Rising employment in Britain in recent quarters argues that a recovery is under way, even though it is disappointing by the standards of the past. Official data in recent quarters almost certainly understate the level and rate of growth of output. The understatement may arise because of the difficulty of calculating price indices in an economy dominated by service output, and characterised by extensive product innovation and improvement. (I have no idea how the national income accountants measure the output of Facebook. Twitter and Google.) At any rate, the persistence of employment growth suggests that macroeconomic conditions are normalizing after the trauma of the Great Recession. How should monetary policy now be organized? Do policy-makers need to ‘do more’ to stimulate the recovery? Or is monetary policy already on the right lines?
The following note proposes that low and stable growth of the quantity of money remains the key to achieving macroeconomic stability with low inflation in line with the official target. It is suggested that the annual growth in the quantity of money, broadly-defined, should lie between 3% and 5% (or perhaps 2% and 6%) if policy-makers want to maintain consumer inflation of about 2% and moderate output growth at roughly the trend rate (which does not seem to be much above 1 ½% a year and may be lower). For the moment banks seem reluctant to expand their loan assets, despite the continuing verbal assault on them from Mervyn King, the media and others. But money growth at the desired low rate can easily be attained by varying the degree to which the budget deficit is financed from the banks rather than non-banks. Theological debates about ‘quantitative easing’ are unnecessary; they symptomize widespread misunderstanding about how monetary policy can and should be conducted. (This is the first half of a note which will be completed next week.)
Mark Carney’s appointment as the new governor of the Bank of England has triggered several rounds of speculation about a new approach to monetary policy. The Conservative-LibDem coalition has made reduction in the budget deficit one of its foremost macroeconomic objectives, which is surely right in view of the build-up of public debt and the climb in interest payments on that debt. But, with so-called ‘fiscal policy’ neutralized in this way, monetary policy activism seems to be the only means of ‘stimulating the economy’. Given the context, it is understandable that there should so much talk about fresh initiatives when Carney takes over. However, the commentariat ought to recognise that tinkering with monetary policy instruments cannot give a large and immediate boost to the economy’s trend growth rate. Deliberate monetary stimulus might ultimately raise the inflation rate, with no long- run benefit to output and employment. In this note a policy framework for delivering monetary stability is briefly described, and remarks are then made on two topics,
- the closeness of actual policy to the policy implied by the framework, and
- the range of methods and instruments that are available to policy-maker
The second of these topics is a very large subject, which will be covered in next week’s e-mail attachment
A framework for monetary stability
According to standard theory, the equilibrium level of national income in nominal terms is determined by the interaction between the demand to hold money balances and the quantity of money created by the banking system. Non-bank private sector agents have a money demand function, with their demand to hold money depending on the level of income (and/or wealth), the attractiveness of money relative to other assets and other variables. (They have a money demand function, just as they have demand functions for Weetabix, red socks and holidays in Spain, and – as with these demand functions – the variables that determine the quantity demanded are relative price, income and other variables.)
With the quantity of money given, and with the non-income variables in the demand function also set at particular values, the money demand function implies that only one level of nominal national income is consistent with macroeconomic equilibrium. In that sense the quantity of money determines nominal national income. Further, if (a big ‘if’) the non-income variables in the money demand function are stable over time, theory says that changes in the quantity of money and equilibrium national income are equi-proportional. In the real world changes in the quantity of money usually differ from changes in nominal national income. Nevertheless, over the long run and in all countries the differences between the annual rates of change of money and national income are typically – indeed, virtually always – very small compared with the cumulative changes in both money and national income.
The discussion so far has a simple message for policy-makers, that over the medium term the behaviour of the quantity of money is fundamental to the achievement of a desired level of nominal national income. By extension, it must also be fundamental to delivering price stability (if a price index is being targeted) or ‘inflation targets’ (if for some reason a low rate of inflation is deemed preferable). For over 20 years the UK has had a policy regime focussed on a low and stable rate of consumer inflation, with the consumer price index allowed to rise by 2% or 2 ½% a year. For most of that period the attraction of holding money has been increasing relative to holding other assets, enabling the quantity of money to rise somewhat faster (about 2% a year) faster than national income. So roughly growth of 6% – 7% a year in the quantity of money has been accompanied by inflation in line with the desired figure of 2% – 2 ½%, as shown in the box below. The year-by-year correlation between money and nominal GDP has not been close, but the persistence of the medium-term relationship between the variables cannot be overlooked. In the last few years the lowest rate of growth of money for many decades has been associated with the lowest rate of increase in nominal GDP. (See the weekly e-mail of 13th November 2012, on the effectiveness of QE.)
Recent disappointing experience argues that the trend growth rate of output in the British economy has fallen from about 2 ½% – 3% a year in the Great Moderation (i.e., 1992 to 2007) to 1% – 1 ½% a year at present. For the time being at least, the 2%-a-year target increase in the consumer price index remains the lodestar of monetary policy-making. So the desired increase in nominal GDP is at most 4% a year. Current very low interest rates have the effect of making interest-bearing money balances unattractive relative to other assets, which will lower the ratio of money to GDP that money-holders favour. Consequently, broad money growth of 3% to 5% a year (or perhaps 2% to 6%) seems roughly in accordance with the wider agenda. Of course judgement plays a role here and the analysis should not be pressed too far. But official blessing for ‘quantitative easing’ (i.e., for action to boost the quantity of money) in the last few years suggests that, whatever the reservations many academic economists may feel about the subject, some form of quantified monetary appraisal must be part of what policy-makers do and think.
Current money growth patterns in the UK
The chart above shows the drastic change in UK money growth between 2007 and 2009. In the final quarter of 2007 the annual growth rate of M4x was just over 10%; in the second half of 2009 M4x was barely rising at all. A large body of previous experience ought to have warned policy-makers, certainly by mid-2007 (and arguably a few quarters earlier), that an annual double-digit rate of money growth risked above-target inflation and so that they were playing with fire. Even so money growth should have been reduced at a moderate pace. The plunge in money growth in 2008 was a major blunder.
The chart above relates to a somewhat shorter period than the Great Moderation, with its length determined by the changing practices of the UK banking system. In the 1990s the Basle capital rules restricted the growth of bank balance sheets, by requiring banks to keep a certain amount of capital against the risk in a particular size of loan. In the late 1990s several banks started to circumvent this restriction by a somewhat invidious means. They held assets in corporate entities that, according to the strict legal definition, were not ‘banks’, even though they were financed by the banks and were intended to facilitate later asset acquisition by them. These entities became known as ‘intermediate other financial corporations’ (or IOFCs) and have to be viewed as a blasted nuisance in monetary analysis. (They also complicated financial regulation, and are now being restructured and closed down.) A long-standing and sensible convention is that inter-bank deposits are excluded from measures of the quantity of money, since it is only non-banks who use their bank deposits as a means of settlement.
But what is to be said about deposits held by ‘intermediate other financial corporations’, which are virtual banks or quasi-banks? They could be excluded or included, according to taste. The Bank of England decided to include such deposits in its broadly-defined measure of the quantity of money, M4. However, experience showed this reduced the usefulness of M4 in macroeconomic analysis. Eventually the Bank’s statistical team prepared a M4x money measure (i.e., of M4 as traditionally calculated, but without the IOFC deposits). The chart above shows the annual growth rate of M4x, in both nominal and real terms, from the start of the M4x series in 1998. It again demonstrates the abruptness and severity of the change in monetary conditions in 2008 and early 2009, with the annual growth rate of real money dropping from over 8% in the final quarter of 2007 to zero a year later.
However, the chart is reassuring in two other respects. First, although the annual growth rate of nominal M4x collapsed from a double-digit rate in late 2007 to only 1% a year or so later, it never went negative. (The quantity of money did fall in several months, but the annual change was always positive.) Second, the annual rate of money growth has slowly returned to a figure in the mid- single digits. Indeed, the annual rate of M4x growth in the final quarter of 2012 was just above 5%, while the annual rate of growth (assuming 2% inflation) was 3%.
In short, money growth at present is in line with the prescription set out earlier, i.e., of an annual growth rate of money of between 3% and 5% (or, more generously), between 2% and 6%). The rise in employment, and very probably the resumption of output growth (when it is being measured properly), in recent quarters agrees with the notion that general macroeconomic conditions are normalizing. Even the banks, battered by post-crisis shocks such as the LIBOR and PPI scandals, can look forward to reporting reasonably clean profit statements in 2014 or 2015.
Reasons for the return of money growth
Why, then, has money growth recovered to a level consistent with wider macroeconomic recovery? The quantity of money is dominated by bank deposits and can be viewed as equal to the banking system’s assets minus its liabilities to non-depositors and the state (i.e., to shareholders and bondholders, mostly, but also deferred tax etc.). Banks’ assets and liabilities are of course identical. If liabilities to non-depositors are constant, the quantity of money increases by banks expanding their assets. The growth of assets is usually motivated by profit, but banks have to comply with regulation (on, for example, their holdings of cash and liquid assets, so that they can repay depositors), and official rules and regulations can oblige them to acquire assets for reasons other than profit maximization.
Banks can extend credit to and hence acquire claims on
i. the economy in which they operate or
ii. the rest of the worl
All economies are split into the private sector and the public sector (or ‘the state’). So banks can grow their balance sheets by increasing their claims on
iii. the domestic private sector,
iv. the domestic public sector, and
v. the rest of the world (i.e., ‘the overseas sector’).
In the normal course of events, in peacetime conditions apart from financial crises, banks grow their assets by increasing loans to the private sector. Claims on the private sector consist of both loans and securities, since banks can purchase securities issued by companies and financial institutions (including such curiosities as intermediate ‘other financial corporations’). Moreover, also in the normal course of events, the private sector’s demand for new bank credit is positive, and has to be kept in check by a high cost of bank loans. The cost of bank loans reflects both the marginal cost of funds to the banks (set by inter-bank rate, which in turn is closely related to the central bank ‘repurchase rate’) and banks’ profit margin. In the historical long run real interest rates have been about 3% on average, so that a 2% inflation target ought to be accompanied by a 5% plus cost of bank loans and a 3% – 4% repo rate (i.e., ‘Bank rate’). In the UK bank credit to the private sector was dynamic from the Competition and Credit Control reforms of late 1971 to the financial crisis of 2007. With only occasional intermissions, it grew faster than both the quantity of money and nominal GDP over this entire 36-year period. However, since 2007 banks have cut their holdings of risky securities (i.e., this type of claim on the private sector) and limited the growth of their mainstream loan portfolios. The chart below shows that their loan portfolios are still falling.
Conclusion: money growth about right, but not because banks are expanding loan portfolios
The chart above was of bank loans to the M4x private sector, i.e., of the private sector excluding IOFCs. It was not the whole story. However, the message is clear enough, that banks are expanding their liabilities not because credit patterns have returned to normal, but because of some other influence. The vital ‘other influence’ has of course been ‘quantitative easing’, understood more broadly as the rise in UK banks’ claims on the state as a result of a number of superficially arcane operations between them, the Bank of England and the government. The larger conclusions are that
- i. money growth has returned to a level consistent over the medium term with both the inflation target and a reasonable growth rate of employment and real output, and
- ii. the rise in money growth does not reflect a fully-fledged recovery in the private sector’s demand for bank credit, but instead the growth of money arising from QE operations.
If officialdom is worried about the effects of QE on inflation, it can readily stop QE operations. At any rate, the sluggishness of banks’ loan growth argues that a significant rise in interest rates is not yet necessary. Without QE the quantity of money in the UK growth would – almost certainly – be showing little change on an annual basis.Tags: Baltic Dry Index, Economic growth, Federal funds rate, Federal Reserve System, Government budget balance, Great Recession, Gross domestic product, India, Price–sales ratio, United States