Going their own way
Money supply matters, especially in the long run. Inflation is, after all, a monetary phenomenon - and financial history is littered with rapid expansions in the money supply preceding dramatically high inflation. But a consensus has emerged among economists that monetary aggregates have limited information content about inflation or activity over typical policy horizons, and central banks have accordingly dropped money supply growth targets. The velocity of money can change, while monetary aggregates are also affected by central bank balance sheets and changes to structures of the financial system. Overall, it' important to look at money supply numbers (often measured as M0, M1, and on up as the assets included as 'money' increase) alongside credit growth, bank lending surveys, and other leading indicators of growth and inflation.
The major central banks will therefore be fairly sanguine about the recent weakening in growth of both narrow and broad monetary aggregates (see Chart 1). In the US, weaker money growth is partly the result of Fed balance sheet run-off, while loan growth looks decent. The Fed last week hiked rates for a second time this year, and expects to do so twice more in 2018 and three times in 2019. We expect the pace of hikes to be faster still. In the UK, weaker money supply growth reflects financial institutions reversing the de-risking of money holdings undertaken after the EU referendum, and is therefore a benign development. The Bank of England is likely to hold rates steady this week, but hike in August. Slowing money growth in the Eurozone is consistent with moderating but still above-trend growth and a gradual re-emergence of inflation pressures. That assessment is shared by the ECB, which last week announced a taper of its asset purchases, albeit with the dovish rider that it expects to keep rates on hold "at least through the summer of 2019". In Japan, money creation by the BOJ has been thwarted by a meaningful deceleration in the velocity of money. Monetary policy may actually be insufficiently stimulative, but options to ease further are constrained by rising policy costs. Finally, regulatory tightening and rapid changes in the structure of China' financial system have distorted M2 as a measure of the policy stance. Policymakers have begun to loosen policy and may be moving towards an easing bias.
Out of fashion
Monetary aggregates used to be all the rage in the US. The Fed started collecting these data in the 1940s and set targets for the growth in money supply from the late 1970s. However, over recent decades these statistics have become less in vogue. From the late 1980s and into the 1990s, the relationship between both M1 and M2 growth and measures of economic activity such as GDP and consumer spending weakened (see Chart 2). In response, the Fed dropped its money growth targets in 2000 and even stopped collating M3 data in 2006. Given this backdrop, should we take much signal from the slowdown in these aggregates over recent quarters? Arguably not, especially since some of these indicators have likely become even more prone to distortions in the post-crisis period. The expansion in the Fed's balance sheet over the subsequent decade represented a radical increase in the monetary base, which more than quadrupled after 2008. With much of this increase reflecting a rise in central bank reserves, the distortions to some of the broader monetary aggregates have been much smaller (see Chart 3). However, M1 and M2 still grew by 14% and 8% respectively in the midst of the crisis in 2009, suggesting some effect on these measures.
Stepping away from the monetary statistics, we can look at trends in credit creation for signs of health. On this front there looks little cause for alarm. Commercial and industrial loan growth increased to 4.7% annualised over the past six months, suggesting upbeat business lending conditions. On the consumer side, both mortgage lending and consumer credit have been steady, at a respectable 2.4% and 4.9% annualised over the same period. Current growth, meanwhile, looks robust. Indeed, consumer spending seems to be rebounding nicely from a temporary Q1 blip, and a narrowing trade deficit suggests that net trade will provide a boost to growth in the second quarter. All in all, we see few reasons to believe that a slowdown is on the way.
One of the fears around quantitative easing (QE) when it was first instigated was that the enormous increase in the monetary base would be funnelled rapidly through the economy, creating rampant growth and inflation. This has clearly not been the case, reflecting in technical terms a decline in the velocity of money through the economy. However, then-Fed Chair Bernanke warned in 2009 that this expansion would need to go into reverse when credit markets and the economy began to recover. A decade on, the Fed is making progress. It continues to mechanically accelerate the roll off of assets purchased under QE, while using short interest rates as the primary tool for conducting monetary policy. On this front, last week the Fed hiked rates for a second time this year, as widely expected. The FOMC also updated its forecasts for the Fed funds rate, with the median estimate now for two more hikes over the course of 2018 and three more in 2019. Scratching beneath the surface, this was triggered by one member becoming more hawkish, rather than a landslide. However, the temperature on the committee over the past six months has clearly shifted towards earlier and more tightening. We expect this migration to continue as fiscal stimulus risks overheating the economy, and continue to look for two more hikes this year, four in 2019 and one in 2020.
(Don't) show me the money!
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.
Monetary pillar crumbles
In the early years of the European Central Bank (ECB), it targeted a reference value for growth of the M3 broad monetary aggregate of 4.5% under its "monetary pillar". The role of the monetary pillar was significantly downgraded after 2003, and the price stability target formally defined as "below but close to 2%", as money growth picked up but with little information content about inflation. So the ECB is unlikely to be perturbed by the recent slowdown in M3 growth (see Chart 6), which in any case is partly a consequences of declining net asset purchases. Growth of the narrow monetary aggregate M1 is a better, although still far from perfect, leading indicator of activity growth, and it too has slowed in recent months. But this has to be set against the decent rate of credit growth and upbeat bank lending surveys. Overall, monetary aggregates look consistent with our forecasts of moderating but still above-trend growth and a very gradual re-emergence of inflation pressures.
The ECB itself broadly agrees with that assessment, and last week announced its intention to taper its net asset purchases over the course of Q4, ceasing purchases by the end of this year. Expectations for the tapering announcement coming at this meeting or in July were more-or-less equally split, although the June announcement was not a huge surprise after ECB Chief Economist Peter Praet's recent hints. The dovish chaser to the tapering announcement was 'enhanced forward guidance' on policy rates, with the ECB stating its intention to keep rates on hold "at least through the summer of 2019". The precise meaning of "at least through the summer of 2019" was the subject of a number of questions at the press conference, but President Draghi refused to be drawn on exact timing. We think it's reasonable to see this language as consistent with our own forecast of an initial rate hike in September 2019, although the risks are skewed to an even later hike. The market certainly took enhanced forward guidance dovishly, with the euro weakening, and both European bond and equity markets rallying.
These policy moves are predicated on the ECB's forecasts for growth and inflation, laid out in the staff macroeconomic projections. Despite the recent softness in the activity data, the ECB's view remains that there is underlying strength in the Eurozone economy. So while the 2018 GDP forecast was lowered to 2.1%, the 2019 and 2020 forecasts were left at a still-above-trend 1.9% and 1.7% respectively. These activity forecasts are now very similar to our own, but where the ECB differ from us is in its upbeat inflation forecasts (see Chart 7). The ECB thinks that a "sustained adjustment in the path of inflation" is now in train. Partly that's a result of the recent rise in oil prices, but the ECB also thinks that the ongoing reduction in spare capacity will feed through powerfully to higher core inflation. We are less convinced, and expect the trade-off between dwindling slack and higher inflation to remain fairly flat over the next few years. So while the ECB is forecasting headline inflation of 1.7% in each of the next three years, our own forecast is for 1.7% in 2018 but then 1.5% and 1.4% in 2019 and 2020 respectively, as oil base effects drop out. The upshot is that, while we expect rate rises to begin towards the end of next year, the pace of tightening is likely to be very gradual.
Putting on a brave face
Japan has struggled to embrace the goldilocks scenario of solid growth, low inflation and low interest rates. Inflation remains too low, with the Bank of Japan forced into a downward revision of its assessment of core CPI to "in the range of 0.5%-1.0%" at last week's policy meeting, from "around 1%" previously. At the same time, risks associated with low interest rates are rising. Implementation costs include impaired functioning of the JGB market, financial sector profitability concerns and some signs of excesses in stock prices, real estate loans to GDP, and lending attitudes of financial institutions. There are also justifiable questions about the cost to Bank of Japan (BoJ) independence, with low borrowing costs an increasingly integral part of the government's fiscal sustainability plan; and costs of exit, with questions over policy firepower in the future in the event of a negative shock, as well as BoJ solvency. At last week's press conference, Governor Kuroda put on a brave face, appearing bullish on the inflation outlook and downplaying the side effects. However, we think the debate is set to become more fractious, with media reports regarding a BoJ review of inflation weakness pointing to growing exasperation.
One line of attack that has captured attention is the failure of policy to lead to a persistent expansion in money supply. Typically, one would expect policy designed to stimulate economic activity to prove consistent with an expansion in the money supply. Governor Kuroda's aggressive bond purchasing programme and negative interest rate policy are certainly the standard policy tools to deliver such an outcome. So why has the monetary supply been so lacklustre? It turns out that the relationship between money supply and output is a far more complicated issue. In Japan's case, money creation by the BoJ has been thwarted by a meaningful deceleration in the velocity of money, meaning that the number of times a yen is being spent on final goods and services has fallen dramatically. The most obvious explanation for this phenomenon has been the massive expansion in financial institutions' excess reserves held at the BoJ. This has reached extreme levels in recent years, peaking at an annualised rate of more than 150%, but has moderated more recently as the BoJ has sought to penalise the practice through the imposition of negative interest rates. Even at the more moderate pace of expansion, money supply growth has been modest (see Chart 8).
This has led some to conclude that Japan's problem is more structural in nature. At its most extreme, this argument suggests the rate of return on investment and companies' willingness to invest has become so low that firms are desensitised to interest rates. This is captured by Japan's so-called 'vertical IS curve'. In this environment, M2 may become completely decoupled from interest rates. What evidence is there that this has occurred in Japan? While the relationship between long-term borrowing costs and outstanding loan growth has been unusual, we think an inverse relationship is increasingly evident of late (see Chart 9). This will be welcome news for Governor Kuroda and explains why he is optimistic that the Bank's target will eventually be met. Our concern is that progress has been far too slow. Unfortunately, current policy settings are unlikely to accelerate this process, while options to ease further are constrained by rising policy costs. The opportunity may be slipping through Kuroda's fingers.
Make M2 great again
Monetary policy in China is front and centre as policymakers grapple with external pressures, including higher rates in the US and escalating trade tensions. With signs of weakening domestic demand in May and the potential for a damaging trade war, policymakers have begun to loosen policy and may be moving towards an easing bias. As we've written before in this column, gauging monetary and credit policy in China can be difficult due to differing signals from money supply, total social finance flows, and aggregate credit growth. This week we look at money supply (M2) growth and its usefulness as an indicator of liquidity and monetary policy.
Since mid-2016, M2 growth in China has fallen sharply and has recently recorded consecutive record lows. This has occurred amid a massive credit expansion, raising questions about the representativeness and relevancy of M2 as a gauge of monetary policy, and as a leading indicator of growth and inflation. Rapid changes to the structure of China's financial system, followed by regulatory tightening, have likely distorted M2 as a measure. But as the system adjusts, M2 will again serve as a relevant indicator. The rapid growth in shadow financing and subsequent policies to reduce financial sector leverage caused the notable deviation between M2 growth and the underlying credit expansion (see Chart 10). This was driven by the diversification of savings away from traditional bank deposits as more people chose to save with non-bank financial institutions and wealth management products, leading to divergence between M1 and M2 (see Chart 11). Although the value of M2 growth as a liquidity measure has been undermined by thriving shadow bank financing in recent years, policy tightening and increased shadow banking regulations will likely make M2 relevant again.
It helps to understand how money creation has changed in China over the past 10 years. Until the end of 2014, the People's Bank of China's (PBoC) balance sheet was largely a factor of China's twin surpluses and their growing pile of FX reserves. To offset the surge in the monetary base, the required reserve ratio (RRR) was hiked as high as 21.5% to rein in loan growth at commercial banks. It was not until outflows picked up in 2014/2015, that domestic money creation became a factor in monetary policy. As a result, the monetary policy framework and policy tools have changed substantially in the last couple of years, as the PBoC became a 'provider' of liquidity. With monetary policy shifting towards an easing bias, mainly driven by RRR cuts, M2 will likely rebound over the next 2-3 quarters. However, in the medium to long run, the structural downtrend in M2 growth will likely continue. As China's economy slowly shifts from an investment-driven growth model to one more reliant on consumption, its demand for credit should also slow. Monetary policy, in the long run, will reflect these conditions. Additionally, a further expansion of the PBoC's balance sheet will be increasingly difficult, as the PBoC has already become the largest central bank in the world. As a result, M2 growth and money creation will become more reliant on commercial banks extending credit. This suggests the PBoC will likely have to continue cutting the RRR in coming years.