Lombard Street Research makes sense of the Bank of England’s monetary data and associated developments in the banking system.

Contrary to popular wisdom, growth in the bank deposits of the private sector – the money supply – is an important indicator of future asset price and demand developments.

Households and companies hold part of their assets in liquid form, as notes/coins or as deposits in banks. A buffer of money is needed to facilitate everyday transactions. Money is also held as a store of value within the overall portfolio of the private sector. Several factors determine how much money firms and individuals choose to hold (e.g. spending patterns, working capital demands, inflation expectations, the relative yields on other assets). But it is not always the case that their actual money balances equal the desired level.

As households and firms continually adjust their money holdings relative to other assets, their spending on goods, services and assets is affected.

The charts below highlight developments in our preferred measure of broad money, M4x. This series aggregates the money holdings of the non-bank private sector. These include cash held, all sterling deposits (including certificates of deposit), banks’ sterling wholesale liabilities up to five years maturity (including commercial paper, bonds and floating rate notes) and claims on UK banks arising from repos. Adjustments are then made to exclude certain parts of the financial sector, which are deemed to do nothing other than intermediate funds between banks or within banking groups. This gives us an appropriate measure of broad money for analytical purposes.

Analysis of May monetary data

The Bank of England rightly argued that its asset purchases were implemented, first and foremost, to raise the rate of monetary growth. So it should be pleased that the money supply now appears to be growing more robustly. Or should it? In the three months to May, the money stock – our preferred monetary aggregate is M4x – expanded at an annualised pace of 9.2%, its fastest rate of growth in over two years. Although there were offsetting sales of Treasury bills and another decline in private non-financial firms’ (PNFCs) unused credit facilities, private sector liquidity conditions have clearly improved over the last three months.

There are reasons for caution, however. First, there has been a slowdown in the rate of growth in money balances within the non-financial sector. Over the last three months, the M4 holdings of households and PNFCs have only expanded at an annualised pace of 1.5%, the slowest rate of increase in a year. The surge in private sector liquidity has, instead, occurred within the non-bank financial sector. Other financial companies’ (OFCs) money balances have grown at a staggering 50% annual rate since February. To the extent that this reflects increased risk aversion – and increased demand to hold liquid instruments – this need not be a positive for future asset prices and demand. Certainly, the counterparts to M4 would suggest this to be the case since the main stimulus to recent monetary growth has been a fall in banks’ ‘net non-deposit liabilities’ rather than any expansion in banks’ assets. Panic focussing on European peripherals sovereign debt could well have spilled over into bank funding markets – curtailing banks’ debt issuance – as investors chose to horde cash.

Going forward, given the intense pressure on banks’ to bolster their capital ratios and ‘term out’ their funding, it seems highly unlikely that monetary growth will be sustained by this source. Banks’ funding structure should move more towards long-dated debt instruments and equity and away from short-term paper that many private sector investors will see as ‘money-like’ (and are included in M4). A sustained pick-up in UK broad money either requires growth in banks’ sterling assets (i.e. lending to domestic private and public sectors) or growth in their net foreign currency and external position. Historically, the latter has not played a major part in domestic monetary growth and is unlikely to in the near-term given regulatory pressure on UK banks to focus their available credit on the domestic economy. The former, meanwhile, offers some hope for decent monetary expansion in the UK; but risks remain to the downside. The stimulus expected from banks’ gilt purchases could be delayed given that the FSA has now pushed back the timetable for implementing its quantitative liquidity regime. It is noteworthy that banks’ net gilt purchases over the last six months have been no larger than in the previous six month period. Lending to the private sector, meanwhile, should remain constrained by elevated borrowing costs, tight lending standards and limited demand for credit.