Money supply growth suggests we’re still too pessimistic about the British economy
The latest broad money supply M4x figures from the Bank of England (up to the end of September this year) paint a picture of an economy getting stronger, not weaker. To understand why, we need a short digression into economic theory.
Broad money supply growth provides an insight into the outlook for nominal GDP growth (not adjusted for inflation). There isn’t a precise relationship, whereby an increase in the money supply raises nominal GDP pound for pound. There are also lags in the impact. A change in the money supply might not impact the economy for three to six months.
I’m very aware that critics of this school of thought argue that the broad money supply is endogenous. In other words, the money supply is caused by changes in the economy, not the other way around.
Clearly some of the change in the broad money supply is endogenous, but that is not the issue here. All that matters for our purposes is to assert that there is a direct link between money and nominal GDP, which there is. Real GDP (adjusted for inflation) growth plus inflation equates to nominal GDP growth.
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There is another factor to consider as well, namely the velocity of money, which can rise or fall. To understand velocity, think about how many times money changes hands. The broad money supply multiplied by the velocity of money equals nominal GDP growth. Readers may be aware of the economic identity MV=PT, where M is money, V is velocity, P is prices and T is transactions. PT is nominal GDP growth i.e. prices multiplied by the number of transactions.
So what do the latest figures show? M4x rose by 4.9 per cent (year-on-year) in May, before rising 6 per cent (year-on-year) in June, 6.9 per cent (year-on-year) in July, 7.4 per cent (year-on-year) in August, and 7.7 per cent (year-on-year) in September.
Three-month annualised rates of growth look even more impressive, almost doubling from 5.7 per cent to 10 per cent between May and September. Three-month annualised rates of growth were 14.7 per cent in July and 11.2 per cent in August. These are strong numbers. Strong money supply growth can also be seen across different sectors of the economy, with household divisia money rising 10.6 per cent (year-on-year), and private non-financial companies divisia money rising by 13 per cent (year-on-year) in September.
So with 7.7 per cent (year-on-year) growth in the broad money supply (M4x measure) in September, and inflation around 1 per cent, the implication is that, going forward, real GDP growth will either be much stronger than the consensus view and/or inflation will accelerate rapidly as well. Broad money M4x growth suggests current expectations for GDP and inflation are far too pessimistic for growth and/or too optimistic for inflation.
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Given what we know already about the behaviour of broad money, and the inherent lags in the way money feeds out across the economy, the strong suggestion from the latest numbers is that economic growth will accelerate into the fourth quarter of this year and the first quarter of 2017.
If I’m correct, the chancellor will need to hold fire on any fiscal stimulus in the Autumn Statement. The latest figures also suggest that at the very least the Bank of England should put a hold on QE.
The consensus view of GDP growth collapsed in the aftermath of Brexit, and has partially bounced back subsequently. The recent behaviour of broad money suggests there will be another round of upward revisions to GDP growth forecasts.