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Economics Weekly - Weak money supply growth argues for continued stimulus; Weekly economic data preview -UK poised to exit recession in Q4, while US recovery gathers further momentum

Economics Weekly -25 January 2010

 

Weak money supply growth argues for continued stimulus

 

A notable feature of the global economic downturn over the past two years has been the marked weakening in money supply growth. Despite unprecedented policy stimulus, the deposits held by the private sector and the amount of bank borrowing undertaken have both slowed sharply. Since peaking at 9.6% in early 2008, OECD annual broad money supply growth has almost halved to 5.4%. As chart a shows, broad money supply in the US, euro zone and UK have all posted sharp slowdowns over the past year, with the annual growth of broad money (M3) in the euro zone recently dipping into negative territory for the first time ever.

 

The desire of monetary financial institutions to repair their balance sheets has led to a decline in the supply of credit, while uncertainty over the economic outlook has weakened demand for loans. The fall in both the supply of, and demand for, credit has contributed to a decline in the money multiplier - how quickly financial intermediaries convert deposits into new lending - and the velocity of money – how many times money is spent in the economy. These declines, in turn, have exacerbated the fall in both money supply and nominal spending growth.

 

That said, there is no clear hard and fast short-term relationship between the money supply and nominal gdp growth. As chart b shows, there was a clear breakdown in the link between UK broad money growth (M4) and nominal gdp from the early to mid-1990s. The breakdown in this relationship, which was also evident in other countries, was largely due to the increased instability of the velocity of money. This was partly related to the growth of debit card transactions and also to changes in the structure of financial intermediation, notably the growth of off-balance sheet vehicles and the increase in capital market funding. The impact of these changes has been to weaken the link between traditional forms of credit growth and nominal spending.

 

As a result, the importance central banks attach to money supply developments in setting

monetary policy has declined since the 1980s. Nonetheless, the relationship may be inexact, but money supply trends can still impart useful information about the prospects for an economy. For example, the contraction in the euro zone money supply strongly suggests that nominal gdp growth across the region is likely to remain weak for some time.

 

More generally, with the world’s central banks having embarked on an unprecedented loosening of monetary policy, money supply is once again being monitored for signs of whether the policy stimulus is working. This is particularly the case in the UK, where the Bank of England has gone a step further than most other central banks by injecting around £200bn into the economy through the purchase of financial  assets (mostly gilts) from the private sector. These purchases have been financed through the creation of central bank reserves (the so-called policy of Quantitative Easing).

 

The Bank of England hoped that these purchases would achieve two aims: (i) boost financial asset prices, both gilts, equities and corporate bonds, and thus boost financial and economic confidence; and (ii) by raising the aggregate amount of deposits and reserves held in the banking system, encourage an increase in bank lending, thus raising money supply growth and, with a lag, nominal spending.

 

So far, evidence of the success of this policy has been mixed. While Quantitative Easing appears to have boosted financial asset prices – equities have risen sharply and corporate bond spreads have narrowed – traditional credit growth and nominal gdp growth have fallen further. As chart b shows, both the headline annual rates of broad money (M4) and nominal gdp growth have continued to drop sharply over the past year.

 

The detail of the money supply data shows an even weaker prognosis. Transfers between banks and intermediate ‘other financial companies’ have grown substantially over the past ten years. These flows, which are captured within the OFCs component of M4, impart little information about trends in nominal spending. To get a better picture of underlying trends, the Bank of England is now publishing a measure of M4 which excludes intermediate OFCs. As chart

c shows, on this measure, annual M4 growth has dropped from over 10% to less than 3% over the past two years, while M4 lending (ex OFCs) has fallen from a peak of over 14% to just 0.1%.

 

The weakness of money supply growth is partly being driven by the desire of both households and companies to pay down their loans. Over the past year, the amount of outstanding borrowing from banks and building societies by households and private non-financial companies (PNFCs) has declined by 0.8% and 2.4%, respectively (i.e. debt has been repaid). The rate of borrowing for house purchase has slowed markedly, while consumers have reduced their unsecured balances. Faced with historically high levels of indebtedness and a weak labour market, this process of balance sheet repair in the household sector is likely to continue.

 

In the corporate sector, the picture is more complicated. While PNFCs have paid down bank debt over the past year, thus reducing M4, the volume of bond and equity issuance has picked up markedly (see chart d). Indeed, it appears that larger companies are actively using the proceeds of capital market financing to reduce their outstanding bank loans.

 

With households and companies likely to continue repairing their balance sheets, the prospect of a meaningful recovery in money supply growth in the UK and other developed economies remains remote. Although there is no automatic link between money supply and nominal GDP, a recovery in money growth (towards a more normal range of around 5-7%) is likely to be viewed by policy makers as an important objective as they seek to put nominal gdp growth on a firmer footing. Indeed, until measures of money supply start to turn higher, speculation of a reversal, or even a suspension, of policy stimulus in the UK, US or euro zone may well be premature.

Adam Chester, Senior UK Macroeconomist

 

Editorial comments to:

Trevor Williams

Chief Economist

Lloyds TSB Corporate

Markets

Economic Research

10 Gresham Street

London, EC2V 7AE

Tel: +44 (0)20 7158 1748

 

Weekly economic data preview -25 January 2010

 

UK poised to exit recession in Q4, while US recovery gathers further momentum

 

􀂄 Financial markets will have to wait until Friday for the data highlight of the week in the US. The advance estimate of Q4 2009 GDP is expected to show economic activity picked up sharply, after belatedly returning to positive territory in Q3. We look for annualised GDP growth of 5%, underpinned by consumer spending and a strong contribution from inventories. Figures for December durable goods orders will be closely watched on Thursday, for clues about business investment trends and to help refine Q4 GDP forecasts. Meanwhile, we expect another contrasting performance from existing and new home sales in December, primarily highlighting the important influence of government initiatives at this time. We expect existing home sales to have declined sharply to 6.0mn (from 6.54mn), but new home sales to have rebounded to 380k (355k). Consumer confidence will be a key determinant of economic prospects - and the housing market – over the year ahead. We look for a third successive rise in the Conference Board’s headline index to 53.5 (from 52.9) on Tuesday, while the University of Michigan sentiment index may be revised up to 73.5 (72.8) in January on Friday.

 

Although the FOMC is widely expected to announce another unanimous decision to keep the target range for the Fed funds rate at 0-0.25% on Wednesday, financial markets will be alert to any changes to other emergency programmes or in the language used in the accompanying press statement. It is also a heavy week for Treasury issuance ($118bn).

 

􀂄 It is a light week for UK data, but still an important one. The first estimate of Q4 GDP (Tuesday) will be the one of the last key data points for the MPC to evaluate before going into its Inflation Report forecasting round (sectoral M4 data released on 1 February will also be of importance to gauge the recent efficacy of the quantitative easing programme). The decision on whether or not to extend the Asset Purchase Facility at the February meeting hangs in the balance and so the detail of the GDP report will be important for marginal voters on the MPC. Our central view, which is predicated, in part, on survey evidence (including our own business barometer) is for a relatively modest 0.4% quarterly expansion, marking the first positive reading in seven quarters. There is also some consumer-related data to digest, with the confidence index (Friday) expected to rise slightly reflecting in part, early signs of an improvement in the labour market. To the extent that retail sales growth was boosted in December by an advancement of consumption ahead of the VAT rise at the turn of the year, a fall in the CBI’s reported retail sales balance for January (Wednesday) is forecast, as this effect washes through the data. The inclement weather conditions earlier this month are also likely to have depressed retail activity. Housing data on both prices and bank mortgage approvals are also released during the week.

 

􀂄 From a financial markets perspective, the euro’s price action will be closely watched as concerns about public finances in peripheral euro-zone countries continue to mount. In terms of data, this week sees a further round of euro-zone business surveys. The main highlight will be Tuesday’s German Ifo report, where we anticipate an improvement in the business climate index to 95.0 in January, from 94.7. Broadly, the underlying picture in Germany is one of healthy current economic sentiment supported by tax cuts to boost economic activity, with expectations relatively less upbeat. The latter reflects concerns over the sustainability of global recovery (vital for Germany’s exports) and also the eventual withdrawal of government labour market subsidies (which potentially presage a sharp rise in unemployment). Meanwhile, weakness in the broad euro-zone monetary aggregates underscore the ECB’s cautious stance on unwinding past monetary stimulus. We look for M3 to contract by some 0.5% in the year to December, with loans to the private sector falling by 0.9% over the same period. Lending to the non-financial sector has been pared back particularly sharply. Finally, January’s euro-zone CPI estimate is published on Friday, where our forecast stands at 1.1% year-on-year.

Jeavon Lolay (Senior Global Macroeconomist), George Johns (UK Macroeconomist), Mark Miller (Global Economist)

 

Economic Research,
Lloyds TSB Corporate
Markets,
10 Gresham Street,
London EC2V 7AE
,
Switchboard:
0207 626 - 1500
www.lloydstsb.com/corporatemarkets

 

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