Why did UK economic growth take off from late 2012? Economists interviewed recently by the Financial Times variously cited QE, housing market stimulus measures and a spontaneous revival in confidence. These explanations are unconvincing. QE2 started much earlier – October 2011 – and seems to have had a limited impact on monetary trends. The Help to Buy guarantee scheme, meanwhile, came into effect well after the growth pick-up. Confidence did revive from late 2012 but why?

Two factors are judged here to have been key for the economic reversal. First, inflation fell sharply between 2011 and 2012, moving below the rate of broad money expansion. The “real balance effect” – the impact of changes in real money holdings on spending intentions – turned from negative to positive.

Secondly, banks’ wholesale funding costs declined from mid-2012, reflecting improved Eurozone financial conditions and the funding for lending scheme, resulting in a large reduction in retail deposit rates in late 2012 and early 2013. This fall encouraged households and firms to spend more of their monetary savings – the velocity of circulation of broad money, in other words, rose.  

The stimulatory effect of lower deposit rates on the economy was signalled by a strong pick-up in narrow money from mid-2012 as funds were shifted from time deposits (“savings money”) to sight deposits (“spending money”).

A representative interest rate on longer-term time deposits has fallen by 1.6 percentage points (pp) since mid-2012 – see chart. This is equivalent to half of the decline between 2007 and 2009, when the MPC cut Bank rate by a total 5.25 pp.

A correct explanation of why growth rebounded is important for assessing current economic prospects and appropriate policy. If QE2 was the key factor, economic momentum should already be fading, since the programme was ended long ago*. The housing stimulus explanation, meanwhile, suggests that the onus is on the government to abolish Help to Buy, rather than on the MPC to raise interest rates. The view that confidence drives economic shifts would also warrant caution about tightening monetary policy, since current “animal spirits” may be fragile.

The “monetarist” explanation offered above, by contrast, suggests that growth will remain strong and may be insensitive to a rise in interest rates. Real broad money expansion is stable and bank deposit rates have fallen further since end-2013. With banks funding comfortably, deposit rates may rise by much less than any increase in Bank rate. Just as earlier Bank rate cuts failed to stimulate the economy because the “transmission mechanism” was broken, a small rise may be ineffective in slowing the economy now that the monetary plumbing has been repaired.

*November 2012.

Japan’s QE programme has failed to boost money supply growth, despite its massive scale. This supports US / UK evidence that the monetary impact of QE has been greatly exaggerated by its supporters. The weak monetary response implies that QE has had little influence on economic developments in the three countries. Its main effect has been to encourage speculative behaviour in financial markets, increasing the risk of asset price bubbles.

Incoming Bank of Japan (BoJ) Governor Kuroda significantly expanded its QE bond-buying operation in April 2013. Annual growth of broad money M3 stood at 2.5% in March 2013; some QE optimists expected the new blitz to drive it up to 10%. There were initial indications of a modest positive effect, with annual M3 expansion reaching 3.5% in November. It has since fallen back to 2.6%, as of May.

Why has the liquidity created by the BoJ to buy securities failed to boost the money supply? An answer to this question requires an analysis of the “monetary counterparts”. The “money supply” is the main liability item on the banking system’s balance sheet. Since the system’s total assets equal liabilities, money supply changes can be “explained” by movements in other balance sheet items. The chart shows the contribution of these other items to annual broad money growth.

QE has had the expected expansionary impact on  banking system assets: the contribution of the BoJ’s lending to the government to annual broad money growth rose from 3.2 to 5.9 percentage points (pp) between March 2013 and April 2014* (blue bars). This increase, however, has been neutralised by larger sales of JGBs by banks: a reduction in their lending to the government subtracted 2.8 pp from money growth in April, up from 0.9 pp in March last year (red bars). Banks are selling mainly because QE has boosted their reserves at the BoJ, so they need to hold fewer JGBs to meet their liquidity targets.

There has been an additional small drag on broad money growth from a slowdown in bank lending to other Japanese residents: such lending contributed 0.9 pp to money growth in April versus 1.3 pp in March 2013.

To a first approximation, therefore, QE has amounted to a large-scale swap of JGBs and reserves between the BoJ and other banks, with no impact on the money supply. The increase in banks’ reserves, moreover, has not resulted in an expansion of their lending to the rest of the economy.

Remarkably, the joint contribution of BoJ and bank lending to the government to broad money growth is smaller now than when QE was launched in October 2010 – 3.3 pp versus 3.1 pp (sum of blue and red bars). Banks were then driving the expansion, buying JGBs to boost their liquidity ratios.

The BoJ is committed to maintaining securities purchases at their current pace but the monetary impact should continue to be neutralised by bank selling. The stock of bank lending to the government still amounts to 25% of the broad money supply so the recent rate of reduction could be sustained for many years.

The BoJ could try to achieve more bang for its buck by buying equities rather than JGBs. Banks, however, would probably still sell JGBs as their reserves expanded so there is no guarantee that the money supply impact would be larger. Higher equity prices, in isolation, would be unlikely to provide even a short-term boost to the economy, given the absence of a “wealth effect” in Japan.

Rather than BoJ intervention, any rise in broad money growth is likely to be driven by a pick-up in bank lending to the private sector or a stronger balance of payments position**. “Abenomics”, however, has so far failed to stimulate credit demand, while the balance of payments has deteriorated recently, reflecting both a lower current account surplus and net direct / portfolio investment outflows.

Current monetary trends suggest modest economic growth and low inflation – probably beneath the BoJ’s 2% target***. Such a scenario is not unsatisfactory given Japan’s demography and could have been achieved without QE.

*The counterparts analysis is not yet available for May.
**A basic balance (i.e. current account plus net direct / portfolio flows) surplus results in a rise in the banking system’s net foreign assets, included under “other counterparts”.
 ***Stripping out sales tax effects.