Monetary divergence – or not

  • Broad money growth among the major world economies is diverging.
  • But the ostensible divergence may be misleading.
  • Meanwhile, central banks are likely to take policy rates back to at least 4%

Recent months have seen what on the face of it seems to be an interesting divergence in monetary trends. In the US, broad money growth (in this case, my own recreation of the M3 measure abolished in 2006), continues to weaken. In the twelve months to September, it grew by 2.1%, the weakest number in 11 years. On a three-month annualised basis, broad money growth has been negative for three of the latest four months; while on the somewhat less volatile six-month annualised measure, it turned negative in September. Weekly data on deposits from commercial banks imply that this trend is going to continue. The bulk of broad money (92% in the United States) is made up of bank deposits. Deposits in commercial banks, which are published on a weekly basis, have been contracting steadily since late August. Unless there is a remarkable change in the near term, we have to assume that even on a 12-month basis, US broad money is going to fall by late 2022 and into 2023. By way of comparison, the last time this happened, in 2010 and 2011, US inflation eventually dropped below first 3% and then below 2%.

UK broad money growth is not as weak as that of the US. However, M4x (that is to say, broad money excluding the bank deposits of financial companies) has been growing at less than 5% for four of the last five months, with three-month annualised growth dropping to 2.2% in August (the latest month available). In real terms, M4x growth has been negative since March this year. Even assuming that UK trend GDP growth has slowed in recent years, sustained broad money growth below 5% is historically consistent with inflation below 3%.

Japan is of course sui generis. Here too, broad money (L) growth has slowed. However, it never did accelerate very far, even during the pandemic, peaking at 7.2% in the year to May 2021. The latest data show a deceleration to around 4% per annum. Three- and six-month annualised rates are higher, but are also coming down. Of course, for the Japanese authorities, the current bout of inflation (3%) is rather more welcome than in other countries. 

Monetary developments in these three countries make the latest euro area data look very much out of sync. After three months of M3 growth between 5% and 6%, broad money grew by 6.1% in the year to August and by 6.3% in September. Three-month annualised M3 grew by 8.4% in September, the highest number since the middle of the pandemic in late 2020/early 2021. True, broad money growth is well below the double-digit numbers seen in the first half of 2020. But why is the euro area moving in a different direction?

In truth, it may not be. My former colleague Simon Ward points out a few things in connection with the latest EA broad money numbers. First, much of the faster broad money growth is explained by the post ‘Others’ in the credit counterparts to broad money growth, in other words, by an erratic residual. Second, the breakdown of the data shows a surge in the holdings of financial sector companies, which are less relevant as a leading indicator of output growth and inflation. And third, the latest ECB Bank Lending Survey shows both the demand for and supply of bank credit likely to weaken sharply in Q4. So the EA broad money numbers will probably ease. This is important, as it doesn’t take much to bring EA M3 growth back down to rates of around 5%, which historically are broadly consistent with inflation in the 2-3% range.

This leaves China as the true outlier. Here, broad money (M2) growth has generally been accelerating since the middle of 2021, moving to double digits from May this year and reaching 12.1% in the year to September. There are a number of reasons why this would be the case. China’s de facto isolation behind its zero-Covid policy is one. There has been a steady easing of monetary policy, presumably intended to support the economy throughout the pandemic (and trade conflicts). It is also possible that the Chinese authorities are welcoming the slight rise in inflation from less than 1% in the first quarter of this year, to close to 3% in September, as a partial way of dealing with the continued overhang of private sector debt. 

Chinese developments may also change following the conclusion of the 20th Party Congress, although that is by no means certain. (It assumes, among other things, that the authorities were deliberately inflating the economy in the runup to the Party Congress. That may be the case, but it would also assume a degree of fine tuning that would be difficult to achieve.)

But a more important question is, if we assume that monetary trends are correct and advanced economy inflation is going to subside in 2023, what will central banks do?

Here, there are three factors to keep in mind. The first is that all central banks ignore broad money developments. They form their views on inflation from other inputs, which means that, just like they missed the imminent rise and persistence of the current bout of inflation (amply signalled by broad money developments in 2020 and 2021), they may well miss signals that inflation will ease. 

The second is that central banks have found it difficult to operate at or near the effective lower bound for interest rates. This is very clear from comments made by many central bankers over the past years, both before and during the pandemic. 

And finally, central banks are acutely aware of the fact that they were seen to miss the rise of inflation and were for a long period perceived to be well behind the curve in terms of monetary policy. This is probably still correct, not least given inflation in the 8-10% range in major western advanced economies and policy interest rates in the 2-3% range. 

All three factors argue that central banks (meaning, in this case, the Federal Reserve, the ECB and the Bank of England) are likely to keep raising interest rates, at least until such time as they are convinced that high inflation will no longer present a threat; and until such time as they feel that they have enough space to cut interest rates if necessary.[1] How far? It is difficult to say, but, based on past performance, I would be surprised if policy interest rates peaked anywhere below 4% — and they may well go higher. 

Gabriel Stein

[1] This can easily become a ridiculous argument: ‘Let us raise interest rates so that we have space to cut them if there is a recession – which we will have caused by raising interest rates.’ But it is still important.