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Beware: the money supply is growing too quickly
The last thing the economy needs is an even looser monetary policy
It was Sir Winston Churchill who warned that “if you put two economists in a room, you get two opinions, unless one of them is Lord Keynes, in which case you get three opinions”. Churchill, of course, was right – but that merely means that we should be discerning in which economists we listen to.
Of those currently working in the City of London, one of my favourites is Simon Ward, chief economist at Henderson. His insights on how money and liquidity interact with the real economy are exceptional. At a time when many economists are worried about deflation, he is worried that liquidity is spiralling out of control and that this could eventually push up inflation.
This is an unfashionable view: hardly anybody cares about monetary aggregates any more. Ward is, broadly speaking, a monetarist, in the sense that he thinks that money matters, and that too much of it can, under certain circumstances, lead to excessive spending, pushing up inflation.
So what is going on? Ward calculates that the quantity of broad money in cash and bank accounts (known as M4) together with National Savings, held by households and private non-financial firms, surged 6.3pc in the year to August. This was the fastest growth rate since June 2008, suggesting a build up of spending and investing power; it was also significantly higher than the 2013-14 average of 4.75pc.
In the past, a large increase in liquidity has always preceded a boom, bubble and bust. In 1986 and 1987, the government (the Bank in those days wasn’t independent) slashed interest rates, which led to the money supply surging by 15pc a year, triggering the Lawson boom and contributing to the eventual catastrophic bust from which the Tories never really recovered. Liquidity was growing by almost 9pc in 2004 as the credit boom was in full swing.
But there is a big downside to using monetary aggregates to predict inflation or anything else, as Ward and all sensible monetarists readily acknowledge. There is no mechanistic connection between more cash in bank accounts and more spending. The rate at which money circulates around the economy (known in the jargon as “velocity”) matters just as much. An acceleration has the same impact as an increase in the amount of money in people’s pockets and bank accounts; a reduction in the rate at which money circulates has the same macroeconomic effect as a slump in the money supply.
(The most recent UK inflation statistics)
If today’s surge in liquidity is accompanied by similar or even faster velocity, spending (on goods, services and assets) would in time shoot up, putting pressure on prices, and most likely also the consumer price index. If velocity drops, the increase in liquidity would prove to be a false alarm – and in any case, money supply growth could easily slow again.
So what is happening this time? Should we be worried by Ward’s rocketing liquidity? Velocity fell by 2.1pc per year between 1995 and 2009, before stabilising. Ward suspects that velocity isn’t about to start dropping again; he points to the fact that bank lending to households and private non-financial corporations rose by 2.5pc annualised in the six months to August, to the increase in mortgage approvals, to arranged but unused credit facilities, and to M&A. But the truth is that nobody knows for sure.
(The most recent mortgage lending figures from the British Banking Association)
The only workable conclusion from these figures is that policymakers should tread carefully. They should stop dropping endless hints that interest rates could be about to fall again. Instead of ignoring monetary aggregates, they should pay close attention to them. They should pronounce explicitly on what they believe to be happening.
We also need more policymakers to start thinking about the exact, detailed connection between increased liquidity on the one hand and prices on the other: in the current economy, would the consumer price index start to go up – in other words, would this become a case of too much money chasing too few goods and services? Or would the extra cash end up pushing up share, bond and property prices?
It’s not just liquidity which is so strong, of course. So are nominal and real wages. Nominal GDP is growing quickly enough, especially given that the GDP deflator used is very different to the CPI measure of inflation. Given all of this, it makes no sense to be considering loosening monetary policy. The fact that the CPI is actually falling by 0.1pc, implying deflation on that measure, merely tells us that there is something very wrong with our monetary policy’s stated aim. We should stop targeting the CPI, ditch the 2pc target and concentrate instead on another measure: a variant of nominal GDP, perhaps.
Deflation is bad when it is caused by too little demand in the economy; but there is also such a thing as good deflation, our current situation. There have been long periods in the UK’s history when the economy has grown and prices have fallen. My favourite monetary policy rule, which is a form of nominal GDP targeting, is called the productivity norm. It was recently repopularised by George Selgin in research published by the Institute of Economic Affairs.
As I have argued in this column in the past, the productivity norm would allow good deflation – when prices fall because of improvements to productivity and other positive supply-side shocks – but also good inflation – when prices rise because of negative supply shocks such as much higher oil prices. There is, sadly no hope of such a monetary policy rule being adopted any time soon in the UK. In the meantime, the authorities need to study carefully what is happening to money and liquidity – and realise that the last thing the economy needs is an even looser monetary policy.
More from Allister Heath
allister.heath@telegraph.co.uk