Unravelling the mysteries of money supply

The opposing forces of buoyant domestic demand and a strong exchange rate have caused forecasters to polarise, between those worried about the economy overheating and those (myself included) expecting a sharp slowdown in activity in 1998. A sharp slowdown in growth in 1998 is a real possibility even if sterling fell significantly in the months ahead. It is not just monetary policy that operates with long and variable lags. Given the lags involved, the rise in sterling to date should be sufficient to lead to much weaker growth next year, particularly with windfalls fading from view and if Gordon Brown, the Chancellor, maintains tight control of public spending.

How, though, can the slow-growth camp reconcile an economic slowdown with the current strength of the money supply? Recent experience has suggested that the factors determining monetary growth can be as, if not more, important for trends in the wider economy, as how quickly the money supply is growing overall.

Latest data again confirmed this. The broad measure of money supply M4 (notes in circulation and bank and building society deposits) grew by 11.5 per cent in the year to the second quarter, far in excess of nominal GDP growth of around 6 per cent. Everything being equal, this would not be consistent with 2.5 per cent inflation, or even 3.5 per cent inflation. Normally when the amount of money is growing more rapidly than the number of transactions within the economy, the risk is that inflation rises. However, everything is not equal, as the chart shows. Alongside M4, we have drawn nominal GDP and a measure of the money supply that excludes what are called by statisticians "Other Financial Institutions" (OFIs). These include pension funds, life assurance companies, leasing companies, investment trusts and unit trusts. Excluding these financial institutions, the money supply is growing at a more modest 7.5 per cent, a figure less out of line with overall growth in the economy.

Moreover, this is no aberration, as the chart confirms. Pension funds, life assurance companies, leasing companies, investment trusts and unit trusts have been playing a key role in the acceleration in the money supply that started in late 1994. Part of the explanation lies with the merger and acquisition boom that occurred during 1995 and 1996, in sectors such as utilities, financial services and pharmaceuticals. Having repaired balance sheets after the last recession, the corporate sector went on a borrowing spree to finance mergers and acquisitions. The money created ended up with institutions.

Why though have pension funds and life assurance companies been prepared to hold on to their cash? Ahead of the election, one could argue that they were happy to build up cash because of the prospect of a change of government. There was also concern about a possible equity market correction, originating in the US. Not only that but banks actively bid for their deposits, yet again confirming the importance of OFIs as a source of finance for the banking system.

A high degree of pension fund liquidity may also be a product of higher equity and bond prices. In an environment of rallying equity and bond markets, institutions need to have higher cash balances to keep the proportion of their assets held in liquid form the same.

On top of the kick-start to M4 from merger and acquisition activity, further financial market restructuring in the form of the introduction of the gilt repo market in January 1996 gave banks an alternative way to attract wholesale deposits relatively easily and cheaply from OFIs. It is fair to say that the gilt repo market has had a larger impact on the money supply than the authorities were envisaging.

But is it fair to completely ignore what is happening to the wholesale deposits of pension funds et al when forecasting growth and inflation? The argument for doing so is that such institutions do not spend their money balances on the high street. Neither are institutions big buyers of physical capital (at least not directly - the exception being leasing companies). They may have exposure to the commercial property market, but have little direct influence on the more important residential housing market. Not surprisingly, their decision to raise cash has had little impact on inflation.

The introduction of the gilt repo market may have given the banks an alternative source for raising finance. However, the impact could be very different depending on what the money is created for. Household borrowing to finance equity withdrawal from the housing market would have a more direct impact on the high street and hence inflation, than an investment trust borrowing in an attempt to profit from a rising equity market.

Whatever the driving forces, the acceleration in the money supply owes much to a rise in institutional liquidity, which can also be seen from institutional investment data and CAPs figures. If and when institutions spend their cash it is likely to be asset prices that rise or, if they invest overseas, the exchange rate that falls.

In the near term, this is bullish for financial markets, rather than bearish for inflation. Witness the way the FTSE 100 index breached 5,000 last week, propelled upwards by the help of high institutional cash balances. While this would have an indirect effect on domestic inflation, the lags involved are likely to prove very long. Most individuals are unaware of the value of their pension fund.

Certainly, the strength of the money supply should not stand in the way of a sharp slowdown in growth in 1998, given the rise in the exchange rate and windfalls fading from view.

It would be different if household borrowing was picking up sharply. Consumer credit has, but it is only a small proportion of overall household borrowing. Moreover, some of the pick-up in consumer credit may be to do with the pre-spending of windfalls. Everything being equal, a sharp slowdown in growth next year should be associated with weaker monetary growth.

However, that need not be the case. The sort of slowdown that we are envisaging, with real GDP growth of between 1.5 per cent and 2 per cent in 1998 would be consistent with rising business bankruptcies and more distress borrowing.

Individuals worried about their job prospects could decide to hold more precautionary savings, boosting retail deposits. Perhaps more importantly, the change to pension fund taxation announced in the Budget has made institutions fiscally indifferent between the form of cash distribution that they receive. In particular, they no longer have a preference because of the tax system to receive a dividend over a share buy-back. Since the Budget a growing number of companies have already announced share buy- backs. In a relatively low-growth environment, we expect Britain to follow the US lead with companies substituting debt for equity to enhance earnings per share and benefit from multiple expansion. Interest cover is far higher in the UK than the US and above its 10-year average.

Just like 1995, when GDP also decelerated, the cash created would be passed over to the institutions, who would then have the asset allocation problem of what to do with an increase in liquidity. The link between the money supply and inflation could remain as tenuous as it is today.

We would be more concerned if the money supply continued growing strongly beyond 1998. Even then it took several years of the money supply consistently growing faster than nominal GDP in the 1980s for the economy to overheat.

David Owen is UK economist and a director of Dresdner Kleinwort Benson.