BoE can push up the money supply but not inflation - Capital Economics
UK Economics

BoE can push up the money supply but not inflation

UK Economics Update
Written by Andrew Wishart

A surge in the money supply has piqued fears of a leap in inflation. But in our view, there is little chance that this expansion of the money supply, driven almost entirely by quantitative easing, will lead to inflation because demand is very weak. There is a possibility that the combination of a large amount of excess reserves sloshing around in the banking system and loose fiscal policy will lead to higher inflation once the economy has recovered. But if that happened, policymakers would rein in the stimulus.

  • A surge in the money supply has piqued fears of a leap in inflation. But in our view, there is little chance that this expansion of the money supply, driven almost entirely by quantitative easing, will lead to inflation because demand is very weak. There is a possibility that the combination of a large amount of excess reserves sloshing around in the banking system and loose fiscal policy will lead to higher inflation once the economy has recovered. But if that happened, policymakers would rein in the stimulus.
  • Growth in the money supply has rocketed in recent months. Annual growth in M1, made up of physical cash, reserves held at the central bank and demand deposits, reached 15% in May, the highest rate since 2000. Meanwhile M2 (M1 plus time deposits) and M4 (the broadest measure of the money supply) are growing at their fastest pace since the financial crisis. (See Chart 1.)
  • This has led to concern in some quarters that a bout of high inflation is around the corner. In theory, a big expansion in the money supply could mean too much money chasing a finite supply of goods, and prices being bid up. Indeed, at face value the 12% rise in M4 in the year to May appears consistent with CPI inflation rising from 0.5% in May to almost 4% in a year’s time. (See Chart 2.)
  • However, whether an expansion in the money supply leads to a surge in inflation depends on what is driving it. A huge increase in bank lending when the economy is strong may well suggest that an unsustainable boom in demand will fuel inflation. But this episode has mostly been driven by unprecedented intervention by central banks at a time when the economy is very weak.
  • Since March the Bank of England has been rapidly purchasing gilts and corporate debt to prevent bond markets from seizing up. The £205bn of assets it purchased through QE and the Covid Corporate Financing Facility between March and June has been matched by an equivalent increase in reserve balances held by banks at the central bank, as the sellers deposited the funds into the banking system. (See Chart 3.) This accounts for the vast majority of the rise in broader money aggregates since February. (See Chart 4.)
  • We can also see this injection on commercial banks’ balance sheet as a surge in deposits. (See Chart 5.) Admittedly, lending did rise sharply initially as large firms drew down existing credit lines – M4 lending rose by £61bn in March. But since then it has fallen by £14bn despite government loan schemes starting in April, through which £30bn of credit was disbursed to PNFCs over the same period.
  • The old textbook idea that there is some mechanical link between reserves, broad monetary conditions and inflation is not right because banks are willing to hold a large amount of excess reserves. So, as in previous rounds of QE, a sharp increase in narrow money has only led to a much smaller increase in broad money growth. (See Chart 6.) Indeed, the money multiplier (the amount of money created by commercial banks through lending relative to that created by the central bank) has been in a precipitous decline since the financial crisis. M2 is now less than 4 times bigger than M0 having been about 25 times the size before the financial crisis. (See Chart 7.)
  • The relationship between broad money and inflation is far from steady too. So we doubt that the still-sizeable increase in M4 will cause any inflation in the near term. The velocity of money, measured as how often each pound of the money supply is spent in a year, has fallen over time. And it falls particularly quickly during recessions, as was the case in Q2. (See Chart 8.)
  • The reduction in the pace of QE will reduce the increase in narrow money from £80bn a month to £20bn. But annual growth in M0 will stay high for some time, rising from 35% in May to a peak of over 60% in early 2021 if QE is extended again as we expect. Nonetheless, as has been the case thus far, while banks could use these additional reserves to issue much more credit, a lack of demand means this is unlikely.
  • Further ahead, the huge amount of excess reserves in the system will mean there is a possibility of an inflation inducing credit boom. But were this to become a reality after the economy has recovered from the pandemic, we think that policymakers would remove the stimulus, nipping any surge in inflation in the bud.

Chart 1: Money Aggregates (% y/y)

Chart 2: Broad Money & Inflation

Chart 3: BoE Asset Holdings & Narrow Money (£bn)

Chart 4: Increase in Money between Feb. and May

Chart 5: Commercial Banks’ Balance Sheet (£bn)

Chart 6: Money Aggregates (% y/y)

Chart 7: M2 as a Multiple of M0

Chart 8: M4 Velocity (Nominal GDP as a % of M4)

 

Sources: Refinitiv, Bank of England, Capital Economics


Andrew Wishart, UK Economist, +44 7427 682411, andrew.wishart@capitaleconomics.com