(Don't) show me the money!
19 June 2018
Money growth has slowed sharply in the UK. The Bank of England’s (BoE) preferred measure of the money supply, M4 excluding intermediate other financial corporations, grew by just 3.3% in the 12 months to April this year, the slowest rate since 2014. Some commentators have argued this slowdown is evidence that UK economic growth will slow further. However, the slowing in M4 growth was concentrated in the financial sector and probably reflects benign developments. Following the EU referendum, financial institutions like insurance companies and pension funds switched away from riskier assets and towards cash. This caused a temporary surge in M4 in the second half of 2016, which, significantly, was not associated with a corresponding surge in economic activity. This process now seems to be unwinding, with financial institutions re-risking, and M4 growth mechanically declining. It is hard to see why this should be associated with a slowing in the economy, and, if anything, may be a sign of growing confidence.
The BoE also publishes the more theoretically sound Divisia monetary index, which has mirrored the slowdown in narrow and broad monetary aggregates (see Chart 4). Standard monetary aggregates are compiled on a simple-sum basis by adding together the components of the index. This embeds the assumption that each of the individual components are perfect substitutes for each other. However, the various money-like assets held by households and businesses differ in how appropriate and available they are for use in transactions. By weighting the components of the index in accordance with the extent to which they provide transaction services, the Divisia index provides a better measure of money. As such, there are good reasons for thinking that movements in this index should be closely tied to movements in total spending in the economy.
However, there is no necessary connection between monetary growth and economic activity. Divisia growth and nominal GDP growth have diverged several times in the past (see Chart 5), and there is no reason why they can’t again. Indeed, in a modern monetary system, fluctuations in the broad money supply are typically not causal, but instead the result of lending behaviour of banks. Credit creates money rather than money creates credit. This is why modern central banks no longer target the money supply directly. Instead, they are able to influence the economy through their control of short-term funding markets, which in turn influence a whole host of other asset prices that feed into the lending decisions of banks and other agents. The reason the money supply and economic activity seem to move together is that they are both driven by the same thing; namely, aggregate demand. To the extent that the slowdown in monetary growth reflects a slowing in demand for credit, this could be a signal of slowing aggregate demand. But this signal would need to be balanced against all the other various measures of economic activity, which, on the whole, point to a decent pick-up in activity. For example, retail sales jumped by 1.3% month-on-month in May, taking the annual rate to a very healthy 3.9%, while financial conditions remain accommodative. Therefore we are relatively confident that the UK economy will recover from its Q1 lull.