The Bank of England ceased publication of the best known measure of narrow money, M0, in May 2006 as part of its Money Market Reform.

However, the Bank still publishes the notes and coin component, i.e. sterling notes and coin in circulation outside the Bank of England (including those held in banks’ and building societies’ tills), which made up almost all of M0, and which still provides a good proxy for narrow money.

The other element, the banks’ operational deposits with the Bank of England was small and tended to be unaffected by economic events.

Narrow money and high street spending

A major reason for looking at narrow money is because of its link with high street spending. Narrow money is thought to be a co-incident or even a slightly leading indicator of such spending so that movements in it may provide a verification or otherwise of trends in retail sales.

The chart above shows the annual growth in retail sales (in value terms) and in the stock of narrow money quarterly since 1990.

The two series track each other closely until early 1998, apart from a period covering most of 1994 and early 1995. The relationship then appears to break down until the middle of 2000. From 2000 until early 2007, the two series move roughly together but from 2007 the two variables have diverged.

Velocity of circulation of narrow money

Partly, at least, the answer for this periodic breakdown in the correlation between the two series can be found by looking at the velocity of circulation of narrow money in this period. Velocity rose sharply through the 1970s and 1980s.

In the first place, financial innovations such as the spread of automated teller machines reduced the necessity to carry large amounts of cash.

Secondly, high and variable inflation and, therefore, high and variable interest rates made holding cash less desirable.

For much of the 1990s, that earlier sharp rise in velocity was replaced, initially, by a gentle but persistent fall but from 1999 onwards by a much steeper drop until mid 2003 when it stabilised (see Chart 9.1 in 9.3 Velocity of Circulation - Changes in technology ).

Although a further increase might have been expected during this period to reflect continuing financial innovation, what seems to have happened is that individuals gradually came to terms with low inflation and low interest rates during the 1990s.

They became more and more willing to hold greater amounts of cash. The opportunity cost of doing so had fallen significantly and by enough to offset the effects of further technological progress.

From 1999 to early 2003 the process of adjusting to low inflation simply speeded up before stabilising from 2003 through to 2007 when the velocity of circulation plummeted.

The Millennium effect

Analysing narrow money from the end of 1999 onwards was further confused by the effects of the Millennium and by worries about the Millennium bug.

Towards the end of 1999, the growth in M0 accelerated sharply as banks and building societies increased their holdings of notes to ensure that their cash machines had sufficient money to meet demand over what would be a particularly long holiday period.

In addition, individuals, worried about the effect of the Millennium bug on bank computer systems, may have stockpiled cash. This build up in the stock of M0 was then reversed during 2000 and although this was essentially a temporary feature it was one which drastically distorted the figures and made analysis of the underlying picture exceedingly difficult.

Divisia money is less well known and less well understood than notes and coin as a measure of narrow money, probably because of the way it is constructed.

Whereas cash held by the general public is easy to understand, divisia money is rather more complicated. One official source defines it as “a chained index, compiled from components of broad money, with the weight of each component determined by its current relative interest rate differential from some benchmark rates.”

What this measure tries to do is to use the information included in a fuller range of money components (i.e. including deposit accounts with banks and building societies as well as cash).

It does this by weighting the different elements together in such a way as to highlight the transactions element in each and to dampen the savings element.

The weights used are interest rates and the assumption is that the lower the rate of interest payable on a deposit account, the more likely it will be held as a transactions account.

Conversely the higher the rate, the less likely it will be used for transactions purposes and the more likely it will be held as savings.

The UK’s measure of broad money, M4, includes notes and coins held by the M4 private sector (individuals and private sector companies other than UK monetary financial institutions) plus the M4 private sector’s holdings of sterling deposits with UK monetary financial institutions.

UK monetary financial institutions (MFIs), strictly speaking, include the Banking Department and the Issue Department of the Bank of England as well as banks and building societies.

The sterling deposits component includes both retail deposits (such as current accounts and savings accounts) and wholesale deposits.

The usefulness of M4 is to provide an indication of future trends in nominal spending. A build up in corporate deposits, for instance, may be interpreted as being the precursor to increased investment or merger and acquisition activity.

Statistics on broad money are available by type of deposit and by the sector making the deposit.

Published data provide deposit holdings with banks and building societies by the personal sector, non-financial private companies (previously called industrial and commercial companies) and other financial corporations (i.e. excluding banks and building societies).

This allows a greater understanding of what is happening in different parts of the economy, which sectors are doing relatively well or badly, which sectors are growing strongly and which are struggling.