a 6-3 majority in favour of easing action, probably in the form of a £50-75 billion expansion of gilt purchases.

The first chart below updates a comparison of key UK house price indices. To recap from the previous post:

• The LSL Acadametrics and Department of Communities and Local Government indices are value-weighted (i.e. giving greater weight to more expensive houses). This is appropriate if the focus is the aggregate value of the existing housing stock.

• The Land Registry, Nationwide and Halifax / HBOS indices are volume-weighted (i.e. giving equal weight to expensive and inexpensive houses). This is appropriate if the focus is the price of a “typical” house.

• The LSL Acadametrics and Land Registry indices are the “best” value- and volume-weighted measures respectively, reflecting their larger sample size and inclusion of cash transactions.

• The Halifax / HBOS index has displayed a downward bias relative to the other two volume-weighted indices in recent years, suggesting caution in its use (and explaining its popularity among housing market bears).

Based on the LSL Acadametrics and Land Registry indices respectively:

• The aggregate value of the housing stock was 5.5% below the 2008 peak in August and up 9.4% from the 2009 low. It has fallen 1.1% so far this year (i.e. between December 2010 and August, adjusting for seasonal factors).

• The price of a “typical” house was 11.3% below the peak in August and up 6.8% from the 2009 low, and has declined 0.3% so far this year.

The key take-away is that house prices have shown limited weakness so far this year and remain far above their lows, defying bearish predictions. Recent stronger mortgage approvals, moreover, suggest a recovery in momentum – second chart.
   

Conventional “quantitative easing” – such as Bank of England gilt purchases financed by creating bank reserves – works by boosting the (broad) money supply, with increased liquidity serving to stimulate spending on assets and goods / services, thereby lifting wealth, economic activity and prices. The case for more QE, therefore, rests on there being insufficient money in the economy to support trend real growth and on-target inflation.

The Bank of England’s favoured broad money measure, M4 excluding deposits held by financial intermediaries, or M4ex, rose by only 2.2% in the year to August, with a similar 2.3% annualised increase over the last three months. This is well below a historically-normal rate of expansion – M4ex, for example, rose by 6.3% annualised between 1998 and 2003, a period of relative “equilibrium” when inflation was close to target.

An assessment of monetary adequacy, however, must also take account of the velocity of circulation, shifts in which have an equivalent effect to money supply changes. Velocity was trending down in the earlier period but has risen since early 2009, probably reflecting negative real deposit interest rates, which have encouraged households and firms to reduce their money holdings. Accordingly, M4ex growth of only 1.25% annualised in the two years from the second quarter of 2009 supported nominal GDP expansion of an estimated 4.75% annualised – about the maximum likely to be consistent with 2% CPI inflation over the medium term.

M4ex, moreover, currently understates liquidity growth because it excludes money substitutes that have been growing rapidly – in particular, foreign currency deposits and repos conducted by the Debt Management Office. A broad liquidity measure incorporating these items as well as Treasury bills and National Savings instruments rose by 4.5% in the year to August, well above the 2.2% M4ex increase and up from only 0.9% a year ago – see chart.

Recent disappointing UK economic performance reflects an adverse real growth / inflation split rather than inadequate nominal GDP expansion symptomatic of a shortage of money. More QE could prove counter-productive by triggering renewed downward pressure on the exchange rate, thereby boosting import prices and delaying much-needed inflation relief.

The Eurozone is probably in recession but recent better monetary trends suggest that weakness will abate from early 2012 – if the authorities succeed in stabilising markets.

Real narrow money, M1, is the best monetary leading indicator of the economy and contracted in late 2010 and early 2011, warning that activity would slump this summer (allowing for the typical six-month lag). Economic weakness, in turn, has undermined fiscal consolidation plans, worsening perceptions of sovereign solvency. Tight money, in other words, has been a key driver of the developing crisis.

Nominal M1, however, rose by 1.1% in August following a gain of 0.3% in both June and July. With inflation slowing, the six-month change in real M1 has recovered from a low of -1.8% in February (not annualised) to 1.1% in August – see first chart. This is still modest by historical standards but suggests that the economy will return to slow expansion from early 2012, barring further negative shocks.

Real broad money, M3, has also picked up, its six-month change rising from -1.4% in March to 1.4% in August. The counterparts analysis shows that this improvement has been driven by foreign and government net lending rather than private-sector credit. The positive foreign contribution casts doubt on claims that large-scale capital flight from the Eurozone to the US has boosted US monetary aggregates. The government contribution was particularly significant in August alone – states borrowed €33 billion from banks while running down their deposits by €50 billion, probably reflecting funding difficulties.

The bad news in today’s numbers is that the M1 recovery has been focused on core economies, with real deposits still contracting in the periphery – second chart. (M1 comprises currency in circulation and overnight deposits. The ECB publishes a country breakdown of deposits but not currency.) An end to the crisis depends on a loosening of monetary conditions in peripheral economies to restore growth. ECB rate cuts and enhanced liquidity provision, in other words, are urgently required – hawks, however, may use the recent Eurozone-wide monetary pick-up as an excuse to delay action.

Within the periphery, real M1 deposits are holding up better in Italy and Ireland than Spain and Portugal, while continuing to contract rapidly in Greece – third chart. The Italian / Spanish divergence questions recent outperformance of Spanish bonds and equities.

Reader’s question: What do you make of the surge in US M1 growth, now around 22% annual?

Answer: M1 comprises currency in circulation, demand deposits and “other checkable deposits”. Two special factors may have boosted the aggregate recently:

• Unlimited FDIC insurance on demand deposits for 2011 and 2012 only, which has probably encouraged funds to shift out of savings deposits and money market mutual funds.

• Repeal of Regulation Q preventing interest on demand deposits, making “sweep programmes” redundant – these programmes transfer institutional funds overnight out of demand deposits into interest-bearing money market funds, thereby depressing M1. (However, M1 was already picking up ahead of this change in July.)

These factors may have exaggerated recent strength but are unlikely to explain it fully:

• The currency component of M1 – unaffected by the above changes – is growing by 9% annual, up from 4% a year ago.

• Broader aggregates – also unaffected by switches between different types of account – have picked up. The broadest available measure – derived from the flow of funds accounts – grew by 10% annualised in the second quarter. Business money holdings are up 15% from a year ago – see previous post.

Some argue that the US numbers have been boosted by large-scale capital flight from the Eurozone. However, this would be expected to depress the Eurozone money supply – the numbers have been weak but not sufficiently to offset US strength, so global money measures have accelerated.  The capital flow argument also seems inconsistent with the stability, until very recently, of the euro-dollar exchange rate.

To sum up, US monetary acceleration is a significant stabilising force for the global economy IMO. The US could still go into recession if the Eurozone melts down but the downturn ought to be limited and short-lived (like 1990-91, when stocks ended the recession higher than when it started). If the Eurozone is somehow stabilised, and the Fed presses ahead with easing (including balance sheet expansion via dollar swap lending), the US economy and markets could surge next year.