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The (Divisia) money trail – a very bullish UK story

Recently, the data for the UK economy has been very strong, and it is very clear that the UK economy is in recovery. So what is the reason? Well, you guessed it – monetary policy.

I think it is fairly easy to understand this recovery if we follow the money trail. It is a story about how UK households are reducing precautionary cash holdings (in long-term time deposits) because they no longer fear a deflationary scenario for the British economy and, that is due to the shift in UK monetary policy that basically started with the Bank of England’s second round of quantitative easing being initiated in October 2011.

The graphs below I think tells most of the story.

Lets start out with a series for growth of the Divisia Money Supply in the UK.

Divisia Money UK

Take a look at the pick-up in Divisia Money growth from around October 2011 and all through 2012 and 2013.

Historically, UK Divisia Money has been a quite strong leading indicator for UK nominal GDP growth so the sharp pick-up in Divisia Money growth is an indication of a future pick-up in NGDP growth. In fact recently, actual NGDP growth has picked up substantially, and other indicators show that the pick-up is continuing.

If you don’t believe me on the correlation between UK Divisia Money growth and NGDP growth, then take a look at this very informative blog post by Duncan Brown, who has done the econometrics to demonstrate the correlation between Divisia (and Broad) Money and NGDP growth in the UK.

Shifting money

So what caused Divisia Money growth to pick-up like this? Well, as I indicated, above the pick-up has coincided with a major movement of money in the UK economy – from less liquid time deposits to more liquid readably available short-term deposits. The graph below shows this.

Deposits UK

So here is the story as I see it.

In October 2011 (A:QE in the chart), the Bank of England restarts its quantitative easing program in response the escalating euro crisis. The BoE then steps up quantitative easing in both February 2012 (B: QE) and in July 2012 (C: QE). This I believe had two impacts.

First of all, it reduced deflationary fears in the UK economy, and as a result households moved to reduced their precautionary holdings of cash in higher-yielding time deposits. This is the drop in time deposits we are starting to see in the Autumn of 2011.

Second, there is a hot potato effect. As the Bank of England is buying assets, banks and financial institutions’ holdings of cash increase. As liquidity is now readily available to these institutions, they no longer to the same extent as earlier need to get liquidity from the household sector, and therefore they become less willing to accept time deposits than before.

Furthermore, it should be noted that in December 2012, the ECB started its so-called Long-Term Refinancing Operation (LTRO), which also made euro liquidity available to UK financial institutions. This further dramatically helped the liquidity situation for UK financial institutions.

Hence, we are seeing both a push and pull effect on the households’ time deposits. The net result has been a marked drop in time deposits and a similar increase in instant access deposits. I believe it has been equally important that there has been a marked shift in expectations about UK monetary policy with the appointment of Mark Carney in December 2012 (D: Carney).

Mark Carney’s hints – also in December 2012 – that he could favour NGDP targeting also helped send the signal that more monetary easing would be forthcoming if needed, as did the introduction of more clear forward guidance in August 2013 (E: ‘Carney Rule’). In addition to that, the general global easing of monetary conditions on the back of the Federal Reserve’s introduction of the Evans rule in September 2012 and the Bank of Japan’s aggressive measures to hit it new 2% inflation undoubtedly have also helped ease financial conditions in Britain.

Hence, I believe the shift in UK (and global) monetary policy that started in the Autumn of 2011 is the main reason for the shift in the UK households’ behaviour over the past two years.

Monetary policy is highly potent

But you might of course say – isn’t it just money being shifted around? How is that impacting the economy? Well, here the Divisia Money concept helps us. Divisia money uses a form of aggregation of money supply components that takes this into account and weights the components of money according to their usefulness in transactions.

Hence, as short-term deposits are more liquid and hence readably available for transactions (consumption or investments) than  time deposits a shift in cash holdings from time deposits to short-term deposits will cause an increase in the Divisia Money supply. This is exactly what we have seen in the UK over the past two years.

And since as we know that UK Divisia Money growth leads UK NGDP growth, there is good reason to expect this to continue to feed through to higher NGDP growth and higher economic activity in Britain.

Concluding, it seems rather clear that the quantitative easing implemented in 2011-12 in the UK and the change in forward guidance overall has not only increased UK money base growth, but also the much broader measures of money supply growth such as Divisia Money. This demonstrates that monetary policy is highly potent and also that expectations of future monetary policy, which helped caused this basic portfolio readjustment process, works quite well.

“Monetary” analysis based on looking at interest rates would never had uncovered this. However, a traditional monetarist analysis of money and the monetary transmission mechanism, combined with Market Monetarist insights about the importance of expectations, can fully explain why we are now seeing a fairly sharp pick-up in UK growth. Now we just need policy makers to understand this.

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Acknowledgements:

I think some acknowledgements are in place here as this blog post has been inspired by the work of a number of other monetarist and monetarists oriented economists and commentators. First of all Britmouse needs thanking for pointing me to the excellent work on the “raid” on UK households’ saving by Sky TV’s economics editor Ed Conway, who himself was inspired by Henderson Economics’ chief economist Simon Ward, who has done excellent work on the dishoarding of money in the UK. My friend professor Anthony Evans also helped altert me to what is going on in UK Divisia Money growth. Anthony himself publishes a similar data series called MA.

Second of course, a thanks to Duncan Brown for his great econometric work on the causality of Divisia Money and NGDP growth in the UK.

And finally, thanks to the godfather of Divisia Money Bill Barnett who nearly single-handledly has pushed the agenda for Divisia Money as an alternative to simple-sum monetary aggregates for decades. In recent years, he has been helped by Josh Hendrickson and Mike Belongia who has done very interesting empirical work on Divisia Money.

For a very recent blog post on Divisia Money, see this excellent piece by JP Koning.

And while you are at it, you might as well buy Bill Barnett’s excellent book “Getting It Wrong” about “how faulty monetary statistics undermine the Fed, the financial system and the economy”.

 

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Duncan Brown’s interesting NGDP wonkery

If you write a blog you obviously want people to read what you write and even better you want to inspire discussion. I was therefore very happy when Duncan Brown sent me his two latest blog posts, which both are inspired by stuff I have written.

Duncan’s posts are very interesting. The first post – Shocking supply and volatile demand – uses a (crude) method I developed to decompose demand and supply inflation. Duncan utilizes this method – Quasi-Real Price Index – on UK data. The second post – In the 1950s, Rab Butler sets an NGDPLPT mandate… – also uses one of my ideas and that is to look a what inflation historical would have been had the central bank had an NGDP target. Duncan looks at the UK, while I earlier have looked at the US.

A Quasi-Real Price Index for the UK

I first time suggested that inflation could be decompose between supply and demand shocks with what I inspired by the brilliant David Eagle termed a Quasi-Real Price Index in a blog post in December 2011.

This is from my 2011 post – A method to decompose supply and demand inflation:

David Eagle in a number of his papers on Quasi-Real Indexing starts out with the equation of exchange:

(1) M*V=P*Y

Eagle rewrites this to what he calls a simple equation of exchange:

(2) N=P*Y where N=M*V

This can be rewritten to

(3) P=N/Y

(3) Shows that consumer prices (P) are determined by the relationship between nominal GDP (N), which is determined by monetary policy (M*V) and by supply factors (Y, real GDP).

We can rewrite as growth rates:

(4) p=n-y

Where p is US headline inflation, n is nominal GDP growth and y is real GDP growth.

Introducing supply shocks

If we assume that we can separate underlining trend growth in y from supply shocks then we can rewrite (4):

(5) p=n-(yp+yt)

Where yp is the permanent growth in productivity and yt is transitory (shocks) changes in productivity.

Defining demand and supply inflation

We can then use (5) to define demand inflation pd:

(6) pd=n- yp

And supply inflation, ps, can then be defined as

(7) ps=p-pd (so p= ps+pd)

Duncan uses this method on UK data and I must say that his results are vey interesting.

Here is a graph from Duncan’s post on the decomposing of UK inflation.

UK-qrpi

Based on his results he concludes:

“Policy may have looked loose in terms of interest rates, but relative to context, this was one of the most extreme tightenings on record. The implication is that while we’re always going to be prey to supply shocks which will create some volatility in output and employment, we need to be careful to allow demand to grow in a predictable, sustainable way. The trouble with an inflation target is that the nightmare combination of an adverse supply shock and a damaging tightening of monetary conditions looks – as it did at the time – like things are on track. Policy should aim to stabilise demand inflation, even as supply inflation moves around; it is a pity that the mandate most likely to be able to achieve this result (a nominal output level path) has been ruled out by the Treasury.”

As a Market Monetarist it is hard to disagree with Duncan’s statement. However, it should certainly also be noted that Duncan’s results give reason to think that the nature of the present crisis in the UK economy to some extent is different from the crisis in the US or the euro zone economies. Hence, it seems like the present subdued growth in the UK economy to a larger extent than is the case in the US or the euro zone (overall) is due to supply side problems (Weak demand is the primary problem, but supply issues seem more important than in the US). In that sense the UK economy might share some similarities with the Icelandic economy. See my earlier post here on why the Geyser crisis to a large extent was caused by an supply shock rather and a demand shock.

A counterfactual inflation story for the UK

In his second post Duncan tells the counterfactual story of what inflation would have been in the UK since the 1950s if the Bank of England had been targeting an 5% NGDP growth path. The method is similar to the one I used in my post The counterfactual US inflation history – the case of NGDP targeting.

You can see Duncan’s counterfactual inflation data in this graph.

Duncan’s results for the UK are rather similar to the result I got for the US. However, it seems that UK inflation under NGDP targeting than would have been in the case in the US in recent years. That do indicate that that the low growth in the UK economy to a larger extent than is the case in US. That, however, also mean you need lower demand inflation to achieve the Bank of England’s present 2% inflation target.

It is not all I agree with in Duncan’s two post – for example I think he misinterprets his results to mean that the primary shocks to the UK economy has been supply, while I think his results in fact shows that demand shocks have been the primary driver of the UK business cycle – but I would nonetheless recommend to all of my readers to have a look at Duncan’s blog. It’s good wonkery.

 

 

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