Hallelujah! The August Inflation Report included a box discussing recent monetary developments. The analysis, however, is flawed.

The box appears to have been included to counter the criticism made here and by others that a rate rise was inappropriate because monetary trends have weakened. As the Report notes, “(t)welve-month growth in broad money slowed to 3½% in 2018 Q2, having been above 7% in 2016 H2”.

So why is this of no concern? The Report concedes that “money growth may provide a signal for recent and future trends in activity and inflation”. However, “developments can … also reflect other factors that have limited implications for spending prospects, which appears to have been the case at present”.

The key “other factor” operating at present, it is claimed, is a reduction in households’ precautionary demand to hold money. The Report argues that broad money growth was boosted in 2016 by households switching out of investment funds into liquid assets, with this switch attributed to “heightened uncertainty around the referendum”. The slowdown in household and overall broad money growth more recently “appears in part to reflect some of that precautionary demand subsiding, as investment fund holdings have risen”.

There are several problems with this argument. It is not at all clear why households should be less uncertain about Brexit now than in 2016. The Report does not offer any corroborating evidence of a fall in the precautionary demand for money, apart from the rise in investment fund holdings.

A reduction in household uncertainty, moreover, would be expected to be associated with a positive reassessment of income prospects and spending plans, leading to a rise in the transactions demand for money. This could, in theory, offset or outweigh the fall in precautionary money demand.

Empirically, the argument in the Report implies that an expanded monetary / savings aggregate incorporating investment funds would have displayed stable growth in recent years, with no slowdown recently. This, surprisingly, was not explored, but is not the case.

The chart compares annual growth rates of narrow (M1) and broad (M4) non-financial* money measures and an expanded aggregate including National Savings products, foreign currency deposits and retail flows into UK-registered unit trusts and OEICs (“non-financial M4++”). Growth of the expanded aggregate fluctuated in a relatively narrow range over 2015-17 but has fallen significantly this year, reaching a six-year low of 3.7% in June.

Inflows to retail investment funds have slowed sharply in recent months – they totalled £4.7 billion in the second quarter compared with £12.1 billion a year earlier (IMA data). On the argument of the Report, this reduction should be boosting household money growth.

The view here remains that money trends are weak because spending plans are subdued, depressing the transactions demand for money. Yesterday’s rate increase, while expected, risks exacerbating this weakness.

*Covering holdings of households and private non-financial corporations but excluding those of financial corporations.

The central expectation here, based on monetary trends, is that global economic momentum will continue to weaken into the fourth quarter of 2018 before reviving slightly into early 2019 – see previous post. The OECD’s composite leading indicators, which in most cases exclude money, are giving stronger support for the forecast of a near-term further economic slowdown.

The OECD will release June data for its indicators on 8 August but most of the component information is already available, allowing an independent calculation. The G7 indicator is estimated to have fallen further in June, with revisions likely to magnify the scale / speed of the decline from a January 2018 peak – see first chart. The indicator is expressed in trend-adjusted form, i.e. the recent fall implies below-trend economic growth.

The decline in the G7 indicator was initially driven by European countries and Japan, with the US indicator continuing to rise. This raised the possibility that non-US weakness would prove temporary as US acceleration boosted global demand – the consensus view when economic data started to disappoint in early 2018.

Monetary trends, however, suggested that convergence would occur by the US losing momentum rather than a pick-up in the rest of the G7. The latest leading indicator estimates are consistent with this expectation, with the US indicator also now falling and no let-up in the declines in Europe / Japan – second chart.

The third chart shows a “global” indicator that combines data for the G7 and seven large emerging economies (the “E7”) while “adding back” an estimate of trend industrial output growth. Six-month growth of this indicator peaked in December 2017 ahead of a March 2018 peak in G7 plus E7 six-month output expansion. It continued to decline in June, consistent with a further loss of output momentum through the third quarter, as suggested by monetary trends.

Based on the monetary forecast that economic momentum will bottom in the fourth quarter, one- and six-month changes in the G7 plus E7 leading indicator may stabilise during the third quarter.

UK monetary trends are showing signs of recovery but remain weak, arguing against the rate hike that the Monetary Policy Committee is expected to deliver this week.

As usual, the focus here is on “non-financial” broad (M4) and narrow (M1) monetary aggregates, comprising money holdings of households and private non-financial businesses. The Bank of England’s M4ex measure additionally includes money held by non-bank financial corporations (excluding intermediaries) but such holdings are volatile and uninformative about future spending on goods and services*.

Annual non-financial M4 growth was 3.1% in June, which compares with a recent low of 3.0% in April and a peak of 6.8% in September 2016. Annual non-financial M1 growth fell further to 4.4% in June, a six-year low and down from 10.1% in September 2016 – see first chart.

As the chart shows, the collapse in money growth since 2016 has been reflected in a significant slowdown in nominal GDP, annual expansion of which is currently estimated by the Office for National Statistics to have fallen to only 2.7% in the first quarter of 2018.

Three-month growth of the two aggregates recovered during the second quarter, suggesting a stabilisation or modest revival in the annual rates of expansion – second chart. A significant pick-up, however, would be required to warrant concern that monetary conditions are too loose for achievement of the inflation target over the medium term.

Current monetary trends, indeed, argue that an inflation undershoot is more likely. The velocity of non-financial M4 – i.e. the ratio of nominal GDP to the aggregate – has fallen at an average rate of 0.7% per annum (pa) since end-2009, compared with a reduction of 3.0% pa over the prior decade. Assuming a continued decline of 0.7% pa, current annual growth of non-financial M4 of 3.1% in June, if sustained, would result in a 2.4% pa rate of increase of nominal GDP. This would imply an inflation undershoot unless potential economic expansion is well below 1% pa.

The MPC has a long tradition of ignoring monetary trends and continues to make serial policy mistakes as a result. It failed to lean against monetary buoyancy in the mid-2000s, prolonging and magnifying the credit bubble. It was slow to launch QE after the bubble burst and monetary trends stagnated.

After an initial recovery, money growth fell back in 2010 but the Bank of England proceeded to wind down the special liquidity scheme, which had provided significant support for bank balance sheet expansion, thereby exacerbating monetary weakness and contributing to the 2011-12 economic slowdown and double-dip scare.

The most recent mistake was to cut rates and launch additional QE in August 2016 despite strong money growth, which signalled that the economy was likely to continue to expand despite the negative shock of the EU referendum result. This unnecessary policy easing magnified sterling weakness and associated upward pressure on import prices and inflation.

The MPC now appears poised to make the opposite mistake. Three-month growth of the money measures fell sharply immediately after the November 2017 rate hike – second chart. A similar response to an August 2018 increase could result in annual rates of expansion declining to dangerously low levels. Why run this risk? The MPC should skip policy action this week and make a November rate increase conditional on a further recovery in monetary trends.

*M4ex is giving a similar message to the non-financial monetary aggregates currently.