The Daily Reckoning UK

It’s All About The Money

David Stevenson


Posted 21st September 2016

Add an equation into an article – and straightaway, half the readers stop reading it. So says one of the old adages about financial journalism.

Today I’m writing about money. Like how much of it’s sloshing around, where the effects could be felt and what it all means for your portfolio. But as I don’t want today’s DR to become an immediate ‘deleted item’, I’ll spare you the key monetary formula.

Here’s the basic premise, though. The total quantity of money that’s circulating around the financial system multiplied by the speed with which it zooms round the said system is equivalent to the overall, known as the nominal, value of economic activity.

And when you think about it, unlike a lot of what economists say, this does seem to make sense. Broadly, the idea is that money supply moves determine both consumer price inflation/deflation and also changes in inflation-adjusted GDP (national output).

By watching variations in the money supply numbers that a country’s central bankers – in the UK’s case, the Bank of England – churn out, it should in theory be possible to forecast other variables. Like how the business sector is likely to fare and also what levels future interest rates might be. As a case in point, I was always taught that long-term interest rates on government bonds were roughly equal to the nominal growth rate of GDP.

Sounds simple enough, doesn’t it? Here, though, is where the problems start. Central bankers have to justify their cushy jobs and pensions somehow. To this end, they produce oodles of details. But they also complicate matters by using lots of impenetrable jargon.

Take the Bank of England. It publishes a range of monetary aggregates ranging from ‘narrow money’ M1 (there was an M0 until the Bank of England had a better idea) to ‘broad money’ M4 (see below). Believe me – as one who’s spent many long hours trying to decipher the data – it’s all as confusing as Britain’s similarly-named motorway network. And current interest rates levels are so distorted that the old rules have gone right out of the window.

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Meanwhile, remember we’re looking at the top-down view of the entire economy. There are lots of moving parts. If just one doesn’t work as expected, it can throw everything else out.

And even if you do reckon you’ve sussed it, those central bankers will still keep obfuscating.

Alan Greenspan, who was chairman of the US Federal Reserve between 1987 and 2006, summed it up best when replying to a questioner with this classic response: “I know you think you understand what you thought I said, but I’m not sure you realize that what you heard is not what I meant”.

Q.E.D. Anyway, where am I going with this rant about money supply and central bankers?

There’s something odd going on with the UK’s money numbers. What’s more, it’s largely gone under the radar.

A money measure called ‘M4ex’, which dates back to 2009 and is the Bank of England’s favourite gauge of broad money – i.e. money in any form including bank or other deposits as well as notes and coins – soared by 14.7% in the three months to the end of July 2016.

Sure, that’s only three months. And the period included the Brexit referendum so it’s bound to have been distorted. Financial institutions holding more liquidity during the vote will have pushed the figure up. But compared with the usual recent range for M4ex of between 3% and 7%, that’s still a massive jump. Indeed it’s a new record for the M4ex series, according to money supply-watcher Dr Andrew Lilico of Europe Economics.

And there are more anomalies. Year-over-year growth in the value of banknotes and coins in circulation has shot up to 8.3% in August from 5.5% in December 2015, notes Samuel Tombs of Pantheon Macroeconomics. Further, he points out that the latest weekly data on notes in circulation indicate that narrow money has continued to accelerate in September.

So did the Bank’s Monetary Policy Committee make a major blunder in August in cutting interest rates and restarting its quantitative easing (QE) debt-buying scheme? Granted, fears over possible future negative interest rates may be twisting the money figures. Yet it’s weird that money supply wasn’t mentioned in the Bank’s August Inflation Report or the minutes of September’s MPC meeting (though today’s Quarterly bulletin may include a comment).

In other words, are these surges in the money numbers indicating that Britain’s potential economic growth and/or inflation numbers are already set to turn out higher than expected?

Tombs doubts that strong growth in Britain’s money supply suggests an economic renaissance is on the way. He believes that on the contrary, uncertainty drives money demand and that “the pick-up in the desire of households and firms to hold money, as opposed to other assets, is a worrying signal”.

I’ve already explained the problems with interpreting money supply data. Time will tell whether the extra cash will leak out into hard assets like property and stocks, creating similar results to the QE programme. Or if the money supply surge could create higher inflation, more uncertainty or possibly both.

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