Not the Road to Bristol

4 July 2007



Britain’s Awash in Money, Rates to Rise

To most Britons, the M4 is the motorway linking London with Bristol and Wales. To economists, it is a rather broad measure of the money supply and to confuse everyone is almost exactly the same as M3 in the US and EU. The current growth rate of Britain’s M4 money supply is 13.8%, which scares the bejesus out of inflation hawks. The market has already priced in another increase in British interest rates from their current base rate of 5.5% as a result of this money supply increase. That is, of course, one way to deal with the problem, but there is another.

Inflation has been aptly defined as too much money chasing too few goods (and services). If the supply of money increases, then the value of each unit of currency (pounds, dollars, euros, sea shells, goats) decreases. That means it takes more of the currency to buy the stuff people want and need. Inflation can also be caused by sudden drops in supply (gasoline after the Hurricanes of 2005 is a good example of this), but that is not the case in Britain today.

M4 is not just the coins and bank notes that rattle and rustle in British pockets (that’s M0). It also includes UK residents’ bank deposits and private sector deposits. Because there are time-restricted conditions on many of these deposits, this is a pretty illiquid measure of the amount of money in the system. The quantity theory of money (the equation MV = PY where M is money supply, V is velocity, P is prices and Y is national income), however, also requires the velocity of money to enter into play – that is, how fast the pound in the pocket moves around the economy. Velocity of money in the UK has actually been declining in recent years, meaning a bigger money supply is less inflationary. Since early 1993, M4 has risen by 200% and the retail price index measure of inflation is up by only 45%, with the difference being the drop in velocity.

So, raising interest rates is likely to decrease the money supply in circulation because it becomes more expensive to borrow, but each point hike is likely to have less effect than it did a decade or so ago. The pound yesterday hit a 26-year high against the US dollar, in large part due to interest rate differentials, and that is bad news for British exporters and manufacturing. Higher interest rates are damaging to the economy at this level.

A better approach is to attack the private sector deposits end of M4. There is something called lending to “other financial companies” [OFC], which is up dramatically. Strip this out, and M4 growth is 9%, which is what the Bank of England believes is the appropriate figure to hit its inflation target of 2%. However, increasing the level of deposits banks must keep on hand, one effectively slashes M4 by reducing OFC lending. Interest rates will rise, to be sure, but the market will determine the rate to a greater extent. Unfortunately, the BoE is in a position where a failure to hike rates damages its credibility. That a pity, because excess M4 is treatable in other ways.

© Copyright 2007 by The Kensington Review, Jeff Myhre, PhD, Editor. No part of this publication may be reproduced without written consent. Produced using Fedora Linux.

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