UK monetary trends continue to support optimism about growth prospects while arguing against more QE.

The preferred narrow and broad money aggregates here are non-financial M1 and M4, comprising holdings of households and private non-financial corporations*. Annual growth in the M1 measure rose further to 6.5% in December, the highest since September 2007 (i.e. before the recession), while M4 expansion was stable at 5.1%, the best since August 2008.

Empirical analysis suggests focusing on six-month growth in real money (i.e. deflated by consumer prices) to forecast the economy. This remains solid at 2.0% (not annualised) for non-financial M1 and 0.8% for M4 – see first chart. The recent further pick-up in nominal money expansion, however, has not resulted in real acceleration because of faster inflation. The main risk to the economy this year is another inflation squeeze on real money, not insufficiently loose policy.

Proponents of more easing may alight on the lack of monthly growth in the Bank of England’s preferred broad money measure, M4ex, in December to suggest that weakness is reemerging following the suspension of QE. M4ex, however, was depressed by a fall in volatile financial sector money holdings – the non-financial M4 measure preferred here rose by 0.3%. The above-discussed aggregates, moreover, exclude foreign currency deposits, which rose strongly in December, possibly reflecting companies switching out of sterling in (correct) anticipation of exchange rate weakness. A wider aggregate comprising M4ex and foreign currency holdings of the non-financial sector grew by 0.8% in December alone.

A further encouraging feature of the monetary data is the concentration of the recent cash build-up in the corporate sector – stronger corporate liquidity typically encourages more investment, hiring and M&A. Sterling and foreign currency deposits of non-financial corporations surged at an 11.5% annualised rate during the fourth quarter, while their bank borrowing continued to contract. The corporate liquidity ratio (i.e. deposits divided by loans) therefore rose sharply to its highest level since the third quarter of 2000. Excluding the overleveraged real estate sector, the ratio is now well above its range in the decade preceding the financial crisis – second chart.

Other stand-outs in today’s data include a further rise in mortgage approvals for house purchase in December to the highest undistorted level since April 2008** and surprisingly strong foreign purchases of gilts, despite reduced Eurozone tensions – foreign buying was £15.4 billion, a 13-month high, with UK banks and non-banks unloading £2.7 billion and £8.0 billion respectively.

*Financial sector money holdings are also important but their volatility can sometimes obscure underlying trends. Non-financial M1 is not calculated by the Bank of England but can be constructed from published data.

**Higher approvals in January 2012 and October-December 2009 reflected a bunching of demand ahead of the expiry of stamp duty holidays.

Eurozone narrow money trends remain consistent with an economic recovery but today’s December numbers were slightly disappointing, showing some loss of momentum into year-end. Country divergences, moreover, remain large, with troubling weakness recently in Spain and, to a lesser extent, France.

Narrow money M1 – comprising physical cash and overnight deposits – is a better economic leading indicator than the broader M3 measure, while credit is a coincident indicator. The six-month change in Eurozone real M1 has recovered from -0.8% (not annualised) in April 2012 to 2.7%* in December, a level historically consistent with respectable economic expansion – see first chart. This is down, however, from a 4.7% peak in October, suggesting that the growth pick-up will fade from the spring, allowing for the typical half-year lead.

A key focus here has been whether capital reflux and returning confidence would be reflected in a rise in narrow money in peripheral economies, warranting recovery hopes. The latest news is mixed: the six-month change in real M1 deposits was positive for a second month in Italy (0.7%) but has plunged further into negative territory in Spain (-4.5%)**. Elsewhere, growth continues in Ireland while Portuguese real M1 deposits are flat and the rate of decline in Greece has slowed – second chart.

The Italian / Spanish divergence within the periphery is mirrored by a contrast between German strength and French weakness in the core, although the decline in French real M1 deposits moderated in December. A recent sharp slowdown in Dutch growth, meanwhile, bears monitoring – third chart.

With the Eurozone monetary pick-up showing signs of stalling, the ECB may have been unwise to allow banks to make large repayments of their three-year LTRO loans, thereby reducing dramatically “excess” system liquidity. Was this Maestro Draghi’s first misstep?

*The six-month M1 change may be artificially inflated by 0.7 of a percentage point because of the initial capital subscriptions, totalling €32 billion, paid by governments to the European Stability Mechanism (ESM) in October. (ESM deposits, unlike those of central governments, are included in the money measures.)

**Spanish banking sector balance sheet statistics for December reflect both a transfer of bad loans to SAREB, a government-sponsored agency, and a capital injection in the form of securities from the ESM. These transactions have distorted credit and capital data but should not have affected deposits.