UK money supply trends continue to suggest an improving economy and no case for more QE.

Annual growth of non-financial M4 (i.e. broad money held by households and non-financial companies) rose to 5.0% in November, the highest since August 2008. The pick-up has been concentrated in liquid forms of money more likely to be associated with future transactions: non-financial M1 grew by an annual 5.8% in November and Divisia by 7.0%*– see chart.

5% broad money expansion is probably too high to be compatible with the 2% inflation target over the medium term, at least on current policy settings. Negative real interest rates on bank deposits depress the demand to hold money and boost the velocity of circulation (i.e. the ratio of nominal GDP to the money stock). Broad money velocity has risen by an average 1.2% per annum from a trough reached in the second quarter of 2009. Extrapolating this trend, 5% money growth, if sustained, suggests nominal GDP expansion of more than 6%. Even assuming, optimistically, that output could rise by 3% per annum, this would entail inflation of 3% plus.

The suspension of QE may cause money growth to moderate but a major slowdown is not expected here – earlier stimulus should have positive lagged effects while the funding for lending scheme should partially substitute for QE by lowering lending rates and stimulating credit demand, and encouraging banks to reduce their non-deposit funding.

*M1 comprises physical cash and sight deposits while Divisia combines broad money components using liquidity weights based on interest rates.

Eurozone monetary trends continue to signal a recovery in regional economic activity in early 2013. Six-month real M1 growth eased in November but remains robust at 3.7% (not annualised)* – see first chart. The November slowdown is attributable to a large rise in May dropping out of the six-month window. M1 grew by a respectable 0.4% in November alone.

Broad money M3 was unchanged in November, with a rise in deposits offset by an outflow from bank securities and money market funds. Holders of the latter may have switched into markets on perceptions of improving prospects. The statistics are consistent with banks accommodating such demand – they ran down their own securities holdings in November. The flat M3 result, in other words, may reflect disintermediation rather than signalling any cause for concern.

The sectoral breakdown of November deposit growth is favourable, showing further solid rises for households and non-financial corporations offset by a fall in financial sector holdings.

Pessimists will highlight continued private sector loan weakness but credit is a coincident rather than leading indicator of the economy – this weakness, in other words, simply confirms other evidence that activity contracted in the fourth quarter. Divergent deposit and loan movements resulted in another large rise in the corporate liquidity ratio in November; a similar surge in 2009 preceded economic recovery – second chart.

While these developments are promising, the “crisis” cannot be deemed to be over until monetary expansion resumes in the periphery. Real M1 deposits rose in November but were still down 1.2% from six months earlier – third chart. This, however, is the smallest decline since June 2010. A further return of flight capital could result in the six-month change turning positive in early 2013. Caution remains warranted until this signal is given.

Country figures reveal interesting divergences. Within the periphery, Italy’s six-month real M1 deposit change joined Ireland’s in positive territory in November – fourth chart. By contrast, French real M1 deposits have slumped since M. Hollande assumed the presidency in May: the six-month decline of 3.1% in November is the weakest result since August 2008** – fifth chart. Italian / French yield spreads may continue to narrow.

*The monetary aggregates were artificially inflated by the initial capital subscriptions, totalling €32 billion, paid by governments to the European Stability Mechanism (ESM) in October. This transfer boosted M1 by 0.7%, i.e. real six-month growth would be 3.0% in its absence.

**There have been strong inflows to tax-free Livret A savings accounts following a recent lifting of the investment ceiling. However, the bulk of such inflows probably reflects transfers from other savings accounts rather than M1 (i.e. overnight) deposits.

UK household debt as percentage of disposable income fell further to 144.3% in the third quarter of 2012, down from a peak of 174.7% in the first quarter of 2008 and the lowest since 2004. With the average interest rate on outstanding debt also declining, the interest service burden dropped to a new low of 5.7% of income, in data extending back to 1987 – see first chart.

Commentators often claim that consumer spending will remain weak until deleveraging ends. The level of spending, however, is related not to the level of the debt to income ratio but rather its rate of change. A slower fall in debt/income, other things being equal, will be associated with a decline in the saving ratio and higher consumption. So spending could strengthen in 2013 even while deleveraging continues (without assuming a rise in real income).

A pessimistic view is that the debt to income ratio must return to the 100-112% range in operation between the late 1980s and early noughties, before the recent credit bubble. The current ratio remains far above this range, suggesting no slowdown in the pace of decline.

The “equilibrium” level of the ratio, however, cannot be judged simply by reference to history but depends on factors such as the interest service burden, wealth and credit supply.  As noted, the former does not suggest that current debt is “too high”. Nor does wealth: debt as a percentage of the value of housing and financial assets is estimated to have ended 2012 at 18.0%, the lowest since 2002 and close to the average since 1987 – second chart. Credit supply has been pushing down on the debt to income ratio but may improve at the margin in 2013, partly in response to the funding for lending scheme.

The expectation here is that consumption expansion in 2013 will be the fastest since 2007 (i.e. above the 1.3% rise in 2010), reflecting slower deleveraging and a pick-up in real income due to higher employment and a narrower inflation-earnings growth gap.