The MPC is debating when to raise interest rates. No member, presumably, thinks that policy should be loosened. A backdoor easing, however, is taking place as banks continue to cut lending and deposit rates. An immediate rise in Bank rate is needed simply to offset this additional monetary stimulus.

The chart shows estimates of the average interest rates banks receive / pay on the outstanding stocks of household lending and deposits. The average lending rate has fallen by 0.24% since end-2012 while the deposit rate has been cut by 0.58%*. The lending / deposit rate spread, nevertheless, remains low by historical standards.

These averages are likely to fall further, since the interest rates on new business are below those on the outstanding stocks. New fixed-rate bonds, for example, now yield just 1.34% versus 2.38% on the yet-to-mature stock. Similarly, the interest rate on new fixed-rate mortgages is 3.23% versus 3.67% on outstanding loans**.

Monetary conditions at end-2012 were sufficiently loose to generate strong nominal and real GDP growth. The fall in lending / deposit rates since then represents an unwarranted further relaxation, requiring an MPC response. With the supply of funding expanding***, a half-point Bank rate hike might be needed to return average deposit / lending rates to end-2012 levels.

MPC officials have argued that it was necessary to maintain official rates at an emergency level because of an unusually large wedge between bank interest rates and Bank rate. With this wedge narrowing, a compensating adjustment in Bank rate is overdue.

*As of May. Averages estimated from Bank of England interest rate and volume data for different types of business.
**Bankstats table G1.4.
***Banks expect an increased supply of household deposits in the third quarter, partly due to the introduction of NISAs, according to the latest Bank of England bank liabilities survey.

Forecasting indicators were giving a more positive message for the global economy and markets at the start of the second quarter. The MSCI World index returned 5.1% in US dollar terms over the quarter, up from 1.4% in the prior three months. The indicators continue to suggest solid near-term economic prospects and a supportive liquidity environment for markets. The main concerns for investors are unappealing valuations, a likely inflation rise as the economy strengthens and increased geopolitical conflict.

The economic forecasting approach here is based on the “monetarist” rule that the real, or inflation-adjusted, money supply leads demand and output by about six months. This rule suggested that global* economic growth would slow between late 2013 and spring 2014 in lagged response to a fall in real narrow** money supply expansion between May and November last year. This forecast proved correct: the six-month change in global industrial output peaked in November 2013, falling to an 11-month low in May – see first chart.



Real money expansion, however, rebounded sharply between November and February and has remained solid more recently. Economic growth, therefore, probably bottomed in May and will recover over the summer. This prospect has been confirmed by short-term leading indicators such as the purchasing managers’ surveys – the US and Chinese surveys, in particular, strengthened significantly in May and June. Growth could peak at the end of the third quarter but will likely stay respectable in late 2014, based on the latest monetary data.

The assessment of the liquidity environment for equity markets is informed by the gap between global real money growth and output expansion – a positive differential suggests that there is “excess” liquidity available to inflate asset prices and has been associated historically with stocks outperforming cash substantially. The gap is at a similar level to three months ago – first chart – though may narrow if economic growth strengthens as expected.

The economic slowdown since late 2013 has been reflected in the pattern of asset market returns, with government bond yields falling and “cyclical” equities underperforming “non-cyclicals”***. A summer growth rebound may reverse these trends; the ratio of cyclical equity prices to non-cyclicals stabilised in June and usually mirrors shifts in the G7 purchasing managers’ survey – second chart.



The assessment has been that there is less slack in the global economy than central banks assume, so stronger growth is likely to be associated with a rise in inflation. The six-month change in global consumer prices has firmed modestly since early 2014, driven by trends in the US and Japan. Equities would be at risk if faster inflation resulted in a sharp reversal of bond yields. Steep yield curves and conservative investor positioning, however, may limit any near-term bond market weakness.

Country-level monetary trends are informative about local economic and market prospects. Real money growth is currently strong in the US, moderate on average across the E7 emerging markets and below-par in the rest of the G7 developed economies – third chart. This pattern is consistent with year-to-date equity market performance – the US outperformed emerging markets, which in turn beat non-US developed market equities, according to MSCI indices.



Why has US real money growth strengthened despite Fed “tapering”? The narrow money measure followed here reflects the changing liquidity demand of households and companies and is only indirectly affected by Fed policy. The recent pick-up is evidence of rising economic confidence and spending intentions. Put differently, the progression towards monetary policy normalisation has not yet damaged economic and market prospects.

Real money growth is sluggish on average across other developed economies but this conceals significant variation – fourth chart. UK strength suggests that the economy will continue to outperform. UK equities have been slightly disappointing year to date, beating Japan but only keeping pace with Eurozone markets, while lagging the US. This is partly explained by rising issuance: the stock of shares outstanding rose by more in the UK than other major markets during the second quarter.



Real money trends have been weakest in Japan, with the six-month change turning negative in April. The latter mainly reflects a temporary inflation boost from the recent sales tax hike but, in addition, nominal money growth has slowed, despite QE. The monetary impact of the Bank of Japan’s (BoJ) bond-buying has been largely offset by sales by banks, while associated reserves creation has yet to stimulate bank lending.

Japanese equities are unappealing based on current monetary trends but lacklustre economic expansion could prompt further policy stimulus, suggesting limiting an underweight position. An extreme possibility is that the BoJ will switch its QE buying from bonds to equities in an effort to gain more traction. More likely, the authorities will achieve the same effect by the back door by forcing public pension funds to raise their domestic equity weighting financed by selling bonds to the BoJ.

The European Central Bank (ECB) eased policy further last quarter, cutting the main refinancing rate to 0.15% in June while moving the deposit rate – the lower bound of the corridor for the overnight rate – to -0.1% and offering banks additional longer-term funding on favourable terms. These changes may have little impact on real money growth, which has slipped since end-2013 and suggests unexciting economic and market prospects.

Eurozone inflation is well below target but this reflects monetary / economic weakness 1-2 years ago and euro strength. “Core” inflation – excluding food and energy – has stabilised since late 2013 and may revive gradually as economic recovery continues and the euro drag abates. This scenario suggests low odds of the ECB launching QE.

As noted, emerging E7 real money growth is now higher than in the G7 ex. the US, though remains moderate by historical standards. There is substantial country variation, with monetary trends strong in Mexico and India, and weak in Brazil and Russia. Chinese real money growth is mid-range but has risen since late 2013, consistent with other evidence that the economy is about to regain momentum.

*”Global” = G7 developed plus E7 emerging economies. E7 defined here as BRIC plus Mexico, Korea and Taiwan.
**Narrow money refers to forms of liquidity held by households and firms, excluding banks, that can be used in immediate settlement of transactions. Country definitions vary but include, at a minimum, currency and demand deposits while excluding time deposits and notice accounts. Narrow money should be distinguished from the monetary base, comprising currency and bank reserves with the central bank.
***”Cyclicals” = the top eight MSCI World level 2 industries ranked by correlation with the economic cycle; “non-cyclicals” = the bottom eight industries.

UK monetary trends remain expansionary, suggesting no slowdown in economic growth and rising medium-term inflation risks.

The preferred narrow and broad monetary aggregates here are non-financial M1 and M4, i.e. comprising holdings of households and non-financial firms. Non-financial M1 grew by 10.3% annualised in the six months to May, while M4 was up by 4.5%.

Demand and output follow the real or inflation-adusted money supply by about six months, according to the Friedmanite rule. Six-month growth in real non-financial M1 surged in 2012, predicting last year’s pick-up in the economy – see chart. It has stabilised since early 2013 at a strong level by historical standards. Recent GDP expansion of 3% plus annualised should be sustained at least through end-2014.

Real non-financial M4 growth is also tracking sideways, albeit at a significantly lower level. Real bank lending, meanwhile, is finally reviving – credit, unlike money, tends to lag rather than lead the economic cycle.

Low deposit interest rates have cut the demand to hold broad money while encouraging a shift from time deposits to sight deposits and cash, which comprise M1. The M4 numbers, in other words, understate monetary laxity while M1 may exaggerate it.

This demand change has been reflected in the velocity of circulation of non-financial M4, which has risen by about 0.5% per annum (pa) since the financial crisis, having fallen by more than 3% pa over the prior decade. Non-financial M4 growth of 4.5% now, therefore, is the equivalent – in terms of nominal GDP generation – of about 8% before the crisis. Put differently, current M4 growth and a velocity rise of 0.5% pa imply nominal GDP expansion of 5% pa – too high to meet the 2% inflation target over the medium term.