By measuring the size and growth of the money supply we can begin to assess the appetite for saving, spending, and borrowing by households and firms and the appetite amongst banks and building societies to supply credit. In this blog we use figures released by the Bank of England in Monetary and Financial Statistics (Bankstats) to begin such an assessment. But, of course, the very first problem we face is measuring the money supply: just what should be include in a measure of money?
One measure of money supply is known as M4. It is a broad measure of money reflecting our need to use money to make transactions, but also our desire to hold money as a store of wealth. According to the Bank of England’s figures the amount of M4 money at the end of October was £2.19 trillion. To put this into some context, the GDP figure for 2009 was £1.4 trillion, so the amount of M4 is equivalent to about 1½ times GDP.
What M4 measures is the stock of notes and coins and sterling-denominated deposits held by households, firms (non-financial corporations or NFCs) and other financial corporations (OFCs), such as insurance companies and pension funds. These groups are collectively referred to as the non-bank private sector or sometimes as the M4 private sector. As well as the deposits that most of us are familiar with, such as sight and time deposits, sterling-denominated deposits also include other less well known, but liquid financial products, such as repos (sale and repurchase agreements) and CDs (certificates of deposit). Repos are essentially secured loans, usually fairly short-term, where individuals or organisations can sell some of their financial assets, such as government debt, to banks in return for cash. Certificates of deposit are a form of time deposit where certificates are issued by banks to customers for usually large deposits for a fixed term.
The Bank of England’s figures also allow us to analyse the actual holdings of M4 by households, private non-financial corporations and other financial corporations. Consequently, we can analyse the source of these particular liabilities. Of the £2.19 trillion of M4 money at the end of October, 42% was attributable to OFCs, 11% to PNFCs and 47% to households. Interestingly, the average shares over the past 10 years have been 28% OFCs, 14% NFCs and 58% households. Therefore, there has been a shift in the share of banks’ M4 liabilities away from households and towards other financial corporations (OFCs).
So why the change in the composition of Sterling M4 liabilities held by the banking system? Part of the answer may well be attributable to Quantitative Easing (QE): the Bank of England’s £200 billion purchase of financial assets. It appears that a large part of this asset-purchase strategy has resulted in other financial corporations (OFCs) – our insurance companies and pension funds – exchanging assets like government bonds for cheques from the Bank of England. Of course, these cheques are deposited with commercial banks and the banks are then credited with funds from the Bank of England. A crucial question is whether these deposits have facilitated additional lending to households and firms and so created credit.
A major ‘counterpart’ to the private sector sterling liabilities that comprise M4 is sterling lending by banks to the non-bank private sector. Of particular interest, is lending to that bit of the private sector comprised by households and private non-financial corporations. The latest Bank of England figures show that in October net lending to households (including unincorporated businesses and non-profit making institutions) was £1.5 billion. This compares with a 10-year monthly average of close to £3.9 billion. Meanwhile, net lending to private non-financial corporations in October, which over the past 10 years has averaged just over £2.1 billion per month, was -£2.2 billion. The negative figure for PNFCs indicates that more debt was being repaid by firms to banks than was being borrowed.
The net lending figures indicate that lending by banks to households and firms remains incredibly subdued. This is not to say that QE has in any way failed since one cannot directly compare the current situation with that which would have resulted in the absence of QE. Rather, we note that the additional deposits created by QE do not appear to have fuelled large amounts of additional credit and, in turn, further deposits fuelling further credit. The limited amount of credit creation for households and private non-financial corporations helps to explain the relatively slow growth in the stock of M4 held by households and PNFCs. While the stock of M4 increased by 6% in the year to October from £2.06 trillion last year, the stock held by households and PNFCs grew by around 2½%.
It is of course difficult to fully appreciate the extent to which the subdued lending numbers reflect restricted bank lending despite QE, or the desire for households and firms to improve their respective financial positions. One could argue that both are a symptom of the same thing: the desire for banks, households and firms alike to be less susceptible to debt. Clearly, these balance sheet effects will continue to have a large impact on the economy’s activity levels.
Articles
Business loans and mortgage approvals falls Financial Times, Norma Cohen (29/11/10)
UK mortgage approvals fall, M4 at record low on yr – BOE MarketNews.Com (29/11/10
Drop in mortgage approval levels The Herald, Mark Williamson (29/11/10)
Mortgage approvals dip to eight-month low Independent, Sean O’Grady (30/11/10)
Mortgage approvals fall to six month low BBC News (29/11/10)
Gross lending up £1 billion in October Mortgage Introducer, Sarah Davidson (29/11/10)
Data
M4 statistics are available from the Bank of England’s statistics publication, Monetary and Financial Statistics (Bankstats) (See Tables in Section A.)
Questions
- What do you understand by a narrow and a broad measure of the money supply? Which of these describes the M4 measure? Explain your answer.
- What other liabilities do you think might be included on the balance sheet of the UK’s banking system which are not included in M4?
- What do you understand by credit creation? Explain how the exchange by OFCs (e.g. insurance companies and pension funds) of government debt for cheques from the Bank of England could facilitate credit creation?
- What factors can affect the extent of credit creation by banks? How might these have affected the ability of QE to get banks lending again.
- What is meant by net lending? And, what does a negative net lending figure show?
- What do you understand by ‘balance sheet effects’? Illustrate with respect to households, firms and banks.
Taxpayers may actually be in profit by several billion pounds, following reports from Lloyds that their profits are up in the first three months of 2010. At current share prices, the taxpayers are in profit by approximately £2 billion and this figure is expected to rise, as share prices continue to rise. Lloyds is 41% owned by the public, after a £17 billion bail-out rescued the debt-ridden bank. These profits follow two years of losses by Lloyds TSB and HBOS of over £6 billion in 2008 and 2009.
So, what has caused this change in fortunes? First, there has been a fall in the number of loans, which have gone bad. The bank said, “In our wholesale division, the level of impairments has been significantly lower than the last quarter of 2009 and is also at a lower level than our initial expectations for 2010″. Second, there has been a widening gap between the interest charged on a loan and the interest paid to depositors. However, despite this good news, this bank (and others) are still not lending enough to stimulate economic growth. Furthermore, as Lloyds still remains heavily dependent on loans both from British and overseas taxpayers, it could be some time before taxpayers see any return on their ‘investment’.
Lloyds: Black is the colour of spring BBC News, Peston’s Picks, Robert Peston (27/4/10)
Lloyds Banking Group returns to profits Guardian, Jill Treanor (27/4/10)
Lloyds profits revive as bad debts imorive Reuters, Edward Taylor and Clara Ferreira-Marques (27/4/10)
Lloyds Bank returns to profit Telegraph (27/4/10)
Lloyds and RBS shares to rise to give taxpayer potential £9bn profit Guardian, Jill Treanor and Larry Elliott (26/4/10)
Questions
- How have fewer bad debts and different lending and saving rates contributed to rising profits for Lloyds?
- If profits are back up, why are British banks still not lending enough?
- What factors will determine when the taxpayers actually see the return on their ‘investment’?
- In the Guardian article, ‘Lloyds Banking Group returns to profit’ what does it mean by “The bank did not change its earlier guidance that it expected to achieve £2bn of synergies and other operating efficiencies from the HBOS takeover by the end of 2011”?
- To what extent is the news about profits at Lloyds Banking Group and RBS a useful tool for the government in the upcoming election?
- Why is it so important that banks begin to increase their lending? What will determine the size of the effect on GDP of any given increase in lending?
Since March 2009, the Bank of England has engaged in a process of quantitative easing (QE). Over the period to January 2010 the Bank of England injected £200 billion of new money into the economy by purchasing assets from the private sector, mainly government bonds. The assets were purchased with new money, which enters the economy as credits to the accounts of those selling the assets to the Bank of England. This increase in narrow money (the monetary base) is then able to form the basis of credit creation, allowing broad money (M4) to increase by a multiple of the increased monetary base. In other words, injecting £200 billion allows M4 to increase by considerably more.
But just how much more will M4 rise? How big is the money multiplier? This depends on the demand for loans from banks, which in turn depends on the confidence of business and households. With the recovery only just beginning, demand is still very dampened. Credit creation also depends on the willingess of banks to lend. But this too has been dampened by banks’ desire to increase liquidity and expand their capital base in the wake of the credit crunch.
Not surprisingly, the growth in M4 has been sluggish. Between March and Decmber 2009, narrow money (notes, coin and banks’ reserve balances in the Bank of England) grew from £91bn to £203bn (an increase of 123%). M4, however, grew from £2011bn to £2048bn: an increase of only 1.8%. In fact, in December it fell back from £2069bn in November.
Despite the continued sluggishness of the economy, at its February meeting the Bank of England announced an end to further quantitiative easing – at least for the time being. Although Bank Rate would be kept on hold at 0.5%, there would be no further injections of money. Part of the reason for this is that there is still considerable scope for a growth in broad money on the basis of the narrow money already created. If QE were to continue, there could be excessive broad money in a few months’ time and that could push inflation well above target. As it is, rising costs have already pushed inflation above the 2% target (see Too much of a push from costs but no pull from demand).
So will this be an end to quantitative easing? The following articles explore the question.
Bank of England halts quantitative easing Guardian, Ashley Seager (4/2/10)
Bank calls time on quantitative easing (including video) Telegraph, Edmund Conway (5/2/10)
Bank of England’s time-out for quantitative easing plan BBC News (4/2/10)
Shifting goalposts keep final score in question Financial Times, Chris Giles and Jessica Winch (5/2/10)
Bank halts QE at £200bn despite ‘sluggish’ recovery Independent, Sean O’Grady (5/2/10)
Easy does it: No further QE BBC News blogs, Stephanomics, Stephanie Flanders (4/2/10)
Leading article: Easing off – but only for now Independent (5/2/10)
Not easy Times Online (5/2/10)
Quantitative easing: What the economists say Guardian (4/2/10)
Questions
- Explain how quantitative easing works?
- What determines the rate of growth of M4?
- Why has the Bank of England decided to call a halt to quantiative easing – at least for the time being?
- What is the transmission mechanism whereby an increase in the monetary base affects real GDP?
- What role does the exchange rate play in the transmission mechanism?
- Why is it difficult to predict the effect of an increase in the monetary base on real GDP?
- What will determine whether or not the Bank of England will raise interest rates in a few months’ time?
After the November 2009 meeting of the Monetary Policy Committee, the Bank of England announced that it would keep Bank Rate on hold at 0.5%, at which rate it has been since March. It also said that it would spend a further £25 billion over the next three months on asset purchases, primarily government bonds, thereby pumping additional money into the economy: the process known as “quantitative easing“. This would bring total asset purchases under the scheme to £200bn.
But although this represents a further increase in money supply, the rate of increase is slowing down. In the previous three months, £50 billion of assets had been purchased. So does this imply that the Bank of England sees a recovery around the corner? Will money supply have been expanded enough to finance the desired increase in spending – on both consumption and investment?
A problem so far is that most of the extra money has not been spent on goods and services. Banks have been building up their reserves, with much of the money simply being re-deposited in the Bank of England as reserve balances (see Table A1.1.1 in “Bankstats). At the same time, households have been taking on very little extra debt – indeed, In July, total household debt actually fell (see “Payback time) and consumer debt (i.e. excluding mortgages) has continued to fall. If quantitative easing is to work, the money must be spent!
But with the monetary base having expanded so much, is there a danger that, once the recovery gathers pace, spending growth will return with a vengeance? Will inflation rapidly become a problem again with an overheating economy? The following articles examine the issues.
Interest rates held at 0.5 per cent (includes video) Channel 4 News (5/11/09)
Bank of England extends quantitative easing to £200bn Guardian, Larry Elliott (5/11/09)
What the economists say: Quantitative easing £25bn boost Guardian (5/11/09)
Bank of England faced with its biggest split on policy in a decade Independent, Sean O’Grady (4/11/09)
Bank of England expands money-printing programme to £200bn to fight downturn (includes video) Telegraph (5/11/09)
The one thing worse than quantitative easing would be no QE at all Telegraph, Edmund Conway (5/11/09)
BoE: It ain’t over till it’s over Telegraph, Edmund Conway blog (5/11/09)
Bank raises stimulus to £200bn to end recession Times Online, Grainne Gilmore (5/11/09)
Bank of England to inject another £25bn of stimulus money Management Today (5/11/09)
Extra £25bn to stimulate economy BBC News (5/11/09)
Quantitative easing ‘not working’ (video of DeAnne Julius: former MPC member) BBC News (5/11/09)
Boxed in BBC Stephanomics (5/11/09)
The BoE’s £25bn gambit Financial Times, Chris Giles blog (5/11/09)
US to reduce Quantitative Easing as rates kept low Telegraph, James Quinn (4/11/09)
Quantitative easing ‘unpleasant’ BBC Today Programme, Stephen Bell and Wilem Buiter (7/11/09)
Experts debate whether quantitative easing is working (video) BBC Newsnight (6/11/09)
Questions
- What has been happening to the velocity of circulation of (narrow) money in the past few months? Explain the significance of this.
- What is likely to happen to the velocity of circulation in the coming months if (a) the economy recovers quite strongly; (b) recovery is modest?
- What is the relationship between quantitative easing and the growth in broad money (i.e. M4 in the UK)? How will banks’ desire to build up their reserves affect this relationship?
- Is the UK economy in a liquidity trap? Explain.
- Why is it likely that the Bank of England may well engage in more quantitative easing next March and beyond? How is the fiscal situation likely to affect Bank of England decisions?
- Examine the argument for the Bank of England buying more private-sector debt (virtually all of the asset purchases have been of public-sector debt)?
A key determinant of the credit crunch was a shortage of liquidity and a breakdown of the interbank lending market. In an attempt to ease the credit situation and restart the interbank lending market, the Bank of England auctioned over £40bn of credit at the end of September. The aim of this was to boost the liquidity position of the banks.
Central banks pump billions into system Guardian (27/9/08)
Bank of England pumps £55bn into credit markets Times Online (26/9/08)
Where has all the money gone? BBC Magazine (15/10/08)
Questions
| 1. |
Explain why the Bank of England needed to boost liquidity in the money markets. |
| 2. |
Using diagrams as appropriate, show the impact of this increase in credit on the money markets. What constraints does the Bank of England face in ensuring that it achieves the desired outcome? |
| 3. |
Discuss whether the approach of raising liquidity is likely to be more or less effective than a change in the regulatory framework. |